The Fuse

Selling SPR Oil Sets Dangerous Precedent as Energy Security Gains Stall

by Matt Piotrowski | October 28, 2015

The two-year budget deal, announced yesterday, that would sell oil from the U.S. Strategic Petroleum Reserve (SPR) to raise money for Treasury’s General Fund sets a poor precedent in terms of both concept and timing. The strategic stockpile, established in 1975 after the Arab Oil Embargo, is a cushion against emergencies in the oil market. In the past, the SPR has been used as a buffer against physical disruptions in the form of hurricanes and geopolitical turmoil, and while the reserve is designed to provide cover for a certain number of days of oil imports, its true function is not as a substitute for imports, but a backstop in the event of emergencies.

The SPR now holds just under 700 million barrels, and the Bipartisan Budget Act of 2015 calls for selling about 8 percent of the oil reserves between 2018 and 2025, while other legislation this year has also proposed selling SPR oil to raise funds for various government programs. There is one silver lining in the legislation—that a small portion of the sales will fund research to modernize the SPR and ensure it remains relevant in a modern context. However, proposals to use revenues from SPR sales to fund everything from drug research to the transportation bill suggests that the SPR will remain on the table as a “cookie jar” for lawmakers to draw from at will, even as recent improvements in energy security are increasingly at risk.

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In fact, there’s a false narrative that because U.S. oil imports have fallen over the past decade, the Strategic Petroleum Reserve is no longer useful. Levels of geopolitical volatility in the system—and the risks of hurricanes and other natural disasters that could sideline production—remain high, making the SPR as relevant today as it has been in the past. Even with oil prices low, U.S. consumers are still vulnerable to outages in volatile oil producing countries. Should the global market tighten again, supply losses, whether in Iraq, Yemen, Libya or elsewhere, could have a profound impact on prices in the U.S.

On one hand, the domestic production boom has bolstered U.S. commercial inventories, which will provide some cover in the event of a disruption. However, Washington’s willingness to look to the SPR as a source of revenue for non-energy initiatives suggests that Congress has taken its eye off the ball when it comes to oil dependence. Current complacency over U.S. energy security has emerged as a result of innovations pioneered from the private sector (such as the domestic production boom driven by fracking) or broader economic forces (the collapse of oil demand following the financial crisis) rather than meaningful policy initiatives. In this context, it’s worth looking at how energy security gains on the supply and demand side in recent years are now at risk in the low price environment.

U.S. Supply

U.S. crude production is now around 9.1 million barrels per day, according to the latest Energy Information Administration (EIA) data. That is up by about 3.5 mbd from the 2011 annual average, but down by .5 mbd from the monthly peak in April. The main storyline in much of the media this year is that high-cost shale production—the backbone of the U.S. output boom—has been resilient in the face of lower prices. Indeed, it has performed better than expectations, but it is noticeably declining. With no end yet in sight for the low oil-price environment, it’s unclear how far shale output will fall. The EIA sees U.S. crude production falling to 8.7 mbd for the third quarter of next year before it rebounds, but other analysts suggest that U.S. onshore production will continue to decline through the beginning of 2017.

USproduction

What’s more, the longer-term picture is highly uncertain. The EIA sees U.S. production peaking in 2020 in its Annual Energy Outlook reference case, before plateauing and eventually dropping off. Such outlooks are of course fraught with risks, given the number of different variables, including price and potential breakthroughs in extraction technology. The EIA could be underestimating shale’s potential, but on the other hand, shale suffers from rapid decline rates, a sober fact that means its longer-term prospects may not be so robust—especially if oil prices remain low in the coming years.

It’s not just the outlook in the U.S. that should be worrisome. In Canada, the top supplier to the U.S., low prices have halted conventional projects and clouded the outlook for oil sands post-2020. Mexico has opened its fields to outside private investment, but the country is still struggling with years of declineOther Latin American producers, particularly Venezuela, have been hurt by low prices and dysfunctional governments. Production in the North Sea and Russia, despite rising this year, will take hits from lower oil prices, with the latter also dealing with sanctions undercutting investment in unconventionals. Meanwhile, the Middle East is as volatile as ever with militant group ISIS using oil revenue in both Syria and Iraq to fund its operations. Libya and Yemen are struggling due to internal conflicts. Another worry is the potential for unrest in Saudi Arabia, which produces more than 10 percent of the world’s oil production.

Even though oil prices are currently weak, spare capacity is at precarious levels.

Importantly, even though oil prices are currently weak, Saudi spare capacity is at precarious levels, hovering around 2 mbd, or just about 2 percent of total production—near levels seen in 2012 when prices shot up to $147 per barrel. With low spare capacity part of the new normal in oil markets, commercial inventories and strategic stockpiles are now security buffers when geopolitical tensions are high. However, although commercial stocks are extremely robust at the moment, slimming down the SPR to raise cash for a budget bill is very myopic.

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U.S. Demand

The current demand recovery should serve as a signal to policymakers not to rest on their laurels when it comes to energy security, instead of using the oil boom as a justification to sell down strategic stockpiles.

On the demand side, the outlook is changing for a variety of reasons. First, the low pump price has stimulated consumption in the U.S. Consumers are also purchasing less fuel-efficient vehicles, a consequence of lower oil prices, and this trend could have negative consequences for years to come. Third, even though the government has required fuel economy standards to rise over the next decade, automakers are well behind schedule, meaning actual efficiency may not reach levels originally mandated. Automakers are expected to use the 2017 midterm review of these standards as an opportunity to push for relaxation of the requirements—another potential blow to nascent energy security gains.

U.S. oil demand is expected to average 19.44 mbd this year, down from the 20.8 mbd peak in 2005, but a roughly 1 mbd increase since 2012. The EIA forecasts demand to rise by another .15 mbd next year as prices stay subdued. With efficiency gains limited and lower prices sticking around for some time, demand may continue to rise even beyond next year.

USdemand

When oil demand fell from the mid-2000s through 2012, it was mostly because of high unemployment and sluggish economic activity in the aftermath of the economic crisis, combined with high prices at the pump, rather than any government policies. The mandates to boost ethanol production and increase CAFE standards only played a modest role—both policies were still ramping up. The current situation of rising demand is a warning sign to policy makers to take energy security seriously again, rather than focus on the abundance of domestic supply as a justification to sell down strategic stockpiles.

U.S. Imports

Lower production and rising demand have already put oil imports back on the rise.

Lower production and rising demand have already put oil imports back on the rise. Since 2004-07, when crude imports averaged above 10 mbd, volumes have dropped precipitously, falling by almost 30 percent to average 7.34 mbd last year. So far in 2015, however, crude imports have leveled off as a result of rising demand and lower domestic production.

If the trends of strengthening demand and declining production persist, the U.S. could eventually be back where it was before the shale boom began, overly reliant on crude imports, including volumes from unstable countries.