Re-envisioning the U.S. Strategic Petroleum Reserve and What Energy Investors Need To Know
- The U.S. Strategic Petroleum Reserve (SPR) is one of the world’s largest stockpiles of crude oil. Conceived as a defensive weapon against geopolitical crises in the ’70s, the SPR’s purpose and function have evolved over time.
- Commodities analyst Rory Johnston says the SPR is a “tremendously unique asset” and argues that U.S. Congress-mandated sales are ill-conceived.
- Rory shares insights on how the SPR works and what energy investors need to know about today’s volatile oil market.
Strategic petroleum reserves exist in the care of governments around the world. But when Americans refer to the SPR, they’re talking about the U.S. Strategic Petroleum Reserve, a massive stockpile of crude oil based mostly in four major locations around the Gulf Coast.
At the beginning of 2020, the SPR held about 650 million barrels of oil. Over the last few years, due to a combination of congressionally mandated sales and the Biden administration’s release of oil from the SPR (which was unprecedented in volume), the U.S. now holds about 370 million barrels.
That halving of the SPR was a “huge drawdown … by far the largest in history,” says Rory Johnston, Founder of Toronto, Canada-based Commodity Context, a physical commodities research firm that specializes in data-driven analysis of global oil markets.
The Strategic Petroleum Reserve sparks plenty of debate about oil market policy in general, but in the commodities space, the SPR is always a hot topic.
My colleague Hari Krishnan welcomed Rory to a Global Macro episode of Top Traders Unplugged for a wide-ranging conversation about the SPR’s relationship to the worldwide oil inventory, today’s volatile market and much more.
Read on for a breakdown of their discussion about the history, purpose and operations of the SPR, as well as the calculus Congress makes about sales and purchases of reserve oil and the SPR’s impact on spot and futures prices.
A ‘defensive weapon’ against economic crises
For years, Rory and a few of his colleagues in the field have been trying to re-envision how to better use the SPR in today’s oil market.
“I think the oil market has changed substantially from when it was initially conceived in the late ’70s, early ’80s, as a response to the dual oil crises,” he says. “First, the Arab OPEC embargo; then the Iranian revolution.”
Those two crises “put energy and oil security front and center,” he adds, making the SPR “the ultimate defensive weapon in a new kind of battlefield.”
Because of its history, he notes that many observers view the SPR as merely the “final line of defense,” released only when the enemy clamors at the gates, so to speak. But Rory thinks that kind of interpretation of the SPR is “ill-conceived and simplistic,” and underestimates the “potential and promise of this tremendously unique asset in the market.”
The SPR is safe — and salty
However, one of the purposes of the SPR is that it is the supply of last resort.
Hari asks: Why does the SPR hold mainly crude, instead of refined products — which would ostensibly be necessary in extreme circumstances?
Rory says that historically, the U.S. “has always had a tremendous amount of refining capacity, but particularly around the late ’70s and early ’80s, there were lots of worries about crude supply. Crude was the main concern so that is what they put in there at the time.”
Crude oil, which naturally exists in holes in the ground, is also much more stable to hold.
“Most of the SPR is stored in artificial salt caverns — essentially, artificially created reservoirs of crude,” Rory adds. Petroleum products can’t be stored in the same way. Gasoline, for example, vaporizes and is much less stable than crude. We shouldn’t leave gas cans in our garages, because they build up fumes that can explode.
“That would be very bad in any kind of strategic reserve,” says Rory. He also notes that the government holds most of the SPR in and around the Gulf Coast, in close proximity to the nation’s major refining centers. In the case of an emergency, SPR crude can feed into those refineries quickly.
While the SPR was initially conceived as a line of defense, the government has rarely released oil under those auspices. Most of the time, oil from the SPR is released in response to natural disasters, such as hurricanes in the Gulf Coast region — because offshore oil production platforms go offline during severe weather. The last emergency drawdown of this kind was in 2005 after Hurricane Katrina.
Does Congress see the SPR as a budget Band-Aid?
So how does oil get released from the SPR?
There are three major ways, says Rory: exchanges, emergency releases and congressionally mandated sales. For the purposes of this discussion, most releases come down to a presidential decision or a Congressional mandate.
“The latter — congressionally mandated releases — are, in my personal opinion, the worst possible use of the Strategic Petroleum Reserve,” Rory says.
He thinks Congress “often looks at this massive pile of crude in the ground, particularly when prices are high, and thinks ‘money,’” he explains. Congress members tend to see selling SPR oil as “a good way of papering over some holes in the budget, to get some discretionary spending capacity.”
Rory points out that Congress mandated the sale of hundreds of millions of barrels between 2017 and 2020. But recent Congressional plans to sell SPR oil have been canceled.
That’s a good thing, “because it’s good to not need to release it,” he says. “Because when you need to release on a schedule, you’re releasing this crude into a market, agnostic of market conditions.”
On a basic level, Rory argues that the SPR should act “as a bit of a residual buffer or a battery on the market.”
What constitutes a “last resort” (triggering SPR sales) should actually be the times “when the market is super, super, super tight when you’re in ultra- or super-backwardation,” he adds.
Conversely, when the market is quite loose, the U.S. should buy additional oil for the reserve.
Because the SPR is a government entity, Rory argues that we can look beyond a pure profit-and-loss motive and see it as a stabilizing force.
“Typically, when you go into super backwardation or super contango, it’s because the commercial side of the market has essentially tapped out all of its operational capacity in this area,” he says.
“One mistake that the SPR made in 2020: [The government] actually did buy a little bit of crude at the very, very bottom of the market. But that was the moment in March, April and May of 2020 when prices were very briefly negative for WTI [West Texas Intermediate].”
That brief, early-pandemic period is when Uncle Sam should have been buying “every single barrel it possibly could have gotten hold of” for the SPR, Rory explains.
That didn’t happen, because although the SPR is a “unique strategic operational oil market asset,” it’s also intensely political. The Democrats in Congress pushed back against the idea of buying more oil “because it was seen as essentially a subsidy to the oil market,” says Rory.
However, it’s important to note that both sides of the aisle dislike leveraging the SPR at all — selling, buying, drawing down and everything in between — for different reasons.
“Ideally, in a pure, idealized future, the SPR would be … much more independent of political, and particularly congressional, meddling,” he adds. “I’m not delusional. I don’t think we can ever imagine seeing a federal reserve of oil or something [like that], but I think any incremental independence we can give to the SPR — along with a very concrete mandate of buying when markets are loose and selling when they’re really, really tight … that would be a much better situation for the market.”
Exchanges and futures
Hari asks Rory to break down the SPR a bit further, particularly its effects on the global oil market.
“If I’m a storage operator and the futures price is way above the flat price or the spot price, I’m going to be buying physical [oil] and filling up my tanks,” Hari says.
“So I’ll store the physical, and that gives me some time optionality. Whereas if the future [price] minus the spot is pretty low,” Hari continues, “I’m going to want to sell the physical and maybe buy forward … you’re [i.e., Rory] saying that if the curve is backwardated, basically, you have the second situation: You won’t be selling physical into the market. But you’re doing both sides of the duration trade. So why wouldn’t the U.S. Department of Energy say, We don’t just want to sell oil; we want to do exchanges or loans where we’re actually explicitly trading the forward curve”?
Physical exchanges do happen, says Rory. But he agrees with Hari’s analogy.
“Let’s go through the commercial side first,” Rory says. “Unlike a purely financial asset, the curve matters … because there are storage and logistical costs associated with storing crude, whether it’s 10 cents or 50 cents a month — in terms of the actual physical storage cost, the insurance, the financing. All of that costs money. So when you need the difference between [a] spot and a future price (let’s say, in a contango market where the curve is upward sloping), you need that difference to be large enough to say, I’ll buy it today and then I’ll sell it 12 months in the future and lock in an arbitrage kind of profit.”
In a backwardated market, however, “you would essentially be selling into spot markets and then buying into the future, kind of flipping it the other way.”
As Hari understands it, SPR exchanges are basically agreements whereby barrels of oil are sold from the reserve — with an understanding that the SPR will add more barrels later.
“Let’s say N barrels are sold,” Hari posits by way of explanation. “And then more than N barrels will be received at some point in the future at specified dates. Isn’t that safer from the standpoint of security? Because there’s some guarantee that the oil will be restocked at a profit. Why take the risk — as was done in 2022 … just making straightforward sales and assuming that price risk in terms of trying to buy back barrels of oil in the future?”
Rory definitely has thoughts about that.
“The SPR wasn’t designed to be as nimble as we’re discussing, first of all,” he says. “Much of what we’re trying to do [in this talk] — and in the broader discussion of the SPR over the past year and a half — has been trying to inject a little novelty into how we think about the SPR. Until very recently, the SPR couldn’t even really sell forward or buy forward. It was all essentially spot transactions … sales or purchases on an indexed basis.”
Imagine you control an oil-buying entity. You agree to purchase a certain number of barrels of crude today and take possession of the oil in a month or two. However, “the price agreed to at sale is indexed to spot prices. So you would essentially just agree to it and then you would converge on spot in the future. That’s obviously not ideal if you’re trying to play any of these angles of the market,” Rory says.
That’s why the government had to change the regulatory structure of how the SPR can operate in the market — introducing the idea of “fixed forward contract buying,” he explains. “You fix the price and say, We will buy it in two months at $65, or we’ll sell it in four months for $80, or whatever else.”
‘Sugar highs’ and forward fixes
The government’s “fixed-forward” maneuver had never been done before.
“I think it was a big, novel government and regulatory change,” says Rory. “That said, it didn’t happen, in my humble opinion, fast enough. Because by the time that was agreed upon, most of the crude was already sold from the reserve. In my idealized world, you would pair every single barrel of sale from the SPR with a forward-contract purchase.”
The reason people take issue with selling barrels from the SPR in the first place is akin to a “sugar high” — thinking the market can be fixed now, even though that means pushing off problems down the road.
“What we ended up realizing in hindsight last year was that [the SPR] actually wasn’t as big a market issue as we expected,” Rory says.
“Now the SPR sale is done and we’re still lingering around $80 … The market is not nearly as tight as we were expecting. But at the beginning of 2022 … we thought we were going to be staring down mega, all-time-large deficits in the market [from] massive losses of Russian supplies.”
Big sales in that kind of environment pose a challenge. Theoretically, reducing prices today reduces the incentives for non-OPEC, non-Russian production to enter the market.
“That’s the criticism,” says Rory. “It reduces incentives — and it reduces our security buffer for dealing with the next oil shock after this one.”
Let’s hope that this kind of shock, if it happens, doesn’t come with a side dish of “awe.”
This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.
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