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SPR Provides Antidote to Financial Contagion

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The coordinated releases of strategic reserves by several International Energy Agency member countries have been widely panned as political gestures aimed at mollifying consumers. The critics are mistaken. The public justifications given for the releases were meant to disguise the real reason: preventing financial contagion. Financial markets were hurtling toward what could have been a 2008-type financial collapse before the US announced on Mar. 31 that it would release 180 million barrels of crude oil from its Strategic Petroleum Reserve (SPR) between April and October. The news of these oil sales eliminated the financial strain. The Opec delegates, reporters and analysts who follow energy markets fell for the ruse. One potential consequence of the need to draw down finite strategic reserves to ensure financial stability is that it will force major industrialized countries to end their reliance on oil more quickly — an outcome some will applaud and others lament.

Expectations play an important role in financial markets. In January, Isabel Schnabel, the German governor of the European Central Bank, explained to an American Finance Association conference that central bankers would not likely respond to the inflationary pressures from higher energy prices if those increases did not affect consumer expectations regarding inflation. Central bankers from other countries are equally focused on this “anchoring” of inflation expectations.

The role of expectations is not limited, however, to inflation or interest rates. Expectations play a critical part in determining commodity prices. A change in expectations regarding future supply can drastically alter market conditions. Inventory levels that seemed more than adequate yesterday may be viewed as insufficient by market players today if expectations regarding future supply or demand change.

Lessons From History

An episode in 1990 that took place during Iraq’s occupation of Kuwait illustrates the impact of changes in expectations. At the end of July, crude oil to be delivered in six months was in contango and traded at a premium of almost 10% to the cash market. Two months later, forward crude traded at a 20% discount to cash crude even though the supply and demand balances had not changed. That prompted John Lichtblau, head of the Petroleum Industry Research Foundation, to make this statement to the Washington Post: “The problem right now is that mathematically it [the oil market] is in balance. Psychologically it’s in imbalance. It’s a strange situation.”

Two years after this remark, I offered this comment in my book Adjusting to Volatile Energy Prices, a title that is as relevant today as it was in 1993: “In reality there was nothing strange about the situation at all. Spot prices increased during August and September in anticipation of projected tightness during the fourth quarter [of 1990]. The increase in spot prices reflected the market’s assessment that stocks might be exhausted. The market’s behavior matched the predictions made by the commodity market theorists.”

The grasp of market expectations in 1990 was limited. Today, the issue is better understood but not by everyone. According to Bloomberg, on Mar. 22, when asked about a request to boost oil production, United Arab Emirates Energy Minister Suhail al-Mazrouei, brushed the question aside with these assertions: “We’re experts in our field and we’ve been doing it for a very long time. We’re trying to balance the market and it’s not an easy job. We’re not the only producers in the world and when we say this is the right way to do it, we know it from experience. So, trust us.”

The markets, however, did not swallow the minister’s claims. As he spoke, six-month-forward Brent was trading at an 18% discount to dated Brent. A month earlier, the discount was only 10%. The sanctions imposed on Russia after it invaded Ukraine had altered buyer expectations regarding future oil supply to the global market.

Solvency Concerns

The market’s tightening, which had really begun last fall when Russia started squeezing European natural gas markets, put intense financial pressure on energy companies. Shell, for example, had to post more than $7 billion in margin deposits during the first quarter, a sum it could afford but one that amounted to roughly one-quarter of its capital expenditure budget. Other companies appeared more constrained by the margin calls.

The pressure led energy traders to ask the world’s central banks for financial support, a request the banks deemed inappropriate and denied. At the same time, the banks' leaders were expressing concern about their firms’ solvency in light of the increased volatility of energy prices.

Andrew Bailey was one of these individuals. The governor of the Bank of England spoke on the issue at a Brussels conference last month. He noted that the rise in energy price volatility created a risk for clearing houses — the institutions that manage futures markets under the watchful eye of the central banks. Bailey also offered this warning: “We have to watch very closely to ensure that the step change in the cost and risk doesn’t cause a market failure. So far, it hasn’t happened. But we must be very alert to it. The bottom line of all that is we can’t take resilience in that part of the market for granted.”

Crisis Averted

Three days after Bailey spoke, the US announced its SPR release. By Apr. 8, 2022, the strategic premium of dated Brent to the sixth futures contract out had shrunk to 1.6%. Obviously, global oil supply and demand balances had not changed in the 10 days. Yet, the backwardation decreased from 18% to less than 2%. Pressure on financial markets eased as well. The risks of financial contagion may have passed.

The strategic stock releases, then, served one of the key purposes for which they were designed: the prevention of a serious economic collapse caused by an energy market disruption. Many in the oil industry do not understand this need, seeing strategic reserves only as a means to close a gap between demand and supply. However, the psychological “gaps” that threaten overall economic activity are the most important. A failure to stop an important bank from failing, for instance, can start a sequence of failures that threaten the entire global economy, as we learned in 2008. The early action taken with strategic reserves may have prevented another such event.

The fly in this ointment is that strategic reserves are finite. In the coming months, policymakers in consuming nations will face an important choice: either replenish strategic inventories, a step that would require the cooperation of oil-exporting countries, or accelerate efforts to end dependence on oil and other imported fuels.

Last week, German legislators started down the second path when they introduced draft legislation that would free the country from fossil fuels by 2035. Other nations are following suit. Energy independence is becoming a global watchword. Major oil producers should pay attention.

Philip Verleger is an economist who has written about energy markets for over 40 years. A graduate of MIT, he has served two presidents, taught at Yale and helped develop energy commodity markets since 1980. Kim Pederson is editorial director of PKVerleger LLC. The views expressed in this article are those of the author.

Topics:
Oil Inventories, Oil Prices, Macroeconomics
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