The Great SPR Income Transfer

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Saudi Arabia’s Oil Minister Prince Abdulaziz bin Salman has asserted that physical and futures markets are “increasingly disconnected” from fundamentals in recent interviews. In his view, the loss of liquidity in futures markets, stories of demand destruction and ambiguity regarding embargoes and sanctions account for the 20% decline in Brent futures since June. The decline in prices obviously stings. However, the real cause of the decline is to be found in Washington and Paris. US President Joe Biden’s Mar. 31 Strategic Petroleum Reserve (SPR) release, which was followed by other International Energy Agency (IEA) members, has effected a transfer of almost $30 per barrel from oil producers since it was announced. Biden’s actions have cost Saudi Arabia alone more than $30 billion. The benefits have gone to the world’s refiners. 

Refiners and processors of crude oil received a huge profit windfall from the Mar. 31 announcement of a very large release of strategic stocks by the US and other IEA countries. Crude oil producers across the world lost. Through Aug. 19 the world’s producers of crude oil have lost $360 billion. If the trend continues through the end of March 2023, a full year, the total will reach almost $1 trillion. The loss to Saudi Arabia would reach $100 billion. Russia’s loss would amount to almost $90 billion.

Broken Arbitrage

The loss occurred because the traditional arbitrage relationship between crude and products broke. Crude prices did not follow product prices higher because refiners had a nearby alternative source of crude and refrained from bidding crude higher. Refiners and marketers captured most of the loses recorded by producers because there is a global shortage of refining capacity. The exception is France, where refiners agreed to large cuts in product prices to avoid a windfall tax on profits. Consumers saw little benefit.

The income transfer occurred because tightening financial conditions imposed on the oil industry broke traditional arbitrage relationships. The refining sector was able to seize the advantage created by the lack of bank lending and the impact of the SPR announcement on speculative activity to drive a wedge between crude and product prices.

The Mar. 31 US announcement that it would release 180 million barrels from the strategic reserve was essentially unilateral — although other IEA countries followed suit with releases of their stocks. Five months later, the average price received by oil producers is at least $27/bbl lower than it would have been in the absence of the action. For Saudi Arabia, which publicly dismissed Biden’s request for increased production, the loss to date totals a little less than $33 billion.

Unintended Consequences

However, the measures have not had the intended effect. Consumers have not seen reductions reflected in the price of gasoline. While the retail price of gasoline in the US has declined from a Jun. 14 peak of $5.02 to $3.90 per gallon, the drop should have been larger given the fall in crude prices. The average retail price should have been around $3.50/gallon if refiners had not captured the benefit of the SPR sales.

The primary beneficiaries of Biden’s move have been refiners. Integrated firms such as Chevron, Exxon Mobil and Shell as well as independent refiners such as Marathon Petroleum, PBF and Valero have captured most of the benefits, along with marketers such as Global Partners, a large New England distributor, and Couche-Tard. Global’s product margins, a measure of the SPR release, rose by more than $100 million, or 52%, from the same quarter of 2021, despite a decline in volumes of sales of 7%. Murphy USA, another retail marketer, reported a 42% increase in profits.

Refiners and marketers reaped the benefits of the release of strategic stockpiles rather than consumers, for whom the releases were intended, for six reasons:

  1. Global refiners were operating at capacity and unable to boost output outside of China. The Saudi minster has noted that the current rise in prices was caused by the lack of refining capacity. The lack of capacity meant that product prices would remain high.
  2. Decisions taken by oil exporting countries to drive down inventories after the 2020 price collapse had left global stocks at an exceedingly low level. The low stocks increased backwardation, increased price volatility and made hedging more difficult. Thus Opec, not markets, deserved much of the blame for volatility.
  3. The wrong type of crude was sold during the early releases of US SPR oil. Heavy oil, which many of the world’s refiners could not convert to needed diesel fuel, was released, not light, sweet crude. The actions fattened Valero’s profits but left diesel markets tight.
  4. The decisions by key banks to limit lending to oil companies reduced the ability of intermediaries to hedge inventories, leading to greater backwardation in product markets. Neither banks nor oil producers are charitable organizations. Opec-plus actions, which cut inventories, led directly to backwardation in markets, which reduced the availability of credit. Traders appealed to central banks to help, but central bankers properly told traders to talk to oil exporters.
  5. The expansion of the oil casinos operated by the CME and ICE increased price volatility, further reducing the ability to hedge. The growth in the use of derivatives has pushed prices higher, particularly as speculators have bet on $200 and $300/bbl crude.
  6. Finally, the polices adopted by the Chinese government to limit product exports reduced the supply of key products from the one nation that had surplus refining capacity. China could have increased diesel and gasoline exports. Its refiners were operating at a rate of 75%. However, domestic concerns led the country to cut export licenses.

The effect of Biden’s SPR release was to transfer money from the pocket of producers to refiners and marketers. Consumers saw very little from the action. Futures prices of gasoline did not fall. Gasoline markets remained in backwardation. The data reveal that the retail price of gasoline followed the futures price of gasoline in most major markets — meaning consumers rarely saw much of a benefit from the SPR release. Indeed, refiners and marketers seem to have captured more than 100% of the benefits from the SPR release in all but the most competitive gasoline markets, such as Houston. There, refiners and marketers may have captured 80% of the benefit.

The SPR release thus represented primarily a transfer of income from one part of the petroleum sector to another. Given constrained refining capacity, the result should not be a surprise.

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.

Oil Inventories, Oil Prices, Oil Products, Refining
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