US Must Build Strategic Diesel Stocks

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The International Energy Agency (IEA) was created in an effort to promote cooperation between consuming countries during serious disruptions of energy supplies. The sharing program is undergoing its first real test. It is failing. Several countries have instituted programs to protect consumers in their countries by limiting exports. Norway, for example, is limiting electricity exports to maintain stability in its domestic market. The US has just warned about similar action, threatening unspecified steps against the US oil industry unless companies divert gasoline and diesel production to US inventories in the Northeast rather than exporting the products. This threat is unnecessary. The Department of Energy could purchase gasoline and diesel fuel on the open market and designate it for storage in commercial facilities that are empty due to the extreme backwardation in product markets. 

Energy Secretary Jennifer Granholm is concerned that low levels of diesel and gasoline inventories expose the US to the risk of shortages this winter. Maine’s governor Janet Mills shares her concern. To resolve the problem Granholm has called on major US oil companies to refill inventories of gasoline and diesel fuel rather than exporting production to meet global demands. Granholm also hinted that the US government could use executive authority to ban or limit exports if her request was ignored.

Similar But Different

The Secretary’s call echoes a similar demand made by the Secretary of Energy in May 1979 during the Iran oil crisis. The major companies, just freed from restrictive prices and allocations met the 1979 request. Today, they are much less likely to head the request because they have abandoned storage activities. Exxon Mobil, for example, sold much of its storage capacity to Global Partners LLP, a long time supplier of gasoline and diesel to New England. Consumers in New England and North Atlantic states rely on Global and other smaller companies to provide most of the petroleum products consumed in the region.

These smaller firms are in no position to act on the request to build inventories because markets are in backwardation — a pricing structure that means oil put in storage will lose value over time. Global’s 10Q filing with the SEC is explicit: “In markets where future prices are higher than current prices, referred to as contango, we may use our storage capacity to improve our margins by storing products we have purchased at lower prices in the current market for delivery to customers at higher prices in the future,” it says. And Global adds that “in markets where future prices are lower than current prices, referred to as backwardation, inventories can depreciate in value and hedging costs are more expensive. For this reason, in these backward markets, we attempt to reduce our inventories in order to minimize these effects.”

Wishful Thinking

Governor Mills and Secretary Granholm may wish that firms such as Global increase inventories. However, these firms lack the financial stature to undertake such activities given current market conditions. The market capitalization of Global Petroleum LLC of $900 million is dwarfed by Exxon’s market capitalization of more than $400 billion. Tanks on the US East Coast will remain empty if the local industry continues to rely on market incentives to promote filling.

Secretary Granholm could, however, address the problem. The DOE currently holds a 1 million barrel reserve of heating oil, down from 2 million bbl when it was created at the start of the century in the Northeast. These reserves are held in commercial facilities leased to the government. Around 200,000 bbl of gasoline and 200,000 bbl of low sulfur diesel fuel are held in facilities owned by Global Partners.

These stocks could be expanded quickly because commercial firms in the Northeast are not using their capacity today. The DOE could issue tenders to lease 20 million to 30 million bbl of storage capacity for the next year and simultaneously purchase 20 million or 30 million bbl of products to fill the leased capacity. The oil could then be sold to the market during the coming winter thereby preventing the feared shortages.

Market Stability

The DOE could even earn a significant profit if diesel prices rise in coming months as expected. However, it is the maintenance of stable domestic and international markets, not profit which should motivate this program. The Secretary put the industry on alert in her letter when she noted that the DOE was considering “additional federal requirements or other emergency measures” if US oil companies did not “proactively address” the need to build inventories.

One such “emergency measure” would be a limit or ban on exports. By leasing more storage capacity and buying oil at competitive prices from these companies now, the government can make sure that inventories are adequate without intervening in the market.

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. John van Schaik is the editor of Oil Market Intelligence and Energy Intelligence's New York bureau chief. The views expressed in this article are those of the authors.

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