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The dangers of an interventionist oil market policy

July 1st, 2011 by Thijs Van de Graaf, Ghent University

The international oil markets have been quite turbulent for the past several months. The wave of protests sweeping the Arab world and the loss of Libyan sweet crude have fueled fears of shortages and have driven oil prices higher. Last week, on June 23, the western industrialized countries therefore decided to play their trump card: the strategic oil reserves. Over the course of the coming month, 60 million barrels of oil will be released onto the market from the emergency supplies of the United States, Japan and some European countries.

With this decision, the Western countries venture to play for high stakes. If all goes well, their decision will calm the oil markets until Saudi Arabia steps in with increased production from its reserve capacity. If things go bad, however, they not only run the risk of injecting even more uncertainty into an already volatile market but also to jeopardize their improved relations with the oil-exporting countries that took years to build up.

Many oil traders will probably have choked on their coffee last week when they heard that some of the strategic oil reserves would be released. The announcement by the head of the International Energy Agency (IEA), Nabuo Tanaka, came indeed as a surprise. Oil prices seemed to have peaked in April, or at least to have stabilized since a few weeks. More importantly, Saudi Arabia and other Gulf states with spare capacity had promised to ramp up their production, even though a majority of OPEC members expressed itself against such a production surge when they met in Vienna on June 8. Nevertheless, the IEA countries felt that they had to act by releasing stocks.

The IEA was established in the aftermath of the first oil crisis of 1973-74 with the primary aim to act as a crisis manager on the oil market. To that end, the agency commands a powerful weapon: each member country is obliged to maintain strategic oil reserves of 90 days. It is only the third time ever that these stocks have effectively been used. The first time was in 1991 after the Iraqi invasion of Kuwait and the second time was in 2005 when Hurricane Katrina wiped out much of the oil production facilities and refineries in the Gulf of Mexico. Both market interventions are considered to be successful.

The western oil-consuming nations have traditionally treaded very carefully with these buffer stocks, which were long considered the “oil market equivalent of a nuclear weapon” as Javier Blas wrote in the Financial Times on June 23. These stocks were never intended to be used as a tool to manipulate the price of crude oil. Instead, they were designed as a last-resort lifeline to be used only in the most extreme circumstances, such as in the case of a severe disruption of oil supplies due to a terrorist attack. The fact that the emergency supplies were not used during major market disturbances such as the Islamic Revolution, the second Gulf War, or the oil price shock of 2008 illustrates the prudence with which the IEA has handled these reserves.

Moreover, in recent years, there seemed to be a gentlemen’s agreement between the IEA and the OPEC countries with spare capacity (mostly Saudi Arabia) with regard to responding to supply shortages. This is remarkable because these two clubs, the IEA and OPEC, were very hostile towards each other until the late 1990s. The agreement was that, when a supply shortage would occur, the IEA member countries would let the OPEC countries act first, before undertaking any actions itself. Sarah Emerson put it very succinctly in a 2006 article in Energy Policy: “30 years of energy security policymaking by the consuming countries of the IEA came to a head in the conclusion that OPEC’s spare production capacity, read Saudi Arabia, would officially be the first line of defense in an oil emergency.”

Today it appears as though the IEA has switched to a new doctrine. For the first time in history, the agency has used its strategic petroleum reserves in a preventive way, not because there is an actual oil supply shortage, but because it believes that such a shortage is imminent. The upcoming summer driving season, the reconstruction of Japan and the end of the maintenance period for many European refineries will push oil demand up in the coming weeks. The IEA has not waited for the shortage to happen, but it has made a bolt move to anticipate it. According to some observers, the decision of last week’s Thursday may be the prelude of a more interventionist oil market policy, in which the western countries will use their buffer stocks to adjust the price of oil.

In such an interventionist policy, however, lies a double threat.

First, while it is true that a stock release can bring temporary relief to a tight oil market, its longer-term effects are far more uncertain. The global strategic petroleum reserves currently stand at record levels but, obviously, they shrink as soon as they are tapped and they will have to be replenished later on (possibly at higher prices). Tapping the reserves for oil price manipulation leaves us with a smaller buffer, which makes us more vulnerable to acute crises caused by unforeseen events, such as terrorist attacks, natural disasters or political embargoes. Uncertainty about the IEA’s doctrine may also increase volatility in the market because it creates confusion with the oil traders. Furthermore, if oil stocks are not used to offset temporary shortages, but to address protracted (structural) oil shortages, the consumers of oil are not forced to adapt their behavior, thus aggravating the underlying problem.

Second, an interventionist oil market policy could undermine the relations between oil producer and consumer countries. While the IEA move was reportedly made in close coordination with Riyadh, it actually places Saudi Arabia in a difficult position. The IEA kept stressing that its stock release was meant to supply the markets with extra crude until additional Saudi Arabian oil production would come online. If the Saudis succeed in increasing their production within a month, they may infuriate other OPEC countries even more and fuel the dissension within the self-proclaimed oil cartel. If they fail to do so, then they pose the IEA for a big problem because the Paris-based agency will then be under pressure to prolong its stock release.

Importantly, besides being bifurcated between these two allegiances, Riyadh’s room for maneuver is limited in yet another way. Over the past months, it has made huge public expenses to buy off domestic social peace. As a result, the Kingdom now needs a much higher oil price than it did just a few years ago to balance its budget. Whatever action they agree on, the decision-makers in Saudi Arabia are likely to tread on someone’s toes in the coming weeks.

Thijs Van de Graaf, Department of Political Science, Ghent University

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2 Responses to “The dangers of an interventionist oil market policy”

  1. Paul Roseau Says:

    Two days ago, the motor gasoline price reached a new record in France, with some gas station selling gasoline above 2€ per liter in the center of Paris. Following that, the government suggested a possible use of French strategic oil reserves. Whereas the Libyan events in late July could have been a motive for the release of 60 millions barrels, there is no such major event that can be advocated to justify a release of French strategic oil reserves.

    This kind of preventive reaction to increasing oil prices seems therefore to continue. It is curious though that such a solution is still considered as the result in last July was not tremendous. On June 23rd, right after Obama’s administration announcement, oil prices had dropped by more than 4 percent. But within a week they had returned to pre-announcement levels, and by July 12 the price of crude was about $2 per barrel higher than it had been on June 22, the day before Obama’s announcement. It seems then that markets can not rely on that kind of action since they are inherently temporary. Moreover the resort to such measures can had a perverse effect, since it can add tension to the markets, as it states, from an official point of view, that the situation is very serious. On the other hand, it can be argued that no one can actually rule out the scenario in which oil prices would have skyrocketed in absence of governmental interventions.

    Such practice can indeed be condemned for its lack of obvious positive results and because it makes one country more vulnerable in case of genuine oil outage (terrorist attack, military needs, etc). But there is even more than that. Indeed, releasing barrels from the SPR is equivalent to lowering gasoline prices, and thus favors oil consumption. One can wonder of the economical consequences of such a policy, as we know that oil is a scarcer and scarcer resource, and that we need to develop alternative sources of energy. However, necessary investments in new energies will be carried out if and only if these energies can have a competitive advantage over oil, that is to say, if oil is expensive enough. As a result a frequent resort to such policies could be a dangerous way to delay the development of new industrial projects.

    One could argue that the latter argument is not valid in the US for example, as the Obama’s administration has launched massive investments and subventions for the development of green energies. Nevertheless, the situation is not the same at all in France, where investments in those fields have been limited. Chances are that the current French government wants to limit consumers’ dissatisfaction, at least during the on-going presidential campaign.

  2. Kais Boubaker Says:

    The danger of an interventionist oil market policy is not its consequences, but the idea of interventionism itself.

    The major conflicts around the globe can be interpreted through energy, especially oil. It is not a moral judgement, it is a fact. For example, the tension between the United Kingdom and Argentina has risen after the discovery of a major offshore oil reserve near the Falk Lands. If this shows something, it shows how the demand over oil is and will be high. It is a national security matter for most countries.

    Of course, there are other energies that many countries and companies are considering. But, despite environmental considerations, oil represents many obvious advantages that make it the energy of choice of many nations and industries. It is also the commodity of choice of many traders who are following closely this market and, in a way, setting the price. They are also blamed because they speculate on this strategic market. Western nations are threatening to use their reserves in order to counter attack the non-stopping rise of oil price.

    I can only make the parallel with European Fund of 1 trillion $ that is supposed to discourage speculators to bet on the bankrupt of a nation. But recently we are witnessing the emerging of speculation against French debt. Can we still be sure that dissuasive actions are really effective?

    The least that we can say is that it is today harder to believe in such thing. The case applies on oil as well. In fact, securitization of commodities is reducing the gap between finance and energy. If interventionism can be quick and effective in the short term, it is totally useless and counter productive in the long run. And unjust too. In fact, it seems like few countries lead by Saudi Arabia are adapting their production plans to calm down markets, and not all the countries that have made benefits from the speculations.

    I believe that having energy reserves is essential to the national security in case of war or major crisis, but it cannot be the magical tool to control speculation because it is a lost cause. If prices should go high so let’s let them go, they will eventually crash. Nobody can deny the cyclical dynamics of financial markets, and it is hard to believe that 90 days of reserves can fix that.

    Markets are not perfect, and everybody knows that. But letting them purge and crash sometimes is far more helpful than trying to control them. Unless we change the rules of the game. But that’s another story.

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