Suppressing The Price Of Oil

The Oil Reserve Plunder Blunder

By Steve McCann

Until this past week, the International Energy Agency had released oil only twice from the emergency reserves of its member nations.  The first time was during the 1991 Gulf War in response to the loss of Iraqi and Kuwaiti oil production, and the other was in the aftermath of Hurricane Katrina, when the Gulf of Mexico fields and regional refineries were shut down. 

The recent decision to release oil, ostensibly to offset the significantly smaller loss of supply caused by the civil war in Libya, was therefore a major policy shift.  This shift is not only misguided but fraught with potential problems for the future.

The IEA was founded in the early seventies to offset the influence and potential threats of oil cutoffs emanating from OPEC.  Since then, the stockpiles have only been used in the most extreme of circumstances.  However, the ramification of last week's action is that the IEA and its member states may intervene more quickly, and for domestic political considerations, in order to smooth over price movements after small disruptions in supply.  While originally conceived as a hedge and strategic reserve in case of a massive cutoff in oil production due to unforeseen circumstances such as major war or political upheaval, the reserve seems to have mutated into a lever to manipulate the market.

The move of releasing 60 million barrels this past week seems to have had its short-term intended effect: the oil price did drop sharply.  Nonetheless, it is not a reliable precedent and one that may only work for the short run.  Now that a new standard has been set, there will always be political pressure brought to bear whenever there is a spike in the price of oil.

Today, because of an increase in demand, particularly in the emerging Asian economies and the refusal of the United States to develop its own reserves, the smallest disruption in supply can have a painful effect.  This is particularly true in Western economies presently struggling with a poisonous mix of low growth, high unemployment, and rising inflation.  These countries, which are loath to raise interest rates to mitigate the effect of high commodity prices, as they are fearful of further strangling any nascent economic recovery as well as an over-sensitivity to the political implications of higher energy prices, have chosen instead to manipulate the market.

The IEA cannot regularly intervene in this manner without depleting its reserves, which then ultimately strips the agency of its ability to intervene.  Prices will not fall if markets perceive that stockpiles will have to be rebuilt.  Moreover the logic of the IEA argument is dubious at best.  Market dynamics will of their own accord bear down on oil prices.  More fuel efficiency is always in the offing and becomes financially feasible as the cost of oil rises.  New investment in oil production, also accelerated by rising prices, will ultimately bring down prices in the long term.  Suppressing the price mechanism through intervention will simply retard this correction.

As in the case of the financial crisis of 2008, in large part brought about by government policy, the decisions made to intervene by massively bailing out numerous banks, financial institutions, and governments were exacerbated by not allowing the markets to function in a normal pattern.  A severe situation has been made potentially catastrophic by the unfettered printing of money and never-ending government and central bank intrusion.  The leaders of the Western world, having so ineptly dealt with the financial crisis, are now bringing the same mindset to the oil markets.

Beyond the short-term price manipulation, the more important consideration is what would happen in the event of a major disruption in oil production, which was the original purpose of the strategic reserves.  The Middle East is undergoing a major political and societal upheaval.  Iran is quickly becoming the dominant power in the region, as the United States and the nations of Europe are making a mad dash for the exits.  There now exists, more so than any time in recent history, the real possibility of a massive conflict in the region.

The worldwide strategic emergency reserves are approximately 1.6 billion barrels.  While that may sound like quite a bit, the world consumes that amount of oil every 20 days.  If the oil were cut off from the Middle East, the emergency reserves would be depleted after 64 days unlessprices are dramatically raised -- by a factor of 2 or 3 times the current level -- so that demand would shrink significantly, with the end result being the world economy so dependent on petroleum-based products would collapse.

Among the most incompetent and ideologically rigid world leaders today, Barack Obama does not seem to understand the incongruity of his position.  While utilizing the petroleum reserve to manipulate the supply and demand equation, thus tacitly acknowledging the viability of market solutions, he refuses to allow new exploration in the United States to increase world supply preferring instead more failed government intrusion.

With the world leaders on stage today, perhaps the worst aggregation in the past hundred years, it is no wonder the globe finds itself rudderless and heading off a cliff.