How the New Budget Deal Will Affect the Oil Market

The House of Representatives just voted to approve a budget deal to raise the U.S. debt ceiling. And buried in this last-minute accord designed to save us from another government shutdown is a provision to sell oil from the Strategic Petroleum Reserve (SPR).

The sales are not scheduled to begin until 2018 and run through 2025. In all, 58 million barrels will be sold – starting with an annual amount of 5 million and then doubling per year beginning in 2023.

In the past, the SPR volume was sold off to offset regional domestic shortages in distillate products or, more rarely, tried in an attempt to influence a price reduction when oil was well above $100 a barrel.

The former has not been a consistent policy and the latter (influencing prices) was a dismal failure.

Today, SPR volume is on the selling block for a very different reason.

So why is the U.S. going to put this oil up for sale now, when domestic producers are under pressure?

U.S. Heading Toward Energy Independence

The SPR was set up after the 1973-1974 Arab oil embargo against the U.S. as a national security matter. In those days (and until a few years ago) America was increasingly dependent upon imports of crude. An embargo by primary providers could have had a serious impact on the economy and even, some would say, the nation’s security.

However, fears over an embargo are now history. For one thing, producers need to sell their oil to meet pressing domestic requirements at home. Never again will oil be used as a weapon to pressure the U.S.

These days, the shale and tight oil revolution in North America has significantly altered where the U.S. will be getting its primary supply. It will be coming from our own backyard, with Canada as the main “foreign” contributor.

That massive transition in oil supply is already well under way. Oil imports are currently down almost 40% from where they were only a few years ago. Prospects are now strong that both the U.S. and Canada will be energy independent within the next decade.

Even OPEC planners are assuming that well before 2050 no member of the cartel will be selling America a single barrel of oil. In fact, that was the assumption even before the rise of shale. Then, OPEC assumed high crude prices would encourage the U.S. to invest in alternative and renewable energies, along with an array of new energy efficiency technologies.

Imports are certainly continuing. But unusual spot increases in what is still coming into the country are largely the result of end users (primarily refineries) playing short-term pricing variations.

The Sell-off Will Be Good for Consumers, Bad for Producers

Unlike previous examples of SPR policy use, this sell-off is unfolding in a very different environment. Prices are hovering about $45 a barrel and the “shale revolution” has introduced the genuine prospect of super-abundant supply surpluses into the foreseeable future.

That may seem good for the consumer but not for the struggling production company facing high debt loads on one side and a diminishing profit margin on the other.

Of course, the SPR sales will not begin for some three years and there is almost without doubt going to be a rebalancing of the market before then. In addition, 58 million barrels spread over eight years is hardly a tidal wave, especially if exports from the U.S. are phased in.

Remember, the largess in known reserves provided by the development of sale and tight oil will allow both a full meeting of any domestic demand and the shipment of additional production to foreign markets providing higher prices. There is no point in providing for local needs by bankrupting large swaths of the energy sector.

Less Need to Buy Additional Volume

A development that came over the past several days may be the first wrinkle in such a policy change. Mexican oil major PEMEX announced that it has received permission to import light grade U.S. oil for refining across the order with some of the resulting oil products coming back to the states.

This is a trading strategy known as “tolling.” Raw materials are exported and more finished products imported back from the processing abroad. It has been used for years in metals and mining, for example.

With SPR capacity declining – the sales account for about 8% of the 695 million barrels in the reserve – there may also be some residual savings from SPR maintenance and the need for a multibillion-dollar upgrade of its pipeline network.

As well, there will be less need to buy additional volume from producers. Those purchases had consistently been a mixed blessing, since companies were sometimes able to sell inferior grades for crude to the government and still charge top dollar. As a result, the “strategic” nature of the SPR was suspect, since not all of its volume could actually be used to produce the full range of distilled product.

Will Oil Prices Be Affected?

The bottom line is this: With the major changes underway, the domestic price of oil in the U.S. will not (and should not anyway) be determined by an amount squirreled away in salt caverns to cover an eventuality that is no longer tenable.

This is just another example of something I have been maintaining here in Oil & Energy Investor for years. Energy prices ought to be set by market exchange… not by traders playing with derivatives… or politicians still living in the 1970s.

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