Energy, Security, and Climate

This post is co-authored by Sagatom Saha, research associate for energy and foreign policy at the Council on Foreign Relations. Read the report from a recent CFR workshop on oil price volatility. The workshop, hosted by Michael Levi and Varun Sivaram, was made possible by the support of the Alfred P. Sloan Foundation. Last month, CFR’s Greenberg Center for Geoeconomic Studies convened a workshop to discuss the causes, consequences, and policy implications of oil price volatility. Most of the roughly forty experts in attendance agreed that volatility—which the workshop defined as price swings in either direction of up to a year—will persist for the foreseeable future. They also broadly agreed that at least some instances of volatility have serious economic and geopolitical consequences. But when it came to proposing policy measures to reduce volatility, controversy replaced consensus; few participants rallied around any recommendation, warning of side effects from trying to manage oil prices. In fact, the only policy recommendations that did attract widespread support were ones that reduced the U.S. economy’s exposure to oil markets by lowering consumption, the only surefire way to decrease the risks from volatility. These discussions happened against the backdrop of a changing global energy landscape. In particular, participants reflected on future sources of “swing supply” to balance supply and demand and moderate oil price volatility. Uncertainty over whether Saudi Arabia has abdicated its historical role as swing supplier and if U.S. shale oil can instead play that role suggests that there is no end to volatility in sight. But, as the workshop report notes, “Given Saudi Arabia’s large spare production capacity—still the world’s biggest—most workshop participants still see the kingdom playing some role as the producer of last resort.” Figure 1 from the report on CFR’s oil price volatility workshop Having established that volatility is likely to persist, the workshop explored its economic and geopolitical consequences at home and abroad. Although the academic literature more commonly focuses on the effects of oil price levels—i.e., high or low oil prices—participants honed in on the effects of price volatility independent of price level. The workshop report elaborates: Even low [oil] prices, if paired with volatility, do not necessarily lead to an economic boost [in the United States], some participants suggested. Fluctuating prices can make consumers wary of spending, thus dampening any stimulus effect of lower oil prices. …For oil-exporting countries, some participants noted that price volatility, more than the price level, is particularly problematic. That is because, as one participant put it, it is easier to build a budget that works with oil at $50 per barrel than one that works when oil zooms between $20 and $80 a barrel. But participants were hard-pressed to provide recommendations to U.S. policymakers for how to reduce the volatility of global oil prices. For example, Columbia’s Jason Bordoff wrote a post for this blog arguing that the United States should not use its Strategic Petroleum Reserve (SPR) as a “Federal Reserve of Oil” to buffer global price volatility on a regular basis. Such a strategy would have grave side effects, including muting price signals to producers and consumers and depleting the SPR, impairing its intended ability to counteract major oil market disruptions. The workshop also explored ways to reduce the elasticity of oil supply and demand—at least theoretically, more price-responsive demand and supply should reduce price volatility. But targeting elasticity can yield impractical policy proposals, like taxes on producers that increase as their production decreases. And some policies that enjoy broad support, like U.S. fuel economy standards, might actually be undesirable if evaluated only by the effect on demand elasticity: Efficiency standards that make the automobile fleet cleaner can actually end up decreasing elasticity and increasing oil price volatility, one participant noted. If cars get better mileage, gasoline prices will matter less to drivers, and consumers will not cut down consumption. Even if more efficient U.S. cars can increase oil price volatility, the effect is likely washed out by the salutary effects of consuming less oil. (Indeed, we recently studied U.S. fuel economy standards and found that the benefits far outweigh the costs.) This does not mean that reducing U.S. oil consumption will mitigate all of the risks of oil price volatility—around the world, volatility still threatens U.S. economic and geopolitical interests. And it is not always a bad idea to try and increase elasticities—the United States should advocate for global reform of fuel subsidies that can insulate major economies from the price signals of oil markets. But to reduce the effects of oil price volatility on the U.S. economy, it is likely best to reduce U.S. exposure to the global oil market rather than attempt to tame it.

This guest post is authored by Jason Bordoff, professor of professional practice and founding director of the Center on Global Energy Policy at Columbia University’s School of International and Public Affairs. For more on the causes, consequences, and policy implications of oil price volatility, read the report from a recent CFR workshop. Oil price volatility—sharp price swings in either direction over a short timespan—can harm economies, provoke political instability, and exacerbate poverty. Moving forward, oil price volatility may increase if Saudi Arabia and the rest of OPEC continue to abstain from efforts to manage the market and hold very little spare capacity to cushion the price impact of global supply disruptions, and if the role of shale as a short-cycle source of supply remains uncertain, as Bob McNally argues in a forthcoming Center on Global Energy Policy book. Although few countries are capable of materially influencing global oil markets, CFR posed the question in a recent workshop whether the United States may be able to smooth the fluctuating price of oil by using its Strategic Petroleum Reserve (SPR), an emergency fuel storage of oil maintained by the United States Department of Energy. But just because the SPR can be used in this way does not mean that it should. In fact, policymakers should avoid using the SPR as a “Federal Reserve of Oil” that actively manages the market on an ongoing basis. This would mute important market price signals to consumers and producers, exceed the competence of U.S. authorities, and create pernicious political temptations to cushion consumers from high fuel prices. Rather, the United States should only use the SPR in infrequent circumstances to protect the U.S. economy from major supply disruptions around the world. What is the SPR? Congress created the SPR in the Energy Policy and Conservation Act (EPCA) of 1975 in the wake of the Arab Oil Embargo to insulate the United States from future petroleum supply disruptions. As a member of the International Energy Agency (EIA), the United States is required to hold stocks of crude oil and/or petroleum products equivalent to ninety days’ worth of net imports for use in an emergency. These stocks can be held either in private inventories or directly by the government. As of February, the SPR contained contains the equivalent of 137 days of net import cover. That figure has risen in recent years in response to both surging oil supply and lower oil demand, dramatically reducing the nation’s dependence on imports. Presently, the SPR holds 695 million barrels of crude oil, with capacity to hold 714 million barrels. EPCA defines the circumstances in which the SPR may be used. Generally, there are three possible types of drawdowns [1]: 1. Full drawdown: The president can order a full drawdown of the reserve to counter a "severe energy supply interruption." 2. Limited drawdown: Up to thirty million barrels if the president finds there is “a domestic or international energy supply shortage of significant scope or duration.” 3. Test sale or exchange: The secretary of energy is authorized to carry out test drawdowns and distribution of crude oil from the SPR not to exceed five million barrels. The New Oil Market Means the SPR Serves a Different Purpose However, the EPCA drew up the SPR under a very different reality than today’s. In the 1970s, oil price controls existed in the United States, and most internationally traded oil was sold under long-term contracts. As a result, a disruption in contracted shipments could result in a physical shortage for the buyer because neither strategic and commercial stockpiles nor a large spot market existed at the time. In the intervening years, the oil market has become the largest and most liquid commodity market on earth with vibrant futures markets. Almost all oil is globally traded for a price indexed to benchmark crude prices and mature pricing hubs in regions including Europe (Brent), the United States (WTI), and the Middle East (Dubai).[2] Given how the oil market has changed, the consequence of a supply disruption anywhere is a price increase everywhere. Hence, the risk against which the SPR needs to guard today is global. A supply disruption from anywhere causes domestic prices to spike regardless of whether U.S. refineries import from the disrupted countries. The effect on prices of such a disruption can be tempered by additional supply released from strategic stocks through coordinated action by countries, as well as by commercial supplies and spare capacity. An increasingly important role for SPR policy may also be managing market expectations.[3]  Markets react very quickly to anticipated supply and demand changes, which can sharply affect price movements. In 2012, for example, the effect on the world oil price of sanctions on Iranian oil sales and other geopolitical fears was tempered, at least in part, by a perception in the market that the United States and other IEA members might release stocks from the SPR if prices rose too far.[4] In the summer of 2012, both the G-20 and G-7 issued statements intended to signal that they might tap strategic oil stocks if necessary.[5] Policymakers sent other signals to this effect as well, such as the reported conversation in March 2012 between President Obama and Prime Minister David Cameron about using strategic oil stocks.[6] As a result, numerous analysts cautioned that the Obama Administration might release SPR crude if oil prices rose above roughly $120 per barrel. Should Policymakers Use the SPR To Mitigate Oil Price Volatility? The answer depends on the cause and duration of the volatility. For short-term price spikes due to supply disruptions, the use of strategic stocks can mitigate the concomitant economic harm until the market disruption is resolved. These disruptions may be driven by natural disasters like hurricanes or the recent wildfires in Canada, by geopolitical events like wars, or even domestic events like labor strikes. Such use of the SPR is consistent with the changes to the global oil market over the past forty years discussed above. In today’s market, the SPR needs to guard against the risk of a global disruption to crude supply that causes domestic prices to spike rather than supply cut-offs to particular importing refineries. Accordingly, the value of the SPR should be measured less by days of import cover than by the ability of the SPR to add supply to the global oil market to mitigate the economic harm of disruptions. Consistent with this approach, the Quadrennial Energy Review recommends updating the EPCA’s usage guidelines for use of the SPR in the following ways: 1. The definition of a "severe energy supply interruption"—in the event of which EPCA authorizes releases of stocks from the SPR—should include any disruption in the global oil market likely to cause a severe increase in the price of petroleum products, regardless of whether the United States would experience lower oil imports. 2. The President should have the authority to release stocks from the SPR if a severe price increase will likely result from an emergency situation, rather than having to wait until a severe fuel price increase has already occurred. To be effective, the SPR’s infrastructure needs to be modernized, because today it may no longer be able to deliver additional and incremental barrels to the market to address supply disruptions.[7] To ensure SPR crude oil can be effectively accessed in a future supply disruption, the Quadrennial Energy Review estimated that $1.5 to $2 billion is needed “to increase the incremental distribution capacity of the SPR by adding dedicated marine loading dock capacity at the Gulf Coast terminus of the SPR distribution systems, as well as undertaking a life extension program for key SPR components.” By contrast, it would be unwise for the federal government to use the SPR as a “Federal Reserve of Oil” on a regular basis—that is, to try to achieve stable oil prices at all times, even when the oil price volatility is not from short-term disruptions but rather from other structural supply and demand shifts. There are several reasons for this. First, perhaps most importantly, using government oil stocks to prevent price spikes and drops would mute the price signal to producers and consumers that would otherwise address the underlying supply and demand imbalance in the market. In response to high prices over the past decade, producers invested hundreds of billions of dollars in new sources of higher cost oil supply, including the investments and innovation that enabled U.S. shale revolution. Oil demand growth also slowed at the time as consumers responded to higher prices. But in response to the current price collapse, demand has rebounded, producers have slashed capital expenditures, and production is falling in the United States and other countries like China, Mexico and Colombia. By muting these price signals to consumers and producers, the SPR could slow the market’s ability to correct itself, risking a prolonged imbalance between supply and demand and depletion of the limited stocks in the SPR. Second, it is not clear whether the U.S. government (or any entity, for that matter) has the necessary expertise to ascertain the causes of near-term oil price volatility, assess the role of supply and demand dynamics vs. other factors like financial speculation, and understand the effects of geopolitical and market conditions in important producing countries. Leading market analysts consistently demonstrate their inability to predict price movements and often confess difficulty in explaining current market shifts. The U.S. government may have officials with experience analyzing the global oil market (as with the current Administrator of the EIA), but often that is not the case, especially among the political appointees making the ultimate decision about SPR use. Third, explicitly using the SPR to mitigate price volatility would likely lead to intense political pressure being brought to bear on policymakers to cushion high gasoline prices (conversely, producing states and firms may discourage policymakers from permitting very low prices, as in today’s environment). High gasoline prices, especially in an election year, often become hot-button issues and lead to calls to tap the SPR. Fourth, unless the US intends to manage the global markets only with its domestic SPR, it is unlikely that IEA countries can agree to release the SPR quickly enough to address short-term oil price volatility. We have seen examples of quick action in the past, such as after Hurricane Katrina, but also cases in which such coordination takes time. In 2011, for example, the Libyan civil war led to a disruption in oil supply in February, but the IEA-coordinated release did not occur until June, in large part due to the time necessary to build support among IEA member countries. In theory, this concern could be addressed by creating an international board to assess market conditions and make recommendations about strategic reserve use to mitigate volatility. Yet that would require (1) IEA members to agree that such use of strategic stocks was sensible; (2) the United States to cede decision-making authority to an international body, which would generate severe opposition; and (3) IEA countries that meet their strategic reserve requirements through private sector inventories, not government-held stocks, to overcome the challenge of coordinating private inventory releases. Fifth, at roughly 700 million barrels, the current SPR may well not be large enough to effectively mitigate oil price volatility in a global market that consumes about 95 million barrels of oil every day. It is unclear exactly how much additional supply would have had to be put on the market from 2011 to 2014 to keep prices at an “acceptable” level rather than in excess of $100 per barrel, but, depending on the extent of the market shortfall, the U.S. SPR could be run down rather quickly. This concern may be addressed by drawing on stocks in other IEA countries, and by building new mechanisms to coordinate stock releases with non-IEA countries that are now holding very large stockpiles, like China. Yet such a coordination mechanism, as noted in the prior point, would come at the expense of timeliness or U.S. autonomy. Sixth, any supply additions to mitigate oil price spikes could be offset by OPEC producers if they wanted to support higher prices. While the ability of OPEC to coordinate, or the willingness of Saudi Arabia to cut production on its own, seems lacking at present, it is possible that OPEC could yet try to reassert its role as a market manager. A Guard Against Global Disruption, Not the Federal Oil Reserve Oil price volatility is harmful to the macro economy and to consumers, and it may be more likely moving forward than in the past because of changes in the behavior of oil producing countries and the emergence of U.S. shale as a short-cycle source of oil supply. Given how the oil market has changed over the past several decades, the SPR today guards against a different risk than it did initially. In today’s market, the risk against which the SPR needs to guard is a global disruption to crude supply that causes domestic prices to spike rather than supplies being cut off to particular importing refineries. Whether the SPR should be used to mitigate oil price volatility depends on the cause and duration of the volatility. In the event of short-term price spikes due to temporary supply disruptions, the use of strategic stocks can mitigate the concomitant economic harm until the market disruption is resolved. By contrast, using the SPR on a regular basis to try to achieve more stable oil prices—a “Federal Reserve of Oil” model—would be ill-advised for many reasons. These include preventing consumers and producers from responding to structural supply and demand shifts; political, market expertise, and SPR governance limitations; and potential producer country responses. Appendix [8] The circumstances that might require the use of the Strategic Petroleum Reserve are defined in the Energy Policy and Conservation Act (EPCA).  Generally, there are three possible types of drawdowns envisioned in the Act: Full drawdown: The President can order a full drawdown of the Reserve to counter a “severe energy supply interruption.” EPCA defines this as “a national energy supply shortage which the President determines – a. is, or is likely to be, of significant scope and duration, and of an emergency nature b. may cause major harm on national safety or the national economy; and c. results, or is likely to result, from (i) an interruption in the supply of imported petroleum products, (ii) an interruption in the supply of domestic petroleum products, or (iii) sabotage or an act of God.” EPCA also states that a severe energy supply interruption “shall be deemed to exist if the President determines that – a. an emergency situation exists and there is a significant reduction in supply which is of significant scope and duration; b. a severe increase in the price of petroleum products has resulted from such emergency situation; and c. such price increase is likely to cause a major adverse impact on the national economy.” Limited drawdown: If the President finds that - a. a circumstance, other than those described [above] exists that constitutes, or is likely to become, a domestic or international energy supply shortage of significant scope or duration; and b.  action taken....would assist directly and significantly in preventing or reducing the adverse impact of such shortage" then the Secretary may drawdown and distribute the Strategic Petroleum Reserve, although in no case: 1) in excess of an aggregate of 30,000,000 barrels, 2) for more than 60 days, or 3) if there are fewer than 500,000,000 barrels....stored in the Reserve. Test Sale or Exchange: The Secretary of Energy is authorized to carry out test drawdowns and distribution of crude oil from the Reserve. If any such test drawdown includes the sale or exchange of crude oil, “then the aggregate quantity of crude oil withdrawn from the Reserve may not exceed 5,000,000 barrels during any such test drawdown or distribution.” [1] "The Energy Policy and Conservation Act (P.L. 94-163, 42 U.S.C. 6201)", enacted December 22, 1975. [2] Jason Bordoff and Trevor Houser, “Navigating the U.S. Oil Export Debate,” Columbia University’s Center on Global Energy Policy, January 2015. [3] Michelle Billig Patron and David L. Goldwyn, “Managing Strategic Reserves,” in Energy and Security: Strategies for a World in Transition (2nd edition), edited by Jan H. Kalicki and David L. Goldwyn, Woodrow Wilson Center Press, 2013. [4] See, e.g., Blake Clayton, “Is the White House the New Federal Reserve of Oil?,” Forbes, October 12, 2012; Izabella Kaminska, “SPR talk as QE3 expectation management,” Financial Times, September 3, 2012. [5] "G7 urges oil supply boost, says ready to call for IEA action," Platts, August 29, 2012; "G20 says vigilant on oil, ready to take measures," Reuters, June 19, 2012. [6] Guy Chazan et al., “Crude Tumbles as Leaders Discuss Supplies,” Financial Times, March 15, 2012; Matt Falloon and Jeff Mason, “Obama, UK’s Cameron Discussed Tapping Oil Reserves: Sources,” Reuters, March 15, 2012. [7] Testimony of Jason E. Bordoff before the Senate Committee on Energy and Natural Resources, October 6, 2015. [8] U.S. Department of Energy, "SPR Quick Facts and FAQs."