Are strategic oil reserves back in vogue as oil market risks escalate?

Are strategic oil reserves back in vogue as oil market risks escalate?

David Flanagan from Infospectrum writes for Splash on the big picture for global oil supplies.

The recent drone strike on Saudi Arabian oil production facilities demonstrated once again how global oil supply can be vulnerable to political risks. Saudi crude oil output of just under 10m barrels-per-day (bpd) makes up around 10% of global oil supply, so any interruption sends shivers down the spines of big oil importers, many of which are concentrated in Asia.

Strategic hedging

Crude oil buyers can manage their oil supply risk through maintenance of a strategic petroleum reserve (SPR), a buffer stock designed to ensure availability of oil at times of heightened political risk. They also offer the added benefit of hedging against high oil prices, if importers buy when oil prices are low, and ease off buying when oil prices are high. SPRs also arguably help to regulate the global oil market. If an importing state depletes its SPR instead of importing more oil, this removes demand from the spot market, and helps to take pressure off oil prices.

The true current capacity of national SPRs is hard to gauge. China’s SPR has been estimated by market analysts as having a capacity of between 400m-600m barrels, and it has more SPR-driven capacity under construction. China’s capacity is also a “movable feast”, whereby the Government-controlled storage element of the SPR may be complemented by capacity held by state-controlled oil companies, in times of particular need. India’s SPR is smaller, but it is also adding new capacity at underground caverns and other locations as its reliance on imported crude oil rises. The International Energy Agency (IEA) encourages importers to maintain SPRs, calculated on the basis of anticipated short-term needs, but, as mentioned, regular and reliable data regarding scale and strategy of SPRs is not disclosed. So, it’s difficult to know exactly what importers are doing. On top of that, relatively low oil prices since the 2014 slide may also have taken some steam out of SPR capacity growth, with the post-2014 market routinely viewed as “lower-risk” for oil importers.

Resurgent demand for SPRs?

With Saudi Arabia now warning that crude oil prices could escalate in the event that US-Iranian tension intensifies, market risks are once again acute, and will drive a sense that SPRs should be accorded greater importance. The principle could also extend into gas, LNG and IMO-compliant low-sulphur fuels, which are gaining market share in China and many other importing states. Strategic reserves of these commodities to avert supply and market risks could play an important role in risk management for energy importers. However, building new oil storage facilities, and the pipeline infrastructure needed to fill them, takes time.

Innovation from producers

Oil producers are also looking at SPRs, and they could offer immediate, innovative solutions. US oil production, now at around 12m bpd, together with extensive storage facilities under construction in and around Houston, means that the US could offer oil importers the use of this capacity to complement their own SPRs. If the risk is rising that a shortage of oil storage capacity in importing states will emerge, and short-term constraints exist in adding new SPR capacity, a market-based solution could help them to manage their oil supply risks.

In other words, a virtual SPR market could emerge, whereby oil storage capacity can be leased from third party states by importers as part of their SPR programme, and a traded market in virtual SPR capacity could even follow.

Where would all this leave oil risk managers?

In a nutshell, the risk of entrusting an element of oil supply to the US storage system, especially if US-China trade relations turn sour again, may not be viewed as any lower than the risks associated with reliance on Middle Eastern oil supply. Second, the creation of a market in SPR capacity looks great in principle, but how could it be regulated? It would be a derivative market, not a physical one, and that would open up major questions for risk managers and traders alike.

There are great opportunities and benefits emerging from the oil storage market and the use of SPRs, but also big questions about how they can be managed and controlled. Moving forward, however oil importers, producers and traders react to this present phase of oil market uncertainty, SPRs will remain a powerful method of combating risk and coping with oil market volatility. Their relevance today has probably been reinforced by the unrest in the Middle East Gulf, and further risks related to trade disputes and sanctions will add to this sentiment, and also drive new and innovative oil and gas reserve strategies.

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