Editor’s Note: The most recent issue of The Energy Strategist, In Review mistakenly referred to a June 10, 2011, Flash Alert in the discussion of Eagle Rock Energy Partners (NSDQ: EROC). This typo may have caused some confusion because the accompanying link sent subscribers to a Flash Alert issued on June 10, 2010. We apologize for any difficulties this typo may have caused.

On June 23, the International Energy Agency (IEA) announced that it would release 60 million barrels of oil held in strategic government reserves over the next 30 days, a pace of roughly 2 million barrels per day. These reserves are oil that’s held in storage as a supply cushion in the event of an emergency or prolonged supply disruption.

Every country that’s a member of the IEA is required to hold enough reserves to cover 90 days’ worth of oil imports. IEA member states that are net oil exporters–Canada, for example–are exempt from the requirement. The most recent data shows that IEA countries, in aggregate, hold more than 145 days of imported supply. Several countries also have side agreements to share their strategic stockpiles in the event of an emergency that impacts supply in a particular country.  

Of the 60 million barrels to be released, the US will sell 30 million barrels over the next month from its Strategic Petroleum Reserve (SPR), half of the total IEA release. The remainder will be spread out among the remaining 23 members of the IEA.

There had been some hints that the US might tap the SPR earlier this year, but such a move appeared unlikely because the price of West Texas Intermediate (WTI) crude oil has fallen precipitously since early May. The price of Brent crude oil–the international and European benchmark–has also declined sharply from almost $130 per barrel, though it continues to trade at elevated prices relative to WTI.

The US continues to benefit from relatively strong domestic production growth and healthy inventories of crude at the Cushing oil terminal in Oklahoma, the official delivery point for WTI. Meanwhile, disruptions to Libyan oil exports because of the country’s civil war have tightened the supply picture in the EU. Even if the conflict is resolved, it will take time for Libya’s oil exports to return to 1.5 million barrels per day; operators must rebuild the country’s infrastructure and evacuated foreign oil workers will need to relocate to the country.

The supply disruption stemming from Libya’s civil war is the sort of emergency that these IEA strategic petroleum inventories were created to address.

But the timing of this announcement caught oil markets by surprise and sent crude prices tumbling by as much as 5 percent in the immediate aftermath of the news. There’s no denying that the release of oil from the US and IEA SPRs is a short-term negative for crude oil prices.

At first blush, 2 million barrels per day of oil supply isn’t much in the context of an almost 90 million barrels per day market. But this is a meaningful quantity of oil when you consider that the Libyan supply disruption amounts to 1.5 million barrels per day and total global spare capacity–the amount of oil that could be brought on stream in OPEC but is not currently under production–stands at about 4 million barrels per day. The oil market supply-demand balance is tight, so a relatively small shift in supply can have a real impact on prices.

IEA’s plan to evaluate the effectiveness of this move in a month’s time also should help cap prices for the balance of the summer because it leaves the door wide open to further releases from strategic inventories if prices fail to respond. And don’t forget that oil prices, alongside other major commodities, had already slipped after a prolonged stretch of weaker-than-expected economic releases. Prior to this development, I had called for oil prices to trade sideways at best because of economic weakness.

However, over the intermediate and longer term, this news is extremely bullish for crude oil and underpins my view that the global market is far tighter than most investors imagine. I still expect crude oil to top its early 2011 highs by late 2011 or early 2012. Here are some points to consider.

The timing of this move is political. President Obama’s approval ratings have undeniably been hit by rising oil and energy prices. The truth is that global oil prices are for the most part beyond the control of any President, but the person in office–Democrat or Republican–gets to take credit for a good economy and gets blamed for a poor economy.

The most important thing is that the president wants to appear to be making an effort to lower oil prices to support economic growth and reduce unemployment. The desire to be proactive is undoubtedly a factor in the shift in the administration’s treatment of deepwater drilling in the Gulf of Mexico. President Obama also wants to be seen as helping Americans at the pump ahead of summer driving season. Never forget that 2012 is an election year in the US. Even if the SPR release provides only a temporary respite for consumers, this move may allow the Obama administration to take some credit for the recent drop in retail gasoline prices in the US.

Europe needs this more than the US. Although US oil prices are up year over year, EU oil prices have been pushed up by the crisis in Libya. This is particularly true of Italy, the country that purchases the most oil from Libya. As I wrote in Advantage USA, the US also enjoys advantages in the form of less onerous regulations, a better domestic supply outlook and ultra-cheap natural gas prices.

The coordinated US-IEA response looks like it may have been driven partly by EU governments’ desire to keep prices down this summer and cool inflation, a major concern for the European Central Bank. Also, remember that several EU nations have scheduled elections over the next couple of years; this move could provide the incumbent parties with a boost at the polls.

Talk of oil speculation is primarily rhetoric. One of the preferred techniques for governments to address high energy prices is to blame someone else–speculators are a common scapegoat. All investors will recall hearing the argument that the rally in oil has nothing to do with supply and demand and stems solely buying and selling oil futures on the major commodity exchanges.

The move to release oil from the SPR is a tacit admission that the speculation argument is rubbish. After all, if the rally in oil is all about speculators and the world is truly awash in oil, then adding an additional 2 million barrels per day to that supply won’t help the situation. It doesn’t make sense to argue that this move is necessary to offset disruptions to Libyan oil exports, while also arguing that supply and demand have nothing to do with oil prices.

Rather, as I’ve said for some time, oil prices have responded to a tight global market; this move is driven by fear that the market will tighten even further.

The oil market is tighter globally than anyone wants to admit. In the IEA’s most recent Oil Market Report (OMR), the agency predicted that global oil demand in 2011 will rise by 1.3 million barrels day compared to 2010 levels–that’s on top of an increase of 2.8 million barrels per day in 2010. According to the report, production from non-OPEC nations will increase by about 560,000 barrels per day, roughly half of the amount it grew in 2010. Non-OPEC supply growth has been revised of late because of weather-related disruptions to US production. That leaves almost 750,000 barrels per day of additional demand that needs to be met through either existing inventories of crude in storage or more OPEC production. OPEC’s production capacity is already stretched by the loss of Libyan output.

To make matters worse, we’re entering a seasonally strong period for demand. The IEA stated that global oil demand will increase by 1 million barrels per day between the second and third quarters of this year alone. This is due to the seasonal ramp in supplies that coincides with the summer driving season in the Northern Hemisphere.

Projections from the IEA and the US Energy Information Administration showed that without much additional OPEC supplies, global commercial oil inventories would decline sharply through the summer amid the ramp-up in demand. Global oil inventories would have thinned substantially by the fourth quarter.

As I recently explained on the Cocktail Stocks blog, commentators have widely misinterpreted OPEC’s recent failure to reach consensus on a Saudi Arabia’s proposal to boost oil output quotas. Most OPEC nations already produce well above their official quotas; OPEC’s official quota has had little meaning for more than a year. Moreover, the nations that have opposed the quota hike most vehemently are those that have the least capacity to boost output.

Saudi Arabia is the only country in OPEC with significant and dependable spare capacity to produce crude. Officially, OPEC’s spare capacity is slightly more 4 million barrels per day, of which Saudi Arabia accounts for about 3.25 million barrels per day. Saudi Arabia has increased its output to offset Libyan oil production declines and promised to unilaterally boost output after OPEC agreed to a cartel-wide production quota increase. Meanwhile, the Saudis continue to invest billions in developing new fields.

Some have conjectured that the Saudis would be unable to meet that commitment to increase output because they’re lying about their output capacity. But the Saudis can increase output. However, to do so, the Saudis would need to tap their spare capacity even more than they have already, lowering the world’s spare capacity. A decline in spare capacity historically has proved bullish–not bearish–for crude oil prices.

Second-round effects. To the extent that the introduction of an additional 2 million barrels per day of oil supply decreases or caps oil prices, such a move also will boost demand and exacerbate an already tight supply-demand balance.

In addition, the US SPR contains more than 700 million barrels of oil per day; 30 million barrels day is less than 5 percent of the total inventory. But that’s only one month of relief. The US would have to release oil from the SPR at that rate for at least the next few months to cover the summer driving season. At some point, the market will begin to worry about depletion of the SPR and the need to refill it, implying higher demand in coming months.

The effect of releases from SPR has been limited and temporary. The table below shows all releases from the SPR over the past few decades. All of the SPR releases from 2000 to 2008 occurred in the context of a rising oil prices.



This is the largest such release, but if history is any guide, the impact on oil price will fade as soon as this initiative ends.

In short, the decision to release 60 million barrels of oil from global SPRs partly a political move designed to bring down oil prices ahead of the summer driving season. That may work over the next few weeks. But the more important point is that it reflects how tight the global oil market has become and that meeting global oil demand growth will require an unacceptable decline in global spare capacity.