Shale oil has created a problem for the Strategic Petroleum Reserve (SPR). And that in turn has created a problem for U.S.-flag vessel operators. Those operators are trying to create problems for Gulf Coast refiners. And this whole situation could create a problem for the crude oil market if new hostilities come to the Middle East…a problem with significant consequences for crude prices.
The story can get a little convoluted. But given the risk of hostilities and the consequences if they come, it is worth spending some time to understand the situation.
[This posting is based in part on comments from Edward Morse, MD & Head of Commodities Research, Citigroup yesterday at the Platts North American Crude Oil Marketing Conference in Houston.]
First some background material. The SPR was created as a response to the 1973 energy crisis. Basically the government buys crude oil and stores it in giant underground salt caverns, similar to those used to store natural gas and NGLs. There are four storage facilities located in Freeport, TX, Winnie, TX, Lake Charles, LA and Baton Rouge, LA. About 630 million barrels (~35 days of total U.S. supply) are in these wells. They are designed for a maximum withdrawal of 4.5 MMb/d, and were originally intended for use when crude oil supplies to the U.S. are cut off. Like what happened in the 70s.
A major assumption in the SPR design is that crude oil would flow out of the caverns and move north into major refinery centers in the mid-continent. That is because Gulf Coast refineries get most of their crude from waterborne sources, and there has been limited pipeline infrastructure to move gas up and down the Gulf coastal region. For decades, the primary flow route for crude has been from the Gulf region (PADD 3) to the mid-continent (PADD 2). Thus the infrequent withdrawals from the SPR over the past four decades have been executed quickly and efficiently from a physical flow point of view.
That is until June 23, 2011. If you recall, that was in the middle of Libyan hostilities. Crude oil prices were running up to $100. The economy was fragile and being stimulated with “Quantitative Easing”. And the Obama administration convinced the European community (the IEA’s 27 member countries) to join the U.S. in a “tactical” release strategic reserve barrels. The U.S. announced a release of 30 million barrels. Ostensibly this volume was supposed to keep the crude oil market in balance after Libyan exports were cut. There was criticism from both sides of the isle. Democrats said it should have been done sooner, before prices ran up. Republicans accused the Obama administration of using this strategic tool as one more way to goose the economy.
But that is neither here nor there. It didn’t work. Fizzled big time. Prices dropped for a few days but returned quickly to their higher levels. Why did it not work? Because the barrels did not flow into the market. They got in, but they could not get out.
What should have been 4.5 Mb/d hitting the market turned out to be only 0.5 Mb/d. That is because the barrels did not move north, as the SPR delivery system is designed. It’s that darned shale oil again.
The oil shale phenomenon has reversed the flow of most crude oil in the U.S. from south-to-north to north-to-south. Instead of moving into the mid-continent, the SPR barrels instead moved to Gulf Coast refineries. But wait! What about the fact that there is limited infrastructure to move barrels up and down the Gulf coast. Yup. So the barrels had to move on crude carriers (i.e., boats). But then there were two more catches. #1 – the SPR was not designed to move the crude on to boats, and #2 any crude loaded on a boat from a U.S. port destined for another U.S. port is subject to the Jones Act.
The Merchant Marine Act of 1920 is a U.S. law that regulates marine commerce. Section 27 – the Jones Act - requires that all goods transported by water between U.S. ports be carried in U.S.-flag ships. But there are no U.S. crude oil tankers suitable for this business. (Why is a whole study in the unintended consequences of government regulation.) But in the summer of 2011, the reasons were irrelevant. There were no Jones Act tankers available, so the administration had to grant wavers to get the crude to move. Ultimately 50 of them. The barrels moved on to foreign flag tankers, and were redistributed to Gulf Coast refineries, getting all 30 million of the barrels out by Halloween. Five months. The barrels reached the market, but not at a rate that had any impact on price.
Next came a wave of protests from various parties complaining about all the wavers, including the American Maritime Partnership (AMP), a lobby for U.S. flag vessel operators. Resulting legislation now requires the Department of Homeland Security, the Department of Transportation and the Department of Energy to jump through hoops to get more wavers in the future. The AMP must be very well connected.
So here’s the problem. The SPR release in June was not that big of a deal. Whether it was really necessary is debatable. The fact that the release was so slow, and the results were so muted supports the notion that it was unnecessary. But what happens if we really need this oil? What happens if the Israelis attack Iran’s nuclear sites and Iran blocks the Strait of Hormuz? Worry about that possibility is the main reason that crude oil prices are in double digits. There are a lot of smart people that think it could happen. In such a scenario we could really need the SPR.
When we are talking roaches, the fact that they can’t get out is a good thing. With SPR crude oil, it could be a very bad thing.
In summary, the SPR might not be there when we need it, or at least not have the market effect for which it was designed. With growing shale production, SPR barrels are not needed in the mid-continent. Due to logistical constraints, that means there will be problems getting significant volumes – anywhere close to 4.5 MMB/d – into the crude oil market. The new Jones Act rules make the situation worse. Consequently, any spike in the price of crude oil will be more severe and longer in duration than it would be otherwise. Has the smart money figured this out? It makes you wonder if that is one reason why the price of crude oil has been so persistently strong in recent weeks.
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Note that I have not used any roach metaphors in this entire posting. Since starting these blogs I’ve consistently said that I don’t want to get political. This topic made it difficult to keep that promise.
Instead of politics, let’s get down to a little Roach Motel boogie.
