IEA Oil Release: A Counterproductive Idea and a Market Opportunity

by: Ian McAbeer, CFA

I don’t usually comment on leading daily news headlines but today I will make an exception. On June 23, the International Energy Agency (IEA) announced that its member countries would undertake a coordinated effort to release 60 million barrels of light crude oil from worldwide petroleum reserves. The release will commence immediately and will proceed at a rate of 2 million barrels per day for the next 30 days. Included in this total, the United States will release approximately 30 million barrels from its own strategic petroleum reserve (SPR), with the balance coming from the other IEA member nations.

The announcement was a surprise to financial markets and naturally the immediate reaction was a sharp drop in the near-term prices for oil, both in the U.S. and in Europe. The official announcement from the IEA indicated that the primary reason for justifying the release was to offset the losses of Libyan oil production in recent months. Since the conflict began, Libyan oil production has declined by 1.5 million barrels per day. As the conflict has continued, the impact of decreased oil production has become more pronounced and is threatening the fragile economic recovery, according to the IEA.

I believe that the IEA’s decision is complete nonsense, is counterproductive and is predicated on specious logic. Here are just a handful of the reasons why the IEA’s decision is utterly foolish:

  • Oil Supply: While the release will artificially increase oil supplies in the next 30 days, it will do nothing to increase worldwide oil production capacity. In other words, once the 30 days is over, the market will revert back to pre-release levels of global oil supply. Will the IEA’s decision stimulate drilling activity? Of course not. If anything, lower prices will only reduce drilling activity with the long-term result leading to tighter oil markets in the future.
  • Oil Demand: If we have lower market prices for oil, the economy will naturally consume more of it. This is true of ANY commodity – lower prices lead to increased demand. Will increased demand restore balance to global oil markets? Of course not, it will have the opposite result. The long-term consequences of higher demand also result in tighter oil markets in the future.
  • Growth and Energy Consumption: Any economy that grows its total output will also have growth in total energy consumption. Let’s think about this. First, the IEA releases oil in order to lower energy prices and foster economic growth. Let’s assume that economic growth does actually increase as a result of temporarily lower oil prices, what happens next? With higher economic activity global energy consumption will be even higher than it was before the oil release. The bottom line is this: if the global economy grows, so too will our total consumption of energy. By temporarily increasing oil supplies to the market, even if it does work to promote economic growth, the long-term affect will simply be even higher oil consumption than before. Economic growth and higher energy consumption simply go hand in hand, so the IEA’s objectives are fundamentally conflicted.
  • Confidence: Does anyone feel better by knowing that a supranational organization is dumping oil on the market to artificially and temporarily lower prices? I don’t, and I have a hard time understanding why anyone else would. Does this increase the confidence for oil companies to develop new wells and increase production? Does this increase the confidence that investors have in buying the stocks of energy companies, or even participating in financial markets at all? It’s hard for investors to be confident in global financial markets when they see one example after another of government intervention to manipulate interest rates, foreign exchange rates, or commodity prices.
  • Price Control: Does anyone believe that the IEA or any other organization knows the correct price of oil? I think that the average person on the street would agree that the government should not attempt to control the price of milk, gas, oil, executive compensation, or any other product or service. The free market does a reasonably good job of determining the appropriate clearing price for products and services through the continuous and willing exchange between a buyers and sellers. Free markets are not perfect but they are far superior to government manipulation of asset prices.

To sum it all up, we’ve got a supranational agency trying to depress oil prices, but whose actions will do nothing to increase long-term oil supply and whose pro-growth objectives will ultimately have the long-term effect of higher oil prices. At this point, the IEA should just change its name to OPIC - the Organization of Petroleum Importing Countries - because 25 of the 28 member nations are oil importers. The IEA is essentially trying to work as a counterbalance to OPEC - the Organization of Petroleum Exporting Countries.

Meanwhile, one more example of government intervention in global financial markets damages the confidence of investors and corporations who operate in the affected industries. Thirty days from now the conflict in Libya will likely be ongoing, so the IEA will need to reassess the market and determine if more oil releases are justified. This apparently one-time event could actually linger for months and simply add greater uncertainty to financial markets. Much like QE1 and QE2, we could witness successive releases of oil during the balance of the year. Even if the Libyan conflict is over in 30 days’ time, it will be a full year or more before Libyan oil production resumes pre-conflict levels. The short-term economic impact of the decision to release strategic petroleum reserves is likely to be negligible, at best, while the long-term consequences are completely counter to the objectives of having oil markets that are stable and adequately supplied.

If you have a longer-term perspective, the IEA's action may present an attractive entry point for investors who have been waiting for a point to get long the stocks of energy companies. Major integrated oil companies like Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX) declined about 1.5% on the day of the announcement and have fallen almost 10% over the preceeding 6 weeks. Foreign oil companies such as Canadian Natural Resources (NYSE:CNQ), Total SA (NYSE:TOT), PetroChina (NYSE:PTR) and Petrobras (NYSE:PBR) performed similarly, dropping 1%-2% on the day. Oil services companies such as Schlumberger (NYSE:SLB) and Baker Hughes (BHI) performed better and declined less than 1% on the day of the IEA announcement, but are also down quite a bit over the preceeding 6 weeks.

One interesting aspect of the market performance has been in the master limited partnership area, with many MLP's trading flat or higher on the day of the IEA's announcement. For example, Kinder Morgan Management (NYSE:KMR), Magellan Midstream Partners (NYSE:MMP) and Williams Partners (NYSE:WPZ) all closed higher for the day, with most other MLPs only down fractionally. I suppose you could make a bullish case for the MLPs based on increased transportation volumes from SPR outflows and lower retail prices, but once again this is very temporary and it's hard to make a case that you would favor the pipeline companies over the producers, simply due to a one-time decision to release strategic reserves.

Disclosure: I am long CVX, KMR, MMP, XOM.