The President Wants To Sell Half The SPR

by: Andrew Hecht


Oil is hovering around $50 per barrel.

OPEC news is expected - will there be a threat in case of higher prices?

Does the U.S. need an SPR these days?

The business of producing petroleum in the U.S. has become a turnkey operation.

The sale of over 300 million barrels will weigh on the market and give the U.S. control.

President Trump ran for the highest office in the United States and perhaps the world pledging to make the nation energy independent. As a supporter of fewer regulations and support for the domestic energy industry, the administration has been seeking to fulfill promises made on the campaign trail.

The U.S. is the world's third largest producer of oil with only Russia and Saudi Arabia pumping more of the energy commodity on a daily basis. Technological advances in drilling and a friendlier regulatory environment have combined to increase production an d lower the cost of extraction. Inventories of U.S. crude oil have increased to record levels in 2017 at times. Shale production continues to increase with the price hovering around the $50 per barrel level; the President told markets last week that he would consider selling a big percentage, perhaps even 50%, of the nation's strategic petroleum reserve (NYSE:SPR). The United States currently holds around 690 million barrels of mostly sour crude oil. The SPR was developed back in 1975 in response to the energy crisis of 1973. In the 1970's Congress and the administration used the SPR as a safeguard and tool against being held hostage by the Middle East when it came to oil requirements. However, over the past decades and most recently, the nation has become a major energy producer making it less likely that any country around the globe could cause a shortage of oil for U.S. consumers. As the price of crude oil dropped to lows of $26.05 in February 2016, China has been in the process of aggressively building their SPR. Now, the administration is considering lightening up on the number of barrels in the U.S. SPR with oil hovering around the $50 per barrel level which has become the sweet spot for U.S. production.

Oil hovering around $50 per barrel

The price of nearby crude oil futures that trades on the NYMEX division of the CME has been hovering around the $50 level since OPEC decided to cut production at their meeting in late November 2016. Source: CQG

As the weekly chart shows, the price range so far in 2017 has been from a low of $43.76 to a high of $55.24. The midpoint of the range is $49.50 per barrel. Crude oil is less than half the price it was in June 2014 when it was trading at over $107 per barrel and almost twice the level seen in February 2016. Therefore, the current pivot point for the energy commodity is a price that satisfies both producers and consumers alike.

OPEC news expected- A threat in case of higher prices?

On May 25 the oil ministers of OPEC met in their biannual gathering in Vienna, Austria to decide on production policy for the second half of 2017. The cartel announced that they voted to extend the production cuts announced in November 2016 through the balance of 2017 and into the first quarter of 2018. With assistance from the Russians to smooth over a troubled relationship between the Saudis and Iranians, the cartel members agreed on a continuation of the current production quotas. Libya and Nigeria were exempt from the cuts, and recently Libyan output has been increasing. At the same time, the cartel has allowed Iran to increase output given years of sanctions on the nation. The Saudis, who in the past would have had a hard time agreeing to shoulder the lion's share of production cuts, have a vested interest in a stable price around the $50 per barrel level. With the largest IPO in history less than one year away, the sale of Aramco shares will allow the Royal Family to diversify the Saudi economy away from petroleum revenues. Investments from a sovereign wealth fund with proceeds from the sale of Aramco will only be enhanced if the valuation of the world's largest oil company comes in at around the $1 trillion mark.

The market had hoped for more from OPEC, and in the days following the May 25 meeting, the price of oil fell to below $48 per barrel on the active month July NYMEX futures contract. A few days before the meeting, the U.S. President said that he was considering the sale of half of the nation's strategic petroleum reserves. The statement may have been a threat in case of higher oil prices as the U.S. has moved many steps closer to energy independence over recent years.

Does the U.S. need an SPR these days?

Shale oil production in the United States caused OPEC, led by the Saudis, to panic and flood the market with the energy commodity in 2015 and 2016. The official policy of the cartel until November 30 was to sell oil without abandon in the hope of forcing U.S. output to shut down so that the members of OPEC could build market share at lower prices. However, technological advances in the form of horizontal drilling and other extraction techniques including hydraulic fracking have brought the production cost in the U.S. down over recent years. Moreover, the election of an energy-friendly President has resulted in appointments to the Department of Energy, Environmental Protection Agency, and even the State Department that are pro-energy independence and production in the nation. Fewer regulations and the potential for tax reform have brought down output costs dramatically. The United States has become the third largest oil producing nation on earth, and it may not be long until output rises to the 10 million barrel per day level. With production rising, massive reserves, and lower output costs, the SPR or strategic petroleum reserve is not as critical as it was in the 1970s-2000s when the nation was dependent on oil imports from around the world, especially from the Middle East.

A turnkey operation

Technology and a friendlier environment for production have made the business of producing petroleum in the United States a turnkey operation. It is now much easier to turn on shale production at higher prices and turn it off when the price drops to or below the cost of production.

The recent threat of a massive sale from the SPR could be a warning to other oil producing nations that the U.S. will tolerate a price of oil that is slightly above its production cost, which is in the $50-$60 per barrel level. Anything above that range may result in sales of over 300 million barrels. The power base in the international oil business has shifted from OPEC to a triad of the world's leading producers over recent months. While the Saudis are still the major force, the Russians and U.S. have a much greater say in oil policy than just a few months ago these days. The Russians mediated the OPEC production cut. The Saudis now depend on the Russians to temper the political and military desires of Iran, their arch-enemy. The Saudis also depend on the United States for military aid and defense. Therefore, between the U.S. and Russia, there is plenty of trade-off with the Saudis when it comes to oil prices now and even into the future. The U.S. is the third largest producer but its trump card, no pun intended, could be the threat of releasing over 300 million barrels into the market that would decimate the price of oil and curtail revenue flows for Russia, Saudi Arabia, and all other OPEC members.

The sale of over 300 million barrels will weigh on the market and give the U.S. control

I believe the President's comments on selling half the SPR is posturing and a negotiating technique aimed at keeping the Russians, Saudis and even the Iranians in line. All three nations depend on the flow of petrodollars, and the sudden appearance of a big percentage of the U.S. SPR would throw an economic monkey wrench into the economies of all three nations.

Meanwhile, the U.S. is in an excellent position these days when it comes to the energy commodity. If the price of oil rallies above $50 per barrel the administration has given U.S. producers all the tools they need on the regulatory and perhaps soon the tax front to ramp up production quickly. At the same time, producers can hedge into the future using the futures market to lock in prices that are above production costs. If the price rallies too far, the threat of additional barrels from the SPR will have a dampening effect on the price of the energy commodity. On the other hand, if prices begin to fall, the U.S. will slow down output as technology has created a turnkey operation. Additionally, at lower prices, the U.S. will begin to take advantage of a bargain in the oil market and import barrels from abroad. Moreover, when prices drop dramatically, producers that hedge will likely repurchase their short futures and lock in profits to put themselves in a position to hedge once again when the price rises because of increasing global demand and fewer supplies created by less U.S. output. The U.S. is now in a position where it has more influence in the worldwide price of oil than ever before in history.

The President stated that he wants to sell half the SPR recently but that may just be in the spirit of the art of the deal with the deal in the most liquid commodity market in the world.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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