Possible Sale for Strategic Oil Reserves on G8 Agenda

At this weekend’s meeting of the leaders of the G8 countries (the US, the UK,Germany, Japan, Canada, Italy, France, and Russia) at Camp David, President Obama is expected to raise the issue of selling crude oil from strategic reserves in a move to lessen the impact of tough restrictions on the sale of Iranian oil which begin in July. Fearful of a another crude price spike, Obama has the support at least of the UK, Japan, and France, according to reports from Reuters. Oil exporting countries like Canada and Russia could be a more difficult sale, and Germany did not support the strategic reserves sales last time around either.

The arguments for a sale are well laid out in this article from the Center for American Progress. Price volatility due to hurricanes in the Gulf of Mexico, political turmoil in Africa or the Middle East, or a more serious confrontation with Iran over its nuclear program could send crude prices soaring again. The main issue that the Center for American Progress focuses on is speculation, and how curbing speculation will keep crude prices lower.

Well, maybe, but not likely, at least not lower for very long. The President and other foreign leaders first broached the subject in March and prices have been falling pretty much ever since. The threat of a release from strategic reserves is often, as in this case, just as good as actually releasing the crude.

Trying to drive speculation out of the oil markets by selling crude from strategic reserves is a blunt instrument that is hard to control. Everyone knows the taps have to be turned off at some point or the strategic reserves no longer serve any strategic purpose. Their availability will just be priced in.

And there’s probably no good reason to drive speculators (that is, non-commercial traders who have no interest in taking delivery of the physical oil) completely out of the market anyway. If that were to happen, the oil markets would once more be controlled by the big oil companies and OPEC. We’ve been down that road before.

A recent article by economist Lutz Kilian of the University of Michigan points out that speculation is not only not bad, it is necessary. The entire article is worth reading, but here are some highlights:

• [T]here is evidence that price increases were somewhat higher for non-exchange traded commodities than for exchange-traded commodities, consistent with the view that financialisation actually dampened price increases.
• There is no compelling evidence that changes in financial traders’ positions predict changes in the price of oil futures.
• Contrary to widely held beliefs that increases in oil futures prices precede increases in the spot price of oil, there is no evidence that oil futures prices significantly improve the out-of-sample accuracy of forecasts of the spot price of oil.
• The oil price–inventory relationship tells us nothing about the quantitative importance of speculation in oil markets. In particular, the absence or presence of speculative pressures in the oil market cannot be inferred from studying oil inventory data without a fully specified structural model.
• There is no empirical evidence that the short-run price elasticity of gasoline demand is literally zero, as required by theoretical models that explain increases in the spot price based on speculation in oil futures markets without an accumulation of oil inventories.

While releasing crude from national strategic reserves is popular among policy makers, its use is usually no better than the threat of its use, and it is only a short-term, temporary solution. The long-term solution is to figure out a way to break the world’s addiction to oil.

Paul Ausick