A strategic slip from the IEA

The IEA's unexpected intervention in the oil market looks to be an all-around bad call. It will serve to heighten volatility in the already highly volatile market. At the same time, it will only hamper the things that need to be done by OECD countries (investing in oil exploration and production) and emerging countries like China (cutting price subsidies), argues Matthew Hulbert.

Any ‘danger’ that oil markets were going to settle has been dispelled by events over the past two weeks. The breakup of OPEC and the decision of the International Energy Agency (IEA) to draw down 60 million barrels of strategic reserves has left the market little clues as to what they should or should not price in. Yes, market prices fell some 7% immediately after the IEA’s action, which will be welcome news in Washington DC, where cheaper petrol means more votes. Cheaper oil may also help to keep OECD economic recoveries going a bit longer. But the IEA is playing a very dangerous game by influencing short term sentiment. The longer-term consequences of its move are anything but positive.

The official line from the IEA is all about Libya of course, which although controversial, has some merit. Around 132 million barrels of light grade, low sulphurous production has been lost as a result of the Libyan war. Releasing IEA stocks is one of the few ways of boosting such production beyond stuttering Algerian and (uncertain) West African sweet supplies. The question is whether 60 million barrels will be nearly enough to boost longer term sweet output, particularly if Algiers gets drawn deeper into the Arab Spring quagmire. The decks have been, and indeed could continue to be, shuffled in terms of Europe taking up the bulk of sweet supplies while Asia settles for the heavy stuff, but that would inevitably come with steep benchmark prices. And it’s the price angle here which explains not just the IEA move, but why Saudi Arabia gave its tacit consent, even to the point of providing active ‘backchannel diplomacy’ to do so.

The Kingdom knows it can only ramp up heavy grades shipped out East to ease broader market pressures, not directly control the price of Brent. When push comes to shove, the Saudi’s prefer controlling price rather than maximising receipts. The priority for any ‘price moderate’ right now (think Kuwait, United Arab Emirates, Qatar, Saudi Arabia) is to keep prices steady (around $100/b), not see demand destruction set in. That would be a lethal combination for any Gulf state now that the Arab Spring is turning into a long, hot summer. It’s also why the Saudi’s want to increase their rig count by 30% next year.

Hurricane Katrina

But the IEA move has added new rules and a new twist to the game. The core assumption was that the Saudi’s would do the heavy lifting to boost supplies. They still will in the medium to long term. The 60

When push comes to shove, the Saudi's prefer controlling price rather than maximising receipts
million barrel drawdown from the IEA is clearly small beer compared to what the Saudis can do. It can accomplish little in the face of continued rising demand and weakening supply. It is unlikely that the US will be willing to delve much deeper into its 727 million barrels of reserves, and the same goes for the other countries that make up the IEA’s total 1.6bn barrels of reserves. 

This points towards the core problem with the Libyan precedent: the fact that the IEA has used reserves as a short term interventionist measure to combat high prices rather than filling an actual or imminent supply shortage – which is what the reserves are there for. That’s why the IEA has only used its reserves on two previous occasions: in the 1990-91 Gulf War and in 2005 when Hurricane Katrina struck. It did not use its reserves when prices peaked at $147/b in 2008.

Play chicken

So what will be the effect of the IEA’s move on the market? Despite protestations from the IEA's Executive Director Nabuo Tanaka, the IEA will not be able to intervene on a regular basis in future. That would deplete its reserves and endanger its real function of filling supplies in times of crisis. So its market power will inevitably remain limited. Indeed, as the IEA is unlikely and unwilling to sustain its interventions, its credibility will suffer.

What the IEA move will do however is create further volatility. OPEC meetings will henceforth not just see speculation about what the cartel does, but what the IEA will do in response. The bulk of OPEC members will be more than happy to play ‘chicken’ with the IEA.

More importantly, manipulating markets in this way will do little to attract upstream investment across all producer states. This should be the core focus on non-OPEC states: opening up new reserves (including offshore and tar sands), enhancing recovery from existing fields, offering attractive fiscal and tax regimes to do so – not hoping quick fixes on spot markets will do the trick.

Failure by non-OPEC states to develop new reserves will inevitably leave the incremental barrel in OPEC hands, given the cartel’s 1,000 billion proven probable reserves. But it’s not just a case of ‘drill

The bulk of OPEC members will be more than happy to play 'chicken' with the IEA
baby drill’. Far from it. Letting the market organically evolve should start seeing more oil to gas substitution. It should also make it far more painful for emerging markets to sustain the huge subsidies with which they keep prices low for their populations. Rather than offering India and China a free ride on IEA drawdowns, they should urgently be brought into (in)formal supply arrangements. In particular China, the second largest oil importer, should not be allowed to stand aloof.

That’s before we even mention other measures OECD countries should be pursuing on the energy front: getting serious about energy efficiency, and pricing or taxing carbon emissions to get excess producer profits back into their pockets would be good places to start. These are harder sells to domestic constituents, but remain better antidotes to long term oil dependency than short term market plays.

Instead, we’re now left with an uncertain OPEC outlook, a marriage of convenience (not love) between Saudi Arabia and the IEA, supply increases consumers will struggle to maintain in the longer term and enhanced market volatility. The Strategic Reserve should be about strategic thinking in times of crisis. This hasn’t been ‘that’ moment – either in terms of the ‘crisis’ or the ‘thinking’. It is actually a strategic slip.

 

About the author

Matthew Hulbert is a Senior Research Fellow at the Center for Security Studies, ETH, Zürich, specialised in energy and political risk.