Introduction
Spot oil prices have substantially declined over the last two months, from over $120 to nearly $85. While a number of factors are responsible for this correction, the administration’s aggressive use of the Strategic Petroleum Reserve (SPR) to release close to 1 million barrels per day (partly consistent with what we called for back in early March) has surely played a part in satisfying spot oil demand and cooling spot prices.
More subtly, but of growing importance, the futures curve has substantially compressed, with some of the recent decline in the spot oil price even coinciding with a rise in long-term prices along the crude oil futures curve. The administration’s proposed regulatory reform allowing the DOE to acquire future crude oil for the SPR through fixed-price contracts has likely played an underrated role here. Consistent with the administration’s intentions and what we have been calling for over the past few months, the proposed reform provides a valuable signal to producers looking to hedge future production.
Even though oil supply risks stemming from the Russian invasion have not fundamentally changed, there is understandably growing concern with whether the recent oil price correction might slow a much needed supply-side investment response from domestic producers. By increasing the flexibility with which the SPR can acquire oil, the DOE can provide valuable stability to supply-demand balances for crude oil, that too at a time when markets are historically volatile and subject to unique sources of supply fragility. The administration’s recently proposed regulation for flexibly refilling the SPR is a groundbreaking policy change with serious potential to deliver price and supply stabilization benefits.
Analysis
On July 26, the Department of Energy (DOE) released a “Notice of Proposed Rulemaking” (a proposed regulation) that would allow DOE to acquire oil for the Strategic Petroleum Reserve (SPR) using a fixed price, rather than an index-based price (as is currently required). Though it seems minor and technical, it is a historic change, enabling the DOE to acquire crude oil in a manner much more aligned to its governing statute.
First let’s dig into the economic security implications. Under current regulation, the DOE can only acquire oil using an index-based price:
“Whether acquisition is by direct purchase or royalty transfer and exchange on a term contract basis, DOE shall use a price index to account for fluctuations in absolute and relative market prices at the time of delivery to reduce market risk to all parties throughout the contract term.
Though the seeming purpose of the index-based pricing requirement is to reduce market risk – it can leave all participants vulnerable. In the event that the price falls between contract and delivery, producers could lose expected revenue. It also could limit the ability of the DOE to refill the SPR in a manner aligned with its statutory objectives, which include minimization of cost to the reserve and mitigation of domestic energy supply risks. Because the DOE has only finite revenue from crude oil releases, a price increase between the time of contractual agreement and the time of delivery could leave the DOE with insufficient funds for refilling the reserve adequately. Tying the price to a varying market index eliminates opportunities for both the SPR and its counterparties to hedge risks efficiently.
If this rule becomes final, the SPR can instead use fixed-price contracts to more effectively minimize our vulnerability to an energy disruption, a Congressionally-mandated statutory objective. We noted in early March that the futures curve was deeply backwardated: the spot price for crude was historically high relative to the future price. The future price is more relevant than the spot price for domestic producers’ investment decisions —creating a situation where investment from producers was likely to be insufficient in the face of the risks posed by the Russian invasion.
The SPR can spur more investment by improving the liquidity and affordability of hedging instruments for producers. When undertaking new investment—producers can hedge their risk through many types of instruments, including futures and options. But the volatility of oil prices and the cost of storing crude oil (among other factors) can make the cost of hedging punitively expensive, thereby restricting producers’ willingness to invest at a given spot oil price. By offering various types of fixed price contracts to refill the SPR, whether through the sale of put options or through fixed-price forward contracts, the SPR can reduce the cost of hedging and spur producers to invest more.
Aside from the economic security angle, the use of fixed price contracts is also more aligned to the objectives of the SPR under its governing statute, and the considerations that the SPR needs to make when developing acquisition procedures. 42 U.S.C. 6240(b) requires that the Secretary acquire oil consonant with four objectives: (1) minimizing the cost of the reserve; (2) minimizing the nation’s vulnerability to a severe energy supply interruption; (3) minimizing the impact of acquisition upon supply levels and market forces; and (4) encouraging competition in the petroleum industry.
If the SPR engages in a market-index based contract and the price rises, the SPR would be exposed to upside price risk, but an alternative fixed-price contract would remove that risk and thereby help minimize the cost of the reserve. This doesn’t mean that fixed-price contracts should always be used – but given that the SPR must balance several objectives, it needs a toolkit that can be deployed as necessary to meet the entire set of objectives.
Furthermore, 42 U.S.C. 6240(c) requires that acquisition procedures take several needs into account, including maximizing the domestic supply of crude oil. The stringent requirement for index-priced contracts undermines this goal–eliminating the ability of producers to hedge their risk with a fixed price contract limits their willingness to invest in future production.
Until most recently, the SPR has largely been seen as a tool aligned with domestic refining capacity, which generally favors sour crude. As is now obvious, the composition of the US energy industry has shifted, with the US maturing into a global leader in terms of crude oil production, while refining capacity winds down and migrates overseas. Should the proposed rule be finalized, the DOE will have the ability to realign its storage capabilities to better support and insure domestic producers against the risk of price crashes that has otherwise left them reluctant to invest.
In the coming weeks, we’ll have a lot more to say on how the DOE should make best use of this regulatory change. But for now, the administration deserves a ton of credit for equipping the SPR with better tools to meet the goals of energy security.
