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Preparing for the Next Oil Price Shock

President Obama Makes the Right Move by Gathering Support for Reserve Oil Sales

SOURCE: AP/Carolyn Kaster

At today's G-8 summit in Camp David, Maryland, President Barack Obama will seek support from other G-8 nations to sell reserve oil in the event of another oil price spike, which could occur due to a number of factors.

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The Group of Eight, or G-8, summit will begin today at Camp David, Maryland, and is hosted by the United States.* Most of these nations have suffered from high oil and gasoline prices this year, which undermines economic growth, particularly for nations that import a significant portion of their oil. Future price spikes this year, which are possible, could derail the lumbering worldwide economic recovery.

To prevent this occurrence, Reuters reports that, “U.S. President Barack Obama will seek support to tap emergency oil reserves from other Group of Eight leaders.” Hopefully President Obama will attempt to reach such an agreement with the G-8. A rapid oil price escalation or supply disruption could devastate the G-8’s struggling economies, but selling some reserve oil could stave off economic disaster if it is done right.

Below we look at why a price spike could happen and how selling reserve oil could help bring down prices.

Another spike in oil prices could cripple economic recovery

The developed world has seen high oil prices in 2012. The Brent crude price for oil consumed in Europe rose from $111 per barrel on January 2 to $128 per barrel on March 13 and eventually receded back to $111 per barrel on May 15. West Texas Intermediate crude oil price, the oil benchmark in the United States, rode a similar cost roller coaster. WTI, which sold for $103 per barrel on January 3, rose to nearly $110 per barrel on February 24 before falling to $93 per barrel on May 16.

oil prices in the u.s. and europe

Such oil price volatility wreaks havoc with tight government, business, and family budgets because frequently these budgets do not have the additional funds necessary to pay for higher fuel costs. In addition, higher oil prices slow economic growth by removing money from the economy that would otherwise pay for other goods and services. For instance, every $10 increase in the price of oil slows economic growth by 0.2 percent in Organisation for Economic Co-operation and Development nations, which includes all the G-8 nations except Russia.

Another oil price spike this year could strangle the sluggish economic recovery, which is why discussing the sale of oil reserves at the G-8 meeting is very timely.

Such a price hike could occur due to a number of unforeseen events. A severe tropical storm in the Gulf of Mexico could temporarily disable oil production from a region that yields 29 percent of American oil. This happened in 2005 in the wake of hurricanes Katrina and Rita and led to former President George W. Bush selling 30 million barrels of reserve oil, which reduced prices by 16 percent.

Political unrest or violence in African or Middle Eastern oil-producing nations could also disrupt oil production or transportation. Such events would likely cause oil prices to escalate. Sanctions against Iran could also cause supply shortages for nations that import Iranian oil, including China and India (the United States does not import Iranian oil).

But a very plausible supply disruption scenario could occur due to the showdown with Iran over its plans to build nuclear weapons. Reuters reports that there may be progress with U.N. negotiations over Iran’s nuclear ambitions, but it remains to be seen whether the current diplomatic track set to resume in Baghdad next week will produce a credible and verifiable deal on Iran’s nuclear program.

That said, the steady effort to combine diplomacy with sanctions has helped eased tensions and reduced talk of a possible military conflict during the past three months. Such a conflict, though, could disrupt the transportation of nearly 20 percent of the world’s oil supply that must travel through the Strait of Hormuz.

As fears of a Persian Gulf supply disruption ease, Wall Street speculators are less able to bid up oil prices in response to fears about a disruption. But an advance agreement to sell reserve oil in case of a supply disruption strengthens the world’s ability to respond, should Iran revive such a threat, or to respond to shortages due to sanctions.

Reserve oil helps ease prices

Selling reserve oil reduces prices by putting a large amount of oil into the marketplace all at once. This can burst a “speculative bubble” that can raise oil prices when Wall Street speculators bid the price up by betting that future oil prices will rise. This drives commercial-end users of oil (such as airlines) to buy oil futures now to lock in a future price out of fear that the price will continue to rise. This action has the effect of bidding up oil futures prices even further. An analysis by McClatchy found Wall Street speculators expanded the oil price bubble this year, exploiting fears of Persian Gulf supply disruption.

Previous reserve oil sales temporarily reduced oil and gasoline prices, which provided some short-term relief to businesses and families.

When to sell reserve oil

Although reports indicate that President Obama intends to seek agreement with the G-8 to sell reserve oil, it is premature to actually sell it now since oil prices have declined over the past weeks from their peak in February and March.

Oil prices are declining now partly because there are ample worldwide supplies. Saudi Arabia raised its production to 10 million barrels per day to offset disruptions in Libya, Sudan, and Syria.

U.S. oil production continues to grow, too. We imported only 45 percent of our oil in 2011, down from 60 percent in 2007. In fact, the Anchorage Daily news recently reported that, “Tankers have returned to the terminal at Valdez [Alaska] still partially laden with Alaska oil. Usually, they come back empty” from delivering oil to the West Coast. This was mostly because west coast refiners had no more storage capacity.

As we pointed out above, though, a number of factors could drive prices up again. If that happens, we should sell reserve oil when the West Texas Intermediate crude oil price hits $110 per barrel, the Brent price rises to $130 per barrel, or the nationwide U.S. average gasoline price exceeds $4 per gallon for several weeks in a row. These are benchmarks that inflict real economic pain. For instance, the U.S. economic recovery stalled in the winter and spring of 2011, as WTI oil prices rose from $92 per barrel on January 3, 2011, and peaked at $112 per barrel on April 22, 2011.

It is also essential that our European allies sell a similar amount of their reserve oil, too. This will put more oil in the market, which should cause a more prompt drop in prices. It also means that the United States will not be the only nation selling its reserve oil to help cut prices and benefit the world economy.

United States and its allies have ample oil reserves

Some argue there should be no sale of reserve oil unless there is actually a severe supply disruption, rather than selling in response to high oil prices driven up by Wall Street speculators in anticipation that there might be a Persian Gulf supply interruption. But the United States and its allies have ample oil reserves that could be used in the event of another huge price spike or a supply disruption so as to pop the speculative bubble and provide economic relief.

The United States has significant oil reserves. The Strategic Petroleum Reserve is 96 percent full with nearly 700 million barrels of oil. The Organisation for Economic Co-operation and Development nations had more than 800 million barrels of oil reserves at the end of 2011. Selling 30 million barrels from each reserve would reduce total reserves by less than 4 percent.

In addition, U.S. reserve oil has been sold under every president beginning with George H.W. Bush. He sold 17.2 million barrels of reserve oil in advance of the 1991 Gulf War in anticipation of supply disruption that did not occur. In 1996 the Republican Congress led by Speaker of the House Newt Gingrich (R-GA) sold 23 million barrels of oil to reduce the federal budget deficit at a time when it was less than 80 percent full.

In other words, the oil in the U.S. Strategic Petroleum Reserve is not some sacred oil supply only to be used during an oil embargo or pipeline destruction.

Nevertheless, some Big Oil advocates and conservatives will undoubtedly oppose President Obama’s efforts to prepare for the next oil price spike, should it occur. It is no coincidence that higher oil prices yield higher oil company profits. Their interests coincide with those who will gain from the next oil price shock—not with those who will suffer from having their budgets drained due to spending more on gasoline.

Hopefully, President Obama will recruit our allies this weekend to commit to sell a relatively small amount of reserve oil to protect the middle class on both sides of the Atlantic, should another oil price spike occur.

Daniel J. Weiss is a Senior Fellow and Director of Climate Strategy at the Center for American Progress.

Thanks to Brian Katulis and Celine Ramstein for their assistance with this piece.

* The countries in the G-8 are Canada, France, Germany, Italy, Japan, Russia, the United Kingdom, and the United States.

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