Contingent Supply: The SPR in The Current Moment

This is the first piece in the Contingent Supply series, which looks at the operational requirements, financial needs, and economic opportunities involved in using the SPR to stabilize oil markets.

Soon after the Russian invasion of Ukraine, we announced a proposal to use the combined powers of the Strategic Petroleum Reserve (SPR), the Exchange Stabilization Fund (ESF) and the Defense Production Act (DPA) to stabilize oil prices and incentivize domestic production through the crisis. So far, the job has been half-done: the Biden Administration has undertaken the largest release in history which has considerably brought down the spot price of oil and announced a major regulatory proposal to allow the use of fixed-price contracts to acquire oil, but has not yet firmly, publicly announced a purchasing structure for refilling the SPR.

To recap our initial proposal, the Department of Energy (DOE) would have announced a series of exchanges by releasing oil in the spot market now, but with contractual commitments to refill the SPR at predetermined future dates. Although exchanges would have offered the benefit of immediate, defined future contracts–they would have required complicated, imperfect logistical and policy tradeoffs.

Our proposal has evolved considerably, most recently calling on the DOE to announce a repurchasing program through put options that pegged the price at which the government would buy oil at a level that ensured domestic production remained profitable. By pressing down on the front of the oil futures curve and pulling up the back, the plan was to reduce price and price volatility by limiting uncertainty for oil producers and households alike.

Recent developments in oil markets show how important it is to follow through on the second half of the SPR strategy. Oil prices have fallen substantially in recent weeks. While this was the goal of the initial SPR releases, we now face the risk of prices falling too much too fast, which would likely push oil producers to further curtail investment in future production, ultimately setting the stage for another shortage and severe price hike.

In determining the exact structure of refilling–the DOE and Biden Administration face a few challenges. In the near term, the SPR should be used to prevent a crash in oil prices. However, it is critical that this prevention be done in a way that supports domestic production over the medium term. Without support to domestic production, we risk price spikes in the future as oil supply and demand continue to gyrate. The repurchasing should be conducted in a manner that best balances these concerns, ensuring refill of the reserve is contingent on prices falling, while simultaneously using that contingency to eliminate tail risks for producers (and all without provoking consumption shifts back to fossil fuels!). If prices continue to fall, discretionary purchases should begin– perhaps immediately following the completion of the emergency release in a few weeks.

To boost domestic production in the medium term, our preferred approach would be to provide price insurance to producers by announcing a facility tasked with the sale of put options or contingency-based forward contracts. This would directly address price risks for producers while maximizing the government’s upside value, given the movement towards increased equity financing in the oil industry.

Alternatively, the facility could “twist” the futures curve by buying futures contracts (complemented by the sales of spot oil already conducted by the SPR). For producers (and investors) who already use futures to hedge against the risk of price movements, this would improve the most relevant price signal. From a market structure perspective, this approach makes sense to the extent that the particular class of producers we are worried about rely on debt financing.

The third approach – reportedly the DOE’s preferred – would be to take a “wait-and-see” approach, while making incremental discretionary purchases on the assumption that prices will continue to fall. This approach has significant drawbacks. If prices don’t continue to fall, or in fact rise, the SPR would not be refilled. Much worse, this approach is far less likely to engender a significant production response, as it provides producers with little to no uncertainty mitigation. Announcing a concrete, strategic repurchasing plan using a variety of tools best-suited to a diverse domestic industry would be far superior to employing a discretionary, “wait and see” approach.

Below a certain price it is no longer economical to drill new wells. The longer prices drift towards this range, the more difficult it will be to persuade producers to continue expanding capacity. These price risks are still there today.

We can see this risk in the fact that oil rig counts are already beginning to fall as prices come down from their earlier highs.

Now is the time to establish a contractual commitment to refill the SPR and support oil prices to prevent a further fall. While some may see this as an unnecessary windfall for oil producers, it stands to be an important plank in support of the climate transition. When oil prices fall, the incentives to switch to alternative energy sources diminish. Worse, when oil prices are excessively volatile, the profitability of investment in clean energy capacity is at risk of excessive volatility as well. Putting a floor under oil prices today will prevent the possibility of another round of price crashes like those seen in 2015 and 2020.

No matter how the war in Ukraine evolves, setting a price floor for US oil producers is key to mitigating Russia’s ability to inflict economic pain by withholding oil and other commodities. If Russian production falls, US supply will help offset, thereby better stabilizing global oil markets. If Russian production doesn’t fall, and the global supply of oil swells, those extra barrels will end up in the SPR caverns without substantially driving prices down and incentivizing further consumption. In fact, stabilizing oil prices may help prevent future inflationary spikes in energy costs, thereby lessening pressure on the Fed to deal with rising energy prices by hiking interest rates to slow the labor market.

Over this series, we will put forward a range of arguments covering the importance, the impact, and the possibilities involved in using the SPR to stabilize oil markets. As will be shown in a future analysis, the economic impact of setting up the SPR to be able to engage with markets in this way could be as significant as an additional 2 million barrels of production annually. Auctions could be used to directly incentivize additional production on the margins, with the SPR tailoring the sale price to that needed in order to increase total output. While the logistics of moving this volume of oil into and out of the SPR are complex, we will also be putting forward a strategy to ensure the plan comes off without a hitch.

Most importantly, there is no reason this strategy should be limited to oil in the long term. The climate transition will require large volumes of a wide range of primary commodities. Establishing a clear approach to the use of strategic reserves for market stabilization sets a clear precedent for the establishment of strategic reserves of other key primary commodities, like metal and minerals.

Oil prices are coming down too quickly. The time for the SPR to step in is now. Using the reserve to set a price floor will make things better for the climate, and better for the world.