Reserve action to cut risk of oil super-spikes

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The oil market is entering a new era in which the International Energy Agency, the western countries’ oil watchdog, could play a much more interventionist role than in the past, diminishing the prospect of oil price “super-spikes”.

For the past two decades, the IEA has seen the strategic petroleum reserve as the oil market equivalent of a nuclear weapon: only to be used in the most extreme circumstances, such as a huge loss of supplies after a terrorist attack on oil installations.

The doctrine, with former US vice-president Dick Cheney championed, also maintained that western nations would take a passenger seat in a crisis, allowing Saudi Arabia, the world’s largest oil exporter, and the rest of Opec to deal with the outage.

Oil traders knew that and speculators felt comfortable pushing up prices on the back of small production glitches, which were not deemed big enough to trigger a release of the reserve but still substantial enough to leave the market temporarily short of supplies.

The past decade is full of examples of inaction by IEA countries and the impact on prices. These include the oil strike in Venezuela in late 2002 and early 2003, which removed more than 2m barrels a day of oil, the US-led invasion of Iraq in 2003, which knocked out nearly 3m b/d, and the sabotage of oil infrastructure in the Niger Delta in Nigeria in 2005, which removed 800,000 b/d.

The IEA first released the reserve in 1991, on the first day of the military campaign to remove Iraqi forces from occupied Kuwait.

The second use came after the devastating hurricanes Katrina and Rita in 2005, which paralysed oil production in the US Gulf of Mexico and a swathe of refining capacity.

Oil consultants and current and former energy officials say the IEA – and Washington – are signalling a new course. From now on, the strategic petroleum reserve will be deployed as a ‘smart bomb’. As such, the IEA’s action now reduces substantially the chances of further price spikes such as the one triggered by the outbreak of civil war in Libya.

“Over the last eight years there was a failure to use the strategic petroleum reserve even when it was clearly necessary,” says David Goldwyn, a Washington-based consultant and until recently the US state department’s top diplomat for energy affairs.

Robert McNally, president of consultants Rapidan Group in Washington and the top White House oil adviser from 2001 to 2003, says the IEA’s message to the market is: “If Opec cannot put a ceiling on the oil price, we will do it”.

The ‘smart bomb’ approach will have a significant influence on long-term price expectations, analysts say. Michael Wittner, global head of oil research at Société Générale in New York, says that political risk, particularly in the Middle East, and the associated threat of supply disruption were bullish for oil.

“But this is the opposite,” he says. The new risk, the prospect of stock releases by the IEA, is “a bearish sword hanging over the head of the market”.

Indeed, the release is likely to have a far-reaching impact on the market in coming weeks and months. The market was already anticipating weaker prices due to the faltering economic recovery in the US and the arrival of extra production from Saudi Arabia. The release is well timed to add to any downward pressure on prices.

Bullish hedge fund traders were on Thursday reviewing their oil price projections. As David Kirsch, head of market intelligence at consultants PFC Energy, puts it, the release has changed the “oil market psychology” for now.

Until recently, the talk among traders was about the risk of prices moving back to $120 a barrel. Now, it is about whether Brent crude, the North Sea benchmark, will drop below $100.

David Greely, energy analyst at Goldman Sachs, immediately cut $10-$12 off his 3-month forecast, lowering it to $105-$107, while Hussein Allidina, head of commodities research at Morgan Stanley, said the release created a $10 a barrel downside risk to his $120 a barrel oil price forecast for 2011.

“The IEA’s move limits the near-term upside to oil prices,” says Lawrence Eagles, head of oil analysis at JPMorgan in New York. On Thursday Brent was trading down $6.90 at $107.31 a barrel.

Yet, the release is more likely to put a ceiling on prices rather than trigger a crash. The barrels from the reserve will offset the loss of Libyan crude, rather than flood the market. Oil demand growth remains healthy, particularly in China. Thus, the impact of the release is likely to be more targeted than had the IEA gone “nuclear”.

Additional reporting by Jack Farchy in London

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