White House uses oil reserve to place giant spread trade: Kemp

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LONDON — US President Joe Biden has pledged to make an average of 1 million barrels of crude per day available from the Strategic Petroleum Reserve (SPR) for the next six months after consulting with other IEA members.

The unprecedented release of 180 million barrels is aimed at allaying supply concerns and curbing upward pressure on prices following Russia’s invasion of Ukraine and the imposition of sanctions in response.

The inventory release is meant to “serve as a bridge through the end of the year when domestic production increases,” according to a statement released Thursday by the White House.

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Proceeds from the sale will be used to restock the SPR for years to come, ensuring it remains available to meet future emergencies (“President Biden’s Plan to Respond to Putin’s Rising Pump Prices” , White House, March 31).

The aim is to ease upward pressure on spot prices by increasing the amount of oil immediately available, while supporting long-term futures and encouraging more drilling by committing to buy back oil later.

Indeed, the White House engaged in a giant swap of 180 million barrels to allay concern over a sudden reduction in Russia’s oil exports as a result of war or sanctions.

SHORT-RUN THE SPREAD

Over the past few weeks, traders have attempted to “buy” the calendar gap, buying futures with close delivery dates and (in some cases) selling contracts with longer delivery times.

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As a result, prices for nearby futures have risen much faster than those expiring later in 2022 and 2023, as traders anticipate a sudden shortage of crude oil, heavy fuel oil and diesel exports from Russia.

Brent futures for June 2022 deliveries had risen nearly $41 a barrel (54%) as of March 25 from the end of 2021, while futures for December 2023 deliveries n increased by only $19 (27%) over the same period.

Brent’s six-month calendar spread hit a record low of over $21 in early March and was still trading in a low of over $18 at the end of last week.

Intense upward pressure on nearby futures has rippled through the supply chain and helped drive up retail gasoline and diesel prices (https://tmsnrt.rs/3iYeHmd) .

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The White House plan in effect uses the SPR to take the other side of the trade, “selling” the spread by selling physical oil in the spot market with the promise of buying it back later.

The main impact should therefore be on the calendar spreads themselves mainly via the prices of the futures contracts closest to delivery.

Following the SPR’s announcement, Brent’s six-month calendar spread has already narrowed to a discount of $9, still historically high, but the lowest since before the invasion of Russia in late February.

The spread between futures contracts for June and July has halved to less than $2 a barrel from a peak of more than $4 early last month.

The promised SPR sales should reduce concern over a physical shortage of oil and relieve some of the recent illiquidity in futures markets by creating a de facto willing counterparty to traders betting on higher oil prices.

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VOLATILITY MANAGEMENT

Prior to this week’s announcement, President Biden had already ordered the release of 32 million barrels of crude from the SPR in November 2021, with oil to be replaced between 2022 and 2024.

Past sales were made in response to the civil war in Libya (30 million barrels), Hurricane Katrina (11 million barrels) and the first US-Iraq war (17 million barrels), with volumes weaker on other occasions.

But the current version eclipses the previous ones and implies that the objective of the reserve shifts from compensating for physical shortages to managing prices (“Historical SPR oil releases and exchanges”, US Department of Energy).

Governments have always maintained stocks of food and other essentials to ensure supplies for vulnerable urban populations, military forces, respond to famines and other catastrophic supply disruptions, and manage prices.

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The SPR was created in the 1970s in response to the Arab oil embargo and its primary purpose was to maintain military readiness and manage risks arising from supply disruptions and physical shortages.

But the SPR increasingly resembles China’s National Food and Strategic Reserve Administration, which has military and strategic functions but also regularly buys and sells stocks to smooth excessive price volatility.

The National Administration of Food and Strategic Reserves draws on an earlier tradition of “ever-normal” granaries and other granaries maintained by the Qing and Song dynasties.

Still normal granaries regularly bought and sold grain to compensate for price variations from season to season and year to year, as well as to meet shortages and famines.

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In recent years, China’s Reserves Administration has also bought and sold oil, industrial metals and agricultural commodities with the explicit aim of reducing excessive volatility. The State Reserve Administration bought commodities during downturns in the business cycle to support prices and struggling producers, then resold them during booms in an attempt to calm the price spike.

The increasing frequency and scale with which the SPR is used strongly suggests that its function is evolving in the same direction.

Filling granaries, always normal, has always been controversial, more difficult than emptying them, as it tended to drive up prices and could prove unpopular with consumers. The ever-normal granaries were normally filled at harvest time, when grain was plentiful, and especially after a bumper harvest, when prices were low.

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Still-normal granaries often went through cycles of depletion and replenishment that could last for years or even decades (“Nourish the people: the state civil greary system in China 1650-1850”, Will and Wong, 1991).

The White House has said it intends to top up the SPR in the coming years – when prices are likely to be lower than they are now.

Assuming the promise is kept, the ideal time to fill the reserve will be during the next downturn in the oil market, when the SPR would not be competing with consumers for scarce barrels, purchases could help support prices and support domestic producers.

If this is the case, the SPR will have become a de facto price risk manager.

John Kemp is a market analyst at Reuters. Opinions expressed are her own (Editing by Louise Heavens)

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