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Use US Strategic Reserves

Years-long reserves will keep prices, and US economy, stable

THE Iraq-Kuwait crisis is an ideal opportunity to use the US Strategic Petroleum Reserve (SPR) to minimize the cost of the US economy of an oil embargo that is designed to do maximum damage to Iraq. The SPR was established to sustain oil supplies in a national security crisis, and that is precisely what we face. Moreover, the current crisis is likely to lead to a shortfall in oil supplies large enough to make it worthwhile to use the SPR, but not so large as to create doubt as to our ability to control oil prices. The US military moves into Saudi Arabia, the closing of the Iraqi pipeline by Turkey, and the overwhelming support for tough sanctions against Iraq from Western Europe, Japan, the Soviet Union, and the UN, appear to be leading to a near cutoff of Iraqi trade. This will require also denial of Iraqi use of the pipeline through Saudi Arabia and a blockade of tankers carrying Iraqi and Kuwaiti oil through the Persian Gulf. An effective embargo, reinforced by pipeline cutoffs and a blockade, would remove some 4.5 million b/d of crude oil from world markets, while halting Iraq's earnings of foreign exchange. Seepage through the blockade would be limited to the oil that could be trucked. The loss of crude oil to the world market would, therefore, be around 4 million b/d, or 7 percent of world oil consumption.

A loss of this magnitude probably could not be fully offset by new production elsewhere. Saudi Arabia has shut in much of its formerly massive excess capacity and would need a year or more to re-drill wells. CIA publications put ``available'' Saudi capacity at 7 million b/d, or some 1.5 million b/d above recent output. Some estimates of ``available'' Saudi capacity go as low as 6.5 million b/d. Substantial excess capacity appears to exist also in Venezuela and Iran (500,000 b/d each), the UAE and Libya (200,000 b/d each), and Nigeria (100,000 b/d). It is by no means certain that all these countries will be willing to produce at full capacity. On the other hand, some countries may be willing to produce at higher rates to take advantage of higher prices. Overall, it seems reasonable to expect that 3 million b/d of new production will be available, leaving only a small shortfall. Such a shortfall could be covered by increased use of other energy sources - natural gas and coal - and by conservation. Sizeable increases in oil prices would be necessary, however, to induce these actions. They would also cause reduction in economic growth that would lower oil demand.

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Even as small a shortfall as 1 million b/d of crude oil is enough to induce a massive price increase unless strong action is taken. Neither the 1973 Arab oil embargo nor the 1979 oil crisis actually resulted in a major decline in oil supply. What directly caused the tripling in oil prices was a huge increase in demand due to speculative and precautionary stock building. The fear of shortages and the expectation of price increases induced everyone - from the consumer to the wholesaler - to increase stocks. The boom in inventory demand rapidly pushed up oil prices until market psychology turned around and a rapid price fall followed.

Currently, the oil market is more volatile than in the 1970s. Even such a relatively minor incident (in terms of affected oil supply) as the Alaskan oil spill triggered a brief several cents a gallon increase. The Iraqi crisis has the potential to raise prices beyond $40 a barrel, with very disruptive economic effects.

This is where the SPR comes in. The use of the SPR would be not only to fill a potential shortfall, but even more to convince the private sector that future oil price increases will be limited, so the incentive to accumulate stocks will disappear. But to achieve this end, government SPR policy must be believable - that is, there can be little doubt as to the ability and will of governments to make the policy stick. Otherwise, the private sector will simply draw from official reserves.

The SPR, together with the strategic reserves of other members of the International Energy Agency (IEA), are ample to cover the current shortfall for a long time. The US SPR alone is nearly 600 million barrels. Japan has 200 million. There's enough oil to cover a shortfall of 1 million b/d for three years, and one of 2 million b/d for a year and a half.

In the likely case that the crisis lasted six months, only one sixth of the strategic reserves would have to be drawn down. The US would probably be able to stabilize the market using only the SPR, but there are economic and political reasons to release strategic reserves on a coordinated international basis. Cooperation through the IEA would maximize strategic reserves and avoid the politically sensitive problem of using ``our'' national security assets to support other countries.

However, as much depends on the price strategy as on the volume of reserves. The price at which strategic reserves are released must be high enough to stimulate widespread substitution of other oil and non-oil sources, but low enough to prevent severe damage to US and world economies. It must also be higher than the price the market can expect after the crisis ends. If not, some will buy oil now from the SPR and hold it. Although oil prices were in the mid-teens before the start of the crisis, many expected a firming next year to $20 a barrel. It will probably take a price of at least $25 a barrel to induce most countries with excess capacity to bring this capacity into production and to stimulate shift from oil to other energy sources. A price of $30 a barrel or above would stimulate more substitution, but do greater economic damage. Some believe that even a $25 price will nudge the US economy from slow growth to recession, but there is little doubt that a $30 price would bring a US, and possibly a global, recession.

In my view the US, in cooperation with the other IEA countries, should quickly move to set a price ceiling for crude oil in the range of $25-30 a barrel by being prepared to release oil from strategic stockpiles. It is not certain whether the price ceiling should be announced from the beginning or whether such an announcement should follow a period of trial and error. Such a policy would hold the loss of real income in the US and other oil consuming countries to moderate amounts, thus making it easier to turn all the screws - food, military supplies - on Iraq. Once convinced the international community was prepared to continue the embargo as long as necessary, it is difficult to imagine why any rational Iraqi would wish to continue its defiance. Unlike the situation during the war with Iran, Iraq's territorial integrity and its political and social systems are not at risk. Saddam Hussein is capable of pursuing irrational policies that do severe damage to his country, but there will be increasingly powerful pressures in Iraq to remove him from power. It seems reasonable to expect that the crisis will be resolved within 6 months, and possibly sooner. In that event, use of the strategic reserves may not even result in any net drawdown. But they will have served their purpose.