Can the US and China bring oil prices under control?

To rid the world of fossil-fuel subsidies, oil prices need to be stabilised. China and the US have made a good start.

The US oil popularly known as “Texas crude” is a lighter and sweeter grade than Brent crude from the North Sea. It has the lowest sulphur content among comparable crudes – at 0.24% – followed by Brent, at 0.37%. As the light and sweet grades are easier to process for common retail fuels like petrol, and they create low pollution, they have historically been more expensive than their heavier counterparts. The price of Texas crude was  traditionally around 5% higher than that of Brent sweet, which in turn sold at a premium over sour grades like Dubai and Venezuelan crudes.

Read more: How speculators manipulated the oil market
Also: Why lower oil prices hold the key to renewable energy

But over the past year, something remarkable has happened. Texas crude is now at least 20% cheaper than Brent. This dramatic turnaround is rooted in US energy-security policy – and offers insights into prospects for calming the volatile oil market.  If other large consumers follow the US lead, they could reduce volatility and the price of crude oil, thus freeing up billions of dollars currently locked up in fossil-fuel subsidies

How Texas crude got cheaper

The West Texas Intermediate [WTI] index of crude is benchmarked from the Cushing hub, the world’s largest crude storage facility located in the state of Oklahoma. The price of Texas crude usually fluctuates with the amount of inventories at Cushing because the buying can be modulated by the tank-farm owners when inventories are high to avoid price peaks. President Obama’s “all of the above” energy strategy – increasing US offshore and shale-oil production as well buying from reliable American sources like Canada and Brazil to reduce dependence on Gulf imports – anticipated rightly that increasing domestic storage and production capacity would reduce prices as well as long-term dependence on oil from volatile regions.

The strategy included a major thrust towards domestic storage, pipelines, refineries and drilling, with federal funds allocated in the energy budget for each sector. At the end of 2009, the installed tank-farm capacity of crude oil at Cushing was 46.3 million tonnes with a stored inventory level of around 30 million tonnes. By May 2012, the installed tank-farm capacity at Cushing was a third more, while stored crude went up by 50% to 44 million tonnes.

The jump in domestic storage capacity at Cushing and the decision to reduce dependence on foreign oil has had a salutary effect on the price of Texas crude. Over the past year, as inventory capacity at Cushing has risen, the spread between WTI and Brent oil has reversed, leaving the superior Texas crude priced at least 20% lower than the Brent sweet grade. In effect, the Midwest Americans who in the past were buying oil at higher prices reduced their energy costs by a quarter compared to their European or Asian counterparts within a year of increased storage. Now, with a network of pipelines connecting the Midwest to coastal refineries, the benefits of higher inventory levels will soon be felt throughout the United States.

The recently commissioned Seaway pipeline, which reverse-pumps 150,000 barrels of crude from the Midwest to the offshore refineries at Freeport Texas, is set to pump 850,000 barrels a day by 2014. This would help the cheaper domestic shale-oil further reduce imports that have already dropped by nearly 10% during the Obama years. Will the gap between Texas and Brent oil grow further, or will it shrink? And why are other Asian and European nations not stepping up their stored oil reserves to temper the speculation in oil prices?

China builds crude carrier fleet

The United States is not the only country to have used market-based techniques to temper buying prices of crude oil. Another big energy user, China, has been doing the same. This is despite the fact that China has not enjoyed the enormous storage capacities built up by the US since the OPEC oil embargo of the 1970s. Rather, China had less than 100 million barrels of storage capacity when oil spiked to US$145 per barrel in the summer of 2008, months before the crash of global financial markets in September that year.

But China too sensed the problem and had the financial muscle to put its plans into operation quickly. Chinese shipping giant COSCO had already taken action to augment its oil-tanker capacity, which would help it build inventory levels by placing orders for 20 bulk oil carriers with state-of-the-art Greek Shipyard Piraeus at a cost of US$2.3 billion. Eventually, it not only increased the purchases of crude carriers, but also invested in Piraeus.

Chinese leaders were aware that energy costs would spike again when the economy recovered and it would be important to augment both storage and handling capacity of crude oil. So while the Greeks started delivering the oil tankers, China started simultaneously leasing out the very large crude carriers (VLCCs) directly from the markets, giving a double boost to their handling capacity.

The global recession had already severely damaged the tanker trade and hiring rates had dipped below US$1 per barrel per month. By January 2010, China had started buying oil far in excess of its monthly needs. It was hiring tankers to store oil at sea, taking advantage of favourable conditions in the futures market – where oil traders bid on the hypothetical pricing of crude oil say six months or a year down the line. In January 2010, the margins in the futures market were such that a trader who bought oil at US$80 a barrel that month could make a profit of US$5 per barrel by simply holding the oil at sea for three months. By holding onto it until September, they could make US$12 a barrel

Such highly speculative positions of the future markets brought immense profits to future traders but also opened opportunities for bulk buyers like US and China who stepped in to spike the profiteering.

Both the US and China stepped up purchases of crude oil when prices ebbed, and slowed buying during peaks. Mitigating risk through “price inversions”, that is heavy buying when prices dip and stopping purchases during price surges, is a time-tested method to reduce price volatility. This makes it difficult for the speculators to hold stocks as the cost of storage is often more if market prices dip due to sudden slackness in demand from big buyers. When China and the US stockpiled heavily in the first half of 2010, hedge funds, Wall Street banks and bull operators panicked and squared up.

Building storage critical to lower prices

China has made massive investments in building its tank farms and oil-tanker capacities over the last few years. Brightoil, a Chinese firm set up in 2009 with an asset base of over US$1.5 billion, sub-leased around 100,000 tonnes of storage capacity off Singapore and 450,000 tonnes in south China to become the largest regional trader of marine oil. Dutch chemical giant Vopak is helping China build a massive 32-million barrel crude oil storage facility at the southern island of Hainan at a cost of US$1 billion. An additional US$5 billion investment that would help raise China’s oil storage capacity to 500 million barrels by 2015 is in the works.

To temper oil prices and reduce volatility, major oil-consuming nations need to build their oil-tank farms to hold enough oil for at least 120 days of consumption. Currently, most OECD nations have 60 to 90 days storage capacity. China and India have 12 weeks and two weeks storage respectively. The Asian giants, as net importers, paid out over US$22 billion and US$21 billion respectively in subsidies last year. In real terms, this investment on tank farms would be around US$10 billion, which is less than the speculative losses incurred annually to buy crude oil. With 120 days storage capacity, the spot buying decisions in the futures markets that form nearly a quarter of the total buying each year can be conveniently modulated and prices reduced.

Reduction of oil prices is key to removing fossil fuel subsidies in most developing nations as well as in the United States. If oil subsidies are removed, billions of dollars of energy subsidies currently handed out can be pumped into the renewable energy sector, today the poor cousin due to the harsh economic realities of high energy prices.

Read more: How speculators manipulated the oil market
Also: Why lower oil prices hold the key to renewable energy