The Blog

The UK and the US Should Not Release Their Strategic Oil Reserves

The UK and the US, along with France and Japan, are currently debating the release of their strategic oil reserves. This is in response to rising oil prices, today at $124 per barrel (Brent), threatening to destabilize an already fragile world economy. Despite its seemingly beneficial effects (i.e. lower oil prices), this policy is plainly wrong.

Oil markets are textbook economics' favorite example. Prices are set by changes in supply and demand. On top of that, you have a global cartel as well as external shocks to spice things up. Notice the big spikes in oil price after any mention of potential disruption in production in the Middle East or the huge drop in price (from roughly $140 to less than $20) during the first few months of the 2008 financial crisis. Oil prices are extremely sensitive to geopolitical developments and have a long history of sudden changes. Nevertheless, recent volatility has been unprecedented.

Because of oil's crucial role in the function of modern economies, governments and consumers are understandably cautious about increases in price. According to some estimates, a 10% rise in oil prices tends to lower US and EU gross domestic product by 0.2% after one year. This is a significant threat, especially at a time when private and public borrowers are deleveraging. However, artificially lowering oil prices by releasing strategic oil reserves is inefficient and adds a major distortion to the energy marketplace. Two points stand out:

First, the policy, even if implemented in a proper and coordinated manner, will do little to address rising oil prices. The reason for the recent price hike is not supply disruption (e.g. sanctions to Iran) but an increasingly obvious imbalance between demand and investment in new field exploration. To put it simply, there is less of the thing while the planet is getting increasingly thirsty. This conclusion is shared by the majority of experts in oil economics and recent studies by Goldman Sachs and the International Energy Agency. Iranian threats do play a role but the bottom-line is clear: with demand for oil from developing markets (especially India and China) surging, a 'cozy' $20 price per barrel is unrealistic.

Second, and most important, the release of strategic oil reserves distorts the function of the energy marketplace and with it the fight against global warming. Low oil prices decrease the attractiveness of other less emission-intensive energy sources and, consequently, their chances to get adopted. Why would anyone switch to expensive wind power when there is plenty of cheap oil and an implicit government guarantee that prices will stay low? Or, why would American households get rid of their SUVs if prices do not reflect the true cost of oil? This is not just an issue about today but primarily about the incentives that will shape investment and energy usage in the medium- and long-term.

But even for those less inclined towards 'saving the planet', there is no basis for such policy. Releasing oil reserves amounts to subsidizing the oil industry and penalizing other market participants. This is unfair and contrasts economic theory's basic premise that markets are better left alone. It is indeed ironic that the proponents of free-market capitalism are supporting blatant market interventionism in oil markets. Sadly, they don't show the same zeal when it comes to regulating financial markets.

Of course, when it comes to poor policy-making there is a usual culprit, upcoming elections. The Obama administration is keen to be seen as responsive to the threat of rising oil prices in view to US presidential elections. It is thus vocal about its intentions to intervene and actively encourages other countries to do so. Yet, the US government's stance is adding a major blow to the struggle against increasing greenhouse gas emissions by effectively discarding one of the most efficient weapons against global warming. There are few measures that do not need legislative approval and can in fact make a difference for energy usage. We better let oil prices rise and leave the market decide the most efficient of the less carbon emission-intensive energy sources.