x Abu Dhabi, UAEWednesday 26 July 2017

The other strategic petroleum reserves

Gulf oil producers are seeking innovative agreements to create stockpiles of their oil in key Asian countries.

China is focusing on the twin poles of securing long-term contracts with major existing and potential suppliers of oil across the world.
China is focusing on the twin poles of securing long-term contracts with major existing and potential suppliers of oil across the world.

Gulf oil producers are moving on innovative deals to establish stockpiles of their oil in the major consuming countries in Asia, which offer significant benefits. Walid Shihabi writes In December, Abu Dhabi delivered the first shipment of oil to a new Japanese strategic petroleum reserve. The crude is being stored in facilities that the Japanese government borrowed last year from Nippon Oil, the national petroleum company, then offered to Abu Dhabi National Oil Company. The UAE company aims to use Japan as a base for Asian oil trading. In return for providing storage, however, Tokyo has priority purchase rights to up to 4 million barrels of immediately accessible crude in the event of an energy crisis.

If oil is relatively cheap, why not buy it and store it? Strategic petroleum reserves (SPR) are a legacy of the Arab oil embargo of 1973, an event that thrust the concept of energy security to the top of the list of priorities for developed oil importing countries of the time. The following year, the International Energy Agency (IEA) was created under the umbrella of the Organisation for Economic Co-operation and Development (OECD). It included as a primary mandate devising a mechanism to safeguard member countries from the effects of severe disruptions in the supply of imported oil.

Member countries were required to hold as a minimum the equivalent of 90 days of oil imports and to commit to a joint strategy for addressing supply disruptions. The practice of stockpiling massive amounts of crude oil, both in terms of privately held domestic supplies as well as government-owned and maintained strategic oil reserves, was born. At the end of last year, the 26 member countries in the IEA collectively retained a stockpile of about 4.3 billion barrels of oil. The US government retains the largest government controlled SPR with a capacity of 727 million barrels, and current reserves of close to that amount.

Other major oil importing countries outside the OECD umbrella have also more recently initiated their own plans for strategic stockpiling of petroleum, most significantly China, which has been actively building an SPR, the capacity of which may rival that of the US by 2020. This is in no way surprising given the fact that China today imports more than half its domestic consumption and has a ferocious and rapidly growing appetite for energy. The country is the second-largest consumer of oil after the US.

In that light, energy policy in China has recently focused on the twin poles of securing long-term contracts with major existing and potential suppliers of oil across the world, as clearly demonstrated by their massive push into Africa over the past decade, and building a robust domestic energy infrastructure. This includes upgrading the country's energy-transport capability, expanding its domestic refining capacity (with an eye to flexibility in order to be able to source different grades of crude from a diversified list of producers) and a large strategic reserve to guard against potential supply disruptions.

And it is somewhat a result of China's drive to secure its energy sources that a new kind of SPR may soon emerge. This new form would not be held by major oil importing countries, but rather by the major oil exporting countries of the Gulf. Even more novel would be the fact that the reserve would be stored at the point of most likely consumption, rather than at the point of ownership. In 2005, the energy economists David Nissen and David Knapp coined the term "forward commercial storage" to describe a proposed strategic reserve system in which low-cost OPEC producers provide or utilise storage facilities located in consuming regions under the producer's commercial control, but with a call option sold to the consuming country for strategic reasons. A variation of this proposal would be the retention of a right of first refusal by the consuming country in the event of the activation of the reserve.

The proposal seemed to carry some resonance in China, as one year later, high on the agenda of the Chinese president Hu Jintao's visit to Saudi Arabia was a proposal to house a Saudi SPR in the country. Significantly, this proposed partnership would help address part of China's energy-security requirement and boost Saudi Arabia's attractiveness as a preferred and secure supplier to one of the world's largest consumers. At the same time it would offer the kingdom some oil-revenue protection in the case of any temporary disruption.

Additionally, it would enable the kingdom to use its excess production capacity (estimated at more than 2 million barrels per day) for filling this reserve without breaching its OPEC production quota, as the oil for the reserve would remain under Saudi ownership and control. Assuming the accuracy of assumptions regarding the excess production capacity of Saudi Arabia, a strategic reserve of 100 million barrels could potentially be filled in months and a 500 million barrel reserve well within a year. This would represent a measurable overground reserve that would be capitalised and potentially valued (in the latter example) at more than US$30 billion (Dh110.19bn) at recent prices. All this without a significant impact on crude prices or market conditions, except maybe a slight reduction in the risk premiums incorporated into oil prices.

Of course, that would require the availability of a suitable location to store the reserves, a significant investment into the required facilities and surrounding infrastructure and a readily accessible and compatible market. The latter condition is served well by the growing energy partnership between China and the kingdom, which has during the past four years seen massive joint investments into refining and petrochemical facilities in Fujian, China, geared exclusively for Saudi oil. Saudi Arabia has become the largest single supplier of imported oil to China, while GCC countries accounted for almost 40 per cent of China's oil imports last year.

While the potential Saudi Arabian SPR in China will be the most significant such development, it seems that it may not be the only one. Although Kuwait, which has invested significantly in boosting its oil supplies to China, has come out clearly denying any intention to establish an SPR in China or anywhere else in Asia, the UAE may be pursuing an SPR in South Korea, which represents another important Gulf-Asian energy partnership.

With the rhetoric across the Gulf continuing to harden and the Strait of Hormuz remaining the strategic bottleneck through which all the Gulf's oil is shipped, it seems that the spectre of significant Gulf-owned SPRs in Asia may, and probably should, become part of the oil market spectrum in the not too distant future. Walid Shihabi is the former head of research at Shuaa Capital and now a freelance consultant and writer