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Report | May 2015

Exploring strategic reserves

The reserves on which the government is presently working are not typically meant for hedging against price risk, but against supply chain disruptions.
The Government of India (GoI) had in 2004 decided to set up 5 million metric tons of strategic crude oil storages at Visakhapatnam, Mangalore and Padur, in order to ensure energy security, which in addition to the existing storages of crude oil and petroleum products with oil companies, serve as a cushion in response to external supply disruptions. The construction of the proposed strategic storage facilities is being managed by Indian Strategic Petroleum Reserves Limited (ISPRL), a Special Purpose Vehicle, owned by the Oil Industry Development Board (OIDB). In 2011 India stated a goal to augment the crude reserve capacity to 132 million barrels by 2020, with the long term aim to have strategic reserves that are inline with the targets of Organization for Economic Co-operation and Development (OECD), who maintain a 90 day buffer as strategic reserves. India has also announced a second phase, to progress in that direction.

Thus, four more caverns of 12.5 million tonnes capacity are expected to be built, for which the Bikaner, Rajkot, Chandikhol and Padur locations have been identified. The projects initially lost a lot of time as governments changed, but plans were re-reviewed and have finally picked up pace in the last couple of years, with first phase storage now nearing completion. Here is a summary of the locations, capacities and completion status for phase I. (See table below) While filling of this reserves a year ago would have cost $4.3 bn and a month ago cost $1.9 bn, the dip in oil prices has been an excellent opportunity which has reduced the cost of filling up these strategic reserves to approx. $2.3 bn. However delays in construction and funding approval risk increasing this cost. Given that construction is almost complete, one would have expected that the contracts to purchase oil were already negotiated and locked in for delivery in Feb, however, it looks like funding for this is not available yet and we may have to wait for the budget to provision for the money need for it.

On the other hand, China has used this opportunity to accelerate building its strategic reserves. According to Reuters, China imported record shipments of crude in December and estimates suggest that it doubled the oil put aside for strategic reserves in 2014 compared with 2013. It also set out a three phase plan to fill its oil reserves to eventually get to a target of 90 days of net imports. The first phase of the government emergency stockpile is storing about 91 million barrels of crude oil, or about nine days of oil use and the second phase is designed to hold 170 million barrels. All of phase 1 has been filled and estimates suggest that two of seven sites in the 191 million-barrel second phase were completed last year and have been filled in 2014. Construction has also begun on two of the three sites for the third phase. It is estimated that they already hold about 30 days worth of crude imports in their SPR. Along with this, a huge amount of commercial reserves have also been setup that Argus estimates at 260 million barrels.

Let´s look at what is the intent of strategic reserves. There is no golden rule for how to use SPRs. These are not reserves that are typically meant for hedging against price risk, but used to hedge against supply chain disruptions. For example, if the Persian gulf were to get blocked because of war, then India would be at significant risk during this time and draw down on the SPR to ensure that the country can continue to function. The US for example has built reserves of approximately 692 million barrels and has only dipped into that bucket 4 times when there were hurricanes/storms etc., which disrupted the supply chain. In such situations, the price of oil is not the biggest concern, but continuity of supply is a far more important factor.

The buildup and drawdown policies can be influenced by many factors, including oil-market elasticity, unit stockpile holding costs, disruption and disruption-continuation probabilities, maximum reserve capacities etc. So not to say that at some point India cannot use the reserves to hedge against price risk, however, the main driver behind this is avoiding supply disruptions.

This exposes an interesting strategy for filling reserves without paying a lot of upfront money for it.

An idea called forward commercial storage agreements allows oil-exporting countries to store petroleum at an oil-importing country. Here the reserves are technically under the control of the oil-exporting country, but in force majeure situations, the oil importing country has the first right of refusal to this oil. This would mean that we would already have oil in storages located in India and we can access it by paying market rates when such a situation arises.

This would elevate the supply chain risks, reduce the procurement cost and potentially help the oil producing countries work around their production quotas by producing more now, for sale later. Countries like South Korea have used this model successfully to augment their SPR and it is heard that the Indian government is working with Kuwait and Abu Dhabi to try and negotiate a similar contract. Given how crude prices are right now, I would say our first preference should be to fill reserves using our own money, as this would help us use this to mitigate some price risk if needed in the future. However if the fiscal deficit ends up being a big factor, we should look at forward storage agreements and fill out these reserves as soon as possible, as OPEC countries may now be more willing to negotiate such deals. This will at least hedge against the supply chain risk. To be sure, building up the reserves is not an exercise that can be completed tomorrow. The US government established its Strategic Petroleum Reserve in 1977, following the 1973-74 Arab oil embargo, and built their approx. 700 million barrels of strategic reserve gradually over two decades. While we have just begun this journey, current oil prices gives us great opportunity to manage and reduce the cost of this activity and I hope the government is working fervently to expedite this.

Authored by Aditya Gandhi, Director, Sapient Global Markets (India)

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