The crisis in Ukraine escalated this week after the pro-Russia Crimea region voted to secede. On Tuesday, Russian President Vladimir Putin signed a treaty with Crimea's new pro-Russian premier on joining Russia even as the U.S. and European Union (EU) opposed the move and called it a violation of international law. The U.S. and EU are now considering several measures to punish Russia. After the U.S. conducted a test sale of crude from its Strategic Petroleum Reserve (SPR) last week, there are calls for the U.S. to release more oil from its strategic reserves to push down oil prices. Proponents of the measure say that such a move will hurt Russia, given its reliance on oil prices. While that will certainly be one result, the move would also have implications for U.S. and European oil producers.
Tapping the SPR
The SPR has been set up by the U.S. Department of Energy (DOE) to maintain fuel supply during an emergency. The reserves, which total 727 million barrels, were last tapped in 2011 when the civil war in Libya disrupted oil supplies.
Last week, the DOE tapped the SPR for a test sale, the first ever such sale since 1990. The DOE released 5 million barrels of oil from the SPR. Among the bidders for the oil were majors such as ExxonMobil (NYSE:XOM) and Royal Dutch Shell (NYSE:RDS-A).
While the DOE said that the release was under discussion for a while, there was speculation that the U.S. tapped the strategic reserves to send a message to Russia that it could push prices lower by unleashing oil from its SPR. Jay Carney, White House Press Secretary, denied that the release was related to the Ukraine crisis and said it was done only for operational purposes.
It is likely that the U.S. administration conducted the test sale for operational purposes only, and has no intention of using its SPR to push down oil prices and hurt Russia. But there have been calls for the U.S. to do so. In an op-ed in the Financial Times, Philip Verleger of the University of Calgary argued that if the U.S. released 500,000 to 750,000 barrels per day of oil, which would push down prices by $10 to $12 per barrel. Such a drop in oil prices would hurt Russia significantly, given that the country relies heavily on oil and gas revenues. According to professor Verleger, since Russian gas monopoly Gazprom (NASDAQOTH:OGZPY) links the price of the gas it supplies to Europe to crude oil prices, the move would also hurt Russia's revenue from gas exports to Europe. The move would make a significant dent on Russia's GDP, according to him. But, lower oil prices would also have a negative impact on U.S. and European oil producers' bottom lines.
Producers need higher prices
Western oil majors such Exxon, Chevron (NYSE:CVX), and Shell have spent heavily over the last few years to boost production. While their oil and gas production has not shown any significant growth, years of heavy investment has resulted in a substantial increase in their debt levels. At the end of 2013, Exxon had $22.7 billion in debt on its balance sheet at the end of 2013, almost double the amount of debt at the end of 2013. Chevron's total long-term debt rose from $12 billion at the end of 2012 to $20 billion at the end of 2013.
Reducing debt levels is a priority for oil majors as is maintaining shareholder distribution. For that they need to reduce capital spending and boost production. But they also need robust oil prices. Recently, Chevron and Exxon had modeled their projections on an oil price assumption of around $110 a barrel; a level which I believe is a little too high given the demand and supply factors.
As I noted in a previous article, Brent crude could average between $100 and $105 a barrel over the next two-three years. At that level, Chevron and Exxon could struggle to meet their cash flow projections, given that they are based on an oil price of around $110 a barrel. If oil prices are pushed another $10 lower as suggested by Philip Verleger by releasing oil from the U.S. SPR, it could have severe consequences for U.S. oil producers such as Chevron and Exxon. While the move would certainly hurt Russia, it could end up hurting U.S. and European oil and gas producers even more.
Varun Chandan Arora has no position in any stocks mentioned. The Motley Fool recommends Chevron. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.