America May Have Just Unveiled a New Weapon to Combat Russia's Action in Ukraine

"The supreme art of war is to subdue the enemy without fighting." 
-- Sun-Tzu, The Art of War

Source: Wikimedia Commons.

There are lots of weary eyes looking at the situation between Russia and Ukraine. Russia has already annexed Crimea, and a very sizable army has been deployed to the Russian-Ukranian border that has many worried there may be more to the conflict. There is little appetite for a military response from America and its Western allies, and the response so far has some concerned it isn't enough to make any significant impact. Recently, though, the U.S. government did something it hasn't done in almost 25 years, and it could be an indication of how the U.S. will retaliate. 

Source: U.S. Department of Energy.

The world's most powerful weapon: Oil
For several years, the United States' Strategic Petroleum Reserve, or SPR, has rarely garnered any attention, mostly because it is used so sparingly. Since 1977, when it was implemented, there have been only a handful of times that it has tapped, the last being in 2011, when President Obama authorized the release of 60 million barrels in response to the crisis in Libya. 

That is what makes the recent "test sale" of 5 million barrels of oil so intriguing. This is the first time since 1990 that there has been a test sale from the SPR, which just happens so coincide with the time there was concern that Iraq could invade Saudi Arabia. While correlation does not always mean causation, the release of those 5 million barrels coincided with a 2.7% drop in crude oil prices.  

Hit 'em where it hurts -- their wallet
It's no secret that Russia is one of the world's leading exporters of oil and gas. It exports about 8.5 million barrels per day of crude oil and refined petroleum products, as well as 19.3% of the worlds natural gas exports. What is less known is Russia's nearly crippling dependence on oil and gas revenues to pay the bills. The $662.3 billion petroleum industry in Russia represents 26.5% of GDP, and over 50% of the federal government's revenue comes from royalties. Unfortunately for Russia, its oil doesn't come cheap. Even with oil at $100 per barrel and current production levels, the country projects only 1.8% GDP growth, and if oil were to fall any lower it would force massive federal budget cuts. 

So what exactly would releasing oil from there do? Let's say U.S. production and imports from Canada and Mexico were to hold place. The U.S. would need to release about 950,000 barrels per day to meet all of the United States' current demand. Based on the SPR's 727 million barrels in storage, we could do this for well over two years and drive down global prices significantly. Surprisingly, though, we don't even need to go to that extreme. According to economist Phillip Verleger in a recent Quartz article, if the U.S. were to release only 500,000 barrels per day from the SPR, it would lead to a $10 drop in oil prices and would cost Russia $40 billion in sales. At this pace, we could maintain this pace for more than four years and could potentially cause Russia's GDP to drop by 4%. 

We've done it before, but it will be harder this time
There are two ways to describe the collapse of the Soviet Union: The storybook version is about the arms race that eventually bankrupted the USSR and led to its evenutal collapse. The one that doesn't get told as much, though, is the other half of what caused the bankruptcy: cheap oil. In a coordinated effort with Saudi Arabia to increase global crude production, inflation-adjusted oil prices fell 69% between 1981 and 1988. This resulted in massive revenue shortfalls for the USSR and became a critical piece that eventually led to its downfall.

The challenging part about such a move this time around is that Saudi Arabia may be less willing to go along with the idea. The Kingdom has been very much against Russia's support of the Syrian regime and even gave some veiled threats about potential terrorist attacks at the Sochi Olympics if it maintained its stance there. However, it has become more and more dependent on high oil prices to maintain its budget as well. According to the International Monetary Fund, Saudi Arabia needs oil at $85 per barrel to keep its own budgets in line. So even though a major price drop would hurt Russia more than the rest, Saudi Arabia may not have the stomach for it, either.

What a Fool believes
There have been several calls from members in Congress to expand the amount of LNG export licenses to take a bite out of Russia's dominance in the global gas markets. It sounds all well and good, but the first US LNG export facility is not expected to come online until the middle of 2015 and the rest until later in the decade. In fact, opening the SPR would actually serve a very similar purpose, because Russian natural gas prices are indexed to the price of oil. 

Using the Strategic Petroleum Reserve as a political tool is something that we have basically never done since it was created following the oil embargos of the 1970s, and using it in this situation would cause some harm to U.S. oil producers because it would lower the price of oil and by default the returns on that barrel of oil. However, most of the shale resources in the U.S. would fare much better than Russia in the event of lower oil prices, and it should be something considered if the situation in Ukraine were to elevate any further.