Phillips 66 Is Tapping the Strategic Petroleum Reserve. What’s the Impact?

Hurricane Harvey caused catastrophic amounts of damage to Texas and Louisiana, and at the end of last week, the Department of Energy authorized an emergency release of 500,000 barrels of oil to Phillips 66's (PSX 0.35%) Lake Charles refinery.

In this week's episode of Industry Focus: Energy, Sarah Priestley and Taylor Muckerman explain what that means. Find out what the Strategic Petroleum Reserve (SPR) is and what it does, whether investors should be worried about this dip into the emergency reserves, what Phillips 66 investors should know about the 500,000-barrel loan, what the not-too-distant future could hold for the SPR, and more.

A full transcript follows the video.

This video was recorded on Sept. 7, 2017.

Sarah Priestley: Welcome to Industry Focus, the show that dives into a different sector of the stock market every day. Today we're talking energy and industrials. It's Thursday, seventh of September, and we're going to be discussing the Strategic Petroleum Reserve after a question from one of our wonderful listeners. Joining me in the studio is Motley Fool Canada premium analyst Taylor Muckerman. Taylor, thank you very much for joining me today!

Taylor Muckerman: Absolutely.

Priestley: Are you refreshed from the long weekend?

Muckerman: My lack of labor over the weekend. [laughs] 

Priestley: [laughs] It was wonderful! As I said, today we're going to be talking about the SPR. Really, the reason we're talking about that is because of the sheer extent of the damage from Hurricane Harvey. We're going to be covering the SPR and its role during these emergency situations. Harvey, thankfully, is now past, although we were just talking about this, there's another three hurricanes apparently out there getting ready. Harvey dumped about 50 inches of rain on parts of Texas and Louisiana. Sadly, it took the lives of 42 people and 40,000 homes were damaged, so there's some serious implications of this. It's been truly terrible for Texas. Just awful images in the media depicting terrible devastation. And as so often happens in these times of crisis, some really wonderful stories of some really great people.

Muckerman: Yes.

Priestley: I saw a great one about people forming a human line to save a woman who was in labor from the floodwater, which is just incredible.

Muckerman: Wow. That's a story to tell your kids in a few years.

Priestley: It's true. Babies won't wait, that's the thing. Texan residents and business owners are left to survey the damage and long-term impact. Preliminary estimates for the cost of recovery are at $190 billion. That figure would make this the costliest natural disaster in U.S. history. Taylor, part of the reason for this, I think, is the concentration of U.S. oil producing and refining industry. Five of the largest U.S. oil refineries are on the Texas and Louisiana Gulf Coast. Two of the largest refineries are near Houston. What will be the aftermath of this? What are they going to be dealing with now?

Muckerman: You have the Lake Charles area, big for refining. The Corpus Christi area, big for refining. Corpus Christi is almost back to pre-Harvey levels. They expect that a few more days, they'll be able to be quite near fully online. You look at, about 20% of the nation's refining capacity was shut down, so that's a big deal. And as a result, you've seen gas prices spike the most since Hurricane Katrina. The average price for regular unleaded, up $0.33 nationwide, up to $2.65 for the average. So people are feeling it. And that's probably going to last for several weeks, especially as you see, like you mentioned, other hurricanes potentially on the way. BP is already evacuating some of its Gulf platforms ahead of Hurricane Irma. So certainly still some risk out there for higher prices. The chemical industry is still offline as well, out of the ethylene production that they need to produce plastics. That's offline. So not only gasoline -- oil and chemicals all impacted. It's going to take a while for the supply chains for these to kick back in.

Priestley: Yeah. I read somewhere that the flooding has been the biggest issue they're about to deal with. It's kind of dangerous sometimes, especially fracking, if they get water in the wells, to start up again. And the other thing that people have got to consider is, the EPA is investigating potentially hazardous carcinogens in the area as a result of some of the explosions that we saw that took a lot of the media that may not be a huge impact on those companies, but on the people around, they definitely will. The reason that we're touching on this is, at the end of last week, the 31st of August, Energy Secretary Rick Perry announced that the Department of Energy is releasing oil from its Strategic Petroleum Reserve in an attempt to mitigate some of this disruption that we're talking about. This authorized the release of 500,000 barrels to Phillips 66's refinery in Lake Charles. This is the first emergency release from the SPR since Hurricane Isaac hit Louisiana in 2012. We got a great question from a listener on Twitter asking, "What are the implications and impact of this?" But first, I thought it might be worth touching on what exactly the SPR is. So, Taylor?

Muckerman: Basically, it's our nation's fall-back plan, if oil imports either get disrupted or we necessarily have to cut off oil imports for any diplomatic reasons. So I think we have about 140-some days of technically U.S. demand for oil, which would then probably be used for gasoline and other things to keep the nation running for almost half a year. So tap this every now and then. It hasn't been tapped in a few years. I think President Obama did it at least once during his two terms as president. I don't think it's necessarily anything to get in an uproar about. It's only 500,000 barrels in this case out of a few hundred million, 700 million, I believe, just north of that. And we're at peak capacity right now in terms of how much oil is actually in the SPR. So it's not like we're starting from a position of weakness letting this out. And in this case, Phillips 66 is a company that tapped it for 500,000 barrels, and they do have to refill it and then some once the term of the agreement -- I haven't seen exactly how long they have to replace this, but I imagine it's not immediate.

Then, for the company itself, you look at it and the refinery that they're using this oil at, it's completely online, so we already talked about high gas prices, so maybe just try to take advantage of the fact that they still can refine some oil. This is in Lake Charles. They do have other refineries that aren't completely online. So maybe just trying to take advantage of some higher margins right now.

Priestley: Interesting. You mentioned this was to protect the U.S. from international issues. I think that's how they started the SPR. They became a founding member of the International Energy Agency after the oil embargo by OPEC in the '70s. Obviously, it's a very different environment now. So that raises a lot of questions that we'll touch on later.

Muckerman: Yeah, we're producing near-record oil in the United States. We were definitely producing oil back then as well, but I think there's a much clearer path to the U.S. sustaining its own oil production if need be.

Priestley: Yeah. You touched on this, but in this instance, this is an exchange, which basically means that the borrower -- in this case, Phillips -- is loaned the barrels. They then have to return the same amount back to the reserves, the same quality of oil, plus extra as interest. So Philips must have requested this exchange, as you said, because they're probably taking advantage of the greater crack spread.

Muckerman: Yes.

Priestley: Should investors be concerned about them servicing this loan? Is it an issue to make good on that loan?

Muckerman: No, I think it's a small enough amount to where, as an investor, maybe it's encouraging to see management trying all options to keep capacity and their inputs coming in, because a lot of pipelines in that area were disrupted. So not only have we seen production be impacted, but even the production in the oil fields that are still running, it's having a hard time making it to the endpoints here and refineries along the Gulf Coast, because not only were the refineries impacted, but the feeding pipelines were as well.

Priestley: Yeah. And a lot of the ports, I can't remember the term for it, but they're essentially filled with silt now, so they have to be excavated.

Muckerman: Yeah, they have to be dredged, probably. We'll wait to see that, because the Gulf area is the hub for all the oil exports that we've seen ramp up over the last couple of years since we released that limit on U.S. oil exportations.

Priestley: Yeah, which is incredible when you think about how vulnerable that area is. I know every area has its risks.

Muckerman: As far west as this one went, it was kind of a surprise to a lot of people. Mid- to eastern region of the Gulf usually gets hit almost on a yearly basis. But as far west as Houston, kind of a shock there.

Priestley: Yeah, it's new to me. We have a lot of rain, but not hurricanes. I think, you said this already, but talking about how serious this is and what the impact is, I think it's important to remember that the reserves are tapped during natural disasters. It's very usual. And, as you said, 500,000 is nothing compared to how it has been. 2008, Hurricane Gustav and Hurricane Ike, they reduced levels by 5.4 million barrels. 2005, Hurricane Katrina, 20.8 million barrels. So there is a precedent for this. We shouldn't be too concerned.

Muckerman: Yeah. When you look at 500,000 barrels, and we're producing 9 million barrels per day as a country, not exactly something to get in a fuss about.

Priestley: Which leads on to my next question. The SPR is often in the news when natural disasters happen. But last year, it was in the news not concerning a disaster. The Energy Department released a report, and it said the SPR was increasingly ineffective due to aging infrastructure and a booming domestic oil industry. The report essentially said that the complex infrastructure was getting too old to function efficiently; they needed money from Congress to fix most of the critical infrastructure, for moving crude within the SPR had exceeded its service for life. So it didn't paint a great picture of the infrastructure there. But the thing that I think is interesting is where the large reserves are needed in the U.S. since the recent oil boom. The rules of the IEA were made when the U.S. wasn't producing as much. So what do you make of that?

Muckerman: Certainly, when you look at the inventory, we just saw crude oil inventories rise by almost 3 million barrels. So that's not necessarily 270 million barrels like we see in the SPR, but at the same time, it's nice to have. And we're not the only country that has one. China has one that I believe is much larger than ours, and as they've started to build that and maintain it, it was actually a pretty nice little driver for demand in the oil markets, because here you are, feeling these vast reserves without even using them. So it's just like a sudden increase in demand. But we've seen that taper off. Not the only country that has it. Nothing special. But I think it's just nice to have. It's kind of interesting. I didn't realize that they were worried about necessarily the quality of the crude within the salt caverns. Because you're right, it's not in its original formations. Technically, oil is several thousands of years old, so you wouldn't think that a few more years in a different area would impact it. But certainly, you could imagine that it's not in such a high-pressure environment, it's not nearly as far down into the Earth anymore, and it has been extracted, so maybe there's some changes going on there. You have to worry about the quality, which I never would have considered.

Priestley: Yeah. They're kept in salt caverns, which are probably the best way that you could keep it, because salt is impervious, it's far down, there's some pressure. But as you said, it's not in its natural state.

Muckerman: Right. And salt caverns are also where a lot of companies will store their wastewater that they inject into fracking wells, or things like that, or they'll store some spare natural gas instead of flaring it. So salt caverns are used for very many reasons.

Priestley: I think, as part of this debate over whether we should have one or not, I think it would be stupid for us to not have one as a country. And also, if you think about the economics of it, I think the per-barrel cost is $27, which even now at the depressed value is a good price.

Muckerman: Yeah, absolutely.

Priestley: And a lot of the exchanges that they do, it's a great way of getting high-quality, very well-priced oil for the U.S. citizens, essentially. And the other thing to factor in is that lawmakers are beginning to see the oil reserves as almost a piggy bank. Congress tapped the oil reserves for funds twice last year. So it may be something that we start to see happen more, but possibly not in this environment.

Muckerman: Yeah, if you think we're strong enough as a producing country now to where there's a little bit more flexibility there versus in the early 2000s, before the fracking boom really kicked in, you could see a steady decline from the 1970, 1971, to 2005 of oil production in the United States. And then, just straight up and to the right in terms of growth. Almost not even straight up to the right, almost just straight up from 2005 until the present. So assuaging a little bit of fears.

Priestley: The bottom line for this is, it sounds like a concerning issue. It sounds like a big thing.

Muckerman: Yeah, Strategic Petroleum Reserve.

Priestley: But it's really not. It's not a big deal. And I guess everybody is going to be keeping their eye on the next three hurricanes.

Muckerman: Yeah. It's interesting, I don't remember a time where a specific company was able to request some oil or make this exchange. I think the last few times was just the country releasing some oil into the general market, probably in an auction format. So kind of interesting to see maybe if that happens again in the future, where a specific company is almost loaned oil, essentially.

Priestley: Yeah. It's like you said, they're probably taking advantage of the situation. And the U.S. is taking advantage of the fact that we now have this glut in production so that we can do that to leverage our position. Which is great to see. It's a good use of that material, I think. So, Taylor, as always, thank you for being awesome and shedding light on the issue.

Muckerman: [laughs] No doubt. What's up next week?

Priestley: Next week is airlines. I don't know if anybody managed to catch the bonus episode that we did. It went out on Saturday over the holiday weekend, but we talked about how we wanted to broaden the scope of the show. So next week, we're trying to deliver on that promise, so we're going to do which of the big four U.S. national airline companies is the better buy right now.

Muckerman: Yeah, those have been some pretty good stocks over the last couple of years.

Priestley: They have. Historically, people have avoided them like the plague.

Muckerman: Yeah. Some consolidation in that area has boosted some stock prices.

Priestley: Yeah. I'm nerdy, so I think that's fascinating. But we'll see if anybody else finds it interesting.

Muckerman: Once Buffett charges in, you have to expect something.

Priestley: Yeah, not everybody wants in. Taylor, thank you very much. As always, you've been wonderfully knowledgeable. That's it from us today. If you would like to get in touch, please feel free to email us at [email protected], or tweet us on Twitter @MFIndustryFocus. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For, Taylor, I'm Sarah Priestley. Thanks for listening, and Fool on!