The Contango Warning

President-Elect Obama is expected to name his energy and environmental team shortly. Whoever is nominated as the next Secretary of Energy will be swamped with an array of competing priorities, including modernizing the nation's electrical grid, managing the nuclear weapons infrastructure, and above all guiding the shift to a greener energy diet that will reduce our greenhouse gas emissions, and perhaps also our dependence on imported energy. With regard to the latter outcome, however, the incoming Secretary should pay careful heed to the signal that the oil market is sending about the importance of boosting declining US petroleum production. While the media focuses on a front-month futures contract price for West Texas Intermediate crude oil in the low $40s per barrel, traders have been paying north of $60 per barrel for delivery in 2010 and $80 for oil in 2016. That suggests that the relief we are seeing at the pump today is only temporary, while the global economy is gripped by a recession and credit crunch. Our oil worries will return soon enough, once the economy recovers.

Aside from the remarkably rapid drop in the price of crude oil for prompt delivery, the current market conditions are unusual because of the steep rise, or "contango", of the prices in successive futures contract months. At yesterday's settlement on the New York Mercantile Exchange, oil for delivery in February carried a $2.59/bbl premium over January, and March was another $2.20/bbl higher. Oil for delivery in December 2009 was a whopping $13.81/bbl higher than the January '09 futures. The fact that sufficient oil is not being bought today and put into storage for future delivery to close the arbitrage opportunity this situation creates is a clear indication of just how tight commercial credit has become, recently. As it is, US oil inventories have climbed by 26 million barrels since the end of September, rising from close to the bottom of their seasonally-adjusted range to near the top.

Although the oil market isn't any more prescient about future oil prices than the stock market is about future corporate earnings, it still reflects the current consensus on the future--and not just of those with an opinion, like me, but of those willing to bet serious money on it. In that light, the extreme contango of the current market reflects many factors, chief among them the extraordinary weakness of current demand that has caused prompt prices to collapse, combined with the seemingly-inevitable collision between limited global supplies and the long-term demand from the large developing economies of Asia. Even if US oil demand never returns to its high-water mark of 20.8 million barrels per day in 2005--a level 6% above our monthly average for 2008, to date--the potential demand from China and India is more than sufficient to drive prices back to OPEC's desired floor price of $75 or more. Throw in a bit of political risk from our old friends Iran, Venezuela and Russia, and it's the current price that looks like the outlier, not today's long-dated futures prices between $60-$80/bbl.

That certainly supports the case for the next Secretary of Energy to push hard for the fuel-saving technology and alternative fuels that can reduce our dependence on expensive sources of foreign oil, but it might be less clear why maintaining domestic oil production and increasing it to the maximum extent possible matters just as much. We can't escape the mathematical certainty that imports must cover the difference between demand and domestic production. Those domestic supplies, which still represent 13 times as much gross energy content as our current 10 billion gallons per year of ethanol production, and contribute more than 30 times as much net energy to our economy, remain essential. Even a modest further drop in US oil production could negate the energy security gains from efficiency and additional biofuels.

There's also a lot of money at stake for the country, not just for oil companies. A new study from ICF International, commissioned by the American Petroleum Institute, confirmed the findings of the 2007 National Petroleum Council study in which I participated, to the effect that allowing drilling on the off-limits portions of the Outer Continental Shelf, onshore federal lands, and the Arctic National Wildlife Refuge could increase US oil production by 2 million barrels per day in 2030, above the expected baseline. That would displace tens of billions of dollars per year of imported oil--even at today's low prices--while cumulatively generating hundreds of billions in state and federal royalties and corporate income tax revenue that would be very helpful in covering the enormous debts being run up combating the financial crisis and recession.

As I noted frequently during the summer's debate over offshore drilling, there's no question of drilling our way to energy independence. We urgently need to expand and diversify our energy supplies and become much more efficient in how we use energy, but that doesn't mean we can turn our backs on oil, just yet. The new Energy Secretary will have to work hard to ensure that the oil replaced by the aggressive adoption of renewable energy and efficiency technology doesn't end up being our own.