As OPEC's members and friends meet in Algeria to agree on deeper cuts in oil output, the effectiveness of their actions will depend greatly on the nature of the demand slump to which they are responding. If it proves to be merely a dip in the long-term growth trend, similar to the one associated with the Asian Financial Crisis of the late 1990s, then their current decline in revenue will likely be short-lived. If, on the other hand, the response in consuming countries is similar to that following the energy crisis of the 1970s and early 1980s, then OPEC and indeed all oil producers face protracted problems. In that case, they might have to hope that the chief economist of the International Energy Agency is correct in his new assessment that the credit crisis will hasten an expected peak in global oil production, perhaps sending oil prices beyond their summer 2008 highs within a few years.
Although the narrative concerning the present financial crisis and global recession is bound up in the collapse of the US housing market and the vast global debt bubble that fueled it--a bubble that had to burst sooner or later--it seems remarkably coincidental that it would begin to deflate just as oil prices raced past their previous inflation-adjusted peak of around $90 per barrel. Because that price rise took place over several years and was driven as much by demand as by supply constraints, the resulting oil shock wasn't as sharp or obvious as the one triggered by the Arab Oil Embargo of 1973 or the Iranian Revolution of 1979. But between 2003 and 2007, the US net oil import bill rose from around $100 billion per year to $300 billion, based on refiner acquisition costs. It crested at an annualized rate of $500 B per year in July. This added significantly to the US trade deficit, and the resulting sustained double-digit inflation in consumer energy costs helped push the annualized consumer-price inflation rate past 5% this summer. With the energy spike having folded, the November 2008 annualized CPI rate has fallen to 1.1%.
If in retrospect these indicators describe a true oil price shock, then what might OPEC and other oil producers expect in the years ahead? Well, in the aftermath of the last oil crisis, from 1979-83 global oil demand fell by 10%, the current equivalent of over 8 million barrels per day (MBD), based on last year's global consumption of 85.8 MBD. It didn't reach its 1979 level again until 1989. The effect on OPEC was devastating. With demand lower and non-OPEC output expanding steadily, OPEC's oil was squeezed out, losing a third of its former market share. Oil prices remained low for another fifteen years, contributing to the growth of the exurbs and the SUV fad.
History rarely repeats exactly, and it would be simplistic to think that we're likely to replicate the oil price environment of the mid-to-late 1980s. There's no tidal wave of non-OPEC conventional oil coming from places like the North Slope and North Sea, which looked technically challenging at the time but seem relatively easy, compared to today's opportunities. Biofuels have added the equivalent of around 0.5 MBD in the last several years, and Canadian oilsands a similar amount, but production in most non-OPEC countries is peaking or in decline, notably in Mexico and Russia. And as the IEA's Dr. Birol notes, tight credit and low prices will slow additions to supply from all sources, while natural decline erodes today's base production. That makes demand the crucial factor, particularly the behavioral elements of demand. Although rarely discussed in these terms, vehicle fuel economy faces diminishing returns. Boosting US fleet average miles per gallon from 13 to 25 under the original CAFE standard in the 1970s and '80s saved three times more fuel per mile than the mandated increase to 35 mpg will--in fact more than moving the entire fleet to 100 mpg plug-in hybrids would. Vehicle miles traveled have recently declined in the US. Along with the appetite of Asian consumers for their first cars, this will have as much impact as fuel economy on total oil consumption, and thus on prices.
Although the oil price shock of the last several years can't be blamed for the full extent of the mess we're in, it is at least a plausible candidate for the trigger that caused the debt bubble to pop now, rather than a few years from now. That has important implications, because current conditions may be setting the stage for another, possibly sharper oil shock shortly after the economy begins to recover. Although we face a drastically altered set of energy concerns going into 2009, energy policies that promote both conservation and increased supply look just as essential as they did a year ago.
Showing posts with label oil market. Show all posts
Showing posts with label oil market. Show all posts
Wednesday, December 17, 2008
Monday, December 01, 2008
The Right Price
So OPEC has kicked the can down the road another two weeks, deferring further production cuts until at least their December 17th meeting in Algeria, when they can better assess the impact of the cuts they've already made--code for observing how badly its members have cheated on their earlier quota reductions. As usual, the cartel's control over prices is much stronger when demand is surging and production capacity strained, than when markets develop considerable slack. This is a much-rehearsed dance, and the market has apparently already discounted it, with the price of light, sweet crude poised to test the $50 mark again this week. The more interesting commentary out of Cairo concerned OPEC's desired price, which is apparently $75 per barrel: well above today's level but far below summer's peak. Wishing won't make it so, but there has been much discussion lately about the "right" price for the most liquid of energy commodities.
I can't help observing the irony that $50 oil, the prospect of which seemed nearly inconceivable to seasoned industry experts only a few years ago, now looks too cheap, not just to OPEC, but also to producers of unconventional oil, developers and supporters of alternative energy, and those concerned about climate change. When you dig a little deeper, however, the insight here seems to be that the absolute price matters less than its volatility, at least from a planning perspective. It's hard for producers of all kinds of energy to plan their business, if the monthly average price of their output--or the key commodity affecting it--can spike up by 150% and then drop by 60%, all within the course of two years. Oil remains a cyclical business, as anyone who's been around it for a while understands, but this is ridiculous.
That $75 per barrel figure from OPEC is interesting for many reasons. It probably represents the minimum level needed to balance the considerable budgetary expansions taken on by its most aggressive spenders, such as Venezuela and Iran, along with pseudo-member Russia. But it also looks like the level that is required to keep additions of new unconventional oil capacity, such as Canadian oil sands, on track. With typical refining margins, instead of the bizarrely-inverted pricing we've seen recently, it would translate into an average gasoline pump price in the US of around $2.50/gal. And because US ethanol distillers are producing well beyond the volumes required to satisfy the federal Renewable Fuel Standard, that would yield an ethanol price after subsidies in the neighborhood of $2/gal., enough to give ethanol producers a 75 cent per gallon "crush spread" over corn at $3.50 per bushel. That's a lot better than the 40 cents or so implied by the current ethanol and corn futures prices.
If the drop to $50 were short-lived, most of those energy producers would experience little lasting impact, other than ethanol firms that have been pushed to the brink by the combination of overly-rapid expansion, tightening credit, and slumping prices. But looking ahead, no one can say with any certainty whether oil will remain here, test $40/bbl, or zoom past $100 again next summer. In this regard the futures market, which last week reflected prices above $70/bbl. beyond 2010, has been a very poor barometer. Nor have the forecasts of government departments or international agencies fared any better at anticipating the volatility that is so disruptive to economies and to the plans of energy companies and oil-exporting countries.
Consumers are in the best position of anyone affected by these developments. If you drive an average car an average amount, your fuel bills ought to be about $90 per month lower than they were in July, which is the equivalent of a $120 per month raise for anyone in the 33% combined federal income and social security tax bracket. Save it or spend it, but don't count on it lasting longer than a year. That means buying your next car with the prudent assumption that at some point in its life, you will be paying $4 or more per gallon, once again.
I can't help observing the irony that $50 oil, the prospect of which seemed nearly inconceivable to seasoned industry experts only a few years ago, now looks too cheap, not just to OPEC, but also to producers of unconventional oil, developers and supporters of alternative energy, and those concerned about climate change. When you dig a little deeper, however, the insight here seems to be that the absolute price matters less than its volatility, at least from a planning perspective. It's hard for producers of all kinds of energy to plan their business, if the monthly average price of their output--or the key commodity affecting it--can spike up by 150% and then drop by 60%, all within the course of two years. Oil remains a cyclical business, as anyone who's been around it for a while understands, but this is ridiculous.
That $75 per barrel figure from OPEC is interesting for many reasons. It probably represents the minimum level needed to balance the considerable budgetary expansions taken on by its most aggressive spenders, such as Venezuela and Iran, along with pseudo-member Russia. But it also looks like the level that is required to keep additions of new unconventional oil capacity, such as Canadian oil sands, on track. With typical refining margins, instead of the bizarrely-inverted pricing we've seen recently, it would translate into an average gasoline pump price in the US of around $2.50/gal. And because US ethanol distillers are producing well beyond the volumes required to satisfy the federal Renewable Fuel Standard, that would yield an ethanol price after subsidies in the neighborhood of $2/gal., enough to give ethanol producers a 75 cent per gallon "crush spread" over corn at $3.50 per bushel. That's a lot better than the 40 cents or so implied by the current ethanol and corn futures prices.
If the drop to $50 were short-lived, most of those energy producers would experience little lasting impact, other than ethanol firms that have been pushed to the brink by the combination of overly-rapid expansion, tightening credit, and slumping prices. But looking ahead, no one can say with any certainty whether oil will remain here, test $40/bbl, or zoom past $100 again next summer. In this regard the futures market, which last week reflected prices above $70/bbl. beyond 2010, has been a very poor barometer. Nor have the forecasts of government departments or international agencies fared any better at anticipating the volatility that is so disruptive to economies and to the plans of energy companies and oil-exporting countries.
Consumers are in the best position of anyone affected by these developments. If you drive an average car an average amount, your fuel bills ought to be about $90 per month lower than they were in July, which is the equivalent of a $120 per month raise for anyone in the 33% combined federal income and social security tax bracket. Save it or spend it, but don't count on it lasting longer than a year. That means buying your next car with the prudent assumption that at some point in its life, you will be paying $4 or more per gallon, once again.
Thursday, August 21, 2008
Defining Speculation
Oil market speculation is back in the news, because Vitol S.A., one of the world's largest oil-trading firms, has apparently been re-classified as a "non-commercial" market participant by the Commodity Futures Trading Commission (CFTC). That marks them as a speculator, this year's scarlet letter. Before we pass judgment on the influence of such firms on the price of oil, and thus on the petroleum products consumers buy, it's worth considering what we really mean by speculation, and how this might be distinct from the activities of the participants that the CFTC deems "commercial", i.e. those conducting futures, options and swap transactions in conjunction with their physical production or consumption of various forms of energy. More importantly, we should evaluate whether speculation is an important enough factor in the oil market to merit distracting us from the urgent pursuit of solutions that would expand energy supplies and shrink demand.
As big as they are, Vitol hardly fits the profile of the kind of speculators that stand accused of driving up the price of oil and everything connected to it to unprecedented levels. Vitol has been trading oil since the 1960s, and I did my first deal with them in the 1980s, when I traded petroleum products for Texaco's West Coast refining and marketing subsidiary. I got a much better sense for just how large a player they were in the physical markets for oil, feedstocks and refined products when I traded international products in London in 1989-91. There were few markets in which Vitol didn't participate, and a few niches that they dominated. Although I haven't had any contact with them in at least 14 years, their growth during that interval has been impressive. So I was hardly shocked to learn that they had apparently accounted for a significant fraction of the open interest in crude oil on the New York Mercantile Exchange (NYMEX) earlier this year. Any non-producer transacting the volumes of physical oil and products deals they do could not manage their business properly without extensive use of futures, options and over-the-counter swaps, little of which could fairly be called speculation.
Texaco's trading division had very firm rules about speculation on futures or options, which it defined as long or short positions that weren't directly linked to a like quantity of physical oil or products we were buying, selling, or holding in inventory, contemporaneously. Even for a group focused on "wet" cargoes--actual liquids on ships, barges, or in pipelines--that was sometimes limiting, because it meant we had to do the physical transaction first, and then scramble to hedge it. But while we couldn't take "naked" long or short positions in the market, we could transact "spreads" that were basically bets on some aspect of the market, such as a widening or narrowing of the price difference between futures contract months, or between different products, or different locations. While we weren't speculating on the absolute price, risking large swings in profit and loss, we were certainly risking smaller amounts on these other market attributes. I think most people would consider that speculation, since we didn't have to do it to support our physical trading or the company's much larger producing and refining businesses. But aside from some modest, inconsistent profits it gave us insights into market trends that passive observers don't usually gain: if you really want to understand a market, you have to be in the market.
Now consider Vitol, buying and selling oil and product cargoes all over the world and owning interests in oil terminals on three continents, a few oil fields, and a small refinery in the Persian Gulf. That doesn't put them in the same league as ExxonMobil--which, unless things have changed a great deal since the Exxon-Mobil merger in 1999, doesn't trade on the NYMEX at all--or legitimize every position they take as non-speculative. However, it's a far cry from the stereotypical view of asset-class commodity speculation by pension funds and hedge funds, executed by twenty-somethings who wouldn't know an octane from an antelope. That's important, because long-established oil trading firms like Vitol have institutional memories that span many up and down cycles of the oil market and know that a trend can turn when you least expect it. It doesn't mean they wouldn't risk a big loss to make a big profit, but in my estimation it makes them poor candidates to be the driving force behind a wave of speculation perceived to have pushed the price of oil beyond the level that could be explained by the fundamentals alone.
The roughly 20% drop in oil prices since the beginning of July should calibrate our estimates of the influence of such speculation. It was clearly not sufficient to maintain momentum in the face of weakening fundamentals of demand, supply and risk. At the same time, our response ought to distinguish between the kind of speculation represented by oil market neophytes hoping to cash in on an attractive investment trend, and the speculation that is an absolute requirement of a smoothly-functioning commodities market. Anyone who thinks the oil market would work just fine with only producers, refiners and end-users has never spent a day trading, or seen liquidity vanish just when a specific transaction was most desirable or necessary, because there was no middleman willing to take it on as a bet. But regardless of whether one variety of speculation should concern us more than another, the market's dramatic response to sliding demand serves notice to policy makers that their best and most productive avenue for addressing the impact of high oil prices is surely prompt and meaningful action on supply and demand, rather than rounding up today's version of the usual suspects.
As big as they are, Vitol hardly fits the profile of the kind of speculators that stand accused of driving up the price of oil and everything connected to it to unprecedented levels. Vitol has been trading oil since the 1960s, and I did my first deal with them in the 1980s, when I traded petroleum products for Texaco's West Coast refining and marketing subsidiary. I got a much better sense for just how large a player they were in the physical markets for oil, feedstocks and refined products when I traded international products in London in 1989-91. There were few markets in which Vitol didn't participate, and a few niches that they dominated. Although I haven't had any contact with them in at least 14 years, their growth during that interval has been impressive. So I was hardly shocked to learn that they had apparently accounted for a significant fraction of the open interest in crude oil on the New York Mercantile Exchange (NYMEX) earlier this year. Any non-producer transacting the volumes of physical oil and products deals they do could not manage their business properly without extensive use of futures, options and over-the-counter swaps, little of which could fairly be called speculation.
Texaco's trading division had very firm rules about speculation on futures or options, which it defined as long or short positions that weren't directly linked to a like quantity of physical oil or products we were buying, selling, or holding in inventory, contemporaneously. Even for a group focused on "wet" cargoes--actual liquids on ships, barges, or in pipelines--that was sometimes limiting, because it meant we had to do the physical transaction first, and then scramble to hedge it. But while we couldn't take "naked" long or short positions in the market, we could transact "spreads" that were basically bets on some aspect of the market, such as a widening or narrowing of the price difference between futures contract months, or between different products, or different locations. While we weren't speculating on the absolute price, risking large swings in profit and loss, we were certainly risking smaller amounts on these other market attributes. I think most people would consider that speculation, since we didn't have to do it to support our physical trading or the company's much larger producing and refining businesses. But aside from some modest, inconsistent profits it gave us insights into market trends that passive observers don't usually gain: if you really want to understand a market, you have to be in the market.
Now consider Vitol, buying and selling oil and product cargoes all over the world and owning interests in oil terminals on three continents, a few oil fields, and a small refinery in the Persian Gulf. That doesn't put them in the same league as ExxonMobil--which, unless things have changed a great deal since the Exxon-Mobil merger in 1999, doesn't trade on the NYMEX at all--or legitimize every position they take as non-speculative. However, it's a far cry from the stereotypical view of asset-class commodity speculation by pension funds and hedge funds, executed by twenty-somethings who wouldn't know an octane from an antelope. That's important, because long-established oil trading firms like Vitol have institutional memories that span many up and down cycles of the oil market and know that a trend can turn when you least expect it. It doesn't mean they wouldn't risk a big loss to make a big profit, but in my estimation it makes them poor candidates to be the driving force behind a wave of speculation perceived to have pushed the price of oil beyond the level that could be explained by the fundamentals alone.
The roughly 20% drop in oil prices since the beginning of July should calibrate our estimates of the influence of such speculation. It was clearly not sufficient to maintain momentum in the face of weakening fundamentals of demand, supply and risk. At the same time, our response ought to distinguish between the kind of speculation represented by oil market neophytes hoping to cash in on an attractive investment trend, and the speculation that is an absolute requirement of a smoothly-functioning commodities market. Anyone who thinks the oil market would work just fine with only producers, refiners and end-users has never spent a day trading, or seen liquidity vanish just when a specific transaction was most desirable or necessary, because there was no middleman willing to take it on as a bet. But regardless of whether one variety of speculation should concern us more than another, the market's dramatic response to sliding demand serves notice to policy makers that their best and most productive avenue for addressing the impact of high oil prices is surely prompt and meaningful action on supply and demand, rather than rounding up today's version of the usual suspects.
Monday, August 11, 2008
Oil in the Crosshairs
For the last several years, the oil market has focused on the risk of a new conflict in the Persian Gulf, evolving from earlier fears of a direct US/Iranian confrontation to recent worries that Israel might attack Iran's nuclear program. I suspect that little of that oft-cited "risk premium" was devoted to the chances of a shooting war breaking out in the Caucasus, virtually on top of a key oil export route from the Caspian Sea. Yet here we are, with Russia intervening Friday on behalf of one of Georgia's breakaway regions, South Ossetia, and bombs apparently falling near the Baku-Tblisi-Ceyhan Pipeline (BTC) that carries oil to the Mediterranean from the giant "ACG" oilfields of Azerbaijan. If the pipeline, which suffered an unrelated fire last week, were forced to shut down for an extended period, about 1% of the world's oil production could go off line, at least until some portion of it could be re-routed. The market shrugged off this prospect initially, with WTI falling $5 to end last week at $115. I would be surprised if the reaction this week proved quite so blasé.
Georgia was occupied by Russia for nearly 200 years prior to the collapse of the USSR, and the Caucasus is at least as strategic today as it was in the time of the czars, considering its role in the transit of the hydrocarbon resources of the Caspian Sea region. Prime Minister Putin, who appears to be calling the shots in this matter, likely regards Georgia as a rightful part of Russia's sphere of influence, but that doesn't give us many clues about the true extent of Russia's war aims. Given the preparations apparent in the current offensive, these could extend to annexation of South Ossetia into the Russian Federation, regime change in Tblisi, or merely putting a good scare into any former Soviet territories flirting with the idea of NATO membership. Although Russia was hardly pleased with the selection of an export route for Caspian oil that deliberately avoided its territory and control, and has gone to great lengths to regain state control over its own oil industry, oil isn't necessary to explain the events in Georgia.
Unfortunately, the implications for oil supplies go beyond the immediate disruption of the roughly 800,000 bbl/day the BTC line was carrying prior to last week's accident. In its latest Oil Market Report, the International Energy Agency cited expected additions to Azeri production of 200,000 bbl/day this year and a like quantity in 2009. As tightly balanced as the oil market remains, with demand destruction largely responsible for the current slump in prices, it would be bad news if those extra supplies could not be accommodated via the BTC or other export routes. Even if the Caspian hasn't quite delivered the oil gusher some expected a decade ago, it is one of a small number of regions in which production trends have been going the right way.
Whoever threw the first punch--and so far neither side seems terribly credible concerning this--the timing of the conflict favors Russia's attaining its goals in this affair. The combination of high energy prices and a highly-distracted America shrinks the odds that either the US or EU will take on Russia in defense of a former Soviet republic, beyond issuing statements asking Mr. Putin to respect Georgia's territorial integrity. Even if the BTC pipeline survives unscathed and quickly resumes deliveries, political risk in the entire region has increased, and future development from this crucial non-OPEC source could slow. That would keep oil prices higher, for longer than otherwise. With roughly $300 billion per year in oil export revenues at current prices, Russia sits near the top of the list of beneficiaries from such an outcome.
Georgia was occupied by Russia for nearly 200 years prior to the collapse of the USSR, and the Caucasus is at least as strategic today as it was in the time of the czars, considering its role in the transit of the hydrocarbon resources of the Caspian Sea region. Prime Minister Putin, who appears to be calling the shots in this matter, likely regards Georgia as a rightful part of Russia's sphere of influence, but that doesn't give us many clues about the true extent of Russia's war aims. Given the preparations apparent in the current offensive, these could extend to annexation of South Ossetia into the Russian Federation, regime change in Tblisi, or merely putting a good scare into any former Soviet territories flirting with the idea of NATO membership. Although Russia was hardly pleased with the selection of an export route for Caspian oil that deliberately avoided its territory and control, and has gone to great lengths to regain state control over its own oil industry, oil isn't necessary to explain the events in Georgia.
Unfortunately, the implications for oil supplies go beyond the immediate disruption of the roughly 800,000 bbl/day the BTC line was carrying prior to last week's accident. In its latest Oil Market Report, the International Energy Agency cited expected additions to Azeri production of 200,000 bbl/day this year and a like quantity in 2009. As tightly balanced as the oil market remains, with demand destruction largely responsible for the current slump in prices, it would be bad news if those extra supplies could not be accommodated via the BTC or other export routes. Even if the Caspian hasn't quite delivered the oil gusher some expected a decade ago, it is one of a small number of regions in which production trends have been going the right way.
Whoever threw the first punch--and so far neither side seems terribly credible concerning this--the timing of the conflict favors Russia's attaining its goals in this affair. The combination of high energy prices and a highly-distracted America shrinks the odds that either the US or EU will take on Russia in defense of a former Soviet republic, beyond issuing statements asking Mr. Putin to respect Georgia's territorial integrity. Even if the BTC pipeline survives unscathed and quickly resumes deliveries, political risk in the entire region has increased, and future development from this crucial non-OPEC source could slow. That would keep oil prices higher, for longer than otherwise. With roughly $300 billion per year in oil export revenues at current prices, Russia sits near the top of the list of beneficiaries from such an outcome.
Friday, June 27, 2008
The Baby and the Bath
Over the course of the last year, speculation has become a primary focus of concerns about the rapid increase in oil prices. For a Congress under intense pressure from constituents to address energy prices, regulating speculation in energy commodities could present the best prospect for appearing to deal decisively with the current energy crisis prior to the November election. Nor would I rule out the possibility that it might even provide some genuine price relief, although there are ample fundamental reasons for oil to be much dearer than it was just a few years ago. However, if Congress is going to take on the energy markets, it is imperative that it does so in a measured way, to avoid impeding their legitimate functions--some of which might be considered as speculative as the "commodity index" investment that has come in for the most severe criticism. Overkill could ultimately cost businesses, and eventually consumers, as much as inaction.
There's no shortage of conflicting opinions on this topic. A number of academics and financial experts have dismissed the possibility that speculation in oil futures could have much influence on the price of the physical commodity, pointing instead to the very real contribution of rapid demand growth in the developing world, slower production growth, particularly among non-OPEC producers, and the disappearance of global spare production capacity. Others have highlighted the recent and substantial flow of funds into the market from a new class of commodity investors, including pension funds and other institutions. They spot a cause-and-effect relationship in the accompanying rise in oil prices and find worrying parallels to the high-tech and housing bubbles. For my own part, I worry about the systematic linkages between the impact of this additional demand on futures prices and the mechanisms by which the price of oil purchased by refineries is set. But while I see a connection between speculation and higher fuel prices, I am skeptical of attempts to quantify it.
My background gives me a unique vantage point on this debate. After my graduate training in business and economics, I acquired a hands-on education in markets during a decade spent trading energy commodities for Texaco, Inc. This included a two-year stint trading international petroleum products from London, involving extensive dealings with our futures trading group and external floor broker. When I returned to Los Angeles, I was responsible for managing the commodity risk profile of the company's West Coast refining and marketing operations. Although this experience wasn't recent, I have no conflicts of interest in this area that would constrain my objectivity about the various proposals for regulating oil market speculation.
Some of the recent suggestions for regulating energy futures and derivatives trading might do more good than harm. This includes raising margin requirements, which might decrease liquidity, but also ought to reduce volatility by deterring investors from putting on enormous positions in hopes of turning small per-unit margins into huge aggregate gains, a strategy that hedge funds have employed in many markets. Shrinking volatility would be bad for traders, who thrive on it, but good for the economy. Closing the so-called "Enron Loophole" probably falls into a similar category of positive benefit vs. cost.
Other ideas seem likely to do much more harm to non-financial firms seeking to manage their business risks. For example, one of Senator Obama's recent anti-speculation proposals would force all energy commodities to trade on regulated exchanges. If this shut down the over-the-counter "swap" transactions that are used to bridge the price gaps between the small selection of crude and products traded on the NYMEX and the actual grades that companies buy and sell, it would make it much harder for businesses to hedge their risks. Airlines come to mind, here. Because there is no futures contract for jet fuel, an airline hedging its fuel supplies by buying crude oil or heating oil futures/options often also executes a swap covering the difference in price between jet and crude or jet and diesel. Otherwise, it runs the risk that when it purchase its jet fuel later, the hedge will have only appreciated by a fraction of the increase in the price of the physical product, or worse yet, might have lost money, while jet fuel prices continued to climb due to local or global scarcity. But as important as this transaction has become to airlines, it seems unlikely to generate the scale and liquidity required to merit launching an exchange-traded futures contract to cover it.
An even worse notion making the rounds on Capitol Hill would require anyone buying a futures contract to take physical delivery of the oil or product. As sensible as this might sound to the public, it would be catastrophic for the market and for the vast majority of participants, large and small, who use these markets to manage the enormous price risks associated with real-world energy activities. Even the small minority of players who rely on the NYMEX for physical supply in the New York Harbor would suffer, as liquidity for these contracts dried up. Consumers used to buying heating oil at a fixed-price for the season or year would probably lose this option, as all but the largest suppliers would be unable to offer this service.
Even the basic principle of limiting futures market activity to entities that produce or consume oil or its products is fundamentally flawed. On any given day, the producers and end-users wouldn't be active enough to make a real, liquid market. I experienced this first hand trading refined products on the West Coast. Top management preferred us to deal mainly with other oil companies, but when our own output fell short, the other refiners weren't always in the mood to sell. Without being able to buy from risk-taking independent traders who had previously taken a bet on the market, we would have run out of product on many occasions, and consumers would ultimately have been harmed.
Speculation plays an important role in lubricating the wheels of commerce, although it may also be contributing to higher oil prices, as investors increasingly turn to these markets as an inflation hedge or as another long-term asset class. My advice to Congress is to err on the side of caution in regulating energy commodity trading, and to specify very precisely which activities they want to rein in, rather than designing indirect and intricate rules that would ultimately entangle many participants that are essential to the efficient functioning of these markets. If Congress disrupted the entire energy market, just to constrain speculation by pension funds and other portfolio investors, the resulting chaos would hardly benefit consumers.
There's no shortage of conflicting opinions on this topic. A number of academics and financial experts have dismissed the possibility that speculation in oil futures could have much influence on the price of the physical commodity, pointing instead to the very real contribution of rapid demand growth in the developing world, slower production growth, particularly among non-OPEC producers, and the disappearance of global spare production capacity. Others have highlighted the recent and substantial flow of funds into the market from a new class of commodity investors, including pension funds and other institutions. They spot a cause-and-effect relationship in the accompanying rise in oil prices and find worrying parallels to the high-tech and housing bubbles. For my own part, I worry about the systematic linkages between the impact of this additional demand on futures prices and the mechanisms by which the price of oil purchased by refineries is set. But while I see a connection between speculation and higher fuel prices, I am skeptical of attempts to quantify it.
My background gives me a unique vantage point on this debate. After my graduate training in business and economics, I acquired a hands-on education in markets during a decade spent trading energy commodities for Texaco, Inc. This included a two-year stint trading international petroleum products from London, involving extensive dealings with our futures trading group and external floor broker. When I returned to Los Angeles, I was responsible for managing the commodity risk profile of the company's West Coast refining and marketing operations. Although this experience wasn't recent, I have no conflicts of interest in this area that would constrain my objectivity about the various proposals for regulating oil market speculation.
Some of the recent suggestions for regulating energy futures and derivatives trading might do more good than harm. This includes raising margin requirements, which might decrease liquidity, but also ought to reduce volatility by deterring investors from putting on enormous positions in hopes of turning small per-unit margins into huge aggregate gains, a strategy that hedge funds have employed in many markets. Shrinking volatility would be bad for traders, who thrive on it, but good for the economy. Closing the so-called "Enron Loophole" probably falls into a similar category of positive benefit vs. cost.
Other ideas seem likely to do much more harm to non-financial firms seeking to manage their business risks. For example, one of Senator Obama's recent anti-speculation proposals would force all energy commodities to trade on regulated exchanges. If this shut down the over-the-counter "swap" transactions that are used to bridge the price gaps between the small selection of crude and products traded on the NYMEX and the actual grades that companies buy and sell, it would make it much harder for businesses to hedge their risks. Airlines come to mind, here. Because there is no futures contract for jet fuel, an airline hedging its fuel supplies by buying crude oil or heating oil futures/options often also executes a swap covering the difference in price between jet and crude or jet and diesel. Otherwise, it runs the risk that when it purchase its jet fuel later, the hedge will have only appreciated by a fraction of the increase in the price of the physical product, or worse yet, might have lost money, while jet fuel prices continued to climb due to local or global scarcity. But as important as this transaction has become to airlines, it seems unlikely to generate the scale and liquidity required to merit launching an exchange-traded futures contract to cover it.
An even worse notion making the rounds on Capitol Hill would require anyone buying a futures contract to take physical delivery of the oil or product. As sensible as this might sound to the public, it would be catastrophic for the market and for the vast majority of participants, large and small, who use these markets to manage the enormous price risks associated with real-world energy activities. Even the small minority of players who rely on the NYMEX for physical supply in the New York Harbor would suffer, as liquidity for these contracts dried up. Consumers used to buying heating oil at a fixed-price for the season or year would probably lose this option, as all but the largest suppliers would be unable to offer this service.
Even the basic principle of limiting futures market activity to entities that produce or consume oil or its products is fundamentally flawed. On any given day, the producers and end-users wouldn't be active enough to make a real, liquid market. I experienced this first hand trading refined products on the West Coast. Top management preferred us to deal mainly with other oil companies, but when our own output fell short, the other refiners weren't always in the mood to sell. Without being able to buy from risk-taking independent traders who had previously taken a bet on the market, we would have run out of product on many occasions, and consumers would ultimately have been harmed.
Speculation plays an important role in lubricating the wheels of commerce, although it may also be contributing to higher oil prices, as investors increasingly turn to these markets as an inflation hedge or as another long-term asset class. My advice to Congress is to err on the side of caution in regulating energy commodity trading, and to specify very precisely which activities they want to rein in, rather than designing indirect and intricate rules that would ultimately entangle many participants that are essential to the efficient functioning of these markets. If Congress disrupted the entire energy market, just to constrain speculation by pension funds and other portfolio investors, the resulting chaos would hardly benefit consumers.
Wednesday, May 28, 2008
Ending Oil's Monopoly
In yesterday's Financial Times (subscription required for full text) Daniel Yergin suggested that the current oil price spike is creating a historical "break point" for petroleum that will result in the loss of oil's dominance in the global transportation fuels market. The commentary by Mr. Yergin, the Chairman of Cambridge Energy Research Associates articulated a shift that has become increasingly apparent to careful observers of the industry. His conclusion that oil will "share the transport market with other sources as never before" is almost certainly correct, even if oil prices were to revert to $60 per barrel next week. There is an important corollary to Mr. Yergin's analysis that he didn't explore in his FT op-ed: At the same time that gasoline and diesel will have to share the market with other fuels, the primary sources of transportation energy will also become much more diverse, as well. That has important implications for both national energy policy and corporate strategies.
Consider the supply chain for petroleum products. Oil is extracted from underground reservoirs and transported to refineries that separate it into its familiar product categories, while transforming low value portions of the barrel into high-quality fuels and removing sulfur and other impurities along the way. A modern refinery is a complex, expensive set of hardware, but its functions would still be recognizable to an oilman from the 1930s. Even ethanol has retained this model, with corn going in one end of an ethanol plant and ethanol and its byproducts coming out the other end. The new transportation energy market that Mr. Yergin hints at will shatter this model. Oil and its products--and corn and its fuel products--will play an important role for decades to come, but they will compete with synthetic diesel and jet fuel from natural gas, coal and biomass; biodiesel, ethanol and other alcohols from a wide variety of feedstocks and technologies; and electricity and hydrogen from a multitude of conventional and renewable sources, both centralized and distributed.
This new model will break three effective monopolies: of spark-ignition and compression-ignition internal combustion engines, of gasoline and diesel fuel as the dominant energy carriers for delivering transportation energy--and note that ethanol has so far only piggy-backed on gasoline's monopoly, rather than breaking it--and of petroleum as the source of primary energy for most forms of transportation. While the market shares of all three of these monopolies are in the high 90%'s today, the signposts of change are all around us. Biotechnology promises to break down the cellulosic material that gives plants their rigid structure and turn it into ethanol and other fuels, but it could eventually give us plants that excrete market-ready fuels. Better batteries will give consumers the choice between plugging in and filling up, but they could also facilitate the much wider adoption of renewable electricity from intermittent sources such as wind and solar power. And fuel cells running on hydrogen might yet provide a practical and more efficient way to turn chemical energy into useful work onboard the vehicle, powering electric motors that will become increasingly ubiquitous on all ground vehicles.
A decade ago, this scenario was just that, one possible future outcome of a number of competing trends and uncertainties. Now, thanks to the combination of concerns about climate change and energy security, and the practical problems of $130 oil, some version of it seems more plausible than the unchallenged continuation of those three "natural monopolies" for another generation. Whatever its other faults, the "farm bill" just passed by the Congress over the President's veto takes a step in that direction, by reducing the subsidy for corn ethanol, the so-called Blenders' Credit, from $0.51 per gallon to $0.45 and using the savings to fund a $1.01/gal. direct subsidy for producers of cellulosic biofuel.
As Mr. Yergin points out, oil "is not going to fade away soon." It will take time to turn over car fleets and move new fuel processes out of the laboratory, through demonstration-scale testing, and into full commercial production. But as frustrating as the wait for these new technologies and fuels may seem, while Americans pay $4 at the pump and Europeans pay the equivalent of $8 per gallon, this energy crisis--unlike the one of the 1970s and early 1980s--might just put in place the means of averting all foreseeable future energy crises centered on oil, by reducing the status of oil producers to that of merely one transportation energy source among many.
Consider the supply chain for petroleum products. Oil is extracted from underground reservoirs and transported to refineries that separate it into its familiar product categories, while transforming low value portions of the barrel into high-quality fuels and removing sulfur and other impurities along the way. A modern refinery is a complex, expensive set of hardware, but its functions would still be recognizable to an oilman from the 1930s. Even ethanol has retained this model, with corn going in one end of an ethanol plant and ethanol and its byproducts coming out the other end. The new transportation energy market that Mr. Yergin hints at will shatter this model. Oil and its products--and corn and its fuel products--will play an important role for decades to come, but they will compete with synthetic diesel and jet fuel from natural gas, coal and biomass; biodiesel, ethanol and other alcohols from a wide variety of feedstocks and technologies; and electricity and hydrogen from a multitude of conventional and renewable sources, both centralized and distributed.
This new model will break three effective monopolies: of spark-ignition and compression-ignition internal combustion engines, of gasoline and diesel fuel as the dominant energy carriers for delivering transportation energy--and note that ethanol has so far only piggy-backed on gasoline's monopoly, rather than breaking it--and of petroleum as the source of primary energy for most forms of transportation. While the market shares of all three of these monopolies are in the high 90%'s today, the signposts of change are all around us. Biotechnology promises to break down the cellulosic material that gives plants their rigid structure and turn it into ethanol and other fuels, but it could eventually give us plants that excrete market-ready fuels. Better batteries will give consumers the choice between plugging in and filling up, but they could also facilitate the much wider adoption of renewable electricity from intermittent sources such as wind and solar power. And fuel cells running on hydrogen might yet provide a practical and more efficient way to turn chemical energy into useful work onboard the vehicle, powering electric motors that will become increasingly ubiquitous on all ground vehicles.
A decade ago, this scenario was just that, one possible future outcome of a number of competing trends and uncertainties. Now, thanks to the combination of concerns about climate change and energy security, and the practical problems of $130 oil, some version of it seems more plausible than the unchallenged continuation of those three "natural monopolies" for another generation. Whatever its other faults, the "farm bill" just passed by the Congress over the President's veto takes a step in that direction, by reducing the subsidy for corn ethanol, the so-called Blenders' Credit, from $0.51 per gallon to $0.45 and using the savings to fund a $1.01/gal. direct subsidy for producers of cellulosic biofuel.
As Mr. Yergin points out, oil "is not going to fade away soon." It will take time to turn over car fleets and move new fuel processes out of the laboratory, through demonstration-scale testing, and into full commercial production. But as frustrating as the wait for these new technologies and fuels may seem, while Americans pay $4 at the pump and Europeans pay the equivalent of $8 per gallon, this energy crisis--unlike the one of the 1970s and early 1980s--might just put in place the means of averting all foreseeable future energy crises centered on oil, by reducing the status of oil producers to that of merely one transportation energy source among many.
Friday, May 23, 2008
Oil Panic Attack
After having mostly yawned our way through the first half of oil's amazing six-year ride, we now watch its movements as intently as any futures trader, and our level of concern seems to be building towards a national anxiety attack. Since 2002 we've seen the price of West Texas Intermediate Crude Oil rise from the mid-$20's to the mid-$70s, then retrace to $51 in early 2007, before beginning its remorseless climb past $100 and every other logical stopping point. Some industry analysts are predicting $200 per barrel oil, and warnings of $6, $10, or even $12 gasoline are treated seriously, bolstered yesterday by a new suggestion from the normally-conservative International Energy Agency that we may be approaching a global production plateau. My crystal ball isn't working any better than anyone else's, and thankfully I'm not paid to forecast oil prices. If we want to understand where we're headed, though, we should examine where we've been.
Until fairly recently, oil was regarded as a cyclical commodity, though its cycles didn't necessarily coincide with those of the global economy. It's also an industry that values experience, so its management includes many who have seen several of oil's up and down sequences. That means the senior members of the tribe can recall from personal experience--even if it was early in their careers--the collapse of oil prices in the mid-1980s after the lagged responses to the first energy crisis took hold. Then came the even more devastating drop in 1998/99, in tandem with the Asian Economic Crisis, when WTI bottomed out at just over $10/bbl, pushing the price of most grades of oil into single digits. Many projects that were planned in the late 1980s, when oil finally reached $20/bbl again, started up in a down market that destroyed billions of dollars of net present value. At the same time that oil companies were learning these painful lessons, the OPEC countries that hold most of the world's known oil reserves were attending a similar school, particularly with regard to the perils of over-capacity. The oil price collapse of the late 90s that squeezed the stock prices and investment budgets of the international oil companies created large external deficits for OPEC's members.
Next consider the unexpectedly large expansion of demand. Between 1998 and 2006, global oil demand grew by 10 million barrels per day. At the same time, the natural decline of mature oil fields would have required the industry to replace somewhere between 1.5 and 3 times that much output, just to stay even, in a period when an increasing proportion of the best opportunities were not available to the companies with the biggest incentive to grow production, and the big producing countries were starting to learn that selling more oil may be a less effective way to make more money than selling less, or at least holding output steady in the face of rising demand.
As a result of these factors, when prices began to rise again, breaking through $30 in 2000, oil companies and producing countries had good reasons to be skeptical that the fundamental relationship between supply and demand was on the verge of a permanent shift. That resulted in a crucial delay in funding new projects--crucial because of the time lags involved in the planning, permitting, procurement and construction stages of such projects. In the interim, most of the world's spare production capacity was tapped, and the industry seems unlikely to catch up, short of a global recession that would halt demand growth in its tracks.
Throw in a few other key factors, such as the dollar's decline, an increase in commodity speculation, and the artificially-low petroleum product prices in a number of developing economies, and we have all the necessary ingredients for the quintupling of oil prices that we have experienced in the last six years--doubling in just the last year. Getting out of the deep hole we have dug will require a combination of higher fuel efficiency, increased non-efficiency conservation, more drilling, greatly expanded non-food biofuels and synfuels output, and the partial electrification of personal transport. With the exception of conservation, none of these solutions will make a dent in the problem in this decade.
No one can predict with certainty where oil prices will go from here. It could be to $200, or back below $100. The market is flirting with contango, suggesting it is reasonably well-supplied for now. Despite this week's 5 million barrel drop in US crude oil inventories, days' supply of crude and gasoline are at a fairly healthy 22 days each. Yet the momentum of this market seems unshakable. In the meantime, I suggest prudent conservation and the avoidance of panic. $200 oil would not mean $12 gasoline. In fact, unless refining margins suddenly came back to life, it might not even get us to a $6 national average retail price for unleaded regular. That's not very reassuring, going into the Memorial Day weekend that signals the start of the peak driving season. Our enjoyment of the summer could depend on our level of stoicism.
Until fairly recently, oil was regarded as a cyclical commodity, though its cycles didn't necessarily coincide with those of the global economy. It's also an industry that values experience, so its management includes many who have seen several of oil's up and down sequences. That means the senior members of the tribe can recall from personal experience--even if it was early in their careers--the collapse of oil prices in the mid-1980s after the lagged responses to the first energy crisis took hold. Then came the even more devastating drop in 1998/99, in tandem with the Asian Economic Crisis, when WTI bottomed out at just over $10/bbl, pushing the price of most grades of oil into single digits. Many projects that were planned in the late 1980s, when oil finally reached $20/bbl again, started up in a down market that destroyed billions of dollars of net present value. At the same time that oil companies were learning these painful lessons, the OPEC countries that hold most of the world's known oil reserves were attending a similar school, particularly with regard to the perils of over-capacity. The oil price collapse of the late 90s that squeezed the stock prices and investment budgets of the international oil companies created large external deficits for OPEC's members.
Next consider the unexpectedly large expansion of demand. Between 1998 and 2006, global oil demand grew by 10 million barrels per day. At the same time, the natural decline of mature oil fields would have required the industry to replace somewhere between 1.5 and 3 times that much output, just to stay even, in a period when an increasing proportion of the best opportunities were not available to the companies with the biggest incentive to grow production, and the big producing countries were starting to learn that selling more oil may be a less effective way to make more money than selling less, or at least holding output steady in the face of rising demand.
As a result of these factors, when prices began to rise again, breaking through $30 in 2000, oil companies and producing countries had good reasons to be skeptical that the fundamental relationship between supply and demand was on the verge of a permanent shift. That resulted in a crucial delay in funding new projects--crucial because of the time lags involved in the planning, permitting, procurement and construction stages of such projects. In the interim, most of the world's spare production capacity was tapped, and the industry seems unlikely to catch up, short of a global recession that would halt demand growth in its tracks.
Throw in a few other key factors, such as the dollar's decline, an increase in commodity speculation, and the artificially-low petroleum product prices in a number of developing economies, and we have all the necessary ingredients for the quintupling of oil prices that we have experienced in the last six years--doubling in just the last year. Getting out of the deep hole we have dug will require a combination of higher fuel efficiency, increased non-efficiency conservation, more drilling, greatly expanded non-food biofuels and synfuels output, and the partial electrification of personal transport. With the exception of conservation, none of these solutions will make a dent in the problem in this decade.
No one can predict with certainty where oil prices will go from here. It could be to $200, or back below $100. The market is flirting with contango, suggesting it is reasonably well-supplied for now. Despite this week's 5 million barrel drop in US crude oil inventories, days' supply of crude and gasoline are at a fairly healthy 22 days each. Yet the momentum of this market seems unshakable. In the meantime, I suggest prudent conservation and the avoidance of panic. $200 oil would not mean $12 gasoline. In fact, unless refining margins suddenly came back to life, it might not even get us to a $6 national average retail price for unleaded regular. That's not very reassuring, going into the Memorial Day weekend that signals the start of the peak driving season. Our enjoyment of the summer could depend on our level of stoicism.
Friday, May 09, 2008
The SPR Debate
The ongoing oil price spike is attracting renewed attention to the government's policy of continuing to fill the Strategic Petroleum Reserve with extremely pricey oil, which I mentioned in Wednesday's posting. Members of Congress and various commentators are calling for a reassessment, as I've done since last October. We're also seeing suggestions such as the one in today's Wall Street Journal for ways to use the SPR not just as a hedge against catastrophic supply disruptions, but as a tool for managing oil prices. A new administration will take office in eight months, and energy is likely to be a key focus of its new policies. I can't imagine a better way to kick off a fresh look at the nation's energy problems than with a complete rethinking of the basis and design of our strategic oil inventories.
The op-ed in today's Journal applies a combination of common sense and questionable judgment to the problem. The author, the chief economist at a firm that supports independent financial planners, is right to point out that $120 oil is too dear to squirrel away against the low likelihood of a massive disruption in oil supplies, the likes of which we haven't seen since the SPR was created in the 1970s. Unfortunately, the rest of his proposal for reducing the scale of the SPR and using it to set a price ceiling for oil relies too much on economic theory and too little on the geopolitical and logistical realities of the situation in which we find ourselves. More importantly, it does not start with a fundamental reexamination of the challenges the SPR was intended to address, and how those have altered in the last three decades.
Consider that when the first barrel of oil went into the SPR's Gulf Coast storage caverns in 1977, the US was relatively self-sufficient in petroleum refining capacity. Crude oil imports accounted for only 45% of the supply to those refineries, compared to 66% last year. At the time, the West Coast was essentially autonomous in crude oil and refined products, with its refineries amply supplied by California's production, which would shortly peak at over one million barrels per day, along with the growing output from Alaska. Much has changed. In addition to importing much larger volumes of crude oil, our refinery capacity hasn't kept pace with demand, resulting in steadily growing imports of gasoline and gasoline blending components. And in the interim, oil production in Alaska and California has fallen into deep decline, requiring substantial crude and product imports into a maxed-out West Coast refining system.
So instead of a strategic reserve designed to provide a back-up supply of crude oil to Gulf Coast and Mid-continent refineries serving the entire US east of the Rockies, our needs have expanded to encompass oil and refined product imports on all three coasts. And with more of our domestic production shifting to the deep waters of the Outer Continental Shelf, the risks against which an SPR must insure us also include potential domestic supply disruptions. We saw that after hurricanes Katrina and Rita shut down much of our Gulf Coast production, and again when pipeline problems in 2006 idled half of the Alaskan North Slope field. These altered circumstances strongly suggest the need for a more diverse and dispersed SPR, perhaps modeled along the lines of the federal Northeast Heating Oil Reserve. Nor do I believe that the only practical model of such a reserve entails government ownership and custody of the hydrocarbons in question. Other countries achieve the same end with a requirement for oil companies to maintain mandatory minimum inventory levels, at no direct cost to taxpayers.
Unfortunately, the risks we face have also evolved in the last thirty years, and that must be factored into our understanding of the necessity and nature of an effective SPR. No one expects his house to burn down in a given year, but most of us still buy fire insurance, because the consequences of that low-probability event would be so disastrous. An SPR works the same way. While Mr. Anderson looks to the pattern of past SPR releases to suggest that as little as 120 million barrels of oil might be adequate to cover any likely contingency, it is all too easy to imagine low-probability/high-impact scenarios that would require the SPR to cover a sudden shortfall exceeding two million barrels per day for longer than a month or two, at a time when global spare production capacity has shrunk to virtually nothing, or sits on the wrong side of a bottleneck. Full-scale civil war in Iraq, conflict with Iran, revolution in Venezuela or Nigeria, or a terrorist attack on the oil export facilities at Ras Tanura would do the trick.
It is high time to re-think the Strategic Petroleum Reserve, more than three decades after it was conceived. Global patterns of oil supply and demand have changed enormously, and so have the patterns of oil use within the US. The nature of the risks that an SPR should insure against have changed, too. We need a vigorous debate on all this, infused with new ideas and new options made possible by technology that didn't even exist in the 1970s. But we also need to be clear about the scope of such a debate, which should not include managing day-to-day oil prices, adding layers of complexity to the problem and a host of unintended consequences into the global energy market. So by all means, let's stop filling it, until we figure out the kind of SPR we really need. In the meantime, we must resist the temptation to expend these reserves on rash schemes to control the price of a commodity of which we only produce 10% of the world's supply.
The op-ed in today's Journal applies a combination of common sense and questionable judgment to the problem. The author, the chief economist at a firm that supports independent financial planners, is right to point out that $120 oil is too dear to squirrel away against the low likelihood of a massive disruption in oil supplies, the likes of which we haven't seen since the SPR was created in the 1970s. Unfortunately, the rest of his proposal for reducing the scale of the SPR and using it to set a price ceiling for oil relies too much on economic theory and too little on the geopolitical and logistical realities of the situation in which we find ourselves. More importantly, it does not start with a fundamental reexamination of the challenges the SPR was intended to address, and how those have altered in the last three decades.
Consider that when the first barrel of oil went into the SPR's Gulf Coast storage caverns in 1977, the US was relatively self-sufficient in petroleum refining capacity. Crude oil imports accounted for only 45% of the supply to those refineries, compared to 66% last year. At the time, the West Coast was essentially autonomous in crude oil and refined products, with its refineries amply supplied by California's production, which would shortly peak at over one million barrels per day, along with the growing output from Alaska. Much has changed. In addition to importing much larger volumes of crude oil, our refinery capacity hasn't kept pace with demand, resulting in steadily growing imports of gasoline and gasoline blending components. And in the interim, oil production in Alaska and California has fallen into deep decline, requiring substantial crude and product imports into a maxed-out West Coast refining system.
So instead of a strategic reserve designed to provide a back-up supply of crude oil to Gulf Coast and Mid-continent refineries serving the entire US east of the Rockies, our needs have expanded to encompass oil and refined product imports on all three coasts. And with more of our domestic production shifting to the deep waters of the Outer Continental Shelf, the risks against which an SPR must insure us also include potential domestic supply disruptions. We saw that after hurricanes Katrina and Rita shut down much of our Gulf Coast production, and again when pipeline problems in 2006 idled half of the Alaskan North Slope field. These altered circumstances strongly suggest the need for a more diverse and dispersed SPR, perhaps modeled along the lines of the federal Northeast Heating Oil Reserve. Nor do I believe that the only practical model of such a reserve entails government ownership and custody of the hydrocarbons in question. Other countries achieve the same end with a requirement for oil companies to maintain mandatory minimum inventory levels, at no direct cost to taxpayers.
Unfortunately, the risks we face have also evolved in the last thirty years, and that must be factored into our understanding of the necessity and nature of an effective SPR. No one expects his house to burn down in a given year, but most of us still buy fire insurance, because the consequences of that low-probability event would be so disastrous. An SPR works the same way. While Mr. Anderson looks to the pattern of past SPR releases to suggest that as little as 120 million barrels of oil might be adequate to cover any likely contingency, it is all too easy to imagine low-probability/high-impact scenarios that would require the SPR to cover a sudden shortfall exceeding two million barrels per day for longer than a month or two, at a time when global spare production capacity has shrunk to virtually nothing, or sits on the wrong side of a bottleneck. Full-scale civil war in Iraq, conflict with Iran, revolution in Venezuela or Nigeria, or a terrorist attack on the oil export facilities at Ras Tanura would do the trick.
It is high time to re-think the Strategic Petroleum Reserve, more than three decades after it was conceived. Global patterns of oil supply and demand have changed enormously, and so have the patterns of oil use within the US. The nature of the risks that an SPR should insure against have changed, too. We need a vigorous debate on all this, infused with new ideas and new options made possible by technology that didn't even exist in the 1970s. But we also need to be clear about the scope of such a debate, which should not include managing day-to-day oil prices, adding layers of complexity to the problem and a host of unintended consequences into the global energy market. So by all means, let's stop filling it, until we figure out the kind of SPR we really need. In the meantime, we must resist the temptation to expend these reserves on rash schemes to control the price of a commodity of which we only produce 10% of the world's supply.
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