The Strategic Petroleum Blunder?
On 22nd September, President Clinton announced that 30 million barrels of oil would be released from the US Strategic Petroleum Reserve on a swap basis. Rather than selling the oil, as it had in 1990, the Department of Energy (DOE) would receive offers based on the volume of replacement oil to be put into the SPR between August and November 2001.
We believe that the SPR release has proved to be unfortunate for four main reasons. First, the release has been handled in a clumsy fashion. Secondly, it did not provide the best value for the DOE and the US taxpayer, and by offering a large hidden discount offered oil traders the possibility of locking in large profits. Thirdly, it was not in any way appropriate for the objective which the release was, at least in public statements, intended to achieve. Finally, it has confused the issue of what the SPR is actually for, and it has at least temporarily blunted the effectiveness of SPR release for the purpose for which it was intended. We consider these separate aspects in the four sections that follow.
1. Operational Flaws
On 4th October, the DOE announced that it had received enough bids to award the full 30 million barrels of SPR oil that was on offer. At first sight, this appeared to be quite a triumph, as many within the industry had questioned whether the full allocation would be taken up. After all, the market has been suffering from a shortage of heating oil, while crude oil availability has not really been a problem in the USA. However, the doubts set in when the list of takers was released.
- The barrels were awarded to the following companies :
- BP – 6 million barrels
- Lance Stroud Enterprises – 4 million barrels
- Marathon Ashland – 3.9 million barrels
- Euell Energy – 3 million barrels
- Burhany Energy – 3 million barrels
- Equiva – 2.5 million barrels
- Morgan Stanley – 2 million barrels
- Hess Energy Trading – 2 million barrels
- Vitol – 1.6 million barrels
- Valero -1 million barrels
- Elf – 1 million barrels
Eight of these eleven companies are well known oil traders or oil refiners. Three are somewhat more surprising, indeed selecting them before seeing any letters of credit seems incomprehensible. Euell Energy is a small Colorado based pipeline company, while Lance Stroud and Burhany Energy are totally unknown. To confirm that they are complete outsiders, an internet search on either Lance Stroud or Burhany Energy brings up nothing of relevance, which is, to say the least, unusual for any company with any degree of oil market experience.
A total of ten million barrels, one-third of the whole SPR release, was then awarded to companies whose credentials in the context of such an operation was open to considerable question. Sure enough, on 12th October Euell Energy’s award was forfeited when it failed to produce letters of credit. Lance Stroud and Burhany Energy were given more time to produce letters of credit, but on 14th October the Lance Stroud bid was also forfeited. Burhany Energy also failed to produce letters of credit. However, as they managed to pass transfer of their bid to Hess Energy, that bid stood. Bids for a total of 23 million barrels were then cleared to move to completion. The remaining 7 million barrels have been reopened for bidding, with a closing date of 23rd October and probable delivery in December. The first transfer out of the original tranche began on 14th October, with Morgan Stanley receiving, and rapidly trading on, the first part of their allocation.
Lance Stroud Enterprises is a one person operation operating out of a New York apartment. Burhany Energy was incorporated just two months ago and has no oil experience. How did these companies get onto the list in the first place? Why did the DOE apparently make no background checks?
One could argue that allowing all bids in the first round is simply a reflection of the desirability of encouraging free enterprise. Opportunity should exist for all, and there should be no list of the acceptable elite. Indeed, the administration has argued precisely that. According to White House spokesman Jake Siewert, “It’s capitalism at work”. If the process had been an auction for surplus Army office equipment I would tend to agree, after all one needs little experience to resell a photocopier. However, this was an auction for crude oil. It is difficult, indeed nearly impossible, for an outsider to handle the transfer of large amounts of crude oil without the benefit of any experience or any reputation. Counterparty risk is extremely important in the oil industry, and the original DOE list included rather a lot of it.
The principle of exclusion for government auctions according to minimal thresholds is not a new one. When it comes to auctioning leases for crude oil exploration and development in federal areas, the government’s Minerals Management Service maintains a list of approved bidders. Yet, when it came to an auction with a fair greater political profile, it appears that not even the most basic of criteria were applied. I would have no wish to stop Lance Stroud becoming a new Rockefeller within the natural cut and thrust of capitalism. I would, however, suggest that he cut his teeth on something less ambitious within oil trading before moving on to SPR oil. The basic sine qua non of oil trading is that the first reaction of your potential trading partners should be something other than “Who?”.
It is course possible that the DOE had decided to trade off one embarrassment for another. Perhaps it was thought better to announce that all the oil had been awarded and then to rescind one-quarter of it, rather than to have to announce that not enough suitable bids had not been received. Perhaps it was thought that the triumph of allocating all the oil would get big headlines, while the forfeits would get little attention. Whatever the reasoning, the whole process was lurched into a state of some disarray by the failure to make even the most basic of checks.
However, the major problem behind the SPR auction is not the selection of companies of dubious suitability. The major problem is the reason why those companies were bidding in the first place. They bid because the SPR auction offered the possibility of an almost riskless cash bonanza. In seeing that, the three small companies moved faster and more intelligently than many established traders, and one must say that they therefore showed some of the most important skills to succeed in oil trading. They had done their numbers and seen the potential. As we demonstrate below, that potential proved to be in reality a windfall of just below $100 million. The real surprise of the SPR auction is that the DOE was prepared to give so much money away in order to move the oil into the marketplace.
2. Financial Naivety and Hidden Discounts
The release of SPR oil provided the chance of a risk-free cash windfall for the winners. We would estimate this handout to be at the very least $93 million, had all the initially accepted bids actually stood. The mechanism for this transfer works as follows. The taker of the oil would receive it by the end of November 2000, and then would have to provide replacement oil within a year. They would be exposed to the risk of a price fall before they took the oil, and a price rise before they replaced it. However, both risks can be hedged, and a guaranteed riskless profit locked in.
Assume that the delivery from the SPR was expected in the first three weeks of November. The nearest futures contract trading at that time will be December 2000. The closing price on the New York Mercantile Exchange (NYMEX) on October 4th, (the day of the award), for December 2000 delivery was $31.24 per barrel. On the same day, November 2001 delivery closed at $28.21 per barrel. If all the SPR barrels were hedged in this way, the profit locked in would be the difference between 30 million barrels at the December 2000 price, and 31.56 million barrels (the total award to be returned to the SPR) at the November 2001 price. This results in a profit of $47 million.
In addition to this $47 million, the traders receive money when they sell the oil on, or alternatively if they are also refiners they benefit from not paying cash now for the oil they are using. We must therefore add one year’s interest payments to the traders’ benefit. In the note at the end of this comment we value the average barrel of oil involved in the SPR release at 74 cents below the NYMEX light sweet crude oil contract. On the October 4th selling prices, (which the traders would have locked in through hedging), the value of the oil was therefore (31.24-0.74)*30 million = $915 million. Assuming a 5 per cent return on capital then adds a further amount of close to $46 million, and thus takes the total windfall up to $93 million.
This a bare minimum figure, as a good trader could have achieved more favourable prices than we have used, particularly if they had taken the risk that they would get SPR oil and put the hedge in place before the announcement of bids on 4th October. Given that the conventional wisdom in the industry was that the DOE would have trouble allocating all the oil, that risk does not seem too large to have taken.
To move the oil, the DOE was thus prepared to transfer at least $93 million to traders. In effect, they were prepared to discount the oil by more than $3 per barrel, which is to say the least generous. Of course, by arranging the release as a swap arrangement rather than a straightforward sale, the extraordinary degree of discounting could more easily be hidden. However, the size of that discount is also very apparent if we consider quantities.
The DOE’s discounting led to it accepting bids that added up to as little as 31.56 million barrels for ultimate replacement into the SPR. They would have done better, from the point of view of the US taxpayer, by simply selling SPR oil and then buying oil back in one year. We can illustrate this as following. Using the derived discount of SPR oil from the futures price, above we derived a value of $915 million on 4th October. Assuming that this capital achieved a 5 per cent return over the year, and dividing the total by the November 2001 delivery price as of October 4th, (which the DOE could have locked in by hedging) minus the SPR quality adjustment, produces the figure of exactly 35 million barrels.
The DOE could then have achieved the same result, but added 5 million barrels instead of 1.5 million barrels to the SPR without incurring risk. They forfeited the opportunity of getting an extra 3.5 million barrels. Valuing those 3.5 million barrels at the November 2001 price as of October 4th, (i.e. the price that could have been locked in) minus the quality adjustment, produces another value for the DOE’s total discount. Our previous calculation put it at $93 million. Using this alternative ‘foregone quantity’ measure produces a comparable figure of $96 million. On both calculations the DOE are seen to have in effect discounted the oil by more $3 per barrel, on one calculation by $3.10 and on the other $3.20. By using the swap mechanism they had in effect put the true size of the discount somewhere where auditors are less likely to pick it up.
Had the DOE decided to take risk and believed that NYMEX prices one year from now will be lower than $28.21, then they might have expected to have done even better in terms of replacement quantities. In the event, the DOE has actually taken on risk with regard to replacement of SPR oil. The bids from the companies contained bonus percentages, which stipulated the extra bonus oil the SPR would receive should prices have fallen by next year. As these details have not been made public, it is impossible to quantify them. However, it is impossible that they would have resulted in the SPR receiving more oil in the case of price falls than if the DOE had mounted the operation themselves, or at least it would have not been commercially rational for a company to make such a bid.
The above shows that the discount is in fact totally transparent when the calculations are made. It has, however, certainly not been presented so transparently in coverage of the SPR auction to date. One does however suspect that if the original announcement of successful placement by the DOE had included the admission that a discount of more than $3 per barrel compared to the fair market value had been given, then some pertinent questions would have had to be answered.
3. The Impossibility of the Stated Objective
The SPR release was designed to reduce the impact of potential heating oil price spikes in the US northeast. According to Energy Secretary Bill Richardson, ‘We need to make sure that American families keep warm this winter’. As rhetoric it may sound laudable. The problem is that SPR release can not have any appreciable effect on heating oil availability in current circumstances.
To increase the availability of heating oil by providing more crude oil would simply require that refiners produce more heating oil. The problem is that US refiners are already at close to full capacity, and hence there is virtually no slack within the system to produce more. One could add that spare space within the key oil product pipelines to the northeast is extremely limited, so it might be difficult to transport the oil even if it could be produced. If there was any theory behind the release, it would be that providing SPR oil would reduce the price of crude oil relative to that of oil products, increase refinery profitability and hence provide an economic signal to refine more oil. It has failed because that signal was already there, refiners were already maximising production. The refining industry has for a long time been an extremely low return business, and therefore one should not begrudge them the potential for increased profits that SPR release provides. On the other hand, a government strategy which is designed to increase heating oil quantities but instead just leads to changes in profits can hardly be thought of as a success.
The connection with heating oil availability seems even stranger when we consider the DOE’s own idea of the overall impact of SPR release. According to the Winter Fuels Outlook 2000-1, published by the Energy Information Administration (EIA) of the DOE, ‘EIA estimates that average distillate stock levels this winter will be about 3 to 5 million barrels above where they would otherwise have been had the President not ordered a swap of 30 million barrels of oil from the Strategic Petroleum Reserve (SPR)’. The logic behind this is that the SPR release will lead to a displacement of 20 million barrels of oil imports that would have come into the USA. The 3 to 5 million barrels of heating oil stock increase is the, rather optimistic, expected yield of heating oil from the remaining 10 million barrels, (the yield of US refineries for all oil distillates was about 25 per cent in September).
One could argue that in a backwardated crude oil market, (i.e. where prompt prices are above those for future delivery and hence where companies have no incentive to hold excess crude oil inventory), when refiners had no spare capacity to refine more, the provision of 30 million barrels of SPR oil would reduce imports by a full 30 million barrels and not the EIA’s 20 million barrels. To force an extra 10 million barrels through the refining system over a month requires capacity utilisation rates to rise by what might seem a trivial 2 per cent. However, the capacity utilisation rate at the time of the release announcement was already 97.5 per cent.
The EIA quote together with our earlier analysis then implies that the US government is willing to transfer nearly $100 million to traders in order to attempt to increase heating oil inventories by just 3 to 5 million barrels. We believe that in the best possible case the increase would be just 2 million barrels. Those barrels then begin to look extremely expensive. At current prices, they would cost $40.50 per barrel on the wholesale market, and then the tax payer would be paying a further $46.50 per barrel through our calculation of the SPR auction transfer to traders. If we were to take at face value the government statement that the SPR release was intended to increase heating oil availability, then we would have to conclude that the result is just 2 million barrels that in effect would cost the US economy $87 per barrel.
To put the 2 million barrels volume in context, US total distillate inventories for the second week of October stand 30.1 million barrels lower than they did in 1999. The expected SPR improvement makes very little impression on this, even if it actually managed to increase inventories by the full 3 to 5 million barrels. The absurdity of giving away so much to achieve so little is illustrated by the following. For the amount of the transfer given to traders in the SPR auction, the DOE could have gone to Europe, bought 2 million barrels of heating oil, transported it across the Atlantic and then given it away to consumers absolutely for free. Absurd of course, but no more expensive and producing no less extra volume of heating oil than what was actually done.
In reality, it appears that the government intended the SPR release to serve more of a political purpose than an oil market purpose. Note the size of the release. The gap between heating oil inventories at the time of the release announcement and the levels from one year ago was 30 million barrels. The choice of 30 million barrels for the SPR release, rather than any other amount, then appears suspicious. It looks all too tempting to try to run through public opinion the fallacious argument that heating oil was 30 million barrels down on 1999 so the government released 30 million barrels of oil to cover for it. The heavy hand of political expediency seems to be at work, for, as the EIA’s report shows, the DOE itself was in doubt that SPR release would be of little usefulness in terms of its stated goal.
4. Bad Timing
The SPR release has created considerable confusion as to whether the purpose of the SPR has changed. The justification for the release in terms of heating oil availability implies micro-management of the oil market. If we accept that the official justification was just a smokescreen, and on the basis of the previous section we must, we have to conclude that the SPR has been used for a combination of internal US political reasons, and as an attempt to directly manage world oil prices. The question is then raised as to the extent to which the USA wishes to become an overt participant in the determination of prices.
A precedent has now been created that the active use of the SPR is a valid policy instrument far beyond the SPR’s original supply security aims. As such, that is a dangerous precedent. At times such as the present, when OPEC members and the USA all wish to take some of the heat out of the market, it may not appear too problematic. It is, however, not at all difficult to imagine circumstances under which the US view would conflict with the OPEC view. The possibility of the USA, through use of the SPR, attempting to counteract the impact of OPEC policy decisions would take us into untested, and potentially hazardous waters. The use of the SPR may just prove to be an aberration brought on by the proximity of the US elections. However, it has muddied the waters sufficiently to raise questions over what precisely the role of the SPR now is. It has shown that the SPR will be released when it is politically expedient to do so. Creating such uncertainty over something as potentially far-reaching as US oil policy can not be helpful in terms of returning the market to any form of longer term stability. In attempting to reduce price volatility, the US government may have achieved the reverse, simply by generating such a large zone of uncertainty for other policy makers and for the market in general.
The SPR was intended to ameliorate supply crises, not as a buffer stock to be used to affect prices. If the US administration had known that within three weeks of the SPR announcement the Middle East situation would have deteriorated, one suspects that they would have preferred to hold back on release until it was more important to do so. Using the SPR for an objective for which it was neither intended nor capable of achieving might seem rather unfortunate given the circumstances. Foresight was impossible, but the danger of early and inappropriate use has been illustrated.
The SPR release has been largely ineffectual in terms of any impact on crude oil prices. The idea of having a SPR for supply crises is that its use should be able to change the dynamics of the market significantly. That is why the reserve is so large, indeed at current prices about $17 billion of federal funds are locked up in the SPR. However, in this case the SPR has been used for peak-shaving the oil price at a time when crude oil availability is not the source of the primary oil market problems. As a result, the SPR release has had no decisive impact, and has not changed the underlying market signals. In particular, the release did not permanently remove price backwardation, the feature of prices that had been responsible for keeping inventory cover low.
The impact of the SPR release on the price level was soon lost in a welter of other factors, particularly the fears surrounding the Middle East situation. The rumours of the announcement of the SPR release came close to the expiry of the October 2000 crude oil contract on NYMEX. This was probably not a coincidence, as the timing had the effect of magnifying the apparent effect of the announcement. The headline figure became that SPR release had driven prices down from $37 to $30. This is something of an exaggeration, which comes from comparing prices for October with those for November, when the former was trading $2 above the latter.
To gauge the effect of SPR release one must compare like with like, i.e. just consider the prices for November delivery. A better calculation is then as follows. The November contract closed on the 20th September at $35.24. We will use that as the pre-release price, given that the $1.12 fall to $34.12 on the 21st September, the day before the announcement, was largely due to anticipation of the release. Its lowest closing price occurred on 28th September at $30.34. The maximum fall was then just $4.90. However, soon it became clear that SPR release had done nothing to help the heating oil situation. Inventory cover was still alarmingly low, and no new dynamic within the market had been set in play that might alleviate the situation. Prices began to rise again. By the end of 11th October, the day before the Middle East situation deteriorated, the price stood at $33.25, just $1.99 down from the pre-SPR release price. After that point, prices started to move with great volatility, driven by news headlines.
Three weeks after the original announcement, the impact of the SPR release had become an indiscernible echo rather than any decisive intervention. The difference was that now a potentially severe Middle East crisis was beginning to unwind. We would argue that the earlier release of the SPR has blunted the ability of any immediate new SPR announcements to moderate prices. The SPR is, for practical purposes, the only effective instrument that the US government has in the oil market beyond strong-arm diplomacy. Having used it already for a purpose for which it is ill suited, it could be argued that its credibility has been undermined. In 1990, the announcement of a limited SPR release drove prices down by $15 immediately, and then kept prices down. In 2000, the impact has been limited to less than $5, and evaporated within three weeks.
The SPR remains a powerful tool, which, given the current uncertainties, could conceivably be needed for its original purpose within the near future. However, its effect on the oil market arises primarily, at least in the short term, from its impact on market psychology. The psychological impact of a weapon can not be anything but reduced and distorted when it has already been used so recently and so ineffectually. When, in addition, a huge uncertainty has been created as to what the American oil weapon is actually for, how often will be it be used, who is it aimed at, and who could it be aimed at, then the overall impact is not a constructive one.
NOTE : Valuing SPR Oil
The notice of tender for the SPR auction detailed that a total withdrawal of 30 million barrels would be achieved by accepting bids of up to 30 million barrels for crude of West Hackberry Sweet, 30 million of Bryan Mound Sour, and 20 million of Bayou Choctaw Sour. The average API gravity and sulphur contents of the three blends are as follows ;
- West Hackberry Sweet, 37 degrees API, 0.29% sulphur
- Bryan Mound Sour, 33.4 degrees API, 1.38% sulphur
- Bayou Choctaw Sour, 32.2 degrees API, 1.43% sulphur
The bids received consisted of 24.95 million barrels of West Hackberry Sweet, 3.05 million barrels of Bryan Mound Sour, and 2 million barrels of Bayou Choctaw Sour. The chemistry of blending oil is not a linear process. However, as an approximation for the average characteristics of oil in the SPR release, we can take the volume weighted characteristics of the separate blends. This produces an average quality for the release as being oil with an API gravity of 36.3 degrees, and a sulphur content of 0.48 per cent.
To value this relative to West Texas Intermediate (WTI), we use the quality adjustments as laid down in the SPR tender as being those to be used for deviations of actual quality from the stated quality of each blend. These adjustments were 15 cents for each degree of API gravity, and 10 cents for each 0.1 per cent of sulphur content.
The main component of the deliverable crude oils for the NYMEX light sweet contract is WTI. The quality of WTI is typically about 40 degrees API and 0.3 per cent sulphur content. We therefore value the SPR crude oil at WTI – 74 cents, (of which 56 cents is due to its lower gravity and 18 cents its higher sulphur content).