TCS Daily

The Destabilizing Oil Speculator

By Arnold Kling - May 24, 2004 12:00 AM

"John Kerry's quick-fix suggestion that the strategic petroleum reserve be opened is simply another example of political opportunism; he made more sense in 2000 when he opposed opening the reserve."
-- James Robbins, National Review Online, 5-19-04

"In short, we don't need the SPR and, in a perfect world, we'd sell off the oil here and now, and then shut the whole thing down."
-- Jerry Taylor and Peter Van Doren, National Review Online. 5-20-04

The policy pundits cannot seem to agree on the best approach for handling the Strategic Petroleum Reserve (SPR). John Kerry and other Democrats have proposed releasing some oil from the SPR in order to provide some relief to motorists stung by high gasoline prices. A Wall Street Journal editorial derides this as "grandstanding," saying that, "The U.S. strategic oil reserve has the serious purpose of ensuring oil supplies in the event of a threat to national security. It is not the play-toy of politicians...We were glad to see Mr. Bush declare yesterday that he won't touch the SPR."

My own view is closest to that of Taylor and Van Doren. It should be the responsibility of the private sector, not the government, to obtain insurance against oil market disruptions. The SPR has introduced government into the oil market as a destabilizing speculator.

A Trader's Proposal

Financial columnist Allan Sloan found an oil market participant with an interesting perspective. "One approach, suggested by Loews CEO Jim Tisch, whose company has extensive energy holdings, is to trade some reserve oil for oil to be delivered in a year."

To explain the trader's mindset, let us use a different example: wine. Suppose that you own a restaurant, and you have some vintage wine in your cellar. Should you sell it today, or let it age another year? The answer depends on three factors: the price of wine today, the price you expect to be able to get for it next year, and the interest rate.

Suppose that you can sell the wine today for $100. If you then put that $100 in the bank at five percent interest, you will have $105. If the wine will cost $103 next year, you can buy back the wine and keep $2 profit. Conversely, if the wine will cost $106 next year, then you can earn a higher return by keeping the wine for a year than by selling it and putting the money in the bank.

What is true for wine is approximately true for any storable commodity. The price for delivery one year from now should be fairly close to the price today, plus the interest rate. If this relationship does not hold, then there are profit opportunities for speculators.


The oil trader is seeing profit opportunities in the pattern of futures prices for crude. My curiosity aroused, I checked this page on May 20th for the market closing prices of the previous day. Indeed, rather than a pattern of prices rising at the rate of interest, it showed crude prices steadily declining, a phenomenon known as backwardation.

For example, the price for delivery in June 2004 was $41.50, while the June 2005 price was $35.83. What this means is that if you have crude oil, you can sell 1000 barrels for delivery this June for $41.50 per barrel and buy a futures contract for 1000 barrels of oil for delivery in June of 2005 for $35.83. As a result, in June of 2005 you get your oil back, along with $5.67 per barrel profit plus the interest that you can earn for one year on $41,500 (the proceeds from selling 1000 barrels at $41.50 per barrel).

Backwardation induces people with oil to sell it today. In principle, if you have oil in inventory, you should sell every drop while the price is at its peak. If you want to benefit from or hedge against further price increases, you can buy oil futures contracts instead.

With backwardation, every rational, profit-maximizing participant in the oil market will unload his inventories. With inventories thin, there will be no buffer in the market, and prices will tend to fluctuate dramatically in response to small shifts in supply and demand. This is what happened in 1996, as described this article.

What Explains Backwardation?

I posed the question of what explains backwardation to two leading business school professors. Robert McDonald of Northwestern University's Kellogg School of Management, who is the author of a treatise on financial derivatives, emailed that "When economic conditions are such that oil is being consumed as fast as it is produced, then there is no storage. The market is saying: supply your oil now, not tomorrow. This is only possible because there's a limited rate at which oil can be extracted -- the storage that occurs is involuntary."

Alan Marcus of Boston College, who is the co-author of a very popular series of graduate-level finance textbooks, emailed that "I have seen examples of even worse backwardation in other commodity markets such as copper. The general rule must be that when current prices are 'high' so will be backwardation, and the only ones storing at those times are the ones who really need to have the commodity at the moment, and are willing to pay up: their expected loss is a measure of the service yield they must enjoy from the commodity."

McDonald pointed out, "The output restriction by OPEC must generate a transfer from OPEC producers to non-OPEC producers, who must be producing as fast as possible, storing as little as possible. The only 'service yield' I can think of is pleasure at watching us squirm."

Along these lines, I suggested that perhaps the Saudis enjoy a "service yield" in the form of a spike in oil prices before the election, which perhaps will hurt President Bush's chances in November. Of course, the same result -- a spike in oil prices now, followed by a decline after the election -- is obtained by the Bush Administration's avidity for filling the SPR. Why they see this as a positive "service yield" is difficult to fathom.

The professors pointed out that there is another way to think about the trader's proposal to sell oil from the SPR and buy futures contracts for delivery in June of 2005. Suppose that the government were to keep the oil in the SPR but speculate against backwardation by selling June '04 oil contracts and buying June '05 oil contracts. In this regard, it is no different than anyone else who wants to bet that the pattern of oil prices will revert to one of increasing at the rate of interest. However, I would point out that one difference is that if there emerged a "squeeze" on June '04 short sellers, the government would be in a position to deliver SPR oil to escape the squeeze.

Looked at this way, the trader's proposal combines a decision to sell oil from the SPR with a decision to bet against backwardation. Those decisions are separable, and it is not clear that betting against backwardation is necessarily a smart move for any speculator, including the government. By the same token, if the taxpayers obtain a "convenience yield" or "service yield" from having oil in the SPR that exceeds the expected loss of 15 percent from holding oil for the next year, then we should keep the oil there rather than sell it.

The Virtual SPR

The futures markets in oil can be thought of as a virtual SPR. The government could insure against an oil market disruption by buying futures contracts, without storing a single drop of oil.

If the government were to switch from a physical SPR to a virtual SPR, this would do two things. First, it would reduce the cost of the SPR, because the cost of trading in the futures market is much lower than the cost of transporting and storing oil. Second, it would make transparent what the SPR amounts to--government speculation in the oil market, supposedly to our benefit.

Taylor and Van Doren point out that the private sector has incentive to protect itself from disruptions in the oil market. Only if you think that the private sector will purchase too little insurance do you think that the government should step in. Even then, one might suggest that the government could increase the incentives of private individuals to buy oil price protection, rather than create a petroleum reserve.

Buy High, Sell Low

When it comes to protecting us from oil price shocks, the government once again is acting as the high-cost producer. By choosing to fill the SPR now, when prices are at a peak, as taxpayers we are buying high and selling low. Moreover, we are contributing to the instability of the oil market, by taking oil out of private inventories and exacerbating the problem of backwardation.

I am not persuaded that the "convenience yield" of the SPR justifies its costs. However, even if it does, I believe it makes sense to have a rule that ties the amount of oil we hold in the SPR to the pattern of oil futures prices. In particular, we should keep less in the SPR when there is backwardation, and fill the SPR when oil futures prices show a pattern of expected increase. Filling the SPR during a period of backwardation, as we are doing now, serves to worsen what the market sees as a temporary price spike.

In contrast to governments, rational speculators buy low and sell high. This process stabilizes markets. Irrational speculators, who buy high and sell low, destabilize markets. That is the effect of the Strategic Petroleum Reserve -- as Karl Kraus once said of psychoanalysis, the SPR is the disease that it purports to cure.


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