Friday, February 25, 2011

Cracking The Oil Debate: What To Do With The SPR?

Social unrest in the Middle East is leading to increased uncertainty in foreign oil and energy markets, with the result being renewed discussions about whether or not this is the appropriate time to tap the Department of Energy's approximately 727 million barrel strong Strategic Petroleum Reserve. According to the WSJ, Democratic parasite-politicians pleaded in a letter to the White House to consider the use of the SPR in light of the approaching summer driving season. Meanwhile, Daniel Yergin, "energy expert" and author of the critically-acclaimed book The Prize: The Epic Quest for Oil, Money & Power, has warned against drawdowns in the SPR, arguing that it is "unwise for the U.S. government to get in the business of price controls."

So, who is correct in this debate? For frequent readers of my commentary here at EPJ, it will likely come as little surprise to know that both sides of the debate are wrong because they're offering a false dichotomy to observers.

Let's take a step back for a moment. The question to be asking in this situation is not, "Given that we have the SPR, how should we utilize its resources?", but rather the question that should be asked is, "Why do we have an SPR in the first place?" or even better, "Should the US government be in the business of establishing something like the SPR?"

Sometimes it's hard for people to see issues like this as clearly as they should because the whole topic has been clouded by politics, which fools observers into thinking such decisions should be made according to arbitrary opinions and pragmatic political concerns. While the resources in question are indeed controlled by political bodies, the problem we are confronted with is, as per usual, economic in nature. At root, the Yergins of the world are arguing, This is not the appropriate/most economically efficient way to utilize the oil in the SPR, while the self-serving Democrat parasite-politicians are arguing, Given the potential alternative uses of the SPR, using some of it to try to keep oil prices down so my constituents don't raise hell with me is the appropriate/most economically efficient way to utilize the oil in the SPR.

But both of these arguments are backed by nothing other than the opinions of the people who put them forth. The reality is that the best use for the oil in the SPR, the one that would make the most economic sense, would be the individual decisions made by end consumers of the oil on the free market. Some individuals might decide to consume the oil immediately by using the oil to fuel their cars; others might choose to use some of the oil as a current capital good to fabricate petrochemical derivative products; still others might decide to transform some of the oil into a long-term capital good by storing it for later use (this is also known as "saving").

Who is Daniel Yergin, or the Democrat "lawmakers", to tell any of these people they are right or wrong for preferring to use the oil as they see fit if they're willing to pay the going price to obtain it?

Instead, we have the worst of all worlds, where the SPR is actually contributing to the very problem it was nominally established to defend against-- oil supply uncertainty and the threat of rising prices. In the grand scheme of things, the SPR's reserve capacity is somewhat laughable. Despite $4B cost of constructing the large, underground salt dome caverns used to store the oil (gee... why pay oil companies to pull their oil out of the ground in one place if it's just going to be put right back into the ground somewhere else at enormous cost?), the SPR only holds enough oil to supply the US for 34 days, at current rates of consumption.

Still, at current oil prices of nearly $100/bbl, that is $72.7B worth of oil being withheld from the market. With supply constrained thusly, prices are that much higher than they would be. Didn't Daniel Yergin say something about how the US government shouldn't be in the business of price controls? Seems like it's too late for that.

As for uncertainty, there's almost zero visibility for investors and consumers of oil as far as what conditions would elicit a decision from the DoE to release some of the oil in the SPR and thus "stabilize" supply. No visibility, that is, unless you're a major oil company. Take a look at a small list of disclosed drawdowns in the SPR available on Wikipedia. How many of those sound like emergencies to you, worthy of tapping into the country's "strategic" reserves?

Now, remind yourself that that's just your opinion, and it's bound to be different from your neighbor's, Daniel Yergin's, vote-hungry Democrat parasite-politicians and even the Big Kahuna, El Presidente, himself. It's all arbitrary. There is nothing scientific or objective about this decision-making process and it's ultimately finalized by the person with the gun (that is, not you).

This isn't planning. It's not strategy. It's whimsical, authoritarian chaos. National strategic petroleum reserves are tools of the State for fighting future wars, winning votes and rewarding politically-connected oil corporations and other members of the elite. They're not for you and me to dip into when we want to go on a summer road trip and Libya happens to be experiencing a revolution.

The SPR and other national reserves like it are a disgrace to "free energy markets" everywhere and they should be ended immediately. All oil to the people, and let them pay for it what they will!

10 comments:

  1. Looks like the CPs accidentally made a profitable investment, even with the $4 B construction cost. Yes, they should sell it all immediately, and throw in Yellow Stone while they're at it. Why not, they're selling Paulson Medallions:

    https://catalog.usmint.gov/webapp/wcs/stores/servlet/ProductDisplay?catalogId=10001&storeId=10001&productId=14725&langId=-1&parent_category_rn=10200

    "The image of the peregrine falcon represents Secretary Paulson’s commitment to conservation and his long-time interest in birds of prey."

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  2. BobE,

    True, but there is more to the story than buying low and selling high. The complicating factor is the use of force.

    After all, people who fence TVs and other stolen electronics make a profit all the time-- that doesn't mean their actions are economically efficient or socially beneficial.

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  3. Hi Taylor,

    I've been hearing the idea that trading in oil futures should be banned a lot lately. Frankly, I haven't heard any arguments for the trade that I am persuaded by.

    I don't see how banning it would help much but I don't get how it would hurt that much.

    Any thoughts you have would be appreciated.

    Allen Thornton

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  4. Hi Allen,

    Without having more specific details about the arguments you are referring to (which, I am sad to see it has already come to discussions of banning oil futures trading as a response to oil price increases) all I can really say is-- there's no moral argument for forcibly banning any voluntary exchange made between two or more consenting adults.

    And economically-speaking, if people are trading oil futures voluntarily (no force or fraud involved), then they must be doing so because they believe such exchanges enhance their wealth. Otherwise, they wouldn't engage in such exchanges in the first place.

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  6. Hi Taylor,

    I know that oil and other futures are useful tools for anyone who wants to lock in oil prices but doesn't have storage capacity. To prohibit the trade would screw up a number of people.

    The argument that is made is as follows:

    There's no current problem with oil supply. Therefore, the rise in the oil price is caused by futures trading. I think I accept that part. Part 2 is: If you ban futures trading in oil, prices will be more stable. I don't buy that but I can't come with the counterargument.

    Allen

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  7. Allen,

    Thanks, I think I have more to go off of here. I am not sure if Bob English is still tuned in to this discussion but hopefully if he is he'll provide his own comment if he finds mine to be lacking, as he understands this stuff better than I, probably.

    To address the first argument:
    Prices are always composed of two sides, supply and demand. It is not enough to have a large supply of something to keep the price low. The size of the supply relative to demand must also be "big enough to overcome". In focusing on the supposed large supply, or stability of supply, the argument ignores the role the demand side plays.

    What of it? Perhaps the demand for oil is growing rather briskly. This could happen if the economy as a whole is growing and thus people have more and more resources (production) with which to bid for a same amount of oil supply, causing the price to rise. It could also happen if there is demand substitution. Maybe a competing alternative to oil gets knocked out (gas, coal supply) and people are forced to rely more on oil for energy, temporarily. Or maybe people are deciding they're willing to eat less or go to the movies less so they can buy more oil. Again, demand-substitution can result in higher oil price even with an oil supply that is stable or not rapidly increasing.

    Now, there is a lot of uncertainty in the Middle East. And markets are, generally, forward-looking. If there are people with knowledge of the Middle East political situation that is not public or well-known, they may bid up oil prices in anticipation of unrest that comes into everyone's awareness weeks or months later. This is completely normal, rational behavior. In fact, it's beneficial for the market as a whole! Higher prices in the present in anticipation of future conflict serves to incentivize better economization of existing oil supplies now, which ostensibly leaves more of the supply available for the most important (highest perceived utility) uses later on when the conflict actually begins to disrupt the supply of oil. In whole, this process serves to smooth and "rationally" ration the oil supply through an unstable period. Without this, people might choose to waste oil on joyriding around town or running their home appliances needlessly or what have you now, completely unaware of the coming conflict, and then when the supply disruption occurs prices ramp so high to compensate that not only do people have to stop joyriding and running appliances, they experience rolling blackouts and actual shortages at the gasoline pump so they can't even get to work.

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  8. The oil price communicates important information to producers and consumers alike.

    However, that's just the supply side. The demand side also has had a strong influence lately that is completely detached from the conflict in the Middle East. This would be expansion of the money supply by Ben Bernanke (and other central bankers). And here, I think, is the most obvious source of the "speculative frenzy" so many observers think they are witnessing. When BS Bernanke runs the printing presses, there is more dollars but the same amount of oil. And those dollars tend to find their way, via primary dealers, into the financial markets first and foremost. The result is speculative bidding up of asset and commodity prices in the capital markets.

    It's funny that the argument you presented before doesn't seem to be concerned with a new $600B infusion of new money (QE2). It's supposed to be a mere coincidence, I guess, that this speculative fervor in the commodity markets made itself known around the same time BS Bernanke started talking about a new half a trillion dollar monetary stimulus program.


    As for the second argument you've heard, I'd like to address it but I wondered if there was anything more to it that you could share, first, so I don't bother knocking down a strong man. By what mechanism or in what fashion is the banning of oil futures trading supposed to result in a "smoother" or more "stable" oil price? What does this term "stable" mean and how is it supposed to be arrived at with the banning of futures trading as the initial motivating cause?

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  9. Taylor, great explanation. I too would focus on just why commodities are an asset class. I concur with Doug Casey that commodities are in a 5,000 year bear market. The capital and labor needed to dig stuff out of the ground (or grow it) and process it continues to decrease. However, clearly, commodities are currently in a secular bull market. It's no coincidence that this is occurring during a period of record global coordinated fiat currency debasement. It should be quite shocking, therefore, that commodities are viewed as a store of value when, absent currency debasement, they would most likely be a losing bet long term.

    The beneficial role of speculators is no different in futures exchanges as it is anywhere else: (1) they provide liquidity, which reduces the bid/ask spread and can actually lower volatility; and more importantly (in my opinion) (2), they conduct invaluable research to aid their forecast of prices, which overall greatly improves the price discovery process. An example is the so-called bond vigilantes, who force profligate governments to come to terms with their reckless policies. Banning speculators does not change the errant ways of governments, it only suppresses valuable insights and preserves an unsustainable illusion.

    Having said all that, and coming back to the futures markets, it clearly does not make sense to have $1 trillion in speculation money chasing a $100 million cash market. This is an extreme example (one I just made up), but one which will exacerbate price action and increase volatility. It also demonstrates that speculator position limits are reasonable. However, they should be set by exchanges that are in competition with each other and subject to the decisions of their consumers (the traders)--not by an exchange that has been given a government-granted monopoly, and certainly not by a regulatory bureaucrat who is likely subject to political influence.

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  10. Sir Taylor,

    After reading your post and replies, I have come to the conclusion your are a gentleman and a scholar of the third degree.

    To read intelligent dialogue between you and THE Alan Thornton was an added plus.

    And the "BS Bernake"... classic.

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