Strategic Petroleum Futures

I have written before that the government should empty its strategic petroleum reserve and buy energy futures contracts instead. At some point, the futures market has to be taken seriously.

I could not disagree more. Having actual (physically immanent) reserves on hand is a great way to reduce risk. Emptying reserves assumes that all contracts will be physically deliverable - but instead leave us vulnerable to blockade, acts of war, etc. from overseas supplier.

I think the question turns on what you are trying to optimize: risk, or money. Having *both* reserves and a hedging vehicle is probably the best way to minimze risk.

Yes, the assumption markets work during times of war is rather ridiculous.

Sounds like a wonderful way for the government to lose vast sums of money, the way some Chinese companies already have.

Energy producers should not be second-guessing the oil futures market. Instead, they should be using it as a hedging vehicle.

I agree.

But I also think there are serious questions as to whether using the futures markets in some of the ways Arnold suggests is a sound strategy. Futures markets work well when the participants are small relative to the size of the market, counterparty risks fall within the range the institution is organized to deal with, and cash settlement is a close-to-perfect substitute for delivery of the underlying asset.

Consider the SPR strategy. The SPR contains about 700 million barrels. Suppose we empty it and buy futures at $60, and then an international crisis drives prices to $100. Well, somebody owes us $28 billion. Are they going to pay? Who will make them? Remember, there is some sort of crisis going on. It's not business as usual.

The financial markets are extremely deep and liquid, but they are not infinite.

I thought the idea Arnold was getting at was that if the US government bought such large oil futures contracts, then private industry would spring up to maintain the reserves (the equivalent of a school voucher system for petroleum reserves).

Of course then the question arises about regulation. Do you require the sellers of the contracts to actually own some fraction of the contract oil and physically keep it in America? That is the only way I can think of to make sure that a physical reserve would actually be maintained on US shores under such a system.

Erik R: There is no requirement that the participant in a contract hold the oil. They are just required to provide it according to the terms of the contract.

The futures market is a big insurance scheme if you ask me. And a sensible one. But there is something known as the insurer of last resorts, particularly when markets produce results that we don't like.

See, that's really what it comes down to. Markets do operate according to a certain type of efficiency--though I don't think many if any understand what is really optimized. It's too complex. But the fact that a market optimizes something doesn't mean that the outcome is good.

In the case of oil, or vaccines, I think a physical supply has arguable merit. One cannot acquire much enery from a futures contract.

The caveat, of course, is that we have never seen an actual need for the strategic petroleum reserve that, up to this time, could not have been more efficiently handled through the futures market. It has been used primarily for political reasons.

Well, if any of these nutjob terrorists find some way of detonating a nuclear bomb in an American city, I think we'll need the reserves to get us through the time when the Middle East is a radioactive hole in the ground and we're starting our crash course energy-independence project. So yes, then we'll want actual oil and not pieces of paper.

His tax plan is bizarre. Why not cut taxes on oil now, including the gargantuan taxes paid by the oil companies?
And nowhere does he mention opening up Alaska's Arctic National Wildlife Refuge for oil drilling.
This article is a convoluted nonsolution to a problem that can best be solved by trying the free market, for a change.

Futures marekts generally clear without significant transfer of physical resourees
taking place.

In many ways the futures market is like the line on a football game. it is the price that brings demand and supply into line so that the people betting on the "over" approximately balance the people betting on the "under". There is no reason to expect the price in the futures market to contain any significant information that is not already in the "spot" market. Almost accross the board the correlation between spot markets and futures market is something like 0.9999999999.

Your proposal completely ignores the true nature of futures markets and has no hope of really generating the supply of "physical" quantities of oil that the strategic supply provides.

Moreover, the strategy for Exxon is false. If Exxon bets the future of the company on $60 oil and the price of oil turns out to be $30 he will destroy the company. But if he bets on $30 oil and the price of oil turns out to be $60 the company will be highly successful.

PS. who will he sell it to -- the Russians or the Chinese, maybe? but didn't we just see an attempt at that.

The idea seems to be that money (a phantom) and oil (the thing) live in the same dimension; that pulling the strings of the monetary superstructure, you can make dance the physical object.

I presume that in a well-ordered world, with some means of enforcement, you may move relatively small objects. But when the physical object is big, like that mountain of copper that had to be delivered but was not there, social or contractual arrangements are worthless. I mean the promise to deliver the real thing is unenforceable (the thing is not in existence) and you are left with a claim to a lot of money. I like money but you cannot it eat nor fill the tank.

The idea is valuable and workable but not in a the strategic oil market. We should find a special limited situation where to make the trial run of this nice idea.

Spencer,

I think your criticism of futures markets is overdone. There is a well-known arbitrage relationship between today's spot price and the futures price, involving storage costs, interest rates, etc. But I think you are confusing that relationship with the accuracy of futures prices as predictors of future spot prices. Here the correlation is nowhere near what you suggest.

For a relatively small player (relative to the size of the market – it could be a large company) the futures markets make sense as a "virtual" storage method. Such a buyer's cost for physical storage would likely exceed those implicit in the futures price, and it is much easier to increase or decrease the number of futures contracts held than to change the size of a physical inventory.

Problems arise, though, for a very large player, such as the US government. The main one is the issue of “counterparty risk.” This is the risk that the person on the other side of your deal reneges. Futures exchanges have various safeguards against this happening, but whether those safeguards would work in the case of a position as large as the SPR is questionable. In addition, the risk of counterparty default is greater for such a large position because events which might cause the price of oil to rise sharply, such as a revolution in Saudi Arabia for example, also increase the chance that the counterparty will be unable to meet its obligations. This is not the case in small-scale transactions.

There might be a case for the US government entering into futures-type contracts directly with some North American or European producers. Whether it could do so at a reasonable price, in useful volumes, and without assuming excessive risks, is not clear.