U.S. Should Defend Against Saudi Arabia's Crude Oil, Investment Strategies

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Includes: BNO, DBO, DNO, DTO, DWTI, OIL, OLEM, OLO, SCO, SZO, UCO, USL, USO, UWTI
by: Robert Boslego

Summary

Short-term risks of low oil prices.

Longer-term risks of low oil prices.

Fed's dual mandate.

SPR intervention on the sell-side.

SPR intervention on the buy-side.

Government intervention in markets is usually not a good idea. But there are circumstances where it makes sense. The Fed intervenes in the bond market, and Congress set up the Strategic Petroleum Reserve (SPR) to intervene in the oil market. Both policies have been supported for decades.

Over the past year, the U.S. experienced a new threat: the intentional flooding of the oil market to drive U.S. producers out-of-business to grab market share. The likely risk is that underinvestment will eventually drive oil prices higher, undermining U.S. energy security and destabilizing prices.

In addition, there is a new layer to Saudi's low-price strategy. Saudi recently signed a Letter of Intent to separate its U.S. refining asset, Motiva. Sources say Saudi Aramco wants to buy refining and chemical assets. Perhaps they are pressuring prices lower to pick up assets in a low oil price environment.

Should the U.S. stand idly by as U.S. goals--supported by Congress-- are undermined by a foreign government?

Yellen Speech

Source: The Federal Reserve Board.

Fed Chair Janet Yellen spoke at the Economic Club of New York on Tuesday. She warned of the risk that low prices posed for future U.S. economic growth:

"The price of oil was nearing a financial tipping point for some countries and energy firms. In the case of countries reliant on oil exports, the result might be a sharp cutback in government spending; for energy-related firms, it could entail significant financial strains and increased layoffs. In the event oil prices were to fall again, either development could have adverse spillover effects to the rest of the global economy.

"If such downside risks to the outlook were to materialize, they would likely slow U.S. economic activity, at least to some extent, both directly and through financial market channels as investors respond by demanding higher returns to hold risky assets, causing financial conditions to tighten.

"To the extent that recent financial market turbulence signals an increased chance of a further slowing of growth abroad, oil prices could resume falling, and the dollar could start rising again."

In her discussion about oil price risks, she failed to mention a much more serious risk of low oil prices: their impact on capital expenditures, which could sow the seeds for higher oil prices down the road.

Saudi Arabia openly started a price war in late 2014, very directly aimed at taking market share from American oil shale companies. The objective is to drive producers out-of-business and to stifle investment in new supply. But if Saudi Arabia and OPEC succeed, the future implications may be disruptive to U.S. interests: reduced energy security and higher oil prices that are inflationary.

The International Energy Agency (IEA), of which the U.S. is a member, warned of the risk of an oil price spike in the later part of its outlook period arising from insufficient investment in its annual Medium-Term Oil Market Report (MTOMR) released in February:

"It is easy for consumers to be lulled into complacency by ample stocks and low prices today, but they should heed the writing on the wall: the historic investment cuts we are seeing raise the odds of unpleasant oil-security surprises in the not-too-distant-future," said IEA Executive Director Fatih Birol.

Fed's Dual Mandate

One of the Fed's mandates is to control inflation. Rising oil prices threaten that goal and yet the Fed has little control over oil prices with its three policy tools of adjusting the discount rate, reserve requirements or intervening in the bond market.

Several years ago, James Bullard, President and CEO, Federal Reserve Bank of St. Louis, presented the Fed's dual mandates and lessons of the 1970s in a speech:

Source: Federal Reserve Bank of St. Louis.

"When the U.S. Congress amended the Federal Reserve Act in 1977, it essentially gave the Fed a dual mandate: to promote maximum sustainable employment and price stability. Price stability is usually interpreted as low and stable inflation, and the impetus for this explicit objective was the highly volatile inflation of the 1970s.

From the late 1960s through the early 1980s, inflation rates were high and variable; for example, over roughly four years, Consumer Price Index (CPI) inflation rose from about 3 percent to 12 percent and then fell to 5 percent. Many were surprised that, along with the swings in inflation, real output was quite volatile and the unemployment rate generally was high, peaking at 10.8 percent in 1982. The U.S. suffered through four recessions in the 13 years from 1970 to 1982. The economy fluctuated from boom to bust. Each cycle ushered in both higher inflation and higher unemployment. In retrospect, the Federal Open Market Committee (FOMC) placed too much emphasis on real output and unemployment during this decade and ended up with the worst of both worlds, a volatile real economy with high and variable inflation.

"Today, it may be tempting to lose sight of the lessons of the 1970s, but I believe they remain as relevant as ever. As both the U.S. and Europe continue to recover from the severe financial crisis and subsequent recession of 2007-2009, many policy changes are in the air. But the fundamental importance of low and stable inflation for the performance of the real economy remains a bedrock principle of central banking."

SPR Sell-Side Intervention

In response to the massive economic impacts of the 1973-74 Arab oil embargo, and the U.S.' high dependence on foreign oil imports, Congress authorized the creation of a 500 million barrel SPR in 1975, to protect the economy in the event of another interruption in oil supplies.

Saudi Arabia participated in the oil embargo against the U.S. Ironically, Saudi Light oil was the first oil purchased to begin filling the Reserve in 1977. I know because I consulted to the SPR office on its oil acquisition strategy and bid evaluation process at that time and reviewed the first bids.

On March 15, 2015, the U.S. House of Representatives Energy and Commerce Committee sent a letter to DOE Secretary Moniz citing the need for a strategic review of the SPR. A major change is in the nature of the threat from OPEC. Instead of disruptions of supply, the threat is the destruction of U.S. oil shale producers and underinvestment in future supplies.

Saudi Arabia seemed to shift its policy in mid-February when it jointly announced a concept to freeze production at January 2016 volumes, and prices have recovered by almost 50%. But late last week, a published interview of Deputy Crown Prince Mohammed bin Salman implied a Saudi pivot on the "freeze" strategy.

SPR Buy-Side Intervention

Authorization of the sell-side of the SPR was the focus of the enabling legislation. What is needed now are guidelines for the buy-side of the SPR. Although it is large enough, the U.S. needs a policy tool to offset the effects of foreign governments who are attempting to interfere with U.S. objectives.

One idea is to authorize the acquisition of oil at prices deemed "too low." The Fed Open Market Committee (FOMC) has decades of experience making judgments like this in the bond market, and that same expertise could be applied in the oil market.

Instead of buying physical oil, the SPR could buy oil futures contracts. The benefit of this approach is that the oil does not need to be stored (incurring storage costs), and futures contracts can be bought on margin (only about 5% of the cost of oil bought on the spot market). Purchases of futures contracts can be exchanged with physical oil in the SPR to keep the program revenue neutral in the short-term because every barrel exchanged in the physical market brings enough cash to buy 20 barrels on the futures market.

If the SPR buys oil at relatively low prices, such as in the current market, and sells some of its oil when prices rise to inflationary levels, it will earn a profit for the Treasury, buying low and selling high, while reducing the volatility of oil prices and keeping the oil industry healthy enough to support new investments. By the way, oil price stability at moderate price levels also provides support for energy alternatives, such as renewables, to eventually replace fossil fuels.

I previously proposed a concept like this but run by the Fed. However, that would require new legislation. In this proposal, all that would be needed is an amendment to existing SPR legislation or an Executive Order.

Conclusions

The U.S. Congress established twin mandates for the Fed in 1977 of inflation control and full employment. It also established a goal for the Strategic Petroleum Reserve in 1975 to intervene prior to, or during, an oil supply disruption or supply shortfall.

The U.S. Congress should amend the SPR legislation to provide a tool on the buy-side of the SPR to prevent foreign countries from threatening U.S. economic policies and goals.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.