The Cato Review of Business & Government
The Cato Review of Business & Government
Stern, Stewart & Co.
Washington policymakers never seem to question the assumption that America's economic health requires a U.S. military defense of the Persian Gulf. In 1990 then-Secretary of State James Baker insisted to reporters that Operation Desert Storm was necessary to preserve American jobs; unfortunately, his assertion went unchallenged even by opponents of U.S. military action in the Gulf. There was virtually no discussion of other ways U.S. consumers might have protected themselves against sharp increases in oil prices or might be able to do so in the future. It is important to recognize now that a free-market alternative to military intervention exists in the form of crude-oil derivatives.
Privately negotiated risk-management contracts such as swaps and caps can protect fuel users from sharp increases in oil prices. These contracts amount to a kind of insurance against violence in the Persian Gulf or any other event that might cause prices to rise. Given that consumers have the opportunity to protect themselves from economic harm at relatively low cost, there is no reason to risk the lives of U.S. servicemen to protect foreign oil fields.
To be sure, the oil fields of the Persian Gulf are extremely valuable resources that benefit the world. Saudi Arabia and the smaller conservative sheikdoms such as Kuwait, Qatar, Oman, and the United Arab Emirates account for over one fifth of the world's crude oil output. Other Persian Gulf countries such as Iran are also very significant producers, and Iraq could be again. Probably half or more of the crude oil reserves in the world lie in these countries. Understandably, people in the United States are concerned about the possibility of Persian Gulf output being interrupted by war or changes of regime.
Nevertheless, Americans can protect themselves without resorting to the enormous human and financial expense of military action. Financial institutions such as commercial banks and investment banks already play a very large role in providing such protection. Through them, some consumers have already locked in energy prices by buying swaps or have established maximum prices for energy (caps) by buying average rate call options. Some use listed futures and options available from the New York Mercantile Exchange, while others prefer customized contracts available in the over-the-counter market from banks, trading companies, and energy producers. The spot price of light, sweet crude oil has been quite volatile over the last 15 years, ranging between $10 and $40 per barrel. What fixed prices could one lock in today? I conducted an informal survey of swap dealers on November 27, 1995 that indicates prices of about $17.75 for the period 1996-2000 and $18.80 for the period 1996-2005.
This is at a time when spot crude is $18.38. In other words, for many years into the future one can guarantee oneself crude oil prices that are lower than current prices. Just as home-buyers can choose between fixed-rate mortgages and adjustable, capped-rate mortgages, oil price caps are available to fuel buyers as well. In general, the lower the cap and the longer the maturity (i.e., the greater the protection), the higher the price for the cap. "Disaster" insurance turns out to be cheaper than many people expect. Anyone wishing to ensure that they pay no more than $30 per barrel during 1996 would only have to pay 2-3 cents per barrel for that protection.
Extensive buying of energy derivative contracts would ultimately require that financial intermediaries "reinsure" themselves against a Middle East oil shock by entering into long-dated contracts with creditworthy hydrocarbon producers in regions subject to much less political risk. As a practical matter, this would mean producers in the United States, Canada, the United Kingdom, and Norway. It is obviously pointless to try to buy insurance from Middle Eastern producers-it is their riskiness that creates the demand for price insurance in the first place. Russia, West Africa, and Latin America are also politically risky regions. On the other hand, U.S., Canadian, and most North Sea producers are private entities that have a long history of honoring contracts and whose reserves are not threatened by invasion or insurrection. It is true that Western governments have interfered in their respective energy marketplaces in the past (price controls, supply allocations, import quotas, punitive taxes, etc.) and could conceivably do so again, but these are purely domestic political risks.
Some may wonder whether enough oil exists in these relatively stable regions to offset a Persian Gulf disruption. Marginal reserves in North America are in fact much larger than is commonly realized. These reserves do not show up in conventional measures because proven reserve figures are based on volumes that are economic to produce at current prices and with current technology. Systematic consumer-energy risk management would benefit western oil and gas production to the extent that it caused forward prices to rise. North American and North Sea producers would be able to exploit high forward prices by locking them in through the sale of derivatives contracts. Their marginal reserves, requiring significant up-front investment, would then be exploited to a much greater extent than would otherwise be the case. Moreover, with volume revenues secure, producers could fund development with debt capital rather than more expensive equity capital.
Owners of above-ground crude oil and refined product inventories have an important role to play. It was just such a role that the Strategic Petroleum Reserve (SPR) was meant to serve but has not. While it has accumulated a crude-oil stockpile of well over half a billion barrels, the SPR has never had a coherent, systematic strategy for selling crude oil during periods when prices spiked upwards. Only small amounts were sold from the stockpile during the 1990-91 Persian Gulf War, and then only after prices had begun to decline from their peak. For the stockpile to have been of any use during periods of distress, SPR managers needed to have a coherent strategy in place and should have communicated their intentions beforehand. Part of the Energy Department's reluctance to sell barrels from the SPR resulted from fears that they would be reducing the stockpile before the shortage was greatest. They could have avoided this problem by doing time swaps that would not permanently reduce the stockpile.
Privately held inventories can be used much more effectively by selling spot crude oil during periods of distress and simultaneously buying it back for delivery in future months at a lower price. This accomplishes two things. First, it provides significant income during periods when the oil market is in "backwardation" (i.e., when the spot or near month price is higher than prices for future delivery). This is not an uncommon phenomenon in the oil market, and is particularly pronounced when fears of oil-supply interruption are greatest. Second, it would maintain the same volume of crude oil in inventory over time. The effect of systematic time swaps on the part of the crude oil stockpile managers would be to push demand for crude oil from the spot market (where it is highest during a crisis) to periods further in the future. This would provide time for fuel users to increase efficiencies and for North American producers to undertake investment, which would increase output. Supply and demand for oil and gas are not very elastic over short periods, but are much more so over longer periods.
Fortunately, many American businesses are already beginning to implement many measures suggested here. Airlines, courier services, trucking companies, and railways are already buying swaps and options on jet and diesel fuel to cover themselves for periods of one to three years forward. The deregulation of utilities has encouraged more extensive use of energy derivatives as risk management tools. Several utilities have bought swaps on natural gas and residual fuel for periods as long as 10 years. Some industrial corporations have done the same. Recently, the "Big Three" automakers entered into a fixed-price power contract with Detroit Edison for a period of 10 years (which, in turn, involved fuel hedges on the utility's side).
Much remains to be done. State utility commissions should deregulate power generation further and do away with fuel adjustment clauses. Such clauses discourage utilities from locking in prices even when they are historically low. Utilities should also be encouraged to offer caps on future price increases to their customers. The U.S. government should permit individuals to buy insurance against increases in gasoline prices. This would involve eliminating the Commodity Futures Trading Commission's power to prevent retail customers from buying off-exchange commodity options (e.g., caps on gasoline prices). By allowing consumers and producers to use risk management tools voluntarily and systematically, we can mitigate the political risks of the Middle East and benefit from the relative security of North America and Western Europe. As these practices become more commonplace and familiar to consumers, a new conventional wisdom regarding U.S. security interests in the Persian Gulf may emerge.
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