Although the full repercussions of the Silicon Valley Bank (SVB) collapse are not yet clear, considerable uncertainty is driving market volatility and an uncertain economic outlook. Should markets drop further, the SVB fallout could reverberate all the way into oil prices. Despite the Federal government’s support for depositors, oil prices have fallen on expectations of weakening economic activity, and now sit firmly in the President’s declared refill range.
Amidst this uncertainty, the Department of Energy (DOE) must be ready to stabilize the oil markets. Having awarded its mandated sales for the year, and with some important lessons in hand from the first pilot, DOE should conduct another pilot with a preference for speedier and simpler acquisition processes. Markets act fast, but by limiting transaction costs and utilizing existing market infrastructure, the DOE can act just as fast to stabilize oil markets in the event of a sustained downturn.
We propose that the DOE test four separate pilot acquisition methods: (1) purchasing a futures contract; (2) a simple fixed-price forward contract; (3) a put option; and (4) a contract with a credible capital acceleration commitment.
Unpacking the First Pilot
The DOE ended its first pilot without acquiring any oil for the SPR. Reports indicated it rejected all offers because they didn’t meet the “required specifications” or were too expensive. Before conducting another pilot—it’s worth examining why this may have happened.
The Specifications Mismatch
It’s plausible that bids did not match the precise specifications for the grade of the crude sought. As Rory Johnston noted, DOE was possibly trying to match its acquisition to US refining capacity, which limits the crude you can accept (particularly difficult because US refining capacity does not necessarily match domestic production, and the acquisition was limited to domestically sourced crude). Furthermore, in order to preserve “SPR cavern homogeneity and maintain overall integrity of its respective crude streams,” DOE only acquires and commingles certain grades in storage. It’s possible (if unlikely) that, on short notice, the firms could not meet the specifications that DOE was requiring. It’s also possible that interest in the new authority (and the WTI price signal) incentivized producers that had not previously interacted with the SPR to participate, but also that these new producers were unfamiliar with the stringent requirements (though, if there were new participants, that in and of itself is an important signal that the fixed price authority is bringing industry interest). Without much detail, it’s hard to say how the DOE can better prepare for this challenge, especially considering that its grade specifications are not particularly onerous. Nevertheless, to the extent that producers do rely on the price floor commitment, strengthening transparency ex-ante on what grades the SPR requires to match its storage streams might help producers plan for future tactical purchases.
The Price Mismatch
It is much easier to understand why bids came in higher than expected when you examine the pilot’s design. The DOE published a solicitation for three million barrels (notably, for sour crude, rather than sweet, light that would match the WTI trigger). The offer period was two weeks and producers had to keep their offers open for that full period. Then, the DOE conducted a two-week evaluation, after which offers would be awarded for delivery in February.
Though this process might have been the most appropriate for DOE’s existing procedures–it imposes a number of costs on sellers–costs that would be reflected in offers.
- First, the DOE required that these offers remain firmly open for a two-week period. That is one-sided optionality that offerors are effectively exposed to. Prospective sellers of crude oil could bear substantial opportunity cost if the spot price rises during the period when offers must remain firmly open for the DOE’s solicitation. The cost of hedging this risk is the cost of buying the corresponding option through financial markets. This cost is not trivial and gets embedded into the offered price.
- Then there is a “contango premium.” At the time of the solicitation, the relevant forward period was in contango (future prices were higher than the spot). Since the curve reflects the current pricing for future barrels, a producer would be at a disadvantage selling to the SPR unless the price reflected those future prices–and that premium that would need to be priced in.
- Furthermore, because delivery was set for February, there’s a holding cost for the producer to keep the crude in inventory until February.
- There’s a delivery cost as well–WTI clears in Cushing, Oklahoma, the “Pipeline Crossing of the World.” For delivery outside Cushing (for example, to the SPR), the price offered would reflect the added delivery cost.
- There’s also a potential differential premium, between the grade of the price trigger and the grade sought–WTI is for light, sweet crude, but the barrels sought by the SPR were medium sour, benchmarked by Argus Mars. The offers may have reflected this differential as well (although Argus Mars, a sour crude benchmark, typically trades below WTI).
The costs imposed demonstrate the challenge that DOE has while implementing this novel authority, and why it should be utilized judiciously in appropriate contexts. The administration specified a price range for WTI, likely because it is among the most liquid, traded price streams and the likeliest to be meaningful as market signal–but one that does not match the delivery or grade requirements that DOE seeks through acquisition. And the pressure to earn a good return for the taxpayer can run counter to the goal of spurring domestic investment. If taxpayer return were the only goal, DOE could simply wait until the bottom of another supercycle, but that would stifle investment, setting up another steep price hike in the future. Moving forward, to make the best of both priorities, the DOE will need to design its next acquisition to minimize transaction costs.
Lessons From the Pilot, and Balancing Conflicting Goals
With these costs imposed, it’s not a surprise that offered prices came in higher than what the WTI trigger would indicate. The new acquisition authority and strategy is intended to achieve two goals: to incentivize domestic producers to invest and to earn the taxpayer a return on the trade. As the pilot demonstrated, these two goals can conflict without well-designed policy. DOE should heed the following lessons:
Minimize Costs by Utilizing Existing Market Infrastructure: In using its new authority, DOE is trying to stabilize the markets. Accordingly, to the extent that it can utilize existing markets, the more likely it can minimize extraneous transaction costs. There would be several benefits to this approach: for example, by using an exchange-traded benchmark contract, DOE could earn a better taxpayer return by getting a market price. It could also drastically cut down the time needed for competitive bidding, essentially by outsourcing that process to an exchange.
For Short-term Tactical Purchases, Every Day An Offer Must Remain Open Adds Costs: Future tactical purchases will likely have to be conducted on short notice, in response to the price falling within the $67-72 range. Unfortunately, the costs associated with the recent pilot procedure will both limit the extent to which the deal “pays off for taxpayers” and stabilizes the market, because of the long open period. DOE must take into account that each day that an offer must remain open adds costs to producers that will be reflected in the offer. These costs intensify when the relevant segment of the crude oil futures curve is in contango. Hypothetically, if you are responding to WTI dropping to $70, but the curve is in contango with respect to crude oil solicited for delivery eight weeks later, offers will come in at substantially higher prices than $70. Tactical purchases in such markets should be aligned with delivering crude oil to the SPR’s caverns as soon as logistically feasible.
Fixed Price (Forward) Contracts Probably Don’t Make Sense for Immediate, Tactical Purchases. Tactical purchases are meant to serve an ex-post benefit: if we knew that markets were moving closer to surplus (gluts), the SPR hoovering up some supply would be beneficial for stabilizing prices. And if producers had confidence in this particular policy, it might support some incremental investment at the margin.
On the other hand, fixed-price forward contracts are meant to deliver an ex-ante benefit. If a hypothetical producer believes that oil could be $40 and $140 (equally possible), a fixed price is quite valuable to hedge the risk of investment. In a short time period, like 6-8 weeks, there is no real ability for domestic producers to adjust the amount of supply they can bring on line. Accordingly, the investment-signaling value of a fixed-price contract goes down considerably.
Be Transparent and Set Fair Expectations: As noted, the prices we follow and see are not the prices that will be paid. Benchmarks like WTI are important signals, but they are only benchmarks, and the actual contracts written in the private market or otherwise reflect a series of costs, including things like storage and transportation. As the administration looks to balance several, sometimes conflicting priorities, it should be transparent about the policy goals it’s seeking and have fair expectations for how producers will respond to those goals.
The Next Pilot: Prioritize Faster, More Efficient Contracts
With these lessons, the DOE should swiftly announce a new pilot, this time prioritizing faster, more efficient contracts. We propose four types of transactions:
- Purchase a Futures Contract: The easiest way to minimize transaction costs would be by purchasing a liquid futures contract via an exchange like the New York Mercantile Exchange (NYMEX) or the Chicago Mercantile Exchange (CME). By utilizing an exchange, DOE would essentially be outsourcing its competitive bidding procedure to a faster, much more capable intermediary, and acquiring crude at the market price to boot. DOE could either use the benchmark index closest to the grade sought, like Argus Mars, which is sufficiently liquid. It could also purchase a WTI contract, and swap it for an Argus Mars contract closer to delivery (in this case, DOE would own the cost risk associated with the swap). This may be preferable because WTI is typically the most liquid of the US benchmark indices. By utilizing the futures market, DOE would be acting directly to stabilize the oil markets in the event of a downturn. Adding demand further along the curve would stabilize prices, feeding into equity valuations by traders and ultimately giving investors license to invest. By lifting the back end of the futures curve, DOE could shift the passive market interpretation away from capital discipline. Purchasing a futures contract can be conducted with advance public notice (as legally required), although given the market turmoil, the good cause exception would be warranted.
- A simple fixed-price forward contract: The DOE should conduct an acquisition through a simple fixed-price forward contract, aligned with its delivery capabilities. As a purely hypothetical example, if the DOE can take delivery next October, it could offer a solicitation now for a 8-month forward contract. Having gone through this process, and because the period is so far out, they could use the same offer and evaluation process (although ideally shortened). The further down the curve it purchases, the less likely it is to receive high-cost bids. Although this would be less impactful on the spot market, it still gives credible force to the President’s commitment and thereby supports a stable path for investment in the process.
- A put option: The DOE should pilot the sale of a put option. We’ve previously written extensively about how these could be conducted and logistical challenges to consider, but DOE should strongly consider the sale of put options. Additional design considerations would include how and when to collect the premium (upfront, or deferred) and how to align the exercise period with SPR’s delivery capabilities (the option premium could be reserved for contracting for storage if the SPR is incapable of taking delivery at exercise), but these are challenges worth undertaking given the unique benefits put options provide.
- An SPR contract that comes with a credible capital acceleration commitment: Ultimately, the goal of this new acquisition strategy is to simultaneously boost domestic production and achieve a good return for the taxpayer. Either through a forward contract or sale of a put option, the DOE should also experiment and develop its capacity to offer SPR contracts that come with credible commitments of capital acceleration. The SPR could offer a discounted cost of hedging in exchange for such a commitment. Structured and implemented correctly, an SPR contract could be a highly valuable hedging instrument amidst an uncertain market. In exchange for that value, it is reasonable for the SPR to prioritize producers who commit to accelerating their capital investment. We’ve written previously about what this could look like, but the important point is that DOE start building muscle memory to do so, by understanding what type of information is necessary to evaluate bids, how to evaluate if bids are credible (including identifying contracting partners who may be able to do so), and what type of pricing would be appropriate to incent producers to participate.
DOE must stand ready to purchase if the current volatility in the markets leads to a sustained price drop in oil prices. Failure to act with necessary speed and efficiency could drive an investment dip and set us on the path for another supercycle. By limiting transaction costs and utilizing existing market infrastructure, the DOE can show itself capable of effectively implementing the President’s groundbreaking strategy.