The Department of Energy (“DOE”) is about to engage in rulemaking to broaden the types of acquisitions it can engage in to help refill the reserve in a manner that is both cost-efficient and consistent with the broader goal of enhancing energy security. This rulemaking is a worthwhile opportunity to ensure that the DOE has the capacity not only to engage in forward contracts, but also to use its uniquely positioned physical inventory and storage capacity to sell physical put options. Allowing this authority would help replenish the reserve more efficiently and support long-term energy-security by helping remove excess uncertainty from the market.
Put options provide the holder the legal right, but not the obligation, to sell a commodity or security at a time and price that are determined when the contract is signed. If the Strategic Petroleum Reserve (SPR) were to write such contracts to private holders, the DOE would have the obligation to acquire barrels of crude oil in the event that a particular strike price (or lower) materializes. Such price-conditional acquisitions – which are highly aligned with DOE’s statutory authority – would ensure that the timeline for refilling the SPR is aligned with global energy markets achieving a better balance of supply with demand.
By allowing the SPR to write options, the agency could effectively offer private producers a form of insurance against global oversupply in general, and against an OPEC-induced price-war in particular. Given the often punitive cost at which private actors typically sell such option contracts, the SPR’s sale of physical puts at more reasonable prices can offer an attractive incentive for certain exploration and production companies (E&Ps) to accelerate investment today. They would thereby retain the option to sell at either (1) spot oil prices in later years (if spot oil prices remain elevated) or (2) a straightforward floor (strike) price to the SPR (if spot oil prices fall to or below the strike price). While forward contracts are time-contingent (SPR contractually replenishes at a particular time), the usage of put option contracts would replenish the reserve on a more state-contingent basis (when spot oil prices fall to a particular price), while potentially earning a return selling option premiums in the interim period.
Discussion of Policymaking Merits
If you have been following our work, you’ll know that we have been calling for a number of administrative actions that can help to alleviate the challenges that ongoing Russian oil production declines poses for oil and gasoline prices. The Administration has taken some meaningful steps consistent with our proposals, including the ongoing release of existing inventories from the Strategic Petroleum Reserve alongside a plan to lock in future supply to refill the reserve in later years. The DOE announced late last week that it would revise its regulations to broaden its authority so that it would have clearer capacity to engage in fixed-price forward contracts. As we already noted, this is a very welcome development, but the proposed rulemaking provides a deeper opportunity to rethink how to use the SPR’s unique capabilities to mitigate uncertainty within the energy industry and deliver greater energy security.
Amidst high spot oil prices, there is routinely talk among those E&Ps that are not debt-dependent about “lifting hedges” because hedging is costly relative to simply selling produced barrels at spot prices. With the oil futures curve still substantially backwardated today, E&Ps have to accept a lower profit margin when they lock in future prices, albeit in exchange for greater price certainty. Given the low level of private inventories, the price associated with a longer-term futures contract is substantially lower than the price of a spot crude oil transaction. Creditors, particularly bank lenders, demand that E&Ps substantially hedge their production through such contracts. But for other E&Ps not dependent on such restrictive financing, the optimal strategy might be to ride the run in high spot oil prices for as long as it might last (and reduce investment and production when spot prices fall sufficiently).
In simpler terms, the costs of hedging in private markets, whether through put options or forward contracts, are especially punitive, despite ample financial market depth. Punitive hedging costs imply that E&Ps are still bearing the bulk of the risk and uncertainty associated with the trajectory of oil prices.
The DOE’s upcoming rulemaking presents an opportunity for a larger innovation that we had not previously discussed, but that is otherwise consistent with the DOE’s statutory authority and obligations: the capacity to sell physical put options to private actors, with the incentive associated with such optionality ideally flowing to domestic E&Ps. Selling a put option would effectively make the SPR’s purchase of crude oil conditional on particular price outcomes.
While forward contracts might benefit those E&Ps that are more capital-constrained and required by creditors to directly hedge their production through such contracts, option contracts could prove attractive to a wider set of E&Ps, especially given that the cost of such options in financial markets are otherwise punitively high.
Caption: 1-Year Downside Price Protection Is Historically Costly (Time Series: Implied Volatility of 1-Year 10-Delta Puts On The Active West Texas Intermediate Oil Futures Contract)
The SPR would effectively be offering a form of OPEC-price-war insurance for private actors, and insurance against global oversupply more generally. If OPEC decides to start a price war in later years, or if markets otherwise stumble into oversupply in later years, domestic E&Ps with such insurance would be better-positioned to offload excess production to the SPR at a price that would still be substantially lower than today’s spot prices, but nevertheless still profitable on a unit-cost basis.
Selling optionality is a risky endeavor for a market actor if they lack the capital to backstop such a sale, but two factors uniquely work in favor of the SPR fulfilling this function: 1) it has the physical storage to take delivery of oil in a price crash, and 2) it already has the proceeds from its ongoing release to purchase the oil in a scenario where oil prices are crashing.
These factors, alongside the SPR’s statutory authority to make acquisitions consistent with certain objectives, particularly “(1) minimization of the cost of the Reserve;” and “(3) minimization of the Nation’s vulnerability to a severe energy supply interruption;” give ample room for such contract structures under revised regulations (for a deeper dive, see the legal discussion below). While forward contracts fix a set timeline for replenishing the SPR, there is no guarantee that such contracts, on their own, will coincide with a better-balanced market.
For the sake of minimizing cost to SPR and aligning incentives towards greater energy security, the DOE should ensure that its rulemaking creates the option for the DOE to sell put option contracts.
Discussion of Legal Authority
The use of optionality is highly-aligned with the letter and spirit of the statute governing SPR acquisition. Furthermore, the flexibility offered by options would align with regulations already found in the regulations governing SPR acquisition and sales.
42 U.S.C. § 6240 governs SPR acquisition, allowing the Secretary to acquire petroleum products through purchase. The statute implicitly contemplates that purchase may take different contractual forms, by allowing the Secretary to determine the “manner of acquisition” so long as it aligns with a set of described objectives, and that the procedures of acquisition account for certain factors.
The statute requires that DOE, “to the greatest extent practicable,” “[minimize the] Nation’s vulnerability to a severe energy supply interruption,” “[minimize] the impact of such acquisition on supply levels and market forces,” and “maximize overall domestic supply of crude oil (including quantities stored in private sector inventories).” As described earlier, the ability to engage in options contracts would boost domestic production and stability, by giving producers greater protection against downside risk while lowering costs through the sale of option premiums, which thereby earn a return for the reserve so long as oil prices remain elevated. Provided the SPR retains sufficient spare storage capacity and sufficient funds available (from its ongoing release), the SPR would only be exposed in a scenario where oil prices materially fall. That scenario would be more consistent with reduced “vulnerability to a severe energy supply interruption.” The unique ability of selling put options to spur the necessary production response to maximize domestic supply of oil and to minimize our vulnerability to a severe energy disruption, and the risk protection they could offer to producers, all point to strong alignment with both the letter and the spirit of the acquisition law.
As the DOE’s recent announcement acknowledged, a new regulatory framework is necessary for forward contracts that allow fixed-price bidding. This is equally true for allowing the SPR to sell put options. However, at a higher level of generality, allowing SPR to sell put options aligns well with the discretion afforded the Secretary in acquisition. 10 CFR 626.5(b) allows the DOE to define the method of crude oil acquisition, and requires it to be based on several factors including “current market conditions,” and “other considerations DOE deems to be relevant.” This regulation is an acknowledgement that the statute affords discretion to DOE in determining the most appropriate method of acquisition and acknowledges the importance and general spirit of the acquisition statute requiring that the SPR should minimize market disruptions and disruptions for producers.