The “Free Market,” as it is often called, is not really “free” – every educated investor knows this. Government regulation is hidden around every corner, and policy changes and new legislation can (and regularly do) have significant effects on market mechanics. Recently, Congress has announced a policy change that could significantly impact the oil market for many years moving forward – a market that has already seen considerable turmoil in the past year. Below is a summary of the policy change, and how I believe it will affect the market moving forward.
Selling The Strategic Petroleum Reserve
Every now and again you read a news story that really grinds your gears. Right now, the sound in my head sounds like when you try to powershift a TR6060 with a worn 2nd gear synchro on a 40 degree morning before it’s fully warmed up. If you’re not a modern muscle car fan, you may not get the analogy. But trust me, it’s a really bad noise. The kind of noise that hurts your soul.
Earlier in the week on October 27, it was announced that the United States plans to sell down the Strategic Oil Reserve (Strategic Petroleum Reserve, or SPR) under a budget deal in order to raise more cash to offset our ever-increasing deficit spending habit. This sale would take place in increments from 2018 to 2025. The proposed sale equates to about 8.5% of the current 695 million barrels of reserves currently held in four sites along the Gulf of Mexico coast. Sales are slated to begin in 2018 at an annual rate of 5 million barrels, rise to 8 million barrels by 2022, 10 million barrels by 2023 and totaling 58 million barrels by 2025’s close.
The money would be deposited into a “general fund” for the United States Treasury. It is part of a two-year budget deal constructed in the wake of yet another debt ceiling fiasco in the 11th hour before a potential government shutdown.
Oil reacted to the news by falling 78 cents, or 1.8%, to close at $43.20 a barrel.
The strategy behind this is ‘strategically’ political.
The Strategic Petroleum Reserve: A Brief History
The establishment of Stragetic Petroleum Reserve was a reaction to the 1973-1974 Arab oil embargo, known as “The First Oil Shock.” It was established in 1975 after the oil crisis saw prices spike as supplies were cut off from import partners in the Middle East.
- The SPR is designed to protect against future domestic economic shocks caused by international trade partners, such as the 1973-1974 oil shock.
- The SPR was tapped in 1991 during the Gulf War to aid in liberating Kuwait from Iraq. During Operation Desert Storm, the US assured its allies the adequacy of global oil supplies when war broke out in the Persian Gulf. An emergency sale of SPR crude oil was announced the day the war began.
- SPR supplies were used in 2005 after hurricane Katrina crippled Gulf of Mexico production.
- In 2011, the SPR was raided after the war in Libya cut supplies.
- Once before, between 1996 and 1997, the US sold 28 million barrels from the SPR to reduce the federal deficit.
National Security And The SPR
The entire purpose of the SPR is national security – hence Strategic Petroleum Reserve. The Strategic Petroleum Reserve exists in case of a “rainy day” scenario – geopolitical tension erupts somewhere, imports become strained and the US cannot get the oil it needs from overseas. The SPR ensures we have enough supply on hand to get by for awhile until tensions (hopefully) reduce and trade liquidity increases again. Selling the SPR is the equivalent of a parent setting up a savings account for their child, then using their child’s savings account to pay the cable bill.
A good parent would cancel the cable service before they raided their kid’s piggy bank.
Senator Tom Coburn publishes a book every year called The Wastebook, which documents all kinds of fiscally irresponsible things our government spends money on. Just a few fun examples below, the government has spent….
- …$181,406 to a researcher at the University of Kentucky to study how cocaine enhances the sex drive of Japanese quail.
- …$856,000 to train three mountain lions to run on a treadmill in order to measure the energy consumption of the cats’ hunting techniques.
- …$2 million/year to maintain the operation of a sheep research site known as the U.S. Sheep Experiment Station in Dubois, Idaho.
- …$77 million/year to ship soda, chicken wings, Clorox wipes and other supplies to remote villages of Alaska.
- …$3 billion/year in “improper food stamp payment.”
- …$80 million to build a Tactical Assault Light Operator Suit – yessir, we’re building Iron Man.
- …$1 billion to destroy $16 billion worth of ammunition that it didn’t actually need after an investigation found much of the ammo became “obsolete, unusable or their use is banned by international treaty. That’s $17 billion wasted, folks.
The sale of oil out of the SPR to fund the deficit is nothing more than political theater – it is a show. Our deficit has grown so gigantic year-over-year that the sale of petroleum out of the Strategic Oil Reserve, a vitally important stash of oil we have had to tap into multiple times over decades during times of geopolitical tensions, will barely amount to a rounding error.
Which brings me to my next point…
Oil Prices Continue To Fall With No Sign Of Reversing
Not only does the government want to sell oil out of our vitally-important-to-national-security Strategic Petroleum Reserve, they want to do it at rock bottom prices. We are in the middle of a massive oil glut with no signs of reversing, and they plan on initiating sales during a time period that is projected to maintain low commodity prices.
Let’s for a moment assume oil prices average $75/barrel from 2018-2025. The sale of 58 million barrels @ $75/barrel amount to $4.35B in revenue over the span of 8 years. That’s hardly more than half a billion dollars a year.
Below, we have past federal budget deficits, and future projected budget deficits.
Selling the oil would amount to a massive loss on the initial investment. The Energy Department, which oversees the reserve, says on average the U.S. paid about $29.70/barrel for the oil in the SPR. After adjusting for inflation and other items, the average cost rises to $74/barrel, according to ClearView Energy Partners. Oil, today, is trading at about $45/barrel. Not only would we be selling out our nation’s energy security blanket, we’d be doing it at a 39% loss on our principle.
With a Strategic Petroleum Reserve that’s nearly full, a government that’s actively trying to sell our national security at a 39% loss while refusing to cut wasteful programs and useless university studies, a Fed that feels our economy is so fragile that a 0.25% interest rate hike would crush the markets and oil that continues to sink lower with no sign of recovery in sight, we are living in interesting times. The oil market looks bleak for the foreseeable future, and with a government that feels oil will be so abundant for years to come it’s willing to sell out its strategic reserves, it may get a lot worse before it gets better.
Implications For The Future Oil Market
Taking a look at the 1 year chart of the United States Oil Fund ETF shows the elevator ride down oil has taken since last year. Moving forward, there is no end in sight to the commodity price collapse. Currently, the US Strategic Petroleum Reserve is nearly at capacity, with 695 million of the 713.5 million barrel capacity being full. Reaching that capacity could cause oil prices to fall markedly lower temporarily in a knee-jerk market reaction.
This reaction is very telling as to where the US Government expects the oil market to be heading in the years to come. The SPR was set up after the 1973-1974 Arab oil embargo against the US as a matter of national security. At this time, the US was extremely dependent on imported crude oil. Today, fears of an oil embargo are few and far between. Domestic crude production in recent years has been unprecedented – just off the charts. OPEC no longer has the power to use oil as a weapon to pressure the United States as the shale revolution has turned oil into a “backyard resource.”
I believe long term crude oil will remain affordable for many years to come for two big reasons:
- The shale revolution has created a landscape where the US is no longer dependent on oil imports.
- OPEC knows that high crude prices will only exacerbate this issue, and will maintain high production and low prices for years, if not decades, to come in order to maintain their market share as long as possible or risk a day where the US doesn’t import a single drop from them.
Plain and simple, we don’t NEED imported oil anymore, so in order for us to continue to import crude, it needs to be cheaper than what we produce. For those awaiting a big oil rebound, you may find yourselves disappointed.
For the casual investor, I feel oil ETF’s and futures trading is a very dangerous way to play the oil market and offers little upside. Oil will likely remain affordable for a very long time, trading in ranges for the foreseeable future. In that type of environment, the only way to profit is to buy the dips and sell the spikes. That is not investing, that is gambling, and humans have shown time and time again we almost always fail when we time the markets. Furthermore, the after-tax gains of a perfect “home run” play are so paltry, why even bother? With the trading range oil has been in, the investor who timed things perfectly couldn’t make more than 20-30% pre-tax. Why would anyone do that when you have 47.37% odds to make 100% profit instantaneously betting BLACK on a roulette table? You’re better off going to the casino than fooling around with this stuff in my opinion.
The only way I would, and actively am, playing this situation is through regular dollar cost averaging into the Supermajors – Exxon, Chevron and Royal Dutch Shell. While I believe the long term oil market will be less volatile and more affordable than the decade before us, I still believe the only natural price path of oil is UP over the very long term. The oil Supermajors will eventually cut costs and become very profitable once again in this environment. You cannot turn an oceanliner on a dime, and it will take months if not years of capex cuts and restructuring to adjust to a new kind of long term oil market. This is a very good thing for long term small investors such as myself – it allows us many years of opportunity to use the power of dollar cost averaging and re-invested dividends to secure an outstanding position. Dividends are closer to historical highs for the Supermajors, and as long as they are maintained (and I think they will be), a few thousand dollars in contributions each year could turn into big rewards for those with a 30+ year horizon.
This further solidifies my belief that oil companies are generational holdings that can only be measured “per oil cycle,” not per annum like most non-cyclical industries. Oil investing takes a stronger stomach than a brain, and history has shown those who hold on for the long term and stick to their strategy have been handsomely rewarded.All information found herein, including any ideas, opinions, views, predictions, commentaries, forecasts, suggestions or stock picks, expressed or implied, are for informational, entertainment or educational purposes only and should not be construed as personal investment advice. I am not a licensed investment adviser.