Streetwise Professor

The IEA and the United States have announced plans to release over the next month 60 million barrels of crude oil from strategic stockpiles, including the US’s Strategic Petroleum Reserve.   Oil prices plunged, by about $5/barrel.  Initially, I was reluctant to attribute most of the price drop to the announcement, because the stock market and virtually all other commodities were down hard too, and the dollar rallied.  These broad changes were plausibly due to bad US job numbers and continued angst about Greece, and given the recent correlations between oil and stocks and the dollar, it was likely that a good part of the oil sell-off was related to these factors.  But when the stock market rebounded later in the day, recovering about 3/4ths of its previous losses, and oil only recovered slightly, it was evident that the oil stockpile release had caused a substantial drop in prices.

To understand the implications of the release, assume initially that the release is considered a one-off, with no implications for the future. In that case, it is like a sudden increase in initial availability of oil. Here is a figure based on a dynamic model of a storage economy that relates the amount of inventory carried out (on the vertical axis) to the amount of the commodity initially available (on the horizontal axis).*

A surprise increase in initial availability is a move along the horizontal axis. Since carry-out is an increasing function of initial availability, some of that new supply released from the reserve is added to private inventories. This would tend to dampen the effect of the release on prices, but some of the increased supply would be consumed, prices would fall. Here is a figure of price as a function of initial availability, which shows that as availability rises price falls. But this curve is flatter–more elastic–than the flow demand curve, because of the fact that some increases of initial supply are put into inventory which buffers the impact on price.

But the key thing here is that you can’t assume that the market believes that this will be a one-off, with no implications for the future. The availability-carry-out function depends crucially on the beliefs of market participants about how the SPR will be used going forward. The current use is unprecedented: previously, the reserve was used in extraordinary circumstances, like supply disruptions resulting from the 2005 hurricanes. Now it is being used to micromanage world oil prices–and to micromanage Obama’s political future. This dramatic change in the employment of the SPR will inevitably affect beliefs, and hence (a) the relation between carry-out and initial availability, and (b) price and initial availability.

In my opinion, the most likely outcome is for the change to affect beliefs in a way that leads to a bigger price response than implied by the two earlier figures. The reasoning goes like this. Those making decisions on how much oil to store do so in anticipation of earning a profit by selling out of those inventories when demand spikes up or supplies spike down. These private storers will now reason that there is a higher likelihood that supplies will be released from SPR under those circumstances. This reduces the amount of money they make on selling out of inventory during those condition. This makes holding private inventories less profitable, so they will hold smaller stocks, all else equal. Put differently, market participants will now view the SPR as a competitor for private storage under a wider range of economic circumstances than was previously the case, and this increased competition from public storage will drive out some private storage.

In terms of the graph, this shift in beliefs about the way the SPR will be used shifts the relation between availability and carry-out. In particular, it shifts it down, from the green curve to the blue one.

This shift moves exacerbates the price impact of the release. It means that a smaller amount of the release will be absorbed into private storage, more of it will be consumed, and hence prices will fall by a larger amount.

Going forward, private inventories will be smaller. This will make the market more reliant on public storage to smooth supply and demand shocks. That’s not comforting, because public storage decisions are not driven by commercial and market realities, but political ones, and by decision makers with poorer information and weaker incentives than commercial market participants.

Ironically, one hypothesis advanced to explain the decision is that it is designed to punish long speculators. Well, the government and the IEA have now just provided much speculative fodder: now market participants have to speculate about how SPR management policy has changed, and how it will change going forward. That is very complicated, given that it will be buffeted by numerous factors. These include how OPEC countries react, how the US reacts to the OPEC countries’ decisions, how it plays politically in the US, and on and on.

This uncertainty, the flow of information relevant to deciphering the policy shift, and the feedback mechanism among traders (e.g., the Bayesian learning dynamic mentioned in the Singleton paper) will all contribute to price volatility. In short, by attempting to punish speculation, the administration has only stoked speculation. The “constructive ambiguity” surrounding the release, and future reserve policies, will only further fuel such speculation. SPR policy will now attract the same kind of scrutiny as Federal Reserve policy, where market participants try to interpret Delphic announcements and actions in order to discern the future course of policy. They will try to infer how external events–say, Obama’s political standing–will drive policy: just what is the function that relates SPR releases to Obama’s poll numbers? All of this interpretation and inference will generate trading that will in turn generate price movements, just as is the case with respect to Fed policy. Alleged concern about volatility has led to a policy that will create volatility.

And note that even though this action has hurt some speculators–those who are long–it has been a huge windfall to others.

The numbers are pretty staggering. Based on Commitment of Trader Reports for 21 June, and just looking at NYMEX and ICE WTI and Brent crude oil futures, given a price impact of about $4/barrel, the announcement led to a shift of wealth from longs to shorts of about $17 billion in crude futures and futures options alone. Add in refined products and you’ll increase that more. Add in swaps and other OTC instruments, you will increase that number substantially. Very substantially.

Within categories, again assuming a $4 price impact and looking only at crude futures and futures options, long swap dealers lost $1.9 billion, short swap dealers made $1.7 billion; long managed money lost $1.5 million and short managed money made $460 million, other reporting long speculators lost $556 million and other reporting shorts made $380 million. Again this overlooks the transfers between longs and shorts in the swap market. And also the capital losses on unhedged private inventories; at the end of May, OECD commercial crude and product stocks totaled about 2.7 million billion barrels. US commercial stocks of crude are about 360 million barrels, and crude and product stocks (ex SPR) about 1 billion barrels. Thus, the value of inventories in private hands in the OECD fell by about $10 billion, and in the US about $4 billion–who knows how much inventories fell in value in China. (And by the way, the value of oil in the SPR fell by about $280 million$2.8 billion.)

A lot of money changing hands. A lot.

Earlier this year, I blogged about potential economic justifications for a strategic petroleum reserve, and how the reserve should be used based on such justifications. In brief, something like the SPR can be justified to correct some other market failure that would depress private storage below its optimal level: the most likely candidate for such a market failure would in fact be a government failure, such as the threat of price controls or other interventions during a crisis.

Suffice it to say that the current action cannot be justified in this way. There is no demonstrable market failure being ameliorated here. This use of public storage is not correcting some deficiency in private storage arising from some market failure or government failure. Indeed, perversely, this use of the SPR’s public storage will, as noted above, discourage private storage.

In US law, there are three elements to proving manipulation: causation, intent, and artificial price. It is clear logically and empirically that the SPR release did cause prices to move. It is also abundantly clear that the administration and the IEA had the specific intent to cause price changes: indeed, they are both boasting about the purpose and effect of the policy. Artificial price is somewhat more ambiguous here. No market failure is being corrected, so a colorable case can be made that the price movement is not moving price closer to where it should be in the absence of such a market failure. That supports a claim of artificiality. But given that the SPR might have distorted price in the first place, it is arguable that perhaps prices are now closer to where they “should” be–but that only means that the price was artificial before because the SPR was inefficiently holding oil off the market.

Causation and particularly intent are often the hardest thing to show in a manipulation case: here, in contrast, they are easily proven. Artificiality is not so clear cut here, but I think it is beyond cavil that the impact of the policy will be to enhance volatility in oil prices and lead to fluctuations based on conjectures about the future course of government policy. That interferes with the operation of these markets and will lead to misallocations of resources, which is what artificial prices do, and what the manipulation laws are intended to combat.

This leads me to conclude that there is a strong prima facie case of manipulation: certainly a stronger case than some others the CFTC has filed in the past. I therefore expect that the agency will move swiftly to file a manipulation action.

That was all tongue in cheek, for those slow on the uptake. I of course know that no such action will be forthcoming; the government has vast discretion in use of the SPR. But if you look at the perverse effects of manipulation by commercial and speculative players–massive transfers of wealth between market participants, distortions of consumption and production decisions by private players, unnecessary price volatility–all of them are present in spades here. Indeed, the effects here are huge, far larger than any private manipulation case that I am familiar with (and I am familiar with all of them, I think).

It is especially ironic that this move came during the same week that the Federal Trade Commission announced that it was launching the most recent in a continuing series of investigations of manipulation by oil companies. This happens every time prices are high, with the same result: the FTC finds nothing. It’s one of the longest running farces in Washington.

If it wants to find manipulation, it should restrict its investigation to the 202 area code.

This is not the first time, certainly, that the US government has attempted to intervene in commodity markets to control prices in order to achieve a political objective. The Hoover administration–you know, that laissez faire bunch (not!)–did so with abandon in the grain markets with the onset of the Depression. That turned out badly. I don’t expect this to turn out much better.

* This is the same model as I analyze extensively in my forthcoming book. Just received the galleys, so the end is in sight!