Lessons from the Pros

I don’t usually comment on politics or politicians, and I’d prefer to keep it that way. There are few things more annoying than hearing the political opinions of a person who has no business spouting them (such as Hollywood actors and actresses). I do not intend to join their ranks. I’m not a political person. I’m a trader.

But when a politician uses his or her considerable weight to influence the economic world, especially the world of trading, that’s when the gloves come off. I’m specifically referring to President Bush’s plan to increase U.S. oil reserves, as announced during last week’s State of the Union address.

The plan is a positive one; the goal to cut gasoline consumption by up to 20 per cent over the next ten years marks a significant shift for the White House. The plan also calls for crude purchases that will double the amount of oil pumped into the Strategic Petroleum Reserve within the next two decades. It is a sensible reaction to concerns over U.S. dependence upon foreign oil and matters of national security.

Bush’s explanation was concise and clear. “For too long our nation has been dependent on foreign oil. This dependence leaves us vulnerable to hostile regimes and to terrorists, who could cause huge disruptions of oil shipments.” These are certainly legitimate concerns.

U.S. Energy Secretary Sam Bodman said the U.S. Department of Energy would begin adding 100,000 barrels per day to the SPR, starting this spring. The announcement triggered the biggest one-day price increase in 16 months, as oil rose 4.7 per cent to $55 a barrel. It was the most dramatic upswing in energy prices since Hurricane Rita tore through the Gulf of Mexico in September of 2005.

The U.S. move may also alert China, India, and South Korea to be more aggressive in building up their own strategic petroleum reserves, which in turn could create even more upward pressure on the energy markets. Now the U.S. has effectively entered into an oil-buying competition with these nations, which have already announced plans to increase their stockpiles.

Let’s be clear; I am not against adding to the Strategic Petroleum Reserve (SPR). That is a wise and prudent decision. However, I do have a problem with the way the announcement was handled. It reminds me of a poker player who tips his hand before the bidding begins in earnest. The timing of this announcement could not have been worse, as energy prices were in a free fall in the days leading up to the State of the Union Address
(see Figure 1).

Figure 1: Oil prices fell sharply in the days prior to the President’s speech (Daily chart). Source: Saxobank.com copyright 2007

Crude oil, traded on the New York Mercantile Exchange, was in the process of testing the huge psychological support level of $50 per barrel, and teased traders by hovering near that price in the days leading up to the announcement. In fact, NYMEX crude touched $49.90 per barrel on Jan. 18, its lowest point since May 25, 2005. A sustained break of the $50 level would have been a boon to consumers, not just in the U.S. but all across the world. It would have helped to douse inflation, lower business and manufacturing costs, and made life easier for human beings in general.

Previously, the U.S. had announced its intention to build the SPR to 1 billion barrels, up from the current estimated stockpile of 727 million. On October 9th, 2001, the U.S. House of Representatives approved House Resolution 250, a non-binding resolution to fill the SPR to its authorized capacity of 1 billion barrels of crude oil, by a 409-3 vote. To achieve this, the U.S. would have to purchase over a quarter-billion barrels of oil. Starting today, at a rate of 100,000 barrels per day, it will take more than seven years to add enough oil to the SPR to achieve that goal.

Since a target of 1 billion barrels has already been publicly declared, why make an announcement at all? Why not just quietly follow through on the prior plan to build the SPR up to 1 billion barrels, and then reassess the situation? The Energy Department could continue to add to the SPR once the goal is achieved, or not – perhaps in the future we will face a different situation in the energy markets. Does anyone know with certainty what the world will look like seven years from today?

The point is, the reserve could have been supplemented in a subtle, stealthy manner. With prices teetering on the $50 mark, the best course of action would be to temporarily halt inventory purchases. Price action and market psychology (which was extremely negative prior to the State of the Union speech) would take care of the rest, and soon traders would be looking at a huge psychological market break, resulting in oil falling to somewhere in the $40′s.

Once the price settles comfortably below $50, the Department of Energy could resume purchasing quantities of oil at its new, lower price – only this time choosing to do so in a manner that reflects an understanding of the laws of supply and demand. This means buying heavily on days when the price is weak, treading lightly on days when the price is strong, and never allowing your own purchases to drive the price through the roof. Why not manage today’s purchases with an eye toward tomorrow’s prices? Like a good pool player, the idea is to set up the next shot.

On the other hand, by announcing to the world beforehand, “HEY EVERYBODY!!! GUESS WHAT? WE’RE GOING TO BUY A BILLION BARRELS OF OIL!!!” and driving the price up to $55 per barrel as a result (see Figure 2), the U.S. is making the entire process considerably more difficult and expensive. There is no logical reason for the U.S. to announce its intentions to the market. To revisit our earlier poker analogy, why not hold your cards a bit closer to your vest? 

Figure 2: Oil prices bounce back after the President’s speech (Daily chart). Source: Saxobank.com copyright 2007

I suppose it’s possible that President Bush and his advisors didn’t fully understand the consequences of his statement, and didn’t expect energy prices to react so dramatically. Saying things that people want to hear is the task of any politician, and striving towards greater energy independence is something that all voters can support. I’d like to believe that the handling of this announcement was a mere lapse in judgment, an oversight by people who should know better.

And they really should know better. After all, Bush received his Master of Business Administration from Harvard Business School in 1975, and is the only US President to serve while holding an MBA. In the 70′s and 80′s he acted as a senior partner or chief executive officer of several energy-related ventures. From 1995 until 2000, Vice President Cheney served as Chairman of the Board and Chief Executive Officer of energy giant Halliburton. If anybody should understand the consequences of the SPR announcement – made during what is arguably the most important Presidential speech of the year – it is these two gentlemen and their advisors.

Again, it’s a good idea to increase amount of oil in the SPR. In the future, could we please do it without creating a disturbance in the energy markets?