Commentary: The Opportunity of a Lifetime
Right now, crude oil futures are offering the opportunity of a lifetime, to traders, but potentially also to the incoming administration. With carrying costs for crude oil lined up for years ahead, arbitrage traders are trying to capture the richest part of the spread, into next summer, but there is a healthy premium stretching all the way to December, 2013.
The richest part of the premium goes to this summer, when traders can sell crude bought today at $13.00 to $15.00 more. That is well above the cost of physically carrying that crude, and traders are scooping up tankers to store oil right now.
But the Strategic Petroleum Reserve (SPR) offers a unique opportunity to President-Elect Obama. He could have the SPR buy up millions of barrels now, take delivery, and could then sell futures against that oil in 2011, 2012 or even 2013. As far out as 2013, December futures can be sold at more than $30 a barrel more than they cost right now. December 2013 futures settled at $73.76/bbl on Friday.
Since the SPR owns the salt domes, it has no rent to pay. And, as a branch of government buying a commodity that it can sell at a higher price in the future, its cost of money would next to nothing right now. But, even at 5% a year, crude oil purchased today would cost $2.00 a year to finance. That implies a profit of almost $20 a barrel in 2013, after paying 5% on money used to purchase and store crude oil today. That would more than cover the throughput costs.
The SPR could then sell call options on the crude it has stored. Last week, December, 2011 $70.00 calls traded at $12.99. Even with extra volumes pushing quotes lower, one would have to believe that the SPR could get $10.00 in collected premium costs for a December, 2011 contract currently quoted at $69.37. If the SPR does this on a million barrels, it could collect $10 million in premium (by selling the $70.00 calls). If prices get to $70.00, the crude would get called away, although it is not until prices were to hit $80.00 that they would take away the entire premium. Still, it would not matter. The SPR would release the oil and help dampen prices. If prices never get above $70.00 by December, 2011, the SPR gets to keep the premium and the oil – which it would then write fresh calls against. If the oil does get called away, the SPR would buy back the futures it had sold short in the first place (actually, it would probably do it somewhat before then).
By buying and storing the crude oil, the administration could effectively hold today’s surplus for a rainy day in the future. And the knowledge that millions or tens of millions of barrels could be released at certain ‘trigger prices’ could prevent unwanted speculative buying below that figure (their eventual absorption and loss would be bullish, which is why there should be scaled-up trigger prices). The premium income derived from calls sold against stored oil would be used to buy additional barrels. In our example above, $10 million (premium income from writing calls against a million barrels) would finance the purchase of nearly 143,000 barrels of crude at $70/bbl, or 200,000 barrels at $50.00/bbl. We can multiply those figures by each batch of a million barrels held with calls written against them.
The oil in storage could also be used as a policy tool. Once the administration had decided that certain specific levels of higher prices were inimical to economic growth, those levels could be used as trigger prices for the release of oil. We believe that this logically works best with the sale of call options, but the two can be used independently. The SPR could sell calls against half of the oil bought now, and could keep the other half to write calls against later or release as seen fit.
The oil already in storage would not need to be used, although we honestly see no reason why the SPR would not want to write calls against at least some of those barrels now, too. Selling calls on 350 million barrels may not be practical, but the SPR could actually go into deeper out-of-the-money calls in closer months to earn at least something. July, 2009 $100 calls last traded at $1.39/bbl. While that is not much of a premium to collect, the odds of it being reached are remote – and the incoming administration is certain not to want prices back at $100 by July. Writing July $100 calls on 20 million barrels would yield $27.8 million at current prices, which would buy another 695,000 barrels right now.
This is less about pushing specific trading strategies than about using a number of strategies and tactics to make the SPR a dynamic policy instrument that can generate revenues to fund the reserve and to purchase additional barrels. The flywheel that gets it all started is the extreme cost of carry-plus that exists right now. The SPR would probably make money just by buying barrels, storing them and selling future contracts against them, in 2010, 2011, 2012 and 2013 – possibly even further out. As long as the market is willing to pay the SPR more than the cost of money to buy the initial barrels, it makes sense from a policy perspective to buy today’s surplus, or a piece of it, and hold it for the future, when we are sure to need it. Selling calls against stored oil may just be the icing on the cake, a dynamic method of generating cash that could actually be used to make the SPR self-sustaining. If done properly, if run by professional who understand arbitrage, the SPR could become the one part of government that makes money. And that could be used for everything from alternate energy research to education to new highways.
To let this opportunity pass the nation by without the SPR making a penny or getting a single barrel free would be a tragedy. The SPR should at the very least be renting out space to those who can do some of these same things, and who can carry the surplus forward until a day in the future when it will be needed more urgently.
The Opportunity of a Lifetime
The chart below shows the crude oil contango for the second month minus the first month. At $5.24 a barrel, carrying crude fore just 30 days pays handsomely – well above the cost of money, renting space (even floating space) and throughput. That is true out to July or even later in the year. Traders can make fantastic profits by buying and storing crude now and delivering it in a month, two months or more.
The most sensational profits are there to be had for carrying crude for a month. There is $5.24/bbl for one month, then $3.04/bbl for the next month, $2.10 for the next month, $1.54 for the next month, and so on. The more months one adds on, the more diluted the profits become. But, that is strictly from a trader’s perspective.
From an administration’s perspective, the question is not how to maximize profits; it is how far into the future one can go without losing money. It is how far into the future today’s surplus could be held over until selling futures no longer pays for the cost of holding crude. In that respect, getting in now, to capture the $5.24 available for the next month, is just a way of extending that time (that barrels can be held) without losing money.
The exciting news for the SPR is that barrels can be sold as far out as December, 2013 without losing money, especially since the SPR gets great rates on borrowed money and has the storage already in place. Its real cost of carry each month is very low. And that means that the steep differences available over the next few or several months could pay for months and years on the other end, into 2011, 2012 and 2013. It might even be able to go further.
And, once the SPR sells calls against its stored oil, at a number of different times and strike prices, it could use that extra generated cash to buy barrels outright or to extend the time that stored barrels can be held. If done properly, there is a chance that tens of millions of barrels could be purchased now and held as far into the future as 2013, 2014 or even 2015. By doing this, the administration could be buying economic stability on the oil front for years. It would be the best present we could give ourselves for the future – and it will not cost us a penny. Instead, it will make money.
