Unlocking the Strategic Petroleum Reserve

The act authorizes holding up to a billion barrels of crude oil in reserve. The oil is obtained largely through in-kind royalty payments for oil leases. The oil (60% sour, 40% sweet) is stored below ground in caverns created in salt domes at four sites in Texas and Louisiana. The current capacity is 727 million BBLs. To put that in some perspective, imagine a ball with a diameter of 0.6 km or 39 Dallas Cowboys stadiums. That's enough oil to replace about 80 days of imports.

The act commingles the concepts of a physical shortage and a price increase. But unless there are controls on the price of oil, there can't be a physical shortage. Supply and demand are always balanced by a variable price. If supply is restricted, the price will move up to a level where there is enough oil for anyone willing to pay the new, higher market price. That's why we haven't seen gas lines since 1974, the last time price controls were in effect.

So why do we ask the President to make a subjective judgment when the market has a rock-solid mechanism - the price - for signaling that demand exceeds the current supply?

What if presidential judgments were transparently codified into a schedule of conditional purchases and sales? Put another way: What if the US government sold options against the SPR?

A quick refresher. A call is the right, but not the obligation, to buy at a given price on or before a given date. A put is the right, but not the obligation, to sell at a given price on or before a given date. The "given" price is called the strike price, and the "given" date is called the expiration date. The thing that is being bought or sold, oil in this case, is called the underlying. Delta is a measure of how the price of the option changes with a change in the price of the underlying.

This proposal would transform a passive asset - a slug of oil kept off the market - into an active hedging tool that would tend to reduce market volatility, frustrate speculators, and generate option premiums. Further, the mix of puts and calls can be managed to maintain the SPR level near any target level. And all this can be accomplished without the backbiting, second guessing, and intrigue of the current political process, and without the need for any further congressional action.

In all cases, the option has a time to expiration of one month and a nominal size of one million barrels. The market price of oil is $100 and a flat 40% volatility is used.

How?

The SPR could sell calls above the current market price. The ensuing delta hedging would have a dampening effect on price volatility. Let's say the SPR sold a $120 call. That option has a delta of 7%. So the likelihood of the option expiring in the money is roughly 7%.

To hedge the purchase, the option buyer will sell the SPR 70,000 BBLs at $100. Now, assume the price jumps to $140. The buyer is virtually certain to exercise the option to buy at $120. The delta is now 91% and the proper hedge is to sell an additional 840,000 BBLs at $140. So the option buyer is selling into the rally.

In reality, the option holder is constantly hedging his portfolio. But the bottom line is the same. If prices move from $100 to $140 on day one, he has 840,000 BBLs to sell to the market.

Hedging a call has a dampening effect even if prices collapse. Let's say prices drop to $80. Now the delta of the $120 call is almost zero. So the option buyer will need to buy back the initial hedge which was based on a 7% delta - the 70,000 BBLs sold at $100. The option buyer is buying as prices move lower, again acting as a drag on the market.

But selling calls is risky! What happens if we need that oil?

We can generate the same hedging dynamics even if the SPR never agrees to be a net seller of oil. Let's see what happens if they only agree to be a net buyer.

The SPR sells a put struck at $100. If the price of oil is above $100 a month from now, the option buyer will make more by selling to the market and the option will expire unexercised. But if the price of oil is under $100, the option buyer will sell oil to the SPR for $100. With oil at $100, this looks like a 50/50 proposition.

To hedge, the option buyer will buy 500,000 BBLs from the SPR at $100. Note that with a put, the hedge is an upfront sale of oil from the SPR and the option is a conditional repurchase of more oil later.

Assume prices gap up to $120. Suddenly the right to sell at $100 doesn't seem so appealing. The delta of the put has fallen from 50% to 5%. So the original hedge of 500,000 BBLs has to be reduced by 450,000 BBLs. The put buyer has 450,000 BBLs to sell at $120. Again, rebalancing is in the opposite direction of the market movement, dampening volatility.

The story is much the same if prices drop to $80. It is now much more likely that the put buyer will chose to sell oil to the SPR at $100. In fact, there is a 97% chance that this will happen. So the put buyer needs to buy another 470,000 BBLs at $80 to hedge the option. Prices fell and the put buyer bought, again acting as a brake on the crowd.

Dirty secret - puts and calls don't matter.

The amount of hedging that will happen is purely a function of the volume of options sold on a particular strike. It makes no difference if the options are puts or calls.

What if the SPR wants to affect hedging at higher prices but doesn't want to sell a call? This can be accomplished by selling an in-the-money (ITM) put. An option is ITM if it would have value if exercised today. So an ITM put has a strike price above the market price. With oil at $100, the SPR might be willing to buy at $120. ITM options have high deltas and are expensive. This put has a delta of 93% and is worth $20.22. The price includes almost $20 of parity value and about $0.30 of time value. The SPR option sale will also include the hedge - the sale of 930,000 BBLs from the SPR.

If the price ends up above $120 at expiration, the option buyer will have sold 930,000 BBLs back to the market and the option will expire unexercised. Here again the option buyer acts against the crowd. The SPR is a shock absorber.

Risk reduction

Technically, if you sell a put, the price could go to zero and you would lose on that particular option sale. But consider the bigger picture. The US is a net importer of about 9 million barrels per day. The SPR exists as a partial hedge. But the net position is short. The US benefits from lower prices. So the risk is on the upside.

What if prices double?

Is there a way the SPR can reduce market volatility while still ensuring oil is on hand for the end-of-the-world scenario? Yes. Instead of simply selling a call, the SPR could sell a call spread. So instead of a naked sale of the $120 call, the SPR sells the $120 call and buys the $150 call. Potentially unlimited losses are replaced by losses capped at $30. So if oil spikes to $200, the SPR will still hold its full inventory, plus the initial hedge. Of course, option buyers pay less for gains capped at $30.

We should note that the hedging dynamics around $150 will be opposite those seen at $120. Instead of hedging going against the crowd, it will be with them. As a result, prices will be more volatile around $150.

Legal considerations

A general drawdown of the SPR requires a presidential finding that an "emergency situation exists." For obvious political reasons, the President may be reluctant to make such a determination. But there are separate, less onerous conditions under which a limited drawdown may be authorized.

If the President finds that there is supply shortage of significant scope or duration that the SPR may ameliorate and that a drawdown would not impair national security, then the Secretary of Energy may authorize sales as long as the quantity is less than 30 million BBLs, the inventory remains above 500 million BBLs, and the drawdown period is less than 60 days.

Energy attorney Aaron Ball of Squire, Sanders & Dempsey (US) LLP's Houston office says, "The discretion Congress gave to the President to manage the SPR has been expanded substantially through legislation since its original establishment. The President would be within his authority to implement an options-driven mechanism without the need for additional congressional action. Further, just as the President delegates his authority to federal agencies or commissions to implement other legislation, he could also invite the assistance and advice of lawmakers and members of industry to manage the SPR. This would not only ensure the mechanism works, but diffuse the use of the SPR as a political lightning rod."

The mechanics

Here is how an option sales program might work. The SPR would sell a rolling series of monthly options. Short-dated options are favored because they are more sensitive to price changes and thus will produce greater hedging. Any entity wishing to bid would be vetted for credit worthiness. The time and particulars of each auction would be communicated in advance to each vetted party.

Note that the SPR's only credit exposure to counterparties is for the option premium. At expiration, only ITM options would be exercised. At that point, the SPR would effectively owe value to the buyer.

Let's say the SPR wants to sell a $120 call on 30 million BBLs. The bidding, quoted in terms of volatility, would start well above the market. If there are no takers, the price is dropped until the full 30 million BBLs are gone. Once the SPR has commitments for the full size, the last price paid applies to all contracts. The reference oil price is confirmed. This reference price serves as the price for all hedges and is used to convert the agreed volatility price for the options into a cash price. Contracts will specify the expected quality of the oil and the price adjustments for any variation. Options will be identical except as necessary to accommodate physical receipt and delivery constraints of the SPR. Option premiums are due in cash two business days later.

At expiration of ITM calls, the strike price is paid and then the oil is released. At expiration of ITM puts, the oil is received and then the strike price is paid.

Warts and all

The SPR will remain a political asset. The government's leaky bucket will still apply. Expect carve outs, set asides, and someone to identify a group that has traditionally been denied access to SPR option auctions. Don't laugh. The enabling legislation has special provisions that apply only to Hawaii.

But the perfect shouldn't be the enemy of the good. We have a powerful shock absorber at our disposal. Respected oil economist Tim Considine estimates that a 30 million barrel release from the SPR would cause global oil prices to drop about 3.5%. That's about an eight-cent drop in the price of a gallon of gasoline. The market response to the Libya release essentially confirmed his calculations.

This option sales strategy is a market-based attempt to finally attach our shock absorber to oil prices. In so doing, we will dampen market volatility, bring transparency to an opaque political process, avoid the hoarding observed to date, and unlock the value of the SPR. It would be a small step in the right direction. OGFJ

About the author

Larry Hickey is a reserved managing director with Aneris XTRM and a frequent contributor to Oil & Gas Financial Journal. He has spent the past 14 years managing implementations of industry leading ETRM solutions. He is often called upon to turn around troubled projects.