Today’s announcement from the Department of Energy (DOE) is a welcome sign that the administration is taking oil price stability seriously. Following the historic release of 180 barrels of oil from the SPR, we called for the Administration to announce purchase contracts “as soon as practicable” to replenish the SPR, thereby providing marginal support and stability to future demand and mitigating some of the fears that make current exploration and production firms (E&Ps) reluctant to invest in expanded production. The announcement that: (1) bids for 60mm barrels of oil would open in the fall; and (2) that those bids would likely – pending regulatory clearance – take the form of forward contracts, is a major step in the right direction.
Unpacking the Announcement
Since financial markets are complex and energy policy can be shrouded in legalese, it is worth taking a minute to translate some of the more abstruse language in the DOE’s announcement. First, in the fall, the SPR will announce bids to purchase 60 million barrels of oil for delivery in future years. These bids represent guaranteed demand for oil in the future at prices that producers can lock in today, and minimize the uncertainty associated with investment in a highly volatile commodity. As the Administration put it:
“In addition to securing contracts for future delivery to refill the SPR, this replenishment structure also will help encourage the production we need to lower prices this year by guaranteeing this demand in the future at a time when market participants anticipate crude oil prices to be significantly lower than they are today.”
By locking in contracts for oil in the future, the administration is encouraging producers to bring more supply online, reducing the supply uncertainty that increases oil prices. As we’ve written, investment from E&Ps is proximately constrained by “shareholder commitment to capital discipline.” That is to say, after having their investments burned multiple times in the last ten years by supply gluts and price wars, investors prefer a price-insensitive investment response, even at otherwise profitable prices. By committing to buy future barrels, the administration is enticing producers to invest with greater confidence in future demand. This commitment offers the type of predictability that can give at least some producers marginally more comfort with accelerating investment now.
Importantly, the Administration also announced a regulatory process to enable more effective use of forward contracts, by allowing the DOE to solicit fixed-price bids. Why is that important? Under 10 CFR 626, (the regulation that sets SPR acquisition procedures), the SPR must use index-pricing for acquisition. By tying the price at delivery to an index, parties to contract are less vulnerable to “market risk” between the initiation and completion of the contract. This pricing method has benefits, but loses value in the context of long-term forward contracts, where the ability to fix a price is a risk-reducing mechanism itself.
Forward contracts are designed to allow parties to hedge risk and increase predictability. Market participants who can forecast their needs have used them for decades. Due to its own regulations, the DOE has opted for an approach to contracting and acquisition that limits this method of risk-sharing and risk mitigation. With a guaranteed sale price, producers are insulated from the risk of a dramatic price drop while the purchaser (in this case, DOE) is insulated from the risk of a significant price increase. But the current regulation requires transactions be based on an index-pricing system, meaning neither producers nor the DOE may be able to hedge in this manner. That’s why the Administration’s announcement is so important–it can facilitate the use of forward contracts precisely for the sake of greater risk mitigation.
Forward contracts are particularly important when the price for oil today and oil in the future diverge sufficiently. While a barrel of oil for delivery today, (on the “spot”) has been above $100 for weeks, an identical barrel of oil purchased today for delivery in five years costs over 30% less.
The Administration is undertaking thoughtful, strategic action here to limit oil price upside risks in the near-term and minimize oil price volatility in the long term, and that deserves recognition. Even better, they are doing so by improving the DOE’s toolkit to manage price volatility in future. However, there is one last, critical step that could meaningfully incentivize further production: affordable and available financing.
Financing is How the Pieces of the Policy Puzzle Can Fit Together
In our original proposal, we called on the Administration to make financing more available for oil producers, especially the relatively marginal producers who often make up the lion's share of investment in new wells. While demand guarantees are critical, it is equally important to facilitate affordable financing for producers. The two in conjunction can help overcome shareholders’ preferences for price-insensitivity of current investment intentions. While producers can seek private financing, several factors limit its affordability and availability, particularly for smaller E&Ps. The government has a prudential role to play in ensuring that investment intentions are aligned with socially desired goals, in this case offsetting the risks stemming from permanently lost Russian oil production.
Oil production is a risky investment, especially given oil price volatility. Over the last decade, many investments made by producers failed to pay off; a dramatic increase in US supply led to cutthroat price wars. That history makes financing a risky proposition for banks–one that would require higher rates of interest to justify. Furthermore, financing oil production is becoming marginally less attractive as some investors attempt to bluntly avoid the industry for the sake of complying with environmental, social, and governance (ESG) standards.
These factors all limit the affordability and availability of financing for oil producers. Without affordable debt financing, a greater share of investment must be paid for with retained earnings, less than ideal from the perspective of shareholders looking for a shorter-term payout. That basic fact limits the extent to which producers will be willing to invest, even with demand guarantees. The government stepping in and offering financing (whether directly through loans, or indirectly through loan guarantees or other financial mechanisms) can overcome this, especially when coupled with demand guarantees. With locked-in sales, the marginal producer can use leverage to make investment more economical, that too at a lower price. Essentially, oil producers could at least theoretically swap a high-risk high-reward investment landscape for one in which certainty and leverage more than offset the effects of lower expected profit margins.
Debt financing support–as we suggested should occur through the Exchange Stabilization Fund–is also the most direct way to achieve investment in new wells. Take the 60 million barrels announcement for the fall. While it is a large announcement, it’s possible that producers would fill at least some of that demand using wells already built into their existing capital expenditure plans. But with the availability of financing for new investment, and the prospect of more stable profit margins, the marginal producer should be able to find value in new investment that extends beyond current capital plans. As more marginal producers make the same tradeoff, the ultimate result would be new rig counts increasing at a pace sufficient to keep up with demand (which we still have yet to see). At that point, we can expect the long-term path of spot oil prices to be both lower, and less volatile.
Conclusion
We are very pleased to see the Administration take important, long-term steps towards delivering greater oil price stability. An SPR that is tailored to delivering future demand certainty stands a better chance of ensuring that the domestic economic fallout from the current crisis is mitigated. Going forward, we hope the Administration continues to explore all avenues for influencing policy and, in particular, takes steps to make debt financing more affordable and available for E&Ps, thereby delivering superior investment outcomes and offsetting the future production shortfalls likely to stem from Russia over the coming years.
