Risk Update II – Forward View Of The U.S. Economy

On April 7, I wrote Risk Analysis Update – A Forward Looking View Of The U.S. Economy, where I listed events to unfold due to the current recession. While I was projecting events to occur well into the 1Q 2009, some of the events have already occurred or are in the process of occurring:

Forecasted: Some companies will reduce the portion on their products and offer it the consumers as being ‘new and improved’

Occurrence: “T.G.I. Friday's, Quiznos and Au Bon Pain and other "fast-casual" restaurants have introduced smaller, cheaper alternatives” – USAToday, May 10

Update: Expect more of downsizing of portions to continue


Forecasted: Restaurants – people will be eating out less frequently and opting to go to lower-cost ‘family style’ restaurants to cut costs

Occurrence: “Struggling with soaring food costs and cash-strapped customers, restaurants across the country are swapping expensive ingredients for cheaper fare and adding new dishes that won't break their bottom line.” – Chicago Tribune, May 10

“The weak dollar is hammering restaurants that buy such imports as French cheese, Italian olive oil and European wines. Add to that, belt-tightening by customers caught in the slowing economy. Ruth's Chris Steak House saw fourth-quarter profit in 2007 fall 62% compared with the same period a year earlier. Similarly, fourth-quarter profit was down 48% at Domino's Pizza and 35% at the Cheesecake Factory.” – WSJ, May 8

Update:A lot of restaurants will go out of business as more and more people opt to eat at home and to bag lunch. Restaurants are desperately trying anything possible to keep from closing. However, replacing ingredients will only provide small and short-term relief as people begin find dining out at low-end restaurants (McDonald’s, Denny’s, etc.) to be an acceptable replacement.

Do expect to see more portion control and ingredient replacement tactics. Also, expect to see more of the gimmick advertising to draw people in. Such gimmicks like far-below cost pricing, two- or three-for-one, and return of the blue plate specials.


Forecasted: Motorcycles & Scooters – Low fuel consumption and low cost will be the draw

Occurrence: “Sales of fuel-efficient motor scooters jumped 24% in the first quarter of 2008 over last year’ – USAToday, May 9

Update: As the weather warms up, see more people venturing to commute on scooters and motorcycles


Forecasted: Automobile manufacturers – with people opting to stay with their car for a few more years, car sales will suffer. Big cars and SUVs will be hit the most, even if they are touted as being a hybrid. The bottom line is the rising fuel price

Occurrence: “High fuel prices are causing the value of used SUVs to plummet, often below what's listed in the buying guides many shoppers use to negotiate with dealers.” - USAToday, May 8.

Update: Trucks, cars with low MPG, and cars that only uses premium high octane gasoline will also rapidly lose their value as people realize that paying $100 for a fill-up isn’t worth it anymore. Even now, if one does a search for new cars with fuel economy up to 15 MPG on Yahoo Auto, it will list 109 vehicles. Most of these are trucks and large cargo vans. However, there are a good representative of cars, mostly muscle and sports cars. These will also lose value rapidly as people will shy away from them to save money at the pump.


Forecasted: FedEx and UPS – Trucker strikes, rising fuel costs, and reduction in delivery, all contributes to lower revenue and challenging times

Occurrence: “The steep rise in the cost of fuel is all the more painful with overall demand for package and freight services slumping due to the state of the U.S. economy.” – MarketWatch, May 9 on FedEx earning

Update: This is only the beginning of more bad news for the overnight delivery companies. The demand for deliveries overall will drop in the U.S. and Europe. The pick up of revenue in Asia will not be sufficient to make up the shortfall. Look for a possible JV talk between FedEx and DHL (a wholly owned subsidiary of Deutsche Post World Net)

More Forward Looking Views
There is a benefit of the current high price of gasoline and recession:

• More people will get healthier as they cut back on consumption and use mass transportation and alternative means for commuting
  
• Traffic should reduce, as more people car pool, take mass transit, or limit the use of their cars
  
• As traffic reduces, air pollution will lessen
  
• As traffic lessens, demand for gasoline will drop, resulting in a slow down in the price increases
  
• Inner cities and locations closer to employment centers will see a revival as more people realize that long commute is killing them at the gas pump
  
• Car companies will begin to advertise fuel efficiency again, instead of power and speed
  
• Use of coupon will be in vogue, again
  
• Second hand thrift stores will gain in popularity; shopping there will no longer mean being poor, just thrifty
  
• As more people being to look for was to save, there will be more recycling, reducing the amount of garbage being dumped into landfills

Areas Of Concern:

• More people will start cutting back on services, including haircuts, nail salons, dry cleaning, house cleaning, pool cleaning, lawn services, as they begin to do it for themselves or reduce the frequency of the service
  
• Organic food companies will see sales slowing as people begin substituting them non-organic products
  
• Rate of people charging on their credit cards will go up. Initially, this will be perceived as consumer strength. However, it is a sign of consumer’s financial weakness. More and more people will use credit cards to make ends meet and then begin defaulting on them
  
• Builders of McMansions won’t be able to sell these houses as people shy away from them for four major reasons: inability obtain the mortgage, high maintenance cost, high taxes, and high costs of commute
  
• Sellers of houses in planned developments located far from employment centers will have to reduce their asking price much more than those selling in developments with access to mass transit or are located close to employment centers. Reason is simple: high cost of commuting, especially gasoline
  
• Makers of bottled and flavored waters will see sales reduced as people find it chic to drink tap water again. After all, Dasani, Aquafina, and a lot of other bottled waters are made from tap water.

Regards,
Ed Kim
Practical Risk Manager

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High Risk Of The Price Of Gasoline Rising Rapidly

Just when news couldn’t get any worst for driver, it just did. MarketWatch reported May 7that the U.S. refiners are now shifting production to make more diesel fuel for export to Europe. What that means is higher prices for the U.S. consumers for gasoline.

The reason for higher gasoline prices is simple. Less gasoline will be produced from a barrel of oil. Therefore, even if the refiners are working overtime, the amount of gasoline being produced will be lower. Just as the demand for gasoline rises over the summer, the refiners are making less of it. The result is a one-two combination that will push the price of gasoline up, perhaps over $4.50 per gallon by mid-summer.

As I had noted in What Should Be The Right Price For A Gallon Of Gasoline, a barrel of oil produces 19.6 gallons of gasoline. However, with the refiners making more diesel, the output ratio will change. Here is a comparison of the refiners’ output in the U.S. and in Europe / Asia (source: ExxonMobil)
Assuming the U.S. refiners also change their refining mix to the European / Asian model, then the potential output of gasoline per barrel of oil will reduce by 50%. With 50% less gasoline coming into the market and demand seasonally rising by about 5% over the summer, the price of gasoline will spike.

Source: EIA Seasonal Petroleum Product Demand 1998-2002

Again, using a quick back of the envelope calculation:

Assumptions:
1. Refineries typically operate at 95% capacity
2. Refineries reduce the output of gasoline by 50%
3. Elasticity of Price to supply is 0.5
4. Elasticity of Demand to price increase, in the short run is 0
5. Demand increase by 5% over the summer

Then the calculation is: 95% x 50% x (0.5 x 1.05) = 24.9% potential increase in the price of gasoline over the short run, excluding speculation.

Using current price of gasoline of $3.61 per gallon, there is the potential that gasoline price may reach $4.51 per gallon ($3.61 x 24.9% increase) by the summer driving season.

Regards,
Ed Kim
Practical Risk Manager

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Veto The Housing Bill!

Bush is saying the right thing when he stated that he would veto the Housing Bill being debated in the House of Representatives. The proposed Housing Bill, at best, would delay for a few months the inevitable housing market correction that it is currently undergoing and, at worse, would send a strong message that the government will bail out speculators and builders who made poor business decisions.

What The Housing Bill Proposes To Do:
1. Give local government $15 billion in grants to buy and guard vacant houses from vandalism
2. Offer $7,500 tax credits to first-time homebuyers
3. Mandate FHA to guaranty up to $300 billion in mortgages on properties that are “underwater”
4. Allow states to issue up to $10 billion in tax-exempt bonds to refinance troubled mortgages

The housing bill will not help those families in danger of losing their house. Instead of bailing out the builders and speculators at a tune of approximately $23 billion, there are better alternatives (click here for the full report from the Joint Tax Committee).

Alternative Measure For The $15 Billion Grant
Why throw good money after bad? The municipalities are claiming that vacant houses attract criminals and are urban blight. True. However, rather than spend money protecting vacant houses that will deteriorate over time, provide grants to the cities to raze the vacant houses and turn them into local green spaces – either community gardens, local park, or public space.

Benefit: lower cost. It will cost about $20,000 per house to raze and cart away the debris opposed to approximately $2,000 to $5,000 per month (guesstimate cost of securing, monitoring, and maintaining) to protect a vacant house from vandals and criminals.

Benefit: Easier policing & lowers crime. It is always easier to police open space than series of houses. One officer can perform a sweep of an open space and easily identify potential problem. Moreover, a well-placed security camera can provide 24/7 surveillance.

Benefit: Better Upside. It is easier to sell a vacant land for development than a run-down house. No matter how well a house has been maintained, if it is not lived in, items requiring repair increases. In the end, the potential developer may decide to raze the house anyway.

Benefit: Clean Slate Design. By razing vacant homes, it is possible to rezone the land for different use in the future. It is also possible for the local government to re-plan their urban landscape with lower cost and less community opposition.

Alternative Measure For The $7,500 Tax Credit To First-Time Buyers
There really isn’t any way to force people to buy a house when (1) most potential buyers are still waiting for the price of houses to come down further; (2) it is more difficult for an average American to obtain financing due to the stricter credit review process; (3) It would delay the necessary housing correction as some sellers will use this to hold firm on their asking price. They can ask all they want but it will not sell.

Just drop this idea. It is a white elephant that our country cannot afford.

Alternative Measure For The $300 Billion In FHA Purchase Of Mortgages That Are Underwater
This is just a bad idea; dead from the get-go. Why do we want to reward banks that relaxed lending guidelines and either allowed or offered up to 100% financing (80% conventional and 20% “piggy-back”). The banks are in the business to take risks or fail. Since their risk management and corporate managers failed terribly, let them have their just dessert. To buy out the portion of the mortgage that is underwater only rewards poor judgment and lending practices and forces the taxpayers to shoulder the burden of their eventual default.

Alternative Measure For States To Issue $10 Billion In Tax-Exempt Bonds To Refinance Troubled Mortgages
One hare-brain scheme leads to another. The state and local governments are already getting squeezed from lower tax receipts and higher costs for services. Why would they now want to tack on an additional burden, especially one that has a high potential for losses?

We have a dysfunctional bond guaranty system with Ambac and other financial guaranty insurance companies having trouble meeting their existing obligations. By offering a tax-exempt bonds backed by payments from troubled mortgages, how much of a spread does the states have to give to induce investors to purchase this toxic security? Will there be any takers?

Perhaps the Congress could take a page from 1989 and do something similar to a Brady Bond.

My Thoughts, A Take On A Super-SIV:
1. Federal Government sponsors a creation of a private trust (super-SIV structure) into which any and all financial institutions may sell their unwanted mortgages and MBS at a discount to face value (‘haircut’) in accordance with established market practices. The Trust gives the Bank marketable securities in exchange, which will be treated as a non-taxable event by the IRC. Additionally, the Federal Government will earmark a reserve equal to 20% of the total value of the discounted value of the trust portfolio that will be there to pay in case there are losses (20% first loss subordination backstop).

2. The Federal Government will then treat the amount of the discount that the financial institution took in selling their mortgages into the trust as a tax credit that can be written off equally over a 10-year period, beginning with the year after the date of the sale.

3. The tax write-off would also be transferable to any business. In exchange for granting the tax credit, the Federal Government will hold the notional piece of the trust security. This way, if the trust is able to recover more than the discounted face amount of the mortgage pool, then the Federal Government will reap the benefit. As the trust sells the mortgage or re-packaged CDOs, each financial institution will receive payment equal to their contribution, pari parsu. After all the mortgages have been sold and Trust securities retired, excess interest or revenue will flow to the Federal Government.

Example: Trust “US” is established. Bank A sells $10 billion in mortgages to Trust “US” at a 25% discount, or $7.5 billion. Trust “US” gives Bank A securities equivalent to $7.5 billion. Federal Government gives Bank A $2.5 billion tax credit that must be written off equally in 10 years. Bank A, knowing that it probably won’t be able to maximize the use of the tax credit, sells the tax credit to Coal Burner Z, which is looking at $5 billion in tax liability over the next 10 years. Bank A sells the $2.5 billion in tax credit to Coal Burner Z for $1.54 billion, using a simple net present valuation at 10%.

In the end, Bank A was able to turn tier 2 or tier 3 asset into a tier 1 asset plus cash. The net loss to Bank A would be about $964 million, or 9.6% of the original face value of the $10 billion mortgage. While the Bank will still experience a loss, it is a manageable loss of less than 10% discount to face value. This is a better scenario for Bank A sine it (1) quantifies the maximum potential loss to a bank’s portfolio, (2) limits the downside to Bank A, and (3) Provides Bank A with more liquidity by replacing tier 2 / 3 assets with more liquid asset: cash and securities with implied government back-stop.

With this simple plan, the government will only be liable for the 20% of the discounted mortgage portfolio and not jeopardize its credit rating (as in the case of allowing FHLMC and FNMA to lower their reserve requirements and buy more mortgages). The shortfall in tax revenue is partially mitigates by the fact that the tax write-off occurs equally over a 10-year period and it will help to kick off a new market in tax credit trading. If the trust securities are well received, then the banks will be re-capitalized within months.

I’d like to hear readers’ thoughts on this idea.

Regards,
Ed Kim
Practical Risk Manager

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What Should Be The “Right Price” For A Gallon Of Gasoline In The U.S.?

With so many people now fixated on the ever rising price of oil, a good question to ask is what is the ‘right’, or fair, price of gasoline, given that supply remains the same. The reason for this analysis is due to so many pundits that publicly state that the price is too low or too high without really providing anything concrete. In other words, all those are speculations and guesses.

Oil closed today at $123.53 per barrel. So, how fair is the price of gasoline based on total cost to produce gasoline and other distillates?

Using the EIA (Energy Information Administration) gasoline components history, from 2000 to 1Q 2008, we can break down the gasoline prices into its major cost components:
We can then convert this into dollars and cents:

If we take the historic average cost of refining, distribution & marketing, and taxes, this comes to $0.95 per gallon (average of FY2007 is $1.18 per gallon). So, the remainder of the current average gas price of $3.61 per gallon and $0.95 per gallon cost of gasoline production should be attributable to the cost of oil.

Since a barrel of oil is $123.53 and it produces 19.6 gallons of gasoline from a total of 49 gallons of distillate from a barrel of crude, we can multiply the ratio of gasoline to total distillate production to the price of barrel of oil to get a good approximation of the cost component of gasoline. So, this comes out to $2.52 per gallon, approximately attributable to the price of oil (19.6 gal/49 gal per barrel x $123.53 per barrel /19.6 gal).

So, using the historic average cost of producing gasoline plus the cost of the oil comes to approximate average of $3.47 per gallon, leaving $0.14 per gallon as the additional cost from gasoline price speculation or excess profit.

Therefore, using this pretty rough calculation (all you math and engineering majors out there know what I mean by rough), the current price of gasoline in the U.S. is pretty much in line with the historic production cost factors. If everything else stays the same, every $1 change in the price of crude should result in approximately 2 cents change in the price of gasoline, excluding speculation, reformulation, and force majeure factors.

However, this does not mean that the price of gasoline will change as quickly as the spot price of oil. Due to time lag from the purchase of oil to refining and delivery of gasoline to your local station, the price of gasoline you pay is a blended value.

If the current projections of $150 to $200 per barrel of oil is to be believed, which I do not expect to occur until sometime around 2012, then the price of gasoline can go up an additional $0.53 to $1.53 per gallon, excluding mark up for speculation, which will always occur.

Regards,
Ed Kim
Practical Risk Manager

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Electricity Shortage in South Africa To Keep Precious Metal Prices Aloft

South Africa (SA) accounts for majority of the world’s precious metal with almost 90% of platinum, 80% of manganese, 73% of chrome, 45% of vanadium and 41% of gold (source: Department of Minerals and Energy). Until 2007, SA was the world leader in gold production. Since 2007, China, with approximately 270 million ounces produced, has taken the lead. SA, with 254 million ounces, remains firmly in second place.[i]


The problem is that mining for these precious metals, as well as diamonds, requires lots of electricity. In 2007, the 1,127 mining companies used 32,421 gigawatt-hours (billion watt-hours) of electricity, or nearly 15% of all electricity produced by Eskom (see chart, below). However, the issue of insufficient supply of electricity is something that South Africa has been dealing with for sometime now.

“The government has blamed the power shortages on increased demand caused by years of economic growth and the provision of electricity to black townships that were not connected in the apartheid era. But it has also admitted it failed to heed a warning from Eskom 10 years ago that without new power stations it might not be able to meet demand by 2007.”[ii]

In January 2008, South African state-owned utility company, Eskom began systemic rolling blackouts and requesting 10% reduction in electrical consumption (or they call it, power load-shedding) to prevent a complete blackout. This had affected the mines, some of which had to shut down operations for several days, thereby putting upward pressure on the spot price of precious metals.[iii]

Potential Risk Events
1. Eskom supplies 95% of all South Africa’s electricity under a government mandated price-cap. As of 2007, the average price for kilowatt-hours was 18.06 SA cents, or $0.024 (2.4 U.S. cents). (By comparison, the average price in 2007 for kilowatt-hours in the US was 9.14 U.S. cents, or 70.5 SA cents.)

The low electric rate discourages new private investments in power generation. Therefore, the potential is high that the rolling blackouts (power load-shedding) will continue, until Eskom is able to bring additional power generations online. This will result in periodic stoppage of mine operations and intermittent spike up in the spot price of precious metals.

2. Eskom’s current reserve capacity is 8%, a decrease from 15%, previously. The combined effect of growing demand for electricity and lack of excess capacity is another factor that raises the potential for a rolling blackout. While Eskom has received the approval to build a new power generation plant in 2004, the likelihood that a new power plant will be built anytime soon is low due to the artificially low electric rates.

The SA government is in a difficult situation. The inflation rate for basic services and staples have been increasing at a high rate; at 5.2% as at 2007:
Even with the continual rate hikes, the electric rates are still too low for a private utility firm to profitably build a power plant. Conversely, the continual increases in the electric rate have put public opinion against Eskom, making it difficult for the utility to raise rates. In fact, Eskom’s latest request for a 53% rate increase was rejected. This will lead to further rolling blackouts until either demand is reduced or supply is increased.

3. Eskom had requested that industries and municipalities reduce their electricity consumption by 10%.[iv] However, this will be too little too late. As there is no reliable way to measure compliance with reducing demand, it is anyone’s guess as to whether this reduction drive is actually working.[v] The danger is that the utility is counting on the 10% savings in their supply projection. If the demand reduction targets are not met, this will lead to continuous rolling blackouts.

4. Effect of the rolling blackouts is playing havoc with the substations, causing one to explode and another to catch on fire. Given the continued stress on the supply of electricity, it is highly likely that the rolling blackouts will continue to tax the electric grid system, leading to more substations to be damaged, and further reduction in the supply of electricity.

5. Even with the continuing concerns about the reliability and sufficiency of electricity in South Africa, there is news of more energy hungry factories slated to come online, including:

• Rio Tinto's $2.7-billion aluminum smelter, capable of producing around 720,000 tons of aluminum annually, near Port Elizabeth in the Eastern Cape.
  
• In September 2006, Russian billionaire Viktor Vekselberg announced plan to invest $1 billion to build a manganese and ferroalloys plant at Coega.
  
• In early in 2008, United Manganese of Kalahari announced plans to spend $200 million to develop an untapped deposit.
  
• De Beers is building a new diamond mine at Voorspoed in the Free State, which is expected to start production towards the end of 2008, producing about 700,000 carats a year.
  
• Tata Steel is constructing a R650 million high-carbon ferrochrome plant in Richards Bay on the KwaZulu-Natal coast.

Conclusion
It bears watching but the chronic electricity shortage in South Africa is highly likely to cause series of blackouts lasting several days. Since the mines require reliable supply of electricity to ensure miner’s safety and smooth operation, any prolonged disruption in the supply of electricity will adversely affect production.

For mining companies, this will result in negative impact on earning, and to their stock prices.[vi] For precious metals, this will result in periodic price spikes.

This problem will not be resolved in a year or two as the problem is endemic in the functioning of the South African government. Therefore, until South Africa has more reliable and sufficient source of electricity, do expect to hear news of rolling blackouts and disruption to mining production.

May your trades be profitable!

Regards,
Ed Kim
Practical Risk Manager
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[i] http://www.southafrica.info/business/economy/sectors/mining.htm
[ii] http://www.guardian.co.uk/world/2008/jan/26/southafrica.international
[iii] http://www.forbes.com/afxnewslimited/feeds/afx/2008/01/28/afx4582329.html
http://www.guardian.co.uk/world/2008/jan/26/southafrica.international
[iv] http://www.forbes.com/afxnewslimited/feeds/afx/2008/03/07/afx4745474.html
http://www.int.iol.co.za/index.php?set_id=1&click_id=2934&art_id=vn20080505112629161C982423
http://www.durban.gov.za/durban/government/munadmin/media/press/pressitem.2008-04-09.8316969748
http://www.busrep.co.za/index.php?fSectionId=566&fArticleId=4368539
[v] http://www.eskomdsm.co.za/dsm_and_ee.php
http://www.eskom.co.za/live/monster.php?URL=%2Fcontent%2FHow+does+Load+shedding+Work.doc&Src=Item+5608
[vi] http://www.reuters.com/article/marketsNews/idUSL0521618520080505
http://www.bloomberg.com/apps/news?pid=20601103&sid=aCUU6NbjPfmM&refer=us

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Risks Of Patents Being Unconstitutional

The New York Times had a legal sidebar article yesterday, May 5. In this article, they cite the work of John F. Duffy, law professor at the George Washington University Law School, who has discovered a serious breach of constitutional due process in the way Board of Patent Appeals and Interferences administrative patent judges are appointed over the last eight years.

“His [John F. Duffy’s] basic point does not appear to be in dispute. Since 2000, patent judges [on the Board of Patent Appeals and Interferences] have been appointed by a government official without the constitutional power to do so.”

The regulation is the center of the conflict of the conflict is 35 U.S.C. § 6, which grants Director of the Patent and Trademark Office (PTO) the authority to appoint the administrative patent judges to the Board of Patent Appeals and Interferences (BPAI). The problem that Professor Duffy found is that this regulation is unconstitutional as it violates the appointment clause of the Constitution (article II, section 2, second paragraph) [bold and italics added to highlight the relevant area]:

“He [The President] shall have power…and he shall nominate, and by and with the advice and consent of the Senate, shall appoint…all other officers of the United States, whose appointments are not herein otherwise provided for, and which shall be established by law: but the Congress may by law vest the appointment of such inferior officers, as they think proper, in the President alone, in the courts of law, or in the heads of departments.”

The Supreme Court had already noted in its decision on Freytag v. Commissioner in 1991, that tax court’s special trial judges are inferior officers even though they do mostly administrative tasks. Since the administrative patent judges on the Board of Patent Appeals and Interferences have more authority and discretion than the tax court’s special trial judges, the appointment of administrative patent judges must adhere to the appointment clause of the Constitution.

According to the NY Times article, “…the Justice Department has already all but conceded that Professor Duffy is right.“

If Professor Duffy is indeed right, then “the impact of Professor Duffy’s discovery could be cataclysmic for the patent world, casting “a cloud over many thousands of board decisions” and “unsettling the expectations of patent holders and licensees across the nation.”

Risks And Consequences
“The patent court hears appeals from people and companies whose patent applications were turned down by patent examiners, and it decides disputes over who invented something first. There is often a lot of money involved.”

We may be talking trillions of dollars at stake here.

The consequences of Professor Duffy’s findings are far reaching, as they would potentially invalidate patents filed from the regulation effective date of “4 months after Nov. 29, 1999.” A quick search of the final decisions rendered by the Board of Patent Appeals and Interferences from March 1, 2000 to May 6, 2008 lists 16,610 items (note: clicking this link will open up a list of all 16,610 items, which may take a bit of time depending on your connection speed).

Potential Events:

• News of major patent litigation being filed
  
• Congress legislating on this matter
  
• Supreme Court potentially reviewing this matter and contemplating a tortured ruling to allow the affected patents to remain

Conclusion
Whichever way the ruling on this matter goes, do expect people to protest the ruling and file lawsuits. In the interim, one should see more focus being put on this issue, including talk of possible Constitutional amendment to allow for the current patents to stand and be considered constitutional.

Regards,
Ed Kim
Practical Risk Manager

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Bush Administration Is Helping To Keep Oil Prices High

There is a very disturbing trend with the Strategic Petroleum Reserve (SPR). In the current environment of rising oil price into record levels, the Bush Administration is adding to the Strategic Petroleum Reserve. In fact, as of May 2, the SPR held 701.5 million barrels of oil, one of the highest levels in the history of SPR. Since the draw down of oil in 1991 2000, the SPR has been steadily rising:


Since the end of 2007 (year-7), the SPR increased from 696,941 million barrels to current 701,500 million barrels, an increase of 4,559 million barrels in the first four months of 2008. The U.S. consumes 20.7 million barrels per day, as of July 2007. (When the EIA (Energy Information Administration) conducts its next study in June 2008, it is likely that our consumption would have gone up.)

So, while the average world spot price of oil has steadily gone up from an average of $54.63 per barrel in January 2007 to $119.27 per barrel, as of close of business May 5, 2008, a 118% increase in price, the Bush Administration has been increasing the SPR.

Why would the federal government add to the SPR while Bush publicly state that there is no short-term solution? The President has the authority to sell the oil from the SPR in an event of energy emergency. This event occurred twice: in 1991 during Operation Desert Storm and in 2005 after Hurricane Katrina.[i]

After Hurricane Katrina, Bush authorized release of 11 million barrels of oil “to mitigate any shortfalls in crude oil that could affect our consumers,” according to his statement back in 2005. The problem with that statement is that it wasn’t any shortfall of oil that caused the increase in the price of gasoline. Rather, the hurricane had reduced refinery operations by about 5.4 million barrels per day.[ii] Therefore, all the release of oil from the SPR would do is to add more oil into the system that could not process them: “Analysts and Energy Secretary Samuel Bodman said the move would be of limited use. The main problem now is lack of refining capacity to turn crude oil into gasoline.”[iii]

In fact, U.S. had to borrow “545,000 bpd of refined crude products from Europe, consisting of 317,000 bpd gasoline, 190,000 bpd middle distillates and 38,000 bpd fuel oil.”[iv]

At the time, $3 gallon of gasoline and $70 per barrel of oil was making people very nervous and concerned about very high-energy prices. Bush even called for Americans to conserve energy.

Questions to Ponder

• What is different today? The prices of oil and gasoline are higher than in 2005. The higher price of oil and gasoline are directly affecting the U.S. economy. Even Bush admitted this today in his statement that it is "like a tax on the working people." So, if it is like a tax on the working people, one of the drivers of the current economic slowdown, does it not merit a draw down from the SPR?
  
• Are we not in an energy emergency? Is the energy emergency defined only as a shortage or disruption in production or does it include its negative effect on the U.S. economy? In the case of the SPR release in 2005, the purpose was to
  
• Is it only energy emergency if the oil refineries are affected?
  
• If 11 million barrels of oils released in 2005 was able to drive down the price of oil and gasoline, then shouldn’t a similar release of oil from the SPR do the same today? I think it would as the price of oil is partially driven by the speculators. As the supply of oil in the market increases, then the spot price of oil will come down, forcing the speculators to sell out of their positions, thereby further reducing the price of oil. Moreover, the 11 million barrels will not affect our SPR goals.
  
• Since the average price of oil in the SPR is $28.42 per barrel, would it not make more economic sense to release oil from the SPR at a profit instead of suspending the federal gas tax over the summer, which would cost the U.S. upwards of $8.5 billion? Since the Department Of Energy will be selling the oil at near market price, the 11 million barrels of oil, if released should fetch an average of $90 per barrel, this would result in gross revenue of $677 million. Isn’t it better to use the SPR in a ‘strategic’ way that can benefit the U.S. economy while making money for the Federal Government? To me, this would be an ideal business approach to the problem.

Conclusion
Given his past records, I highly doubt that Bush will do anything that will be beneficial to the economy or anything that would be considered to be a smart move. Therefore, I am not going to continue questioning his reason for adding to the SPR instead of releasing the supply. Bush made several promises when he was elected President in 2001. However, the only promise that he is able to keep is his 2001 Fill Initiative, which will bring the reserves up to 700 million barrels.

Regards,
Ed Kim
Practical Risk Manager
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[i] http://fossil.energy.gov/programs/reserves/spr/
[ii] http://money.cnn.com/2005/09/26/news/economy/bush/index.htm
[iii] http://www.mywire.com/pubs/USATODAY/2005/09/01/986781?extID=10051
[iv] http://www.forbes.com/home/feeds/afx/2005/09/07/afx2210961.html

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