Protection from Oil Price Surges and Inflation

Published April 15, 2011

On March 30, President Obama repeated the familiar energy policy refrain of increasing the nation’s independence from foreign oil in order to control energy prices. As The Wall Street Journal observed a day later, this cliche has been repeated by every president since Richard Nixon. That alone ought to make the prescription suspect.

But if this  policy objective is wrong, what is the correct course of action? In the long run, the answer is to allow the world-wide market to increase the supply of oil and other forms of energy. The idea is to make any short-term interruption in supplies a smaller percentage of the total. Government incentives will not help; they can only hinder. History and The Wall Street Journal have shown that to be true.
It is generally thought that nothing helpful can be done in the short run. It is worth examining that idea. A useful prescription has been on the books for a long time. We need go no farther than the Book of Genesis in the Bible. Remember that the Pharaoh was having dreams that Joseph (a shrewd policy analyst) interpreted as a prediction of seven years of good grain crops, followed by seven years of famine. The divinely inspired recommendation was to set aside one-fifth of the crops in the good years for each of the seven years of famine. Not included in the policy was a price ceiling on grain. Indeed, when hungry foreigners showed up at the Pharaoh’s door, they paid the elevated market price just as the Egyptians did.
The modern version of the program by Joseph and the Pharaoh is the Strategic Petroleum Reserve. This has been used in the past, notably after Hurricane Katrina cut off oil production in the Gulf of Mexico in August of 2005. Refiners had enough excess capacity to handle the releases from the SPR and the oil prices were moderated.
New Market Institution

Since that time, a new market institution has emerged. It is the oil price volatility index (OVX) traded on the Chicago Board Options Exchange. It is equivalent to the implied volatility from crude oil puts and calls which have been traded on the NYMEX since 1986. The implied volatility is a forward measure of price risk. As such it measures the value of oil price insurance. That, in turn, means that it is also a signal for releases from the SPR. The policy importance of the OVX is substantial. That is probably why it is not used. Government likes discretion in energy policy in order to obtain political advantage in exchange.
There were two occasions over the last year when the index exceeded 40. One was a result of the BP oil spill in the Gulf of Mexico in April 2010. The other episode coincided with the 2011 revolutions in Middle Eastern oil-producing states. In these pair of cases the volatilities rose because of unexpected increases in oil prices. The jump in volatilities would have been a signal to release from the SPR. That is what a private owner of stored oil would have done. Refiners could have handled the extra crude oil supply because they were then operating at just 88 percent of capacity on average. The idle capacity at U.S. refineries as of January 2011 was on the order of three-quarters of a million barrels. The inventory at the SPR as of November 30, 2010 was a little less than three quarters of a billion barrels. Thus, there is almost a thousand days of crude oil supply in the SPR if U.S. refineries were to operate at full capacity.
The OVX index for April 2011 has since declined to a level that prevails when there is no crisis. The reason for the decline is that implied volatilities are mean-reverting, and not random walks, like futures prices are. In the very short run after a shock occurs, there is little that can be done to increase supply or decrease demand. The only thing that can yield is price. But over time, adjustments in supply and demand do occur and the volatilities decline correspondingly. That seems to be what is now happening.
Defensive Measures

Since the current U.S. government, unlike the Pharaoh, is ignoring good energy advice, little relief is likely to be forthcoming from Washington. But not to worry, large producers and consumers of oil have already come to that conclusion and have adopted defensive measures. They are using futures and options to hedge their price risk exposure. This includes not only derivatives for energy but also for share prices, foreign exchange, other commodities. The Wall Street Journal reported on April 1 that the trading of puts and calls reached record levels for March 2011. The main driver for surge in options trading, according to the WSJ, is the Federal Reserve’s QE2 bond-buying program.
There is a frequently ignored connection between the Fed’s increasing the money supply and the high oil prices. When inflation is anticipated, as it is now, one of the defenses is to switch out of dollars and into commodities. This pushes nominal oil prices higher. Thus, the Fed is contributing to the high oil prices, about which President Obama is complaining.
As with oil, Washington is ignoring several market indicators of future inflation. Commodities like gold, silver, copper are all near historic high levels. Foreign exchange futures are also higher, as are interest rate futures. The gold volatility index (GVZ) is in the range of 16 to 17, not at a historic high level. But it should be remembered that it is not a prediction of the expected price of gold. That is contained in the CBOE’s GLD yield structure, which shows ever increasing dollar denominated price of gold out to 2016. What the market seems to say is that there will be less variation in the increasing future price of gold. This is more valuable information than the consumer price index, which is the current guide to Fed policy.
An even more important implication is that businesses threatened with future inflation can lock in the value of the dollar using gold and other derivatives. In a sense, these offer protection from the policies of the Federal Reserve.
Thus, for two risky events – energy price surges and inflation –  market hedges are more useful than ill informed government programs.
Jim Johnston is a policy advisor to The Heartland Institute.