Strategic Petroleum Futures
By Arnold Kling
The market for long-dated oil futures contracts is not sufficiently large or liquid enough to fully and inexpensively hedge the vast quantity of investment that is needed for the U.S. to substantively reduce its dependency. Hedging is also too expensive for many small- to medium-size entrepreneurs. Even bigger domestic oil producers, who have endured extended periods of low prices in the past, aren’t yet investing in line with their current profits. Some oil producers argue that they need prices consistently above $35 a barrel to justify unconventional projects.
I recall reading that the President of Exxon was forecasting oil prices much lower than the futures markets and thinking that if he believes his own forecast, then he should put his company up for sale.
Energy producers should not be second-guessing the oil futures market. Instead, they should be using it as a hedging vehicle.
If you are developing an alternative energy source that will be economical in 2009 at an oil price of $60 per barrel, then you should hedge your risk of a drop in oil prices by buying long-term put options on energy. If the price of oil is only $40 a barrel in 2009, the increase in the value of the put options makes up for the fact that your alternative energy source is not economical then.
I have written before that the government should empty its strategic petroleum reserve and buy energy futures contracts instead. At some point, the futures market has to be taken seriously.
The government has all sorts of subsidies for alternative energy. However, the most efficient subsidy would be to buy oil futures contracts. If we must have an energy policy, it should consist solely of strategic futures market purchases.