All posts by Juramentado

The Great Oil Contango of 2008-2009 & Maritime Security: A Retrospective

Oil storage commodities swinging at anchor in idled VLCCs.
                                                                     Fill ‘er up! 

The following article is special to our International Maritime Shipping Week. While we often discuss the threats to maritime shipping, this week looks at dangers arising from such global trade, and possible mitigations.

It sounds like a variant of a famous and complex Latin dance, but Contango is actually a financial phenomenon involving the trading of futures-based commodities. For the layman it goes like this: take a product such as crude oil. If you buy it now, you pay X, the “spot price”. Due to market conditions, you’re confident that a year from now you can sell it for a higher price of X+, the “future price”. Such a situation is a Contango. To take advantage of it you sell contracts now to purchasers willing to take the commodity at the future date, price, and quantity. You are now a speculator or “arbitraguer”. The challenge becomes storing enough of it until that time comes to deliver the agreed commodity. As long as storage and other overhead costs didn’t exceed X+ (the “spread”), you turn a profit.

Like many historical events, the so-called Oil Contango of 2008-2009 was a the result of several factors:

  • The first year of the Global Financial Crisis had passed and the effects were being felt in full, namely low consumer spending and unfavorable market conditions (sub-prime mortgages, credit collapse, etc)
  • OPEC was reluctant to reduce production rates for fear of sending the already unstable markets into free-fall – the surplus was growing at a rate of 1 to 2 million barrels daily
  • The resulting oil glut combined with low spending because of the crisis resulted in a low spot price (X), but with an expectation of a higher future delivery price (X+) as the economy slowly recovered

The key of for those willing to do business was to find storage at cheap enough prices that made large purchases of oil contracts profitable. Here’s where history becomes stranger than fiction. The glut literally overran land-based storage facilities. In the United States, a small Oklahoma town called Cushing is considered the benchmark for crude oil as traded on the New York Mercantile Exchange. It’s status is derived from being a primary hub connecting many delivery points within North America, and it’s maximum storage capability is approximately 42 million barrels (about 10% of U.S. oil production). At the time of the Contango, it cost approximately $1 a barrel per day to store crude there. But the oil glut had a big side effect – a lot of tankers were idled, and thus their operating prices declined. Around November of 2009, the daily rate for a million barrel capacity crude carrier was $10,000 a day at it’s lowest. The profit “spread” looked to be about $10 a barrel. Those market conditions made it very attractive for firms with the wherewithal to take full advantage of the Contango.

No one turns down Mr. Gere for a dance Contango.
                    Care for a dance Contango?

And what a list of arbitrage firms there were – Citibank, Morgan Stanley among them. While banks are typically loath to touch anything but paper instruments of commodities (i.e. not purchase the assets themselves), here they were directly chartering any decent-sized vessel capable of holding a million barrels or more. These were some of the very same institutions that took it on the chin during the Global Financial Crisis, and had every incentive to make up for their losses.

The result is a sweeping trend of world-wide seaborne oil-storage. In the end, all the tankers that the various arbitrage players could get their hands on could have formed a 26-mile long convoy of Very Large Crude Carriers (VLCC), totaling about 130 million barrels, or a little over 12 times what would normally be found at sea at any given time in recent history. All of it swinging at anchorage in major ports around the globe, for a year or more. The maritime security implications are numerous, and represent challenges for consideration.

With that much crude afloat and idle, the period of The Great Oil Contango presented one of the largest and most tempting targets for terrorist and other actors to strike and prolong what was already an immensely unstable global financial crisis. The risk potential was heightened by the fact that the glut easily overwhelmed the best efforts of ashore storage locations such as Cushing to supplement their capacity, adding anywhere from 5-to-10 million barrels of space.

The second-order effects are worth noting too: First, the chartering frenzy impacted not only the industries that used crude carriers, but spilled over to other sectors as firms moved beyond floating tankers and hired other types of ships for their storage capacity. Second, oil refineries eventually had to shut down or reduce shifts as OPEC and other oil producing concerns acknowledged market forces and cut back production output.

The potential environmental and safety impacts of that much oil afloat is staggering. As a comparison, the worst spill in modern history is the Deepwater Horizon well disaster – which sent about 90 million barrels into the Gulf of Mexico, devastated the U.S. southern coastline and surrounding waters, and required two years to complete major cleanup operations. The number of ships filled to the brim also increases the risk of partial spills and fire/collision hazards during the offloading, such as ship-to-ship transfers.

The Contango also caused an unintended and negative effect on the Strategic Petroleum Reserve (SPR) – several countries released their SPRs because of the market’s perception that there wasn’t enough oil in distribution – that was true – to the extent that much of it was being set aside by the arbitrageurs. While the SPR technically increased the amount of oil available on the market, it also further drove down the Spot Price (X), thereby increasing the “spread” or price differential of the Futures Price (X+). Therefore, there the incentive for abitrageurs to release any of the oil they already had was further reduced. In fact, by releasing the SPR, those nations put at risk their capability to respond to a crisis such as a wartime footing where energy to power the military is most needed.

Historically, the Contango ended, or more accurately declined, when too many arbitrageurs entered the market and wiped out the remaining availability of product, driving up prices. By doing so, they reduced the price “spread.” Additionally, the particularly harsh winter of 2010 made it attractive to unload stockpiles and cash-in as fuel demands were at an all-time high. Finally, a regulatory investigation by the U.S. Commodities Futures Trading Commission (CFTC) on practices such as the oil-storage trade convinced investments firms and traders to move on to greener pastures.

Lessons Learned: the vagaries and complexities of the modern financial market have many effects, most of them unpredictable, especially when dealing with energy supplies. In 2008-2009, several factors came together that not only artificially imposed limitations upon the world’s oil supply, but had indirect effects upon world shipping and national petroleum reserves. What was also interesting to note is that as instability began to threaten traditional supplies of oil (say the Libyan Uprising), the market price spread started to narrow as consumers were more than willing to pay an elevated spot price for energy now. The Contango also highlighted the growing influence of non-state actors such as corporations and financial firms to indirectly influence the availability and price of oil. Previously, the oil commodity market was a reasonable reflection of global supply and demand, the presence and practices of OPEC notwithstanding.

Surprisingly, for the time period during and shortly after, there wasn’t a lot of open-source intelligence or even published articles on the strategic and security implications of The Great Oil Contango. Everyone appeared to be focused on the monetary and market impact, but little else. It behooves us as industry professionals and observers to be aware of these developments and understand better the linkages to strategic security and public policy. One future trend we can expect is the greening of major navies as nations seek to minimize energy supply impacts to their foreign policy and military capabilities.

Juramentado is the pseudonym for Armando J. Heredia, a civilian observer of naval affairs. He is an IT Risk and Information Security practitioner, with a background in the defense and financial services industries.  The views and opinions expressed in this article are those of the author, and do not necessarily represent the views of, and should not be attributed to, any particular nation’s government or related agency.

Gaps in the Wall: The Capability Upgrade Challenges for the Philippine Navy

Just as Subic Bay is no longer in it's illustrated prime, the Navy of the Philippines has seen better days.
Just as Subic Bay is no longer in its once geo-strategic prime, the Navy of the Philippines has seen better days.

As history records it, the Philippines has traditionally occupied the roles of both a logistical base and buffer for the West in modern 20th-Century conflicts. As one of the first U.S. outposts to be attacked and overrun in World War II, and later serving as one of the largest regional ports and airbases during the Cold War, the country finds itself on the cusp of the Asian Century serving once more as part of a virtual wall, this time holding back China’s slow but inexorable encroachment upon the second island chain.

Article II of U.S. and the Philippines’ Mutual Defense Treaty (MDT) calls for both nations to sustain territorial control and maintain a basic self-defense capability. It’s hard to imagine now, but there was a time when the Philippines had one of the most advanced and well-equipped armed services in Southeast Asia. In the days following World War II, the geographical importance of the island nation and close ties to Washington brought a wealth of weapons aid to Manila while neighbors were rebuilding their war-torn infrastructure and fighting off internal security threats.

Fast-forward to the present-day Philippines and the decades of underfunding and neglect are painfully apparent. The causes are numerous; most notably endemic corruption, a weak economy and focus on internal stability operations, but the end result is that the Armed Forces of the Philippines (AFP) is unable to put up a basic credible defense of the nation’s territory. Among other things, this undermines America’s China-containment strategy requiring allies to use political, and if needed, military options to mitigate a de-facto surrender of territory or economic resources.

In 2003 under President Gloria Macapagal Arroyo’s administration, the AFP embarked upon what is now known as the Capability Upgrade Program (CUP). The plan’s core described eighteen blocks that span from Human Resources to doctrine and training all the way to force and infrastructure modernization. The funding would come from a variety of sources, including excise taxes and profits made from the joint venture Malampaya Oil Fields located off the coast of Palawan facing the Western Philippine Sea (WPS). A decade later, President Benigno Aquino the III’s term in office has most progressed this effort.

While theoretically well-funded, the CUP is hamstrung by several factors: a convoluted, inefficient, and supplier-unfriendly logistics and acquisition process; the interference of serving politicos seeking to direct purchase decisions for their own benefits; systemic graft and corruption within public and military agencies; a struggling economy; and, competing needs to maintain and upgrade basic infrastructure and services required throughout the rest of the country.

What’s missing for the Philippine Navy (PN):

 

BRP Gregorio del Pilar, a Hamilton class US Coast Guard-Weather High Endurance Cutter.
BRP Gregorio del Pilar, a Hamilton class US Coast Guard-Weather High Endurance Cutter.

Foremost lacking for the PN are surface combatants with a baseline contemporary self-defense and offensive capability. With the exception of the recent U.S. Coast Guard WHEC cutters and South Korean attack craft, most of the Philippine Navy’s fleet is well past the age (some are as old as 1943) where other nations would have decommissioned the vessels on safety and maintenance principles alone. None of the vessels are missile-armed nor anti-submarine equipped, and with the exception of recent acquisitions, most combat suites and sensors date back to the 1960s or earlier. For most of the fleet, major organic fires are limited to 5″ guns and smaller caliber cannons and machine guns. PF-16 Ramon Alcaraz (the newest of the WHECs) will receive the first upgraded shipborne weapons in several decades: two Mk 38 Mod 2 remotely controlled Bushmaster cannons.

Immediate major combatant vessel acquisitions would likely be in the frigate class. Initially, there was consideration to purchase another nation’s Excess Defense Articles (EDA) – in the running were USN Perry class and Italian Maestraele frigates; but the recent experience with converting and refurbishing the former Coast Guard WHECs (particularly the delay with PF-16, the former USCG Dallas) educated PN and political leadership that buying new makes more fiscal sense then perpetuating the process of keeping older vessels going beyond their projected life-cycle. However, a recent boost in US military assistance aid could result in a third WHEC being obtained while bidding continues on the new frigate build.

While quite a few manufacturers responded, the serious bids seemed to come down to a few – including Spain’s Avante 1800, Israel’s SAAR V, South Korea’s Incheon class FFG and unspecified options from Australia, Croatia and the United States .

One of the benefits of having more recent used articles is that crews finally get training and experience on contemporary marine technology, such as Gas Turbine powerplants, and even the WHEC’s older combat integration system is still years ahead of what’s present in the rest of the fleet.

The Coast Guard Dilemma

What the PN also needs is more Off-shore Patrol Vessels (OPVs). The proposed re-integration of the Philippine Coast Guard back in the Department of National Defense (DND) highlights the service’s severe lack of assets to cover basic patrol and presence operations, never mind being able to deal with operations-other-than war (OOTW) such as the Sabah Crisis. A stop-gap purchase of a used French Patrol Vessel will help to restore PCG capability. Projected purchases include new build French 83m and 24m vessels and ten unspecified new patrol boats from Japan.

As an unintended consequence, the PCG’s dearth of assets caused escalation in clashes with China. Confrontations over resources such as the Scarborough Fishing shoals forced the AFP to initially send assets that had the range and speed to reach the intrusion point in a timely fashion. This meant sending gray hulls like the newly arrived PF-15 WHEC while Beijing had only dispatched China Marine Surveillance hulls. The end result is that the Philippines inadvertently looked like they were escalating by using overwhelming force.

Aviation Support and Maritime Surveillance

Naval Aviation assets are sorely lacking. Due to attrition and the need to gain efficiencies with remaining inventory, serviceable military aircraft lie mostly in Philippine Air Force (PAF) inventories. The PN would especially benefit from long-range Maritime Patrol Aircraft (MPAs) to effectively cover areas such as fishing zones in the WPS and the contested Spratleys. Currently, a few BO-105 rotary craft and BN Islanders are providing surveillance roles. In 2012, a contract to deliver three AW-109 Augusta helicopters for utility and ship-borne aviation was concluded. These assets would presumably be paired with the new WHECs to deliver surveillance and potentially stand-off strike capability.

There is a strong reliance on the PAF to provide the air defense and monitoring component – namely replacement military radar sites to complement the existing ATC network and tactical jets for basic offense and defense. There are enormous gaps in Strike and non-existent Air Defense/Interception assets. The Air Force is slogging through a long-convoluted deal with Korean Aerospace International for purchase of the T/A-50 Golden Eagle – a spinoff of the Lockheed Martin F-16 Falcon. The T/A-50 would play the role of a Lead-In Fighter Trainer/Surface Attack Aircraft (LIFT/SAA), paving the way to indoctrinate pilots in a future Multi-Role Fighter (MRF) yet to be selected.

Lift, Logistics and Basing

For logistical and lift needs, the PN has also been investigating MRVs (Multi-Role Vessels) such as the Indonesian Makassar Landing Platform Dock (LPD), a useful asset in both combat and Humanitarian Assistance / Disaster Response (HA/DR) operations – especially so for a nation often in the path of tropical typhoons. This is a gap that could be filled locally; an appropriate ferry with roll-on/roll-off ramps and a helipad could be converted or purpose-built.

Additional basing and expanded facilities in the Spratleys and the Palawan peninsula are needed to complement any increase in force modernization. Ports, airfields, and refueling points within and  facing the WPS would reduce reaction times and increase operational range of any assigned assets. With current basing, major combat assets face a 200 nm transit to get to contested areas.

As an extreme example of infrastructure need, the Philippine Marine “garrison” in the contested islands is actually a grounded 1940s Tank Landing Ship (LST). A proposed expanded logistics and supply base in Ulugan Bay on Palawan would allow direct access to the WPS (instead of sailing around the island), as well as proximity security to the nearby Malampaya Oil Fields. And after years of commercial use, the Philippine government is contemplating more useful contingent access to the former naval base at Subic, which would allow visiting allies more than just courtesy access to one of the finest deepwater ports in the region.

Despite all that, successful defense projects are possible to fulfill compelling strategic goals, even with limited resources. The Coast Watch South initiative shows that the AFP can deliver a competent maritime security environment with political and modest but sufficient fiscal support. The latter two are the critical factors to CUP success.

Time is the Challenge

It is the glacial pace of modernization that is ultimately the biggest threat to the CUP. As time passes, the opportunity cost to bring the major budget requisitions to fruition is rising ever higher. From a political perspective, there is the perpetual notion that EDA and stop-gap efforts are “good enough;” permissive factors in the past which in fact led to the current sad state of affairs for the AFP. The Philippine Congress and Aquino III’s administration are now suffering from sticker shock as they collectively realize what it will take to bring a “credible defense” to reality. That was most notable in the President’s most recent State of the Nation Address. The competing needs of domestic issues and persistent problems in the economy, healthcare, jobs and housing could end up diverting funding away from the CUP. With only two years left in Aquino’s term, the next Administration could have an agenda brings the progress made to a screeching halt. The cascade implications to the U.S. Pivot to the Pacific could put more burden upon the US Navy and Air Force to take up activities and responsibilities that rightfully belong to the treaty partner.

Juramentado is the pseudonym for Armando J. Heredia, a civilian observer of naval affairs. He is an IT Risk and Information Security practitioner, with a background in the defense and financial services industries.  The views and opinions expressed in this article are those of the author, and do not necessarily represent the views of, and should not be attributed to, any particular nation’s government or related agency.

The View from the Cheap Seats: Alternatives to DDG-51 Flight III

As a civilian observer of naval affairs, I’m forever fascinated by the churn that surrounds every major platform design or acquisition.  The nice thing about viewing all this from the cheap seats is a wider perspective – you get to look around just because you’re that much removed from the action on the floor.  The downside is a lack of resolving power when it comes to details.

Man, we're gonna have to double the number of grills for Steel Beach day!
Yes, but where does the hot tub module go?

From the view up here in the nose-bleed section, I see some tantalizing glimpses.  One that caught my eye recently was Huntington Ingall’s proposed LPD Flight II, which had among it’s variants, a very large Ballistic Missile Defense (BMD) platform.  Does such a configuration make sense?  Based on displacement alone, such an LPD doesn’t appear to be as constrained by hull space or power plant as the proposed Flight III, squeezing everything in.  While the LPD Flight II wasn’t pitched as a arsenal ship, that’s a lot of deck space that could be filled with VLS packs or laser arrays.  I can only imagine what additional strike capability might be gained should the Long-range Anti-ship Missile (LRASM) come to fruition.

Speaking of arsenal ships, the Navy should consider building a ship that can deliver naval gunfire and heavy strike missions.  While the Zumwalt is a very expensive technology demonstrator, it will deliver base capabilities that should make it’s way into the next large combatant.  It’s Total Ship Computing Environment (TSCE), tumblehome waveform, and the Advanced Gun System (AGS) all bring us one step closer to reaching those strike-mission goals.  Whether or not we are facing the same threats for which the DDG-1000 was originally envisioned is another question – nonetheless, the Burke doesn’t have the capacity to fulfill those missions, period.

As for missions, Flight III is supposed to do two things well: BMD and Anti-Air Warfare (AAW).  This brings us to the other half of the operational dilemma – it can’t do all the other missions the Navy must execute – certainly not well enough to justify putting it into a theater for the purpose of executing those other missions, where smaller or better equipped ships would suffice.  The elephant in the room: there HAVE to be alternatives for operational commanders to the DDG-51 because it can’t do everything.  It’s a specialist, and in the Navy’s “office”, the “all other duties” falls upon another class.  For the forseeable future – that’s Littoral Combat Ship (LCS).

Bad, bad USV!
           Bad, bad USV!

But this doesn’t mean Flight III is stuck in a rut.  As unmanned aircraft and vessels make greater strides in autonomous performance, DDG-51 in a pinch could conceivably deploy in a limited operational zone, standing off safely while allowing it’s robotic minions to conduct Intelligence, Surveillance, and Reconnaissance (ISR) and other critical functions. And while it doesn’t meet the “payloads not platforms” call to a ‘T’, it does allow the venerable Burke design to remain versatile for the near future.

Other considerations: shipbuilding and the secondary/tertiary supply tiers that support the technology behind a modern military vessel are very perishable bases.  It is vital to preserve this knowledge and the structure behind it in order to deliver sophisticated ships in the future.  The only way to do so is to keep building complex weapons platforms; certainly a self-fulfilling prophecy (or a vicious cycle), but that is the operational reality.  In the end, it really doesn’t matter if it’s Flight III or some other combatant, it just has to be built in frequent enough batches to sustain the industrial base.

You should see my other gun at home...
My other gun is a railgun.

Finally, all talk of the cruiser-destroyer gap aside, there’s an emotional response to the idea that the U.S. Navy is shrinking.  Coupled with the perception that a spanking new surface combatant is unable to adequately show the flag and you a have a situation that’s hard to stomach.  And let’s face it – reputation risk is just as important as other operational risks.  Carriers may overwhelm by their presence, but cruisers and destroyers deliver the diplomacy of gunboats – elegant and graceful when visiting solo but menacing enough to remind everyone watching about realpolitik.

Juramentado is the pseudonym for Armando J. Heredia, a civilian observer of naval affairs. He is an IT Risk and Information Security practitioner, with a background in the defense and financial services industries.  The views and opinions expressed in this article are those of the author, and do not necessarily represent the views of, and should not be attributed to, any particular nation’s government or related agency.