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Beans Boots Bullets

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

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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.

Beans Boots Bullets, Strategic Outlook

Hagel’s Sequestration Speech: A Warning, Not a Plan

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There is no other hand...
There is no other hand…

Before his appointment as U.S. Secretary of Defense, concerns existed that Chuck Hagel was a proponent of the massive cuts envisioned for the DoD as part of Sequestration. With his Statement on Strategic Choices and Management Review (SCMR) (31/07/13), the Secretary has made it very clear that he is no bedfellow of austerity.

Followers of security policy have already drawn out two possible paths from the Secretary’s words. However, the real thrust of the speech was that these were not options, as he sums up in his closing:

The inescapable conclusion is that letting sequester-level cuts persist would be a huge strategic miscalculation that would not be in our country’s best interests…

 

It is the responsibility of our nation’s leaders to work together to replace the mindless and irresponsible policy of sequestration.  It is unworthy of the service and sacrifice of our nation’s men and women in uniform and their families.  And even as we confront tough fiscal realities, our decisions must always be worthy of the sacrifices we ask America’s sons and daughters to make for our country.”

At multiple points within his piece, the Secretary reiterates that Sequestration cuts are not only damaging, but roughly impossible:

The review showed that the “in-between” budget scenario we evaluated would “bend” our defense strategy in important ways, and sequester-level cuts would “break” some parts of the strategy, no matter how the cuts were made.  Under sequester-level cuts, our military options and flexibility will be severely constrained…

 

Unlike the private sector, the federal government, and the Defense Department in particular – simply does not have the option of quickly shutting down excess facilities, eliminating entire organizations and operations, or shutting massive numbers of employees – at least not in a responsible, moral, and legal way…

 

In closing, one of the most striking conclusions of the Strategic Choices and Management Review is that if DoD combines all the reductions I’ve described, including significant cuts to the military’s size and capability – the savings fall well short of meeting sequester-level cuts, particularly during the first five years of these steep, decade-long reductions.”

That is to say, even if we break the back of our armed forces, we still fall short of the required austerity. The original intent of Sequestration, as an “impossible scenario,” is unfortunately coming to pass – not in possibility but in functionality.

The reality is that the real portion from which the cuts must come is the compensation that consumes “roughly half of the DoD budget,” but even then…

The efficiencies in compensation reforms identified in the review – even the most aggressive changes – still leave DoD some $350 billion to $400 billion short of the $500 billion in cuts required by sequestration over the next ten years.  The review had to take a hard look at changes to our force structure and modernization plans.”

The most worrisome reality check laid down by the Secretary is that if Sequestration is not rescinded for DoD, the reforms suggested will require the agreement of a recalcitrant Congress that was more than willing to execute Sequestration, but unwilling to bear the political consequences of the actions they’ve forced. Most likely, that scenario will only lead us deeper down the strategically damaging rabbit-hole:

These shortfalls will be even larger if Congress is unwilling to enact changes to compensation or adopt other management reforms and infrastructure cuts we’ve proposed in our Fiscal Year 2014 budget.  Opposition to these proposals must be engaged and overcome, or we will be forced to take even more draconian steps in the future.”

The Secretary has not, through the SCMR’s response to Sequestration, put down a viable plan for the future. He has set down a warning of what is to come. Let us hope that warning is heeded.

Matt Hipple is a surface warfare officer in the U.S. Navy.  The opinions and views expressed in this post are his alone and are presented in his personal capacity.  They do not necessarily represent the views of U.S. Department of Defense or the U.S. Navy.

Beans Boots Bullets, Future Tech

Supply Bots

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If you haven’t spent much time aboard a naval vessel, the Supply Department is the part of the ship charged with managing spare parts and ordering more. The Supply Department’s spaces also have a strange tendency to be the first fitted out with the nicest kit and upgrades. So it wouldn’t shock me to one day stroll in and find something like this:

A voice-activated storage unit with to help keep track of thousands of parts:

According to Danh Trinh, creator of the StorageBot:

The hardest parts to find were always those rare miscellaneous parts that were thrown somewhere into a “junk” bin. StorageBot solves the location problem by listening to my voice commands, processing the location of parts from a master database and then delivering the matching bins in a manner that only a robot can do!

Of course all the normal disclaimers bear stating: the system would need to be ruggedized, would likely have sea state restrictions, and each user would need to set up their voice recognition. Then again there’s the question of whether such a system would be worth it, or even practical. At a COTS or DIY price of roughly $700 (according to a PopSci.com article I can no longer access) the monetary burden doesn’t appear to high, and after all, Supply could never let one of the other shipboard “shops” get their hands on this tech first.

Beans Boots Bullets

Supply: Now Lactose Free

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This article was first posted to the USNI blog.

The demands of the warfighter are like cheese processed through the lactose intolerant digestive tract that is military supply; though digestion is a vital process, it can be unspeakably painful and smell of rotten eggs. End-users already plagued by rapidly decreasing manning and time are now interrupted by long backorder lead times, artificial constraints on off-the-shelf solutions, and funding. Personnel are known to skip the supply system altogether, purchasing parts or equipment out of pocket when an inspection is on the line. This both hides the problem and takes from the pockets our sailors. The military has forgotten that supply exists for the utility the operator, not the ease of the audited. For the military supply system to regain the trust and capabilities necessary to serve the end-user, reforms to the way supplies are selected, commercial purchases are managed, and funding requested are necessary.

COSAL:

The first major problem is the Coordinated Shipboard Allowance List (COSAL). COSAL is a process by which the navy’s supply system determines what supplies it should stock on the shelves; items are ordered through the in-house supply system and the hits in the system raise the priority to stock. Unfortunately, COSAL is reactive rather than predictive and cannot meet the needs of either the new aches of an aging fleet or the growing pains of new ships. As ships grow long-in-the-tooth, parts and equipment once reliable require replacement or repair. New ships find casualties in systems meant to last several years. Equipment lists also change, leading to fleet-wide demands for devices only in limited, if any, supply. The non-COSAL items are suddenly in great demand but nowhere to be found. Critical casualties have month+ long wait-times for repairs as parts are back-ordered from little COSAL support. Commands attempt to fill their time-sensitive need by open purchasing these items from the external market, which are not COSAL tracked. This leads to either supply forcing the workcenter to order through supply and end-users waiting potentially months for critical backordered items, or the open purchase being accomplished and COSAL staying unchanged. Although difficult, the supply system should be more flexible to open-purchasing stock item equivalents due to time constraints while integrating open purchase equivalence tracking into the COSAL process. This bypasses the faults of COSAL’s reactionary nature while still updating the supply system with the changing demands.

Split Purchasing:

The limitations on open purchasing (buying commercial off-the-shelf) create artificial shortages of material easily available on the street. Namely, when items are not under General Services Administration (GSA) contract, single vendor purchases or purchases for a single purpose cannot exceed $3,000, no matter how the critical need or short the deadline. This further exacerbates the problems from an unsupportive COSAL; if requirements exceed purchase limitations, requests are sent through a lengthy contracting process which wastes more time than money saved. The contracting requirement ignores the fact that from the work-center supervisor to the supply officer, everyone now has the ability to search the internet for companies and can compare quotes. Purchasers need not be encouraged to spend less money, since they have the natural deisre to stretch their budget as far as possible. Contracting opportunities also become more scarce as the end of the fiscal year approaches, since money “dedicated” to a contracting purchase is lost if the clock turns over and no resolution is found. This means money lost to the command and vital equipment left unpurchased. For deployed/deployable units, this can be unacceptable. The supply system exists to fulfill the operational needs of the training/deployed demand-side, not to streamline the risk-averse audit demands of the supply side. If not raising the price-ceilings of non-GSA purchases for operational commands, the rule against split purchasing by spreading single-type purchases across multiple vendors should be removed. Breaking out a single purchase amongst several vendors alleviates the risk that large purchases are being made to single vendors due to kick-backs. This would call for more diligence on the part of Supply Officers, but that is why they exist.

Funding:

Finally, the recent Presidential Debates have shown the military’s poor ability to communicate the message that funding is becoming an increasingly critical issue force-wide. To many, the defense budget is so large that cuts are academic, savings no doubt hiding throughout the labyrinthine bureaucracy. However, for those of us who had no money to buy everything from tools to toilet paper for a month, it’s a more practical problem. Long before sequestration, Secretary Gates started the DoD on the path of making pre-emptive cuts before outside entities made those choices for the DoD. However, the military has made a poor show of communicating that these cuts have become excessive and are now cutting into the muscle of the force. Obeying the directive to cut funding does not require quietly accepting these cuts; now the Commander and Chief believes the military not even in need of a cut freeze, let alone a funding increase. With Hydra of manning, material, and training issues constantly growing new heads, the strategic communicators must come out in force to correct this misconception. While administrative savings can be found, our capabilities are paying the price for the budgetary experiment. Military leadership should, in part, involve advocacy; obedience requires the resources to execute the mission.

The supply system is a painful process, but with rather humble reforms, that pain can be both lessened and taken off the shoulders of whom the system exists to serve. With a reformed COSAL tracking open purchases, a loosened open-purchase limit that puts the stress on the supplier rather than operator, and better strategic communications about funding, we can apply a bit of lactaid to an otherwise painful process.

Matt Hipple is a surface warfare officer in the U.S. Navy. The opinions and views expressed in this post are his alone and are presented in his personal capacity. They do not necessarily represent the views of U.S. Department of Defense or the U.S. Navy.