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.

Current Operations

Smashing Maritime Ratlines – A Team Sport

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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.

 

A boarding near Cape Verde

U.S. Navy publications often describe the sea as a global commons; the idea being that the oceans represent a resource to be shared for the benefit of all.  The reality, however, is that although the world’s oceans facilitate billions of dollars of legitimate commerce and trade every day, criminal networks, insurgent groups, and transnational terrorist organizations exploit sea lanes for more nefarious ends. The same ports and ocean routes used by sailors for thousands of years also provide today’s afloat highways, over which both legal and illicit cargoes move. These routes – or “ratlines”, when used for illicit traffic – exist amid a complex international patchwork of intertwined economies, diverse cultures, and varying legal authorities and levels of governance.

Disrupting these ratlines requires teamwork and a networked approach.  Accordingly, a number of U.S. government agencies have responsibility of some sort or another for stemming the flow of illegal shipments at sea. Obvious players are Department of Homeland Security organizations, including the U.S. Coast Guard, Immigrations and Customs Enforcement, U.S. Navy, and the U.S. Drug Enforcement Agency. The Human Smuggling and Trafficking Center is a relatively new agency charged by Congress to work against smuggling, illegal trafficking of people against their will, and terrorist travel. Many other agencies play an important role in supporting interdiction efforts with intelligence and law enforcement expertise.
 
Many readers are familiar with the efforts of the Joint Interagency Task Force South, at Naval Air Station Key West, Fla. This long-standing organization consists of several U.S. agencies working with numerous partner nations to counter narcotics trafficking moving through the Caribbean and Eastern Pacific into North America. In addition to this major drug transit zone, lesser-known maritime facilitation routes throughout the world move people, money, and materials illicitly for both financial profit and malign intent.

One example is Islamic foreign fighters who leave their home country and travel over sea, land, and air routes to train and take up arms in conflict zones. The foreign fighter pipeline has supported numerous jihadi battlefields, including Afghanistan, Iraq, Pakistan, Chechnya, Bosnia, Kashmir, Somalia, Yemen, Libya, and Syria. The relatively short ocean crossing connecting Yemen and Somalia, and their long coastlines, has resulted in significant foreign fighter flow between two countries, further destabilizing the region. Estimates of the number of foreigners who traveled in the late 2000s to train and fight with Somalia’s Al Shabaab militant Islamist group range from 200 to more than 1,000. Several of these foreign fighters were westerners from the United States and United Kingdom, including the first known U.S. suicide bomber. The problem garnered significant attention, such that the African Union’s commissioner for peace and security pressed the U.N. Security Council to authorize a naval blockade in order to prevent the entry of foreign fighters into Somalia. 

pic_03A more-obscure maritime ratline involves Afghani hashish and heroin smuggled from Pakistan’s Makran Coast to the Gulf States and East Africa. These smuggling routes reflect a nexus between criminal drug-trafficking and the funding of ongoing conflict and corruption in Afghanistan. In 2009, a U.S. Navy cruiser patrolling in the Gulf of Aden seized a skiff carrying 4 tons of hashish with a street value of $28 million. In all, international naval forces operating in the Indian Ocean seized 53 tons of drugs along the “hashish highway” in 2008 and more than 22 tons during 2009. This success notwithstanding, a lack of maritime patrol and reconnaissance assets combined with lax customs laws, and competing priorities of the various countries involved make narcotics interdiction along these sea routes a challenging proposition.

A different facet of illicit maritime networks is the transport of weapons and bomb-making materials into war zones. This usually involves a combination of legitimate businesses from source countries where electronics or other “dual-use” improvised explosive device (IED) components are produced and witting smugglers, who ship the goods sometimes hidden in legitimate cargoes.

In an operation a few years back (in which this author was personally involved), a non-DOD intelligence tipper on possible maritime facilitation of IED components was passed to a U.S. military special operations task force, which pushed the information to conventional naval forces. The Navy teams interdicted the vessel of interest, boarded it, and conducted an exhaustive search. Though they did not find the incriminating cargo, irregularities in the cargo manifest warranted further investigation. The ship was allowed to proceed to the next port of call where the host nation’s authorities, assisted by U.S. officials, conducted additional inspections. Through these searches the dual-use material was found and host nation authorities seized the cargo, with disruptive effects on the IED network. Moreover, because the effort required coordination between at least five U.S. government agencies, multiple DOD commands, and several countries, valuable lessons were learned that will pave the way for success in future counter-maritime facilitation actions. 

Above all, countering illicit maritime networks requires open and flat communications at multiple levels – both interagency and international. Traditional command-and-control structures that are comfortable to most military operators are not appropriate for an interdiction effort involving multiple agencies and countries. Rather, early and frequent meetings – such as secure teleconferences – will foster an environment of collaboration and coordination.  Because maritime targets are dynamic, rapid dissemination of intelligence and intent is necessary for a successful interdiction. In the above example, only about 12 hours passed between the initial intelligence tipper and the vessel’s identification, boarding, and interdiction. In some cases, the vessel of interest must be intercepted and boarded before it passes into territorial waters. At other times, coordinating for partner nation authorities at the next port of call to inspect the cargo ashore might be more feasible. 

Africa Partnership Station 2012Differing security classifications and communication systems between agencies and countries complicate the flow of information, but these obstacles can be overcome by persistent outreach and liaison. While advances in technology have certainly helped ease information-sharing blockages, it is often viewed as a panacea. Nothing beats the information flow that can be achieved from a closely tied liaison network working towards a common end state. Along these lines, countering illicit maritime facilitation requires a careful balance between various military, agency, and partner-nation equities. Sometimes these equities are competing; in other cases they are complementary. Law enforcement agencies often require that the chain of custody for any evidence seized during a maritime interdiction be carefully preserved in order to build a legal case against an individual facilitator. These efforts are sometimes at odds with the exploitation of a seizure for intelligence purposes and the need to maintain operational security. Meanwhile, a partner nation may see broadcasting the results of a successful interdiction effort through information operations as a way to gain legitimacy in the eyes of its population. Finally, internecine struggles and political friction between various institutions often stifle coordination despite the best efforts and intentions of those involved.

The maritime facilitation networks of criminals and terrorists present serious challenges to the security interests of the United States and friendly governments. Disrupting these ratlines requires a thoughtful and integrated approach by various organizations focusing on all aspects of the interdiction problem: intelligence, legal, diplomatic, and physical.

CDR Chris Rawley serves in the special operations community. He led boarding teams during maritime interception operations against oil smugglers in the Persian Gulf and coordinated operational level maritime interdiction efforts in the Middle East and the Horn of Africa. He is the author of Unconventional Warfare 2.0: A Better Path to Regime Change in the Twenty-First Century and blogs regularly at Information Dissemination. The above opinions are his own.

For more articles in our International Maritime Shipping Week, click here.

New Initiatives

Welcome to International Maritime Shipping Week

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ContainersYou’re reading this on a screen made in Malaysia, connected to a hard-drive made in Taiwan, supported by a bevy of parts made in China. Sitting here in Bahrain, I’m eating Pistachios grown in California on a ship with British diesels with other like ships brought here on even bigger ships. We take for granted the virtue of global shipping and the ease with which international trade is now executed over the high seas.

Yet as the more nuanced critics of globalization have long pointed out, a network is not inherently good or evil, rather it merely more rapidly facilitates the intent of those that use it. The roads of the Incan Empire not only served to streamline the administration of their realm, but also hasten their destruction. While international shipping has far more check-valves than an open road, and we need not worry about Pizarro’s men pouring out in Seattle’s ports to storm the town hall, we should consider how this intricate seaborne network might cause us harm: from the vulnerabilities of relying on seaborne trade to the instability caused by illicit weapons proliferation to the use of commercial vessels as Trojan horses.

This week, we take a moment away from our Amazon, Best Buy, and Home Depot bounties to consider the defenses necessary to prevent this seaborne boon from becoming a curse. Click here to see the International Maritime Shipping Week contributor line-up.

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.

Capability Analysis

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

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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.

Fostering the Discussion on Securing the Seas.