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 reluctantto reduce production rates for fear of sending the already unstable markets into free-fall – the surpluswas 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.
Care for a dance Contango?
And what a list of arbitrage firms there were – Citibank, Morgan Stanleyamong 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 mosttempting 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 greeningof 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.
HMS Barhham, a Queen Elizabeth-class battleship, one of the Royal Navy’s first oil-powered ships
It has been more than a month since the Senate failed to pass legislation that would have blocked U.S. Navy efforts to develop and use biofuels. This passage of time means it might now be possible to make a less emotional and more measured comparison of the Navy’s “Great Green Fleet” to the decision-making processes behind previous similar historic transitions in propulsion.
The stated goal of the Great Green Fleet is to fuel an entire Carrier Strike Group with “alternative sources of energy” by 2016 (the definition of which helpfully includes nuclear-powered aircraft carriers and submarines). Most of the controversy surrounding the project has been over the amount spent developing sources of biofuels ($170 million), a main focus of the Navy’s drive to find half its fuel from “alternative sources by 2020”.
Comparisons between the U.S.’s current naval situation and that of Great Britain a century ago may be so common now as to be cliche (a topic I’ve dabbled in myself on a few different occasions), but this potential change in the preferred source of propulsion for the surface fleet is reminiscent of the Royal Navy’s shift from coal to oil before the First World War. Convinced that oil was necessary to make new ships that would outperform and outfight those of the Germans, Winston Churchill, civilian head of the Royal Navy as First Lord of the Admiralty from 1911 to 1915, created a commission led by then-former First Sea Lord Admiral Jackie Fisher with instructions to figure out how to implement the change: “You have got to find the oil; to show how it can be stored cheaply: how it can be purchased regularly & cheaply in peace, and with absolute certainty during war.”
Some of the factors used by the leaders of the U.S. Navy today in evaluating the fuel issue echo the way that it was framed by Churchill a century ago, with the performance implications of the fuel, costs, and the security of supply informing the decision-making process to different degrees.
Since the biofuels to be used by the Great Green Fleet are interchangeable with current oil-derived fuels, the actual performance benefits for the U.S. Navy are minimal, and the difference between old and new fuel sources ought to be transparent to the operator. There were significant performance advantages associated with a switch from coal to oil by the Royal Navy, however. While coal was less prone than oil to explosion if struck by enemy fire, this was greatly outweighed by oil’s much diminished labor requirements – no need for stokers to haul coal from storage spaces to the plant – and ease of refueling at sea. On a pure performance comparison, oil-driven engines also generally allowed ships to go faster and further.
Although the cost of oil was not necessarily the biggest issue in debates over the switch from coal in the early twentieth century it has been the main item of contention surrounding the Great Green Fleet. Biofuels for the Great Green Fleet have regularly been described as four times the cost of regular fuel. The Secretary of the Navy has countered that the high costs associated with the initial investment will be worthwhile because the investment will help make alternative fuels “more commercially viable” and cheaper in the long run. While biofuels are much more costly now, price volatility means that oil’s current price advantage is not always guaranteed.
In fact the vulnerability of the global oil supply is the primary issue both debates considered, although each set of decision-makers reached an opposite set of conclusions. While the U.S. is not necessarily dependent on oil extracted in the Middle East, the volume of oil originating from major suppliers like Saudi Arabia has a significant impact on its price, which in turn affects the American economy and consumers (including the military). In its public pronouncements on the Great Green Fleet, the U.S. Navy has made such a consideration clear, arguing that “the purpose of these energy goals is to improve our combat capability and to increase our energy security by addressing a significant military vulnerability: dependence on foreign oil.” “Market volatility” in its own right has been a significant Department of Defense cost, with price increases alone accounting for a $19 billion bill in 2011.
Skeptics of the Royal Navy’s proposed switch to oil propulsion had serious reservations about its supply. Wales was a rich source of the high-grade coal used by warships of that era, and the U.K. at the time had no domestic source of oil (Jackie Fisher famously stated that “Oil don’t grow in England.”). Fortunately, oil exploration had just seriously begun in the Middle East, and Britain “solved” its oil supply problem by government investment in the new Anglo-Persian Oil Company and an agreement for a twenty year oil supply. A revisionist assessment also puts the supply question on its head, holding that British leaders, fearful of labor unrest, felt Middle Eastern oil was a more secure commodity than coal taken out of the ground.
“Oil! Glorious, Oil! Hot, sweet crude in barrels!”
Regardless of why the decision to adopt oil propulsion was made, its implications (oil historian Daniel Yergin called it “Churchill’s great gamble”, pushing “for conversion to oil before the supply problem had been solved”) were significant, committing Britain to maintaining a secure supply line to the Middle Eastern oil fields in order to keep its military machine going. This may not have necessarily been a major new commitment when Britain still maintained India and a variety of other Asian territories as part of its Empire, but it was a significant geopolitical decision, one mirrored decades later by the U.S. when President Carter outlined what has since been labeled as the Carter Doctrine, a policy of U.S. military commitment to the region that has been acted upon by each of his successors. Carter stated in his 1980 State of the Union address that:
“An attempt by any outside force to gain control of the Persian Gulf region will be regarded as an assault on the vital interests of the United States of America, and any such an assault will be repelled by any means necessary, including military force.”
Ironically, the British shift to oil-powered ships had little to no impact on the fight at sea during the First World War. In fact, the Royal Navy was faced with shortages caused by German U-Boat attacks on tankers, resulting in extended stays in port and speed limits on some ships. To Winston Churchill, however, the tactical advantages of oil outweighed other considerations like the cost of oil and any potential supply vulnerabilities. He felt that oil would help the Royal Navy win a war at sea with Germany and that “Mastery itself was the prize of the venture.”
The relevant question today is whether the strategic calculus has changed since that time. To the Royal Navy a century ago, the risk of an uncertain supply of fuel was mitigated by the expectation of better fighting ships. Does the current uncertainty associated with oil make it a vulnerability to the fleet, and can that vulnerability be managed or hedged against by biofuels or other energy sources?
Lieutenant Commander Mark Munson is a Naval Intelligence officer currently serving on the OPNAV staff. He has previously served at Naval Special Warfare Group FOUR, the Office of Naval Intelligence, and onboard USS Essex (LHD 2). The views expressed are solely those of the author and do not reflect the official viewpoints or policies of the Department of Defense or the US Government.
Gulf of Guinea Pirate Attacks in 2012. Source: IMB
On August 4, 2012, pirates attacked an oil barge, killing two local security personnel and kidnapping four foreign workers. Two weeks later, pirates hijacked and held for five days a British-managed oil tanker as they unloaded its cargo, a style of attack that repeated the following fortnight on a much larger Greek owned tanker.
While such events were routine of late off the coast of Somalia, these attacks occurred on the other side of the continent, in the West African territorial waters of Nigeria and Togo. Piracy has now declined in the Indian Ocean—a trend attributed to international naval patrols, the increased use of armed guards aboard ships, and political developments in Somalia—but in the Gulf of Guinea it is on the rise. The region reported 47 incidents of piracy (it is estimated that up to 60% of attacks go unreported) to the International Maritime Organization (IMO) in 2010, a number which rose to 61 in 2011 and will likely be surpassed by 2012 figures.
Highlighting this growing danger, Lloyd’s Market Association, a London-based group of insurer representatives, recently added the Gulf of Guinea to its “Hull War, Strikes, Terrorism and Related Perils Listed Areas,” placing the waters of Nigeria and Benin in the same category as those of Somalia and Iraq. Seeking to examine the intricacies of this oft-overlooked security threat, this article intends to do three things in three posts: chart the evolution of West African piracy, assess whether or not a “Somalization” is occurring, and evaluate regional and international plans to combat the mounting crisis.
From Fishermen to “Freedom Fighters”
MEND Pirates/Militants. Likes: Walks along the beach; oil.
The problem of piracy in the Gulf of Guinea extends from Senegal in the north to Angola in the south, and affects over a dozen countries in between. The historical epicenter is Nigeria, where pirates have parasitically fed off the country’s oil boom since the 1970s. During Nigeria’s first iteration of piracy, the crime began as simple economic opportunism. Ransacking docked ships was common, while bolder pirates—equipped with little more than canoes and machetes—ventured slightly further from port in attempts to board and rob slow-moving vessels. The theft of crude oil from refueling or anchored ships, referred to as “bunkering,” also brought a tidy profit through resale on a black market that spans the continent.
In the early 2000s, a drastic change occurred as piracy, while remaining an economic-minded crime, became infused with politics. The basic grievance was that the federal government in Abuja had taken too great a share of Nigeria’s petroleum wealth, while distributing little back to the oil-soaked communities of the Niger Delta. A plethora of militant groups emerged to “reddress” the oil issue during this period, the most significant of which was the Movement for the Emancipation of the Niger Delta (MEND).
Seen by its practitioners as an effective tool for the “redistribution” of oil wealth, pirate attacks increased dramatically at the turn of the century. From 2000 to 2005, Nigeria’s waters were more pirate-prone than those of Somalia. By 2006 an estimated $1.5 billion in annual revenues for the country was lost through a combination of piracy, bunkering, and militant attacks on oil infrastructure.1
Politically motivated attacks on offshore platforms, the kidnapping of oil workers, and the theft of crude oil has challenged the traditional definition of piracy, as the crime is only recognized under international law if it is committed “for private ends.” Certain incidents are clearly socio-political in nature. In 2000, for example, militants stormed a Royal Dutch Shell oil storage platform, taking 165 employees hostage before releasing them in exchange for talks with the government.2
Piracy expert Martin Murphy concludes that in West Africa, the “line between the political and the criminal is hard to draw.”3 In Somalia, pioneering pirates first made claims of “restitution” for illegal foreign fishing and toxic dumping before expanding into indiscriminate hijacking and hostage taking, driven solely by profits. Similarly in the Gulf of Guinea, bunkering began as a form of economic protest but has grown into a multi-million dollar industry as oil tankers’ valuable cargos are robbed and resold.
Go Forth and Multiply
Not at all a tempting target…
Attacks off the coast of Nigeria have ebbed and flowed in recent years. Intensified naval patrols and a 2009 government amnesty offered to Delta militants resulted in a decline in reported attacks – from a high of 42 in 2007 to 10 in 2011.4 Nigerian piracy has increased in 2012, however, with 23 incidents already reported in the first three quarters.
According to piracy expert J. Peter Pham, the gangs now operating across the Gulf of Guinea are “composed mainly of, and certainly led by, Nigerians, with perhaps a smattering of other nationalities.” They have shifted their operations into neighbouring states as the authorities there lack the capacity to survey and patrol their own waters.
Piracy is but one symptom of the lack of maritime order in the region, as endemic drug smuggling; human and weapons trafficking; and attacks against oil infrastructure have threatened to turn West Africa’s seaways into a criminal super-highway. These manifestations of maritime insecurity are linked, speculates Bronwyn Bruton, as international criminal syndicates previously involved in weapons and drug trafficking “[jump] on the pirate ship” as a new source of revenue. This claim was reiterated by Abdel Fatua Musah, Director of Political Affairs for the 15-member Economic Community of West African States (ECOWAS), who reported to the UN Security Council that piracy has dovetailed into other forms of transnational organized crime.
Piracy and theft are believed to cost Nigeria 7% of its annual oil revenues. Benin’s port of Cotonou—taxes from which account for 40% of the country’s GDP—is witnessing a reported 70% decline in shipping activity due to piracy.5 In total, it is estimated that piracy costs the littoral states of the Gulf of Guinea an annual $2 billion in stolen cargo, rising insurance premiums, and other security costs. As the menace expands, the export of metals, cocoa, and agriculture products—vital to both local development and world markets—will also come under threat.
James Bridger is a Maritime Security Consultant and piracy specialist at Delex Systems Inc. He can be reached at [email protected]. This article is a modified form of James’ work with the Atlantic Council of Canada’s Maritime Nation Programpublication “From Sea to Sea: The Search for Maritime Security“.
1. Martin Murphy, Small Boats, Weak States, Dirty Money: Piracy and Maritime Terrorism in the Modern World, London: Hurst and Company, 2009, pg. 117
2. Ibid, pg. 119
3. Ibid, pg. 122
4. International Maritime Bureau, “Piracy and Armed Robbery Against Ships: Report for 2011,” International Chamber of Commerce, January 2012.
5. “An Emerging Threat? Piracy in the Gulf of Guinea”.
