LPL Financial Research

Lincoln Anderson Commentary

March 20, 2008

Lincoln Anderson
Managing Director, Chief Economist, Chief Investment Officer, LPL Financial

The Strategic Petroleum Reserve: STOP FILLING IT!
The Federal government has continued to add crude oil to the Strategic Petroleum Reserve (SPR). Over the last six months the Dept. of Energy has purchased more than 9 million barrels of crude oil for the SPR. They were still at it last week, buying 682,000 barrels with crude oil prices above $100! Meanwhile, the U.S. private sector, responding rationally to high prices, has cut stocks by almost 11 million barrels, and demand for petroleum and products has fallen by 850,000 barrels per day. The fall in demand has more than offset the reduced stocks leaving the supply level at 21.3 days – close to the average number over the last eight years. Continuing to fill the SPR is not sensible energy policy, and with oil prices sky-high makes no sense whatsoever. It puts upward pressure on oil prices at the worst possible time. It is a waste of taxpayer money. It gives aid and comfort to unfriendly nations. And it is an insurance policy that, for the most part, is no longer needed. We should be selling oil from the SPR, not filling it.

US Stocks of Crude Oil in the SPR
000bbls, DOE

Crude Oil Price
$/Barrel for West Texas Intermediate
700000 698000 696000 90 694000 80 692000 690000 688000 JUN JUL AUG SEP OCT NOV DEC JAN FEB MAR 07 70 110

100

60

Source: DOE, Wall Street Journal/Haver Analytics

03/20/08

The SPR was established in February 1976 in response to the growing instability of the Persian Gulf oil supply and subsequent embargoes, and to address the threat to oil imports in the event of a war with the Soviet Union. We now have nearly 700 million barrels of oil stored in salt domes in Texas and Louisiana. The SPR can pump out 4.4 million barrels a day, potentially replacing about 80% of total OPEC imports for 159 days. We have spent about $23 billion to build the SPR ($5 billion for facilities, $18 billion for crude oil). The SPR has been used very sparingly over its 30-year history, with the largest previous drawdown being 17 million barrels in 1991 during Desert Storm. In the 1976 legislation creating the SPR, use was limited to national emergencies with strong restrictions on
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its use for any other purpose. Those restrictions were created in response to legitimate fears that the government might use the SPR to interfere with the functioning of a free market for petroleum. In 1976 we had just escaped a disastrous bout of price controls, and OPEC had yet to really establish its price fixing cartel; so back then, those restrictions made sense. Now however, with the Soviet Union and the threat of a world war gone, while OPEC continues to function smoothly as a cartel, do these restrictions still make sense? It seems highly unlikely to me that a mandate and set of restrictions established thirty years ago would still be optimal today. I believe that the SPR could be used as a powerful tool to improve the functioning of world oil markets. However, we first need to dispel two views about oil that are no longer true. First and most important is the erroneous view that the oil market is free and efficient. First and most important is the erroneous view that the oil market is free and efficient. It is not. Oil prices are controlled by the OPEC cartel. If you don’t believe me, just go to the Dept. of Energy website and review their discussion of OPEC price controls at: http://www.eia.doe.gov/cabs/opec. html. Some disagree, noting that non-OPEC production has gone up 68% since 1973. These gains came despite dwindling proven reserves and much higher production costs. Meanwhile, OPEC production is about the same today as it was in 1973, despite a large rise in OPEC’s proven oil reserves over the last 34 years and much lower production costs. OPEC has kept oil production flat for the past thirty four years in order to raise oil prices. OPEC just sits there as the biggest organized producer with 40% of world oil production controlling oil prices. The only price the cartel pays is a gradual erosion of market share from 52% in 1973 to 40% today. But they can afford to wait; nonOPEC production is already starting to falter. Others say that OPEC is not controlling prices because prices fluctuate in a wide range. But controlling prices and keeping them in a narrow band is not the same thing. OPEC wants a high average oil price, not stability. One of OPEC’s most powerful tools to control non-OPEC oil production and alternative energy development is to allow price crashes to occur from time to time to discipline nonOPEC energy producers. These price crashes teach the other oil producers and alternative energy investors that they had better be careful and not invest in energy projects that require oil prices to be even medium high. All OPEC has to do is keep their production steady, but low, and allow prices to gyrate up and down unpredictably with demand. The end result is a higher average price and cowed competition. The second outdated view that should go is that we need a brim full SPR for “national emergencies” . The second outdated view that should go is that we need a brim full SPR for “national emergencies”. That view made sense when we were worried about a war with the Soviet Union that might result in oil imports being cut off by submarine and bomber attacks on tankers and terminals. I participated in these discussions while in the Reagan Administration, and it was clear that the oil stockpile was necessary, given the threat to the entire tanker fleet. But now there is no global threat to tankers and terminals. Yes there is a local terrorist threat, but that would not shut down oil imports to the U.S. Other types of energy crises require much smaller oil releases or are not related to import supply constraints. Most energy problems are price issues and, due to the global nature of oil pricing, will not be helped by having a brim full SPR just sitting there. The purpose of a constantly full SPR is gone. It’s like keeping auto insurance on a car that is up on blocks. Once you acknowledge that the two views above are no longer correct; then a review of the SPR’s uses becomes imperative. We have a $23 billion energy policy tool that we are not using for anything. So, what should we be doing with the SPR? I think the answer is perfectly straightforward. We should be selling oil out of the SPR when oil prices are high, say above $80 a barrel, and buying oil back when oil prices drop below $30. The SPR would then become a powerful tool to stabilize crude oil prices, while generating a sizable profit for the Federal government.
LPL Financial Member FINRA/SIPC Lincoln Anderson Commentary | March 20, 2008 | Page 2 of 4

I recognize that the free markets crowd would howl that this is government intervention in the crude oil market. And it certainly is. But again, right now it is not a free oil market. It is a market controlled by OPEC wherein they encourage wild price gyrations, within a higher than free market average price range, of course…. Using the SPR to dampen price volatility would reduce price risk in oil and alternative energy investments, thereby increasing those investments and raising non-OPEC sources of energy supplies of all types. Given the current observed behavior of the integrated oil companies – only sparingly investing their cash hordes in energy projects even though oil prices are near $100 – surely indicates that they consider this price risk to be high. Lowering price volatility would likely increase energy investments substantially. What is the downside? Well, it would be unwise to empty the SPR. Some oil, perhaps as much as a 120 million barrels, should probably be the minimum. That would be seven times as big as the largest drawdown and would provide more than adequate insurance against a supply disruption. Having an SPR that is 80% empty is a very valuable thing when oil prices fall. It would be standing ready to be filled when oil prices drop below $30. A full SPR has no value when oil prices are low. A full SPR has value when oil prices are high, but only if you start selling oil in order to drive prices back down and empty it to prepare for the next refill. Keeping the SPR full with oil prices near $100 is like holding your portfolio in tech stocks at the end of 1999. It would be better to sell, hold the cash and buy the tech stocks back after prices have dropped to normal levels. When the stock market is irrationally exuberant it is very valuable to convert to cash and then wait for your next buying opportunity. It is the same story with oil, especially when we do not have a free market. The SPR could be a highly profitable oil portfolio machine, but only if it is used. Why would the U.S. oil industry oppose this use? Well for starters, the oil companies make huge amounts of money when oil prices are sky-high and they like that – who wouldn’t? But that view is shortsighted. Oil prices gyrate in a wide trading range, and they make a lot less, or lose money, when oil prices are low. (Remember – when oil prices fall to $15, OPEC is still making money.) Using the SPR to dampen price gyrations would not negatively affect U.S. oil companies’ long run profitability; it would likely improve it. Remember, the SPR is not a source of supply; it is just a machine to move supply around in time. With lower price volatility, energy companies would be able to make better investment decisions, enhancing their ROE. As shown in the chart below, crude oil prices have spent a fair amount of time below the $30 line.

Crude Oil Price
$/Barrel for West Texas Intermediate
120 100 80 60 40 20 0 85 90 95 00 05 120 100 80 60 40 20 0

Source: Wall Street Journal/Haver Analytics

03/20/08

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Lincoln Anderson Commentary | March 20, 2008 | Page 3 of 4

Environmentalists should love this proposal. Oil price gyrations create havoc for long-term investments in alternative energies. Who wants to build a fabrication plant for solar cells that is profitable at prices consistent with $50 oil, when you know a drop to $30 is coming at some unpredictable time in the future? Who would want to invest heavily in wind power or hydrogen for that same reason? And when oil drops below $30, consumers throw energy conservation to the wind and buy SUVs. Oil price gyrations hurt everybody but OPEC. When oil prices are $100, OPEC makes a huge amount of money. When oil prices are $15, OPEC still makes a profit because their production costs are so low. Meanwhile everybody else gets slammed around. Businesses end up with unprofitable investments, consumers make bad decisions on energy use and conservation, and environmentalists complain about under-investment in alternative energy. It amounts to a sizable drain on our national wealth. We have a great machine to address the problem – the SPR.

IMPORTANT DISCLOSURE
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

This research material has been prepared by LPL Financial.
The LPL Financial family of affiliated companies includes LPL Financial, UVEST Financial Services Group, Inc., IFMG Securities, Inc., Mutual Service Corporation, Waterstone Financial Group, Inc., and Associated Securities Corp., each of which is a member of FINRA/SIPC.

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