On the Strategic Petroleum Reserve (1991 thoughts for today)

By Robert Bradley Jr. -- May 2, 2016

“Expanding the Strategic Petroleum Reserve would be throwing good money after bad. Instead of remaining a valuable asset mired in the political swamp, the SPR can be turned into an entrepreneurial asset. The reserve can be privatized by selling off either the entire operation or its individual parts.” – RLB (1991)

Good analysis on empirical matters, even from long ago (a quarter-century in this case) must stand the test of time.

It is regular fare at MasterResource to document the false claims of energy Malthusians (neo-Malthusians) from the 1970s until the present (now in their fifth decade!). And from time to time, MasterResource produces analyses from the past by free-market scholars for their relevancy and accuracy for current energy debates.

The example below, from 1991, is a quarter-century old. It concerns the Strategic Petroleum Reserve (SPR), a forgotten, obsolete oil stockpile that could disappear tomorrow and not be noticed by the market. Created by the Energy Policy and Conservation Act of 1975 (EPCA), the SPR began operations in 1977.

With a design capacity of 714 million barrels, today’s crude-oil inventory is 695.1 million barrels (97 percent of capacity). One million gallon product inventories are held for fuel oil and for gasoline in the Northeast.

The SPR stands today as a tens-of-billions-of-dollar monument to government overreaction to an energy crisis that was not caused by the free market, but by 1970s government price and allocation controls that stymied the market process. (For a five-part history of the Strategic Petroleum Reserve, see here.)

Scholars such as Robert Murphy have called for SPR privatization as an alternative to increasing the federal debt ceiling. Presidential candidates on the Republican side (Ted Cruz; Donald Trump) are open to privatizing the SPR as a means for federal deficit reduction and federal debt retirement. (John Kasich has not responded to the questionnaire sent out by the American Energy Alliance, the advocacy arm of IER.)

And some bad ideas never die, such as a proposal two years ago by DOE Secretary Moniz to create an oil product SPR, which I critically assessed at the time at Forbes.com.

So here are/were my thoughts from back in 1991 on the SPR (full article here).

What Now For U.S. Energy Policy?
A Free-Market Perspective

January 29, 1991

by Robert L. Bradley, Jr

Despite unprecedented criticism that the Strategic Petroleum Reserve has been poorly utilized in the current crisis, there have been calls to enlarge the stockpile from its present target of 750 million barrels to 1 billion barrels. The proposed 10-year, $6 billion expansion is unwarranted. (1) Private entrepreneurship should be the first and last line of defense in an energy “emergency,” given the real and theoretical problems of the reserve.

The SPR, hitherto unused when the opportunity seemed to beckon, has attracted media scrutiny that has uncovered a series of problems with the stockpile. A front-page Wall Street Journal evaluation pointed out the following problems: a distribution system untested in a true emergency, high-sulfur crude that cannot be distilled by many U.S. refineries, corrosion problems, the loss of a $90 million facility when its oil is withdrawn, a requirement that only U.S.-flag tankers carry released oil between domestic ports, and a 10 percent DOE set-aside for political distribution. (2)

Are critics of the SPR just complaining after the fact about the costs of an insurance policy that has not been used? Or are there fundamental problems–retrospective and prospective–that suggest that the reserve has been and will continue to be a mistake?

Looking back, it is clear that the SPR has not been a success. It was authorized in 1975, but it was nowhere to be seen when the energy crisis hit in the summer of 1979. There were some 80 million barrels in the ground but no drawdown plan or drawdown capability. The SPR was solely an injection, not a withdrawal, program. All President Carter could do was to suspend purchases because of higher prices.

With President Reagan’s reserve build-up in 1981 and 1982, which reversed Carter’s fiscal prudence, the average cost of a barrel of SPR oil shot up. Today some 590 million barrels of oil that have cost approximately $20 billion are held in five caverns in Texas and Louisiana. Simple division gives an average cost of over $30 per barrel. In 1990 dollars, the per barrel cost is more than $40. The SPR has not only been expensive insurance, it has been prohibitively expensive insurance.

Its ‘insurance’ is growing more expensive each day. Each year adds another dollar per barrel to the cost of the reserve. (3) In any case, the SPR will not “pay back its cost many times over” as one of its early government architects recently stated. (4)

How long will it take to effect an SPR drawdown, and will it be too late when the crude leaves the caverns? The procedure is for the Department of Energy to recommend a drawdown to the president. Then the serious politicking will start. For example, military interests will argue against a drawdown to preserve their stake vis-a-vis civilian supply. Assuming the president agrees to a drawdown, the DOE is to publish a notice of bidding, solicit bids, pick the winners, and physically draw down the oil.

How long would it all take? The DOE estimates that it could all be done in 20 days, but that is just a “best guess.” (5) Indecision could add weeks or longer. In the recent test sale of 5 million barrels, the time between Bush’s withdrawal announcement (September 27) and the physical flow (late October/early November) was four weeks or more. More than 20 percent of the oil (1.1 million of 5 million barrels) attracted no bids because of quality problems. In addition to its prohibitive cost, the reserve has uncertain redemption value.

Even the belief that the reserve would “work” by damping a market panic and lowering prices has been deservedly criticized. For the petroleum industry, the prospect of a drawdown discourages precautionary (“speculative”) stockpiling since government oil would be available and prices would fall when the SPR “flooded” the market. The National Petroleum Council has complained that “excessive reliance on early drawdown of SPR stocks in a disruption could . . . undermine efforts to encourage producer stockpiling and consumer conservation.” (6) President Bush’s reluctance to begin a major drawdown has reflected those disincentives as well as concern about indirect federal price manipulation.

Recent pronouncements about when the SPR would be activated demonstrate that the incentives created by the reserve are a double-edged sword. The American Petroleum Institute has deviated from its free-market position to support the reserve as an alternative to price and allocation regulation. But the official line from the DOE and the International Energy Agency is that strategic stockpiles should not be activated until “physical shortages” appear. (7) What would trigger physical shortages? Federal price and allocation controls. The API should reconsider its pragmatic support; the Strategic Petroleum Reserve does not pass muster even as “second best.” 

Privatize the SPR

Expanding the Strategic Petroleum Reserve would be throwing good money after bad. Instead of remaining a valuable asset mired in the political swamp, the SPR can be turned into an entrepreneurial asset. The reserve can be privatized by selling off either the entire operation or its individual parts.

The new owner or owners should have full rein to buy and sell SPR crude as they desire. Foreign ownership (by Saudi Arabia, for example) should not be prohibited. Even a decision by the new owners to liquidate the crude and mothball the reserve must be respected. After all, the private market would not have constructed the reserve in the first place.

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(1) Those estimates were made by the Department of Energy. See U.S. Department of Energy, The Secretary’s Annual Report to Congress: 1988–1989 (Washington: Government Printing Office, 1990), p. 125.

(2) Caleb Solomon and Rose Gutfeld, “Petroleum Reserve Has Lots of Oil, But Using It Could Be a Challenge,” Wall Street Journal, September 5, 1990, pp. A1, A4.

(3) Assuming that the SPR has a market worth of over $8 billion by valuing its oil at $15 per barrel, the opportunity cost is around $600 million annually using an interest rate of 7.5 percent. Dividing that amount by the 590 mil lion barrels in the reserve gives a per barrel cost of 98 cents.

(4) Eric Zausner, “The Strategic Petroleum Reserve: Use It or Lose It,” Energy Daily, August 23, 1990, p. 5.

(5) Conversation with Edward Badolato, deputy assistant secretary for energy emergencies, U.S. Department of Energy, January 18, 1989.

(6) Quoted in Mark Emond, “Strategic Petroleum Reserves: Boon or Boondoggle?” National Petroleum News, March 1988, p. 41.

(7) See, for example, OGJ Newsletter, August 13, 1990.