A Free-Market Energy Blog

The Strategic Petroleum Reserve Reconsidered (Part V)

By Robert Bradley Jr. -- July 31, 2015

“There is evidence that experience reduced the scope and se­verity of earlier errors [with the Strategic Petroleum Reserve]–that the 1981–84 perfor­mance was superior to the 1977–79 performance. But new facets of the pro­gram have brought new problems.”

“Combined with the $5 per barrel handling and storing expense [as of 1984], the overall market value of SPR oil is billions of dollars less than its embedded average cost of over $35 per barrel.”

A sacred cow of U.S. energy policy is the Strategic Petroleum Reserve. The case for the reserve assumes that another energy crisis lies around the corner, the reserve will be efficiently managed during the crisis to alleviate the emergency, and private inventories and entrepreneurship alone would be inadequate. The reserve is seen by proponents as the nation’s insurance policy against the inherent instability of the world oil market.

Program Inefficiency and Cost

The previous section, tracing the history of the reserve’s early years, offered many performance miscues. This is not surprising. The SPR is susceptible to inefficiency because it is a gov­ernment program outside of the competitive marketplace where entrepreneurial discovery continually reallocates resources toward consumer preferences. Private business decisions under the discipline of profit and loss tailor costs toward expected revenue.

Poor budgeting and cost overruns would be fatal with unforgiving consumers. Government programs such as the SPR, on the other hand, are heavily end-specific with expenditure being of secondary importance. Political considerations also prevail over fiscal prudency. The fate of the project is immune from cost overruns and performance failings. The program is simply amended and continues as a luxury of tax finance and borrowing on the “full faith and credit” of the U.S. government.

An inventory program predicated on buying in low-demand (surplus) periods to sell in high-demand (shortage) periods should be very sensitive to price. Yet as prices increased to higher and higher levels, peaking in the first half of 1981, the capacity goals of the SPR remained unchanged. A purchase slowdown by one administration because of rising prices was followed by a major buildup by the next administration despite record prices.

The result was a program costing much more than planned. In the original Strategic Petroleum Reserve Plan of December 15, 1976, the total cost of a 500 million barrel reserve was estimated to be between $7.5 and $8 billion – between $15 and $16 per barrel. [1] Over twice this amount has been spent with the 500 million barrel goal not yet reached.

The “insurance policy” of public oil stockpiling, incurring a $15 billion “premium” through 1984 with another $10 billion projected, is a case study in nonmarket decision-making. A sacrosanct, illusory end – “se­curity” – justified the means of high taxpayer expense and incrementally higher world oil prices.

Start-up problems often were multi-million dollar mistakes. There is evidence that experience reduced the scope and se­verity of earlier errors – that the 1981-84 perfor­mance was superior to the 1977-79 performance. But new facets of the pro­gram have brought new problems. [2] Early purchases at “low” prices (between $15 and $20 per barrel) were canceled out by later purchases at “high” prices (between $30 and $38 per barrel).

Combined with the $5 per barrel handling and storing expense, the overall market value of SPR oil is billions of dollars less than its embedded average cost of over $35 per barrel. [3] By any profit/loss calculation, the program has been fiscally problematic, underscoring why it was not undertaken much less considered by the private sector.

A second cost of the SPR, in addition to direct taxpayer expense, is far less quantifiable but real. Oil purchases for the reserve, mainly imports, have supported world oil prices at the expense of the domestic economy since the U.S. is a net oil consumer.

Political Constraints and Risks

Political factors have contributed to the costly and inefficient performance of the stockpile program. The Jones Act in­creased trans­portation costs by as much as $1 per barrel by requiring Alaskan oil and one-half of the im­ported oil purchased by the reserve to be shipped on U.S.-flag vessels. [4] In late 1982, a major contract was signed with be­leaguered Mexico as part of a U.S. aid package. (A year before, a 50,000 barrel per day contract for 110 million barrels was signed with Pemex at market rates.) Reflecting its political nature, contract terms were classified, but one publicized fact was one billion dollars in front money for Mexico. The loan was intended to help Mexico repay its debt to major U.S. banks, which made the SPR contract a taxpayer subsidy to a corrupt, socialistic govern­ment and its creditors.

Although unsuccessful to date, above-ground storage interests have pounded the Capital Hill pavement for greater participation in the reserve program. With the “unmistakable aroma of pork,” the steel industry, tank fabricators, oil tanker owners, and steel tank owners lobbied in 1982 for permanent surface storage at dispersed sites. [5] These interests may be heard from again, along with other special interests, so long as the SPR remains a public sector good.

The exclusive location of the oil reserves near Gulf Coast refineries has sparked criticism and calls for geographical diversification. John Lichtblau of the Petroleum Industry Research Foundation has recommended a residual oil reserve for the East Coast. Senator Spark Matsunaga of Hawaii, noting that the reserves are as far away from his state as New York is from Istanbul, has urged for crude storage in Hawaii. Under present conditions, SPR oil must travel through the Panama Canal to reach the Pacific basin. [6]

The biggest political element is yet to come – who gets what, how much, and where in the event of an “emergency” drawdown. The fact that the “emergency” is not objectively defined all but ensures that the reserve will not be deployed in a timely manner – as all the positive net social cost calculations assume. [7] Painstaking rules via the Standard Sales Provisions are yet to be tested in real emergencies. Only a real life drawdown will unveil opportunities to game the program. While the potential for error is is not unique to public-sector economic decisions, timely amendment will be burdened by procedural requirements.

The stockpile is a public good directed by temporary political majorities. What constitutes an emergency to trigger an SPR allocation is a political unknown, but when “it” occurs, a dogfight can be expected between members of Congress, different federal agencies, segments of the oil industry, and consumer groups. What should the minimum bid be, and how will discretionary supply be allocated? Should the oil go to government use (such as the military) or to the private sector? How will the Western U.S. interests who are geographically removed from the oil participate? Domestic producers will want as little drawdown as possible and sales at high prices to avoid being crowd­ed out. Consumers will want as much supply as possible at low prices, with region competing against region with the Northeast at the forefront.

The 1979 oil crisis found no drawdown capability and not even an allocation plan for the reserve. While there is now drawdown capacity and a procedural blueprint, not all is well. Assuming another crisis, which may be assuming too much as argued below, fundamental questions such as when the drawdown should begin and how much should be withdrawn will receive political/bureaucratic answers, not entrepreneurial ones as in a market.

Policy Contradictions

Policy contradictions have proven no obstacle to the reputation of the SPR within academia and the political arena. The Elk Hills Naval Petroleum Reserve, originally intended to be a warehouse of proven oil reserves for emer­gency military use, has been producing around 140,000 daily barrels for government sale and use, while the Strategic Petro­leum Reserve has been storing oil in similar quantities in the name of secur­ity.

While the NPR has raised revenue, the SPR has been a major cost item; while the SPR has “increased” security, the NPR has “decreased” it. The “wash” has rarely involved transporting NPR oil several thousand miles from California to Texas-Louisiana caverns, but the irony of the two government programs working at cross-purposes should be noted even with the greater drawdown capacity of the Strategic Petroleum Reserve.

Another contraction is between public and private oil inventory. The massive government stockpile discourages precautionary oil inventory held by the private sector for unforseen emergencies. But the majority of the stockpile would not have been assumed by the private sector, underscoring the fact that the federal government misdiagnosed and overreacted to the energy crises of the 1970s. On the other hand, to the extent that the private market believes that the SPR will not be effectively used, and the reserve itself lessens the chance of reimposed price and allocation regulation, private inventories will be maintained.

The emergency supply and price buffer of the SPR reduces the potential need of alternative-fuel technologies in a crisis, which not only discourages private synthetic fuel develop­ment (to the extent there is still interest) but increases the cost-ineffectiveness of government-subsidized synfuel projects as well.

A fourth policy tension is the promotion of oil imports. While official U.S. policy has decried our dependence on oil imports, the Strategic Petroleum Reserve from the start has been hooked on the same. A policy of reducing oil imports could begin with reduced fillage of the reserve.

Finally, the promise of the reserve thwarting higher oil prices during an oil import interruption contradicts another sacred pillar of U.S. energy policy – conservation. Consumers presumably would be more conservative about energy usage if they understood that they not “protected” from the risks of the world oil market. “Insurance” in this case sends a wrong signal to not only energy suppliers but energy demanders.

The Strategic Petroleum Reserve is at odds with the nation’s true first line of defense in a true oil emergency – private entrepreneurship. The government’s hand is also strengthened for counterproductive short-run policies in a real emergency. The much-touted “insurance” of the Strategic Petroleum Reserve could be to negate bad government policy elsewhere – say the reimposition of price and allocation regulation – rather than consumer protection against an adverse change in the world oil market.

The Mirage of the “Optimal” Reserve

A technical literature has developed to justify import regulation and public oil storage to blunt a future oil emergency. [8] Through economic modeling and empirical estimation, the marginal social cost of imports if found to exceed the marginal private import costs because importers do not factor the negative externalities associated with a potential supply disruption into their decisions. The price difference between (lower) private costs and (higher) social costs has been labeled the oil import premium.

Douglas Bohi and David Montgomery have argued for a government oil stockpile to mitigate the “macroeconomic dislocations that are produced by an oil price shock and the economic cost of wealth transferred abroad when the price of imports rises.” [9] Michael Barron makes a similar point when he states that “private incentives are insuffic­ient to induce an appropriate stockpile level,” necessitating a public reserve to “stabilize the general economy by limiting the inflation and loss of aggregate output and income induced by oil shortfalls.” [10]

Estimates of the oil import premium vary, but one influential calculation of the reduction in Gross National Product from a year-long cutoff by the Congressional Budget Office in 1980 was $146 billion, which gave a hypothecated SPR stockpile of 730 million barrels a social value of $200 per barrel. [11]

Before considering the legitimacy of the oil import premium, one positive contribution of this technical literature should be acknowledged. Most critics of oil imports have acknowledged that the potential problem of oil-import dependence is higher prices and not physical shortages. If markets are free to clear, supply and demand will equalize; the price at which this occurs is the primary concern. Proponents of the SPR see the major benefit as preventing a price spike more than preventing shortages.

The proof of a negative externality with oil imports rests upon questionable methodology and faulty assumptions. The key concept of social cost is computed as if cost was objectively measurable. This is incorrect. Cost – which economists define as the most attractive opportunity foregone – is notoriously subjective and open to varying estimation. It cannot be quantitatively expressed in the aggregate with scientific precision – which invites prejudice and political manipulation. [12]

It is not surprising that 20 government and private studies favoring a stockpile found the “optimal” reserve to contain from as little as 250 million barrels to over 1 billion barrels. [13] It depends on the assumptions and the philosophical outlook of the modeler.

Model-building and “crystal ball” predictions in the energy field have proven notoriously unreliable. [14] The case for a strategic stockpile, created out of the same cloth, is no more sturdy.

The externality literature assigns a high probability of a oil import disruption and assumes an almost omniscient drawdown response from the reserve. Both pivotal assumptions are incorrect. As argued in chapter 13 and the next section, the energy crises of the 1970s were caused by government intervention and not the mere fact of import dependence. A long era of oil oversupply and a buyers’ market can be expected to reign so long as the free market reigns.

Interruptions and the higher prices therein should be seen as the flip side of OPEC price wars and a general buyers’ market. As such, higher oil prices in certain periods are akin to the “bad luck” of a cold winter or hot summer for energy rate-payers. It can and sometimes happens – but it is not debilitating and reason for expensive and uncertain “insurance.”

The “macroeconomic dislocation” of oil import disrup­tions is also exaggerated. The two major externalities from private import decisions – inflation and an unfavorable balance of trade – are questionable building blocks to derive an oil import premium. First, increasing oil imports can lead prices down and not up as the experience of recent years has shown. Second, higher oil prices are not necessarily inflationary.

A change in relative prices cannot cause a general price change (short of a simultaneous increase in the money stock) unless the output of the economy is reduced or inflationary expectations are increased. Oil-substitute prices will increase from higher oil prices, but oil-complement prices will behave oppositely. Indeed, as more income is spent on energy, less income is left to spend elsewhere, decreasing demand and thus prices. The net effect is a similar price “level,” with the above qualifications, although the relative prices comprising the aggregate will be quite different.

Changed relative prices from increased oil scarcity is not a Keynesian aggregate demand prob­lem but an adjustment process that free market forces can be expected to anticipate and absorb short of triggering an economy-wide business cycle. The oil traumas of 1973-74 and 1979 are case studies of how government intervention prevented market forces from oper­ating. Experienced difficulties did not result from exogenous price shocks to the market alone.

An “unfavorable” balance of trade – money leaving the U.S. with increasing oil-import dependence – invents more of a problem than it verifies. Greater imports, as mentioned, can well be at lower prices to make the net effect on the trade balance ambiguous. (On the other hand, import interruptions will create a tradeoff between higher prices and less imports.) But the whole trade balance issue, more fundamentally, is a non-problem since exported dollars are “recycled” to either buy U.S. goods or invested back in the U.S. The overlooked recycling effect means that the “negative” externality is counter-balanced by a “positive” externality.

The Verdict of Market-Process Analysis

Once its scientific gloss is removed, the case for an “optimal” tariff, quota, or public stockpile is revealed to be a mirage. In place of ambiguous oil import premium derivations, qualitative discussion of market processes complements a historical reinterpretation of past oil import reductions. The size of the reserve becomes secondary to whether the reserve can be justified at all. A market-process perspective concludes that the SPR fails the cost/benefit “test” and is superfluous to the vicissitudes of the world petroleum market of the 1980s.

Without the Strategic Petroleum Reserve, the United States would not be helpless against the whims of the world petroleum market. The market’s “insurance” policy is forward-looking entrepreneurship unencumbered by tax and regulatory disincentives.

The 1970s ener­gy crisis cannot be properly interpreted without understanding the role of government intervention in precip­itating and exacerbating the crisis. The “oil weapon” used to punish the U.S. resulted in 1973 from U.S. aid to Israel and in 1979 from longstanding U.S. intervention in Iranian politics. A less interven­tionist foreign policy, a handmaiden to free market domestic policy, would be less likely to arouse nationalistic and xenophobic sentiment to trigger retaliatory disruptions of petroleum imports.

Further­more, the world petroleum market has diver­sified its output in the 1980s to lessen the chances of an effective embargo or concerted production cut. In late 1982, Mexico surpassed Saudi Arabia as the leading crude oil importer to the U.S., and two years later Venezuela, Canada, Britain, and Nigeria rose to the top of the list as well. An embargo by Saudi Arabia or another country today would only effectuate a highly profit­able substi­tution by other producing countries. Slack capacity by exporting countries is a growing phenomenon that makes the worst-case scenario of oil-import interruptions much less likely and less consequential than in the last decade.

Turning from international to domestic policy, U.S. energy policy in the 1970s made the country dependent and vulner­able to imports by artificially encouraging consumption, subsidizing imports, and dis­couraging production and inventory speculation. Price and allocation controls set the stage for OPEC profit-maximization through higher prices and lower output.

Specifically, as seen in previous chapters, domestic price ceilings lowered U.S. output under unregulated levels, the refinery entitlements program subsidized the quantity and price of imports, and allocation programs erased the profit potential of increased oil storage, and price ceilings delayed conservation and the development and implemen­tation of new energy-efficient technologies.

Gas lines and other petroleum product shortages, creating vast microeconomic distortions that adversely affected the national economy, were created by price controls and worsened by allocation controls. With decontrol in early 1981, the artificial props to imports were taken away, and crude prices and imports have subsequently declined. The rationale for and anticipated use of the SPR has become more and more questionable in the free-market 1980s.

The likelihood of a crisis aside, the presence of market forces to counter disruptions constitutes a strong case against federal stockpiling. Free market entre­preneurship is an anticipatory function. Profits are gained by correctly anticipating the future state of supply and demand. When future supply is uncertain, profit-seekers increase inventory to pro­fitably use or sell when market conditions change.

By storing in relatively plenti­ful times and selling in tight situations, price fluc­tua­tions are mitigated to better stabilize the market. In the 1970s, regulatory programs such as buy-sell, entitlements, and price controls removed incentive for firms to increase inventory to internally draw down or exter­nally sell. Quite the opposite, firms with less inventory were rewarded and firms with more inventory were penalized. [15]

While market actions are anticipatory, another important market process is the adjustment to less supply and higher prices. Consumers reduce use and turn to other fuels where possible such as coal and natural gas. Conservation and substitution are key consumer strategies to adapt to the new reality.

Producers increase crude output over normal levels (surge production) and sink development wells in existing fields. Wildcat drilling also becomes more economical. These are responses that state and federal regulation, from state output restrictions to federal price controls, have historically discouraged. Thus broad-based market-oriented energy policies should be considered in lieu of the Strategic Petroleum Reserve.

Another market process to ensure adequate supply over time was delayed by regulation in the 1970s but made a grand appearance in the 1980s – the crude oil and petroleum product futures market. This institution has better internalized expectations of supply and demand to prepare for the future as discussed in the next section of this chapter.

A common defense for a reserve is that the mar­ket could be taken by complete surprise and have inadequate inventory to cush­ion a sudden import cutoff. This view tenuously assumes that mar­ket entrepreneurs are inferior forecasters than government officials. If this were true, broad empirical support could be found for state bureaucratic direction of economic activity?

The government could win profits, become self-financing, and enrich the economy in the process. Theory and experience, however, suggest the opposite. Bureaucracy has not been able to discover and exploit profit opportunities. The record of the Strategic Petroleum Reserve and the Synthetic Fuels Program, predicted on a pessimistic world view of energy resources, attests to this fact.

In conclusion, the Strategic Petroleum Reserve is conceptually and empirically open to complete review. As the first decade of the program draws to a close, it is apparent that the government has mismanaged a program that could not be cost-justified in the first place. With an embedded cost of around $35 per barrel, a multi-billion dollar paper loss has been incurred.

Government oil insurance is more than prohibitively expensive; it is unneeded. The free market era in petroleum in the 1980s does not hint toward a repeat of the regulated 1970s. There will be no crisis for the reserve to mitigate so long as such counterproductive policies as price and allocation controls are not resorted too. (And even if they were, the SPR still would not be the savoir.)

Even if there was a crisis lurking around the corner, free-market entrepreneurship and not the uncertain utilization of a political asset should be the nation’s first line of defense. Chapter 31, the policy chapter of Oil, Gas, and Government: The U.S. Experience, will consider a nonpolitical, entrepreneurial future for the Strategic Petroleum Reserve.

[1] FEA, Strategic Petroleum Reserve Plan, pp. 3, 182.

[2] The exchange program that began late in 1980, whereby the Project Office traded Naval Petroleum Reserve oil for SPR crude, for example, has come under criticism for poor trading strategies that cost taxpayers millions of dollars. These cumbersome trades were made to stay out of the world market to appease Saudi Arabia. Weimer, The Strategic Petroleum Reserve, p. 71.

[3] The average acquisition cost of crude oil alone has been over $27 per barrel. This price is the average delivered price including import fees, superfund taxes, terminaling costs, and a premium paid for delivery in U.S tankers. The approximately $8 per barrel balance covers all other facility and overhead costs. It is also net of entitlements benefits. Conversation with Howard Borgstrom, Director of Strategic Planning, Strategic Petroleum Reserve (January 24, 1985).

[4] Forbes, July 5, 1982, p. 44. The Jones Act is examined in chapter 16, pp. .

[5] Forbes, July 5, 1982, p. 44. See the testimony of the American Iron and Steel Institute, the Steel Plate Fabricators Association, and the Independent Fuel Terminal Operators Association in Current Condition of the Strategic Petroleum Reserve (Washington, D.C., GPO: 1982), pp. 278-330.

[6] Ibid., pp. 27-28, 222.

[7] “Any Reserve size is cost beneficial if it is assumed that a shortfall will occur that would require use of the bulk of the Reserve.” FEA, Strategic Petroleum Reserve Plan, p. 34.

[8] Also see the discussion in chapter 13, pp. 761–62.

[9] Douglas Bohi and David Montgomery, Oil Prices, Energy Security, and Import Policy (Baltimore: Johns Hopkins University Press, 1982), p. 130.

[10] Michael Barron, “Private-Sector Financing of Oil-Stockpile Acquisition,” in George Horwich and Edward Mitchell, ed., Policies for Coping with Oil-Supply Disruptions (Washington, D.C.: American Enterprise Institute, 1982), pp. 112-13.

[11] Fortune, September 8, 1980, p. 67.

[12] For an explanation of subjective cost theory, see James Buchanan, Cost and Choice (Chicago: University of Chicago Press, 1969). For estimation problems involved in policy-oriented research, see Steven Cheung, The Myth of Social Cost (San Francisco: Cato Institute, 1980).

[13] National Petroleum Council, Emergency Preparedness for Interruption of Petroleum Imports into the United States, April 1981.

[14] “By now [1979] it should be clear that the predictions derived from energy models are subject to a great deal of imprecision. The derivation of coefficients that are necessary to generate forecasts often requires the modeler to make assumptions that cannot be completely substantiated, or to make assumptions that may obscure the representation of the system being analyzed.” “Limits to Models,” in Robert Stobaugh and Daniel Yergin, eds., Energy Future (New York: Random House, 1979), p. 262. This evaluation would be even more valid five years later.

[15] See chapter 20, p. 1204. Unlike during the 1973 and 1979 disruptions, the Iran-Iraq war in 1980, which reduced imports by 3 million barrels per day, was effectively countered by private sector inventory drawdowns. Less restrictive regulation was at the forefront. Oil price ceilings were being phased out, and product prices were either deregulated or superfluous. Allocation regulation did not restrict inventory buildups, and with price incentives, quasi-market preparation and response were possible. The Strategic Petroleum Reserve, meanwhile, lacking drawdown capacity, was superfluous.


NOTE: This week, MasterResource reviewed the history of state and federal oil (and natural gas) storage regulation and ownership. Part I examined early (pre-SPR) regulation. Part II the prehistory and beginnings of the SPR; Part III the early problems with the Federal storage program; Part IV early fill and financing controversies.

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