Insights Robert W . Hartman Editor

Candidates for inclusion in the Insights section may be sent directly to the Insights Editor. His address is: Robert W. Hartman, Congressional Budget Office, Ford House Office Building, Washington, DC 205 15.

ANOTHER LOOK AT THE STRATEGIC PETROLEUM RESERVE: SHOULD ITS OIL HOLDINGS BE PRIVATIZED?

1 Carl Blumstein and Paul Komor

The sharp increases in crude oil prices that occurred in 1973-1974 and in 1978-1979 unleashed a veritable gusher of economic and policy analyses concerning energy security [for a recent review, see Toman, 19931. Although these analyses by no means resolved all of the outstanding issues, something of a consensus emerged concerning the desirability of building and using a large stock of oil to cushion the effects of a sudden loss of oil supply [Hogan, 19831. No one argued that an oil stockpile would eliminate U.S. dependence on foreign oil. Rather, it was expected that a stockpile would provide a buffer against short-term disruptions in supply. In times of disruption, releases from the stockpile would militate against sharp price increases. This would buy time during which the conditions causing the disruption might dissipate or adjustments in the economy could occur that would increase supply and reduce demand. The overarching purpose for an oil stockpile would be to reduce the adverse macroeconomic impacts that can result from oil price shocks.' The Strategic Petroleum Reserve (SPR), established in 1976, was seen as the instrument for achieving these policy goals.

Today the SPR consists of five storage facilities operated by the U.S. Depart-

' Recently, the consensus on the need for strategic reserxc's to reduce potential adverse macroeco- nomic impacts of oil price shocks has begun to fray a little. Some observers question the strength of the relationship between oil price shocks and macroeconomic performance; they suggest that, however important the relationship may have been, it has been significantly weakened by changes in the oil market [see, e.g., Farmer, 19931.

Journal of Policy Analysis and Management, Vol. 15, No. 2, 271-275 (1996) 0 1996 b the Association for Public Policy Analysis and Management Publishedlby John Wiley & Sons, Inc. CCC 0276-8739/96/02027 1-05

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ment of Energy on the gulf coasts of Texas and Louisiana. These facilities have a capacity of 750 million barrels of underground storage in salt domes. The SPR holds about 590 million barrels of crude oil [Office of Strategic Petroleum Reserve, 1995, p. 221. At 1994 rates, this is equivalent to 74 days of imports. Title XIV of the Energy Policy Act of 1992 established a target fill for the SPR of one billion barrels [U.S. House of Representatives, 1992, p. 2291, but additions to the Reserve stopped in July, 1994, because of limited appropriations. Although still well short of its targeted holdings, the Reserve is large enough to have a presence in the world oil market. Indeed, some observers believe that the announcement that the United States was prepared to use the SPR was a significant factor in the historic oil price collapse in January, 1991, at the outbreak of the allied military action in the Persian Gulf [Lichtblau, 19941.

The SPR, however, has some serious problems. First, it costs taxpayers a lot of money. In Fiscal Year 1995, although only $9 million is available for oil acquisition, $244 million has been appropriated for management and operation of the Reserve.’ From 1976 through 1994 more than $20 billion has been spent on the SPR-about $4 billion for storage facilities development and operations and about $16 billion for oil acquisition [Office of Strategic Petroleum Reserve, 1995, p. 351. Many more billions of dollars would have to be appropriated if the Department of Energy were to construct the facilities and purchase the oil needed to reach the one billion barrel goal. In addition, the carrying cost of the $20 billion that has already been spent certainly exceeds $1 billion per year in interest payments.

Second, because the SPR is an insurance policy against import disruptions, these costs are effectively a hidden taxpayer-supported subsidy for foreign oil. And, since the cost of this subsidy is not reflected in the price of imported oil, the price is artificially low. Artificially low oil prices lead to overconsump- tion of oil.

A third problem with the SPR is that, to release oil during a supply disrup- tion, the president must declare that an emergency situation exists. This would be a dramatic and politically charged event that might heighten ten- sions in an already tense situation. Short-run political concerns could compli- cate the decision about when to take action. Moreover, there could be some delays in releasing the oil because, according to current procedures, an auc- tion must be organized to sell the oil. A final related problem is that there is no mechanism for adjusting the amount of oil stored in the SPR in response to changing levels of imports, short of presidential determination that an emergency situation exists. To provide a consistent level of protection, the SPR ideally should rise and fall in proportion to changing U . S . dependence on imported petroleum.

The problems with the SPR are not new, nor have they been unrecognized. Policy analysts have given considerable attention to alternative methods of financing and operating the SPR [see, e.g., Plummer, 1984; Horwich and Weimer, 1984; U . S . General Accounting Office, 1989; and U.S. Department of Energy, 19901. Thus far, the Congress has been resistant to any fundamental change in the SPR. However, changes in our dependence on imports and changes in American politics suggest that it is time to take another look at the SPR. After cutting back on its oil imports in the wake of the supply

Part of these funds will be used in decommissioning the Weeks Island facility, which is deterio- rating because water is seeping into the storage chamber. This will reduce the storage capacity of the SPR to 680 million barrels [Office of Strategic Petroleum Reserve, 1995, p. 121.

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disruptions of the 1970s, the United States has in the past decade steadily increased its reliance on imported oil. In 1982 the United States imported 28 percent of its oil; in 1994 net imports provided 45 percent of the oil supplied for domestic consumption [Energy Information Administration, 1995, p. 21. This growing dependence on foreign petroleum worsens the U.S. trade imbal- ance and makes the U.S. economy increasingly vulnerable to supply disrup- tions. In addition, there is tremendous pressure to reduce or eliminate the federal buget deficit. It is hard to imagine Congress appropriating the funds necessary to expand the SPR to one billion barrels. It may even be difficult to obtain the funds needed to maintain the existing reserve.

The following discussion describes how the problems of the SPR-high taxpayer expense; little prospect of obtaining sufficient funding to meet con- gressionally mandated fill levels; encouragement of imports by hidden sub- sidy; potential political difficulties in deciding to release oil during a supply disruption; and the lack of an adjustment mechanism for oil levels-could be solved by making the SPR more responsive to market forces.

We consider a strategy that would privatize most of the oil in, but not the operation of, the SPR. A federally chartered SPR Corporation (SPRC) would be established with the assets of the SPR, including its storage facilities and the oil it now contains. The SPRC would be directed by a board of governors, somewhat like the board of governors of the Federal Reserve system. Like the Federal Reserve, the SPRC would be organized to serve the public interest, not to make a profit. Initially, the SPRC’s liabilities would be notes payable to the government in the amount of the government’s acquisition costs for the assets. The corporation would earn revenues by selling oil and by charging fees for storing oil. It would use its revenues to pay back the government and to maintain the Reserve. Through the repayment the government would receive more than $1 billion per year. A market for the SPRC’s oil and storage facilities would exist because importers would be required to maintain re- serves in the SPR equal to a fraction (probably about 0.4) of their annual imports. This reserve requirement would be set and, as necessary, adjusted by the board of governors of the SPRC.3

For example, an importer who wanted to bring in 1000 barrels would have to acquire 400 barrels in the SPR. These 400 barrels would have to remain in the SPR for a t least one year. After one year, the 400 barrels could be used to satisfy the reserve requirement for another 1000 barrels of imports or they could be withdrawn from the SPR. Under this arrangement, importers would bear the cost of holding oil in the SPR, thus removing the hidden import subsidy that now exists. With a reserve requirement of 0.4 barrels per barrel imported, a $1 S O per barrel per year storage fee (to cover operating expenses, debt service and debt retirement), an interest rate of 10 percent, and a world oil price of $20 per barrel, the cost of importing a barrel of oil would increase by $1.40.

If this cost increase is simply passed on to consumers, then there is little to differentiate it from an oil import fee. It is not clear, however, how much of the increase consumers would see. In this privatization strategy a market

Quasi-public management of the reserves and ownership of the storage facilities distinguishes this proposal from an Industrial Petroleum Reserve, which, although never implemented, is authorized in the same statute that created the SPR. Other antecedents for elements of our proposal can be found in the literature cited. Of course, this is not the first time that the creation a semiautonomous body within the State has been proposed as a means of buffering economic policy decisions from short-run political concerns [see, e.g., Keynes, 19261.

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for the exchange of rights to SPR oil would improve economic efficiency. In this market, which might be an existing commodity exchange, most transac- tions would only affect ownership rights and would not involve the physical movement of oil into or out of the SPR. Our hypothetical importer could sell his interest in the 400 barrels as soon as he landed his imports. However, because his 400 barrels would still have to remain in storage and could not be used to satisfy additional import reserve requirements until a year had elapsed, he would have to sell a t a discount from the world price. If there were no expectation that oil prices would change, then the discount would be $3.50 per barrel-the full cost of holding a barrel of oil in the SPR for one year. There are theoretical reasons, however, to expect that future prices will be higher on average. To the extent that the market reflected such expecta- tions, the discount would be reduced, which would, in turn, reduce prices to consumers.

The proposed method of privatizing the oil held in the SPR provides an automatic adjustment mechanism for the Reserve. When a firm’s imports rise, it must store more oil. When the firm’s imports fall, it has a strong incentive to sell oil to consumers because it has more oil in storage than required to satis@ its import reserve requirement. In the aggregate of all firms, oil storage in the SPR would rise and fall as total imports rise and fall. This automatic adjustment mechanism makes the SPR a more credible policy instrument. An oil exporting nation or group of nations that is tempted to disrupt the world oil market for political reasons will know with greater certainty that its actions will trigger releases from the Reserve.

Any proposal for placing SPR oil in private hands must address the concern that private actors would not serve the public interest when a supply disrup- tion occurs. In one sense the concern is misguided because, when a supply disruption occurs, one of the first priorities would be to get SPR oil on the market (i.e., into private hands). A better question to address is: What is thc best way for the government to influence the behavior of the oil market when a supply disruption occurs? The policy objective would be to help the economy make a smooth adjustment-avoiding wild fluctuations in the market that might cause unnecessary dislocations. Price controls and crude oil allocations have been tried and found wanting. A better alternative is for the government to participate in the oil market in much the same way that the Federal Reserve participates in the market for government securities. This is clearly not a good role for direct presidential authority; a corporation like the SPRC would be much more appropriate.

The SPRC could buy and sell oil for its own account and it would also have other levers of power. In addition to raising or lowering the reserve requirement for importers, it could raise or lower the fee for storing oil in the SPR. Higher storage fees could apply to all oil in the SPR or only to oil that is held in excess of the reserve requirement. This would make it difficult to hold oil in the SPR for speculative purposes. Of course, the SPRC cannot guarantee a stable oil market. That will depend very much on the circum- stances of supply disruptions. The SPRC, however, appears to be much better suited to the task of market stabilization than past policy instruments.

There will, of course, be some difficulties in moving from the current system to a more market-oriented system. Rapid and complete privatization of the oil held in the SPR would be disruptive because it would require importers to put up large amounts of capital in the first year to buy SPR oil. Furthermore, the SPR does not contain the one billion barrels needed to accommodate an

lnsights I 2 7 5

import reserve requirement of 0.4 barrels per barrel imported. Rapid filling of the SPR would push world oil prices up. These difficulties could be allevi- ated by a transition period during which the import reserve requirement was increased in several steps. For example, the requirement could be 0.1 barrel in the first year and then be increased by 0.1 barrel per year until i t reached the desired level. The filling of the SPR could be completed during this transition period.

Details of the organization of an SPRC and of a transition from the existing system will certainly require further discussion and analysis. The case for privatizing the oil in the SPR, however, seems strong-taxpayers will save money, imported oil’s costs will be borne by those who buy the oil, and the nation will be better prepared for the next oil shock.

We thank Severin Borenstein and C. Bart McCuire for helpful comments and advice.

CARL BLUMSTEIN is Research Policy Analyst at the University of California Energy Institute, University of California, Berkeley.

PAUL KOMOR is a researcher at E Source, Inc., in Boulder, Colorado. Before joining E Source, he was Senior Analyst at the Congressional Ofice of Technology Assessment (OTA), in Washington, DC.

REFERENCES

Energy Information Administration (1993, Petroleum Supply Monthly, DOE/EIA-

Farmer, Richard D. (1993), “Forward Markets and Changes in Macroeconomic Perfor-

Hogan, William W. (1983), “Oil Stockpiling: Help Thy Neighbor,” The Energy Journal

Honvich, George and David Leo Weimer (1984), Oil Price Shocks, Market Response, and Contingency Planning (Washington, DC: American Enterprise Institute).

Keynes, John Maynard (1926), “The End of Laissez-Faire,” republished 1972 in Col- lected Writings of John Maynard Keynes, vol. 9, pp. 272-294 (London: Macmillan).

Lichtblau, John H. (1 994), “Oil Imports and National Security: Is There Still a Connec- tion?” The Energy Journal 15(Special Issue), pp. 329-346.

Office of Strategic Petroleum Reserve (1995), Strategic Petroleum Reserve AnnuallQuar- terly Report, DOE/EE-0055 (Washington, DC: U.S. Department of Energy).

Plummer, James L. (1984), “Institutional Alternatives for Financing and Operating the Strategic Petroleum Reserve,” in Alvin L. Alm and Robert J . Weiner (eds.), Oil Shock: Policy Response and Implementation (Cambridge, MA: Ballinger).

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4(3), pp. 49-71.