May

22

For decades we listened to the squeal when radio stations ran mandated tests of the Emergency Broadcast System. And when there is a real local or national crisis, most TV and radio stations break in quickly to give us the details.

When the Strategic Petroleum Reserve was established by legislation in 1975, and began receiving oil in 1977, oil had recently risen from $2 a barrel to $12. In today's prices, oil rose from $9.68 a barrel in 1973 to $43 in 1977. This big jump followed an inflation-induced fall in real price over many years. Oil rose to an inflation-adjusted price of $104 in April 1980, following the turmoil of the Iranian Revolution.

The federal government had imposed prices control from 1971 to 1974, so the private sector had little incentive to stockpile oil against future supply disruptions. Oil storage firms would need to charge higher prices during disruptions to recover storage costs. But companies like Exxon were busy buying computer, office equipment, and other companies in part to shield themselves from threatened nationalization.

In any case, the strategic value of a petroleum reserve can be appreciated as oil prices fell in the 1990s. Oil from the Middle Eastern could be produced at prices below $10 a barrel, and these low prices led U.S. oil firms to dramatically cut back exploration and development. The fear that oil prices could be pushed back below $10 led U.S. oil firms to hold back on expensive exploration and development projects. Even as oil prices rose to $20, $30 and $40 a barrel, firms knew that cheap production from the Middle East could quickly drive prices back down.

Now however, oil prices are well above the $50-$70 a barrel cost for profitable oil production in dozens of major and hundreds of smaller operations around the world. These high prices are spurring major oil development and production in diverse on-shore and deep-water locations around the world, and dramatically reduce the need for a large strategic oil reserve.

Congress has passed legislation to halt additional oil purchases when current SPR contracts expire in July. The President could test the SPR emergency "oil cast" system by pumping out 100,000 to 1 million barrels a day through June. Why wait for a full-scale emergency to see if someone forgot to properly design or build some key pieces of the emergency system. Three of the four major SPR facilities are designed to draw down over one million barrels a day. But can they? Who knows.

An added benefit would be income the federal government could use to reduce federal debt and perhaps strengthen the dollar. And, as I suggested in an earlier post, the federal government could use this opportunity to establish a long-term oil futures market by selling, say, 100 million barrels of oil over the next few months and offering to purchase this oil back at, say, an inflation-adjusted price of $50 a barrel in five to ten years.

Another interesting consideration is that the recent rapid rise in gasoline prices has likely drained the nation's most effective strategic petroleum reserve–the one 100 million U.S. households have in their two automobile gas tanks. At high prices people run low on gas more often, and have less reserve in times of local crises. If other people's behavior is similar to mine, most have gas tanks at least half as full now as they have when prices are stable or dropping (this could be tested with data from recent average gas station purchases–far fewer people now fill up at the gas station).

So if 50 million barrels of oil from the SPR are returned to the private sector over the next few months, with each barrel providing 20 gallons of gasoline (plus other petroleum products like jet fuel), that one billion gallons could be nicely distributed across 200 million gas tanks providing an average cushion of 5 gallons for each American car. With lower prices, people are more likely to keep their own "strategic" reserve.


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3 Comments so far

  1. Bob Johnson on May 23, 2008 8:04 am

    I prefer the rational choice of stockpiling goods when prices are rising, not falling.

  2. Anatoly Veltman on May 23, 2008 12:13 pm

    Actually Bob, you may be confused by semantics: bona-fide hedgers always bid under and offer scale-up. Unless you're a trend-follower, truly confident that the trend you've uncovered will materially continue. Otherwise, you simply pile-up the short-term edge and count on eventual reversion to the mean.

  3. Bob Johnson on May 23, 2008 1:23 pm

    My comments are of a more general consumer oriented nature, as in the gasoline example. In an inflationary environment, hoarding goods, especially consumable necessities, is the rational decision.

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