Thursday, June 10, 2004

What Should We Do with the SPR? (Rerun)
Last week's Barron's carried an editorial suggesting the sale of the Strategic Petroleum Reserve to private investors, arguing that this would remove another layer of government interference in the market. That approach is a somewhat more radical than my own modest suggestion of February 18:

Following on from yesterday's posting about the Strategic Petroleum Reserve, rather than asking about the timing of adding oil to the existing SPR, Senators Levin and Collins might instead have asked whether the SPR itself is the most efficient way to provide the desired protection from supply disruption.

The tricky aspect of such a strategic reserve is that it sends two signals: the intended one to suppliers about our ability to do without them in extremis, and an unintentional signal to the market affecting the overall psychology of holding inventory. In the last twenty years commercial crude oil stocks--in absolute terms and particularly when measured in days' supply--have declined significantly. While this might be coincidental, the mere existence of the SPR has reduced the risk of holding lower commercial inventories.

In addition, President Clinton's decision in the fall of 2000 to release crude oil from the SPR to try to hold down home heating oil prices sent a particularly confusing signal, since it directly undermined the incentive for companies to build inventories during low demand for use in periods of higher seasonal demand and prices.

The basic issue is providing an adequate backstop in case of actual disruption of supply, not trying to run the SPR for a profit or using it as a political tool to influence prices. This can certainly be done by a combination of government-owned storage and iron discipline on when to release stocks, as with the current SPR, but it could also be achieved or augmented by making commercial inventories less onerous for companies to hold.

Refiners are conservative people by nature. They are rewarded for running their facilities safely and profitably, and they work hard to avoid anything that interferes with that. Left to their own devices, they would hold lots of inventory, because it increases their flexibility and reduces the risk of running short of crucial inputs. But their accountants have been telling them for years that holding more inventory than absolutely necessary has dire tax and working capital consequences, and reduces the rates of return on their huge capital base. If companies were given incentives that eliminated these detriments, refinery managers would happily increase their inventories.

The other benefit of a scheme like this would be to circumvent the limits on how quickly the reserve could be drawn down when needed. The current limit on the SPR is 4.3 million barrels/day (MBD). At this rate, it would take almost six months to draw down the entire 700 million barrels on hand today. Holding equivalent volumes in hundreds of facilities, instead of a handful, would avoid this bottleneck.

Of course no one foreign supplier sells the US this much oil today, so one could argue that the likelihood of needing to draw down more than 4.3 MBD is low. But the loss of Saudi Arabia--not so hard to imagine in today's world--would take much more oil out of the world market and create major disruptions as traders tried to rebalance supply and demand.

But a side benefit of moving to a commercialized, incentivized structure would address precisely the concern of the two Senators. Decisions on when to add to inventory would be made by managers who are actively in the market, routinely making such decisions, rather than by government bureaucrats. Could such a system be gamed, a la Enron? Perhaps, but the incentives could be structured to minimize such behavior.

In many respects, though useful and better than blind faith, the SPR is an anachronistic holdover of a period of extreme regulation--remember the wage & price controls of the 1970s? Given the waves of deregulation that have swept industry after industry, it might be timely to look at this relic in a new light.

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