Shrinking the Strategic Petroleum Reserve

• Selling oil from the Strategic Petroleum Reserve as part of the Congressional budget compromise raises serious questions about the SPR's future role.
• Shrinking the SPR without first bringing its coverage into line with 21st century needs risks strengthening OPEC's hand. 

Last month's Congressional budget compromise included plans to sell 58 million barrels of oil from the US Strategic Petroleum Reserve, beginning in 2018. That decision raises serious questions. The world has changed enormously since the SPR was established in the 1970s, but the realignment of such an asset for the 21st century deserves a full strategic review and debate. Leaping ahead to treat the SPR like an ATM  seems unwise on multiple grounds.

My initial reaction was that the sale would result in the US government effectively buying high and selling low. However, using the last-in, first-out (LIFO) accounting common in the oil industry, the SPR release during the 2011 Libyan revolution should have removed any barrels purchased as prices surged past $100 per barrel (bbl) to over $140, prior to the financial crisis. The oil now slated to be sold in 2018-25 was likely injected between December 2003 and June 2005, when West Texas Intermediate crude oil averaged around $44/bbl. The Treasury should at least break even on these sales, allowing us to dispense with judging the trading acumen of the Congress and focus on the strategic aspects of this decision.

It is also true that the combination of revived US oil production and lower domestic petroleum demand effectively doubled the notional import protection that the SPR provides. That has made policy makers comfortable enough with the coverage the reserve provides to consider shrinking it. Yet as Energy Secretary Moniz  and a growing body of experts have concluded, the SPR's present configuration is inadequate to deal with whole categories of plausible oil-supply disruptions.

Today's SPR consists entirely of crude oil stored in caverns near the major refining centers of the Gulf Coast, to which it is connected via pipelines. However, while crude oil imports into the Gulf Coast have fallen dramatically, the long-term decline of oil production in Alaska and California has forced West Coast refiners to import 1-1.5 million bbl/day of oil, including more than half of California's crude supply, much of it from OPEC producers. In the event of an interruption of those deliveries, and under current oil-export restrictions, getting SPR oil from Texas and Louisiana to L.A. and San Francisco would pose enormous logistical challenges.

We have also learned that natural disasters such as hurricanes Katrina and Rita in 2005 and Superstorm Sandy in 2012 affect refinery operations, as well as oil deliveries.  A crude oil SPR is of little value if its contents can't be processed into the fuels that consumers and industry actually use.  The newer Northeast heating oil and gasoline reserves were intended to address that limitation, though on a much smaller scale.

It is thus fair to say that the SPR established in the Ford Administration and filled by the next five US presidents to a level now equivalent to 137 days of US crude oil imports is not diverse enough in its composition or locations, and too big for our current needs. If we could count on a continuation of cheap, abundant oil for the next two decades, selling off some SPR inventory wouldn't create problems. However, the purpose of such a reserve is to mitigate the risks of uncertain and inherently unpredictable future conditions and events. That should be factored into any decision to shrink it.

We don't have to look far to find reasons to suspect that oil prices might someday be higher and more volatile--perhaps as soon as the 2018-25 legislated sales period--or to worry that oil supplies from the Middle East might become less secure. Consider the consequences of the oil price collapse that began over a year ago. Low oil prices have indeed put pressure on the highly flexible US shale sector, where production is now expected to drop by around 500,000 bbl/day by next year. The impact on large-scale, long-lead-time capital investments in places like Canada, the North Sea and Gulf of Mexico has been even more profound. Over $200 billion of new projects and exploration activity have been deferred or canceled. Unlike shale, most of these projects could not be revived quickly if prices rebounded.

As production from existing fields declines without replacement, the current global oil surplus will dissipate, bringing the market back into balance. However, that balance is likely to be more precarious than before, since last fall's strategic shift by OPEC to protect its market share instead of managing prices entails the depletion of OPEC's "spare capacity." That means that in a future crisis, Saudi Arabia and other OPEC producers will have little flexibility to increase production to make up for lost output elsewhere.

Barring an unforeseen reduction in global  oil demand, the scenario that is beginning to take shape fits the  pattern of risks that the SPR was originally intended to address. It includes the prospect of rising US oil imports, increasing reliance on OPEC, and the threat posed by ISIS in the world's oil "breadbasket".  In that light it is hard to justify reducing the size of the SPR without a clear plan for making the remaining volume more effective at shoring up future vulnerabilities in US energy security.

In their haste to reach a deal, Congressional negotiators may also have overlooked some SPR-related alternatives that could generate revenue without draining inventories. These might include allowing other countries to buy into the reserve by means of "special drawing rights," or simply selling long-dated call options backed by the SPR, to be settled in the future by delivery or cash, at the government's discretion.

Taken together, there are ample reasons for the next Congress and administration to revisit the SPR sales provisions of the 2016 budget deal, before they go into effect.

A different version of this posting was previously published on the website of Pacific Energy Development Corporation

China Seizes Opportunity to Fill Its Petroleum Reserve. Should Others?

• China is apparently snapping up cheap oil cargoes to fill its strategic petroleum reserve.
• That might make sense for the US, too, if earmarked for new regional SPRs, rather than refilling the existing one on the Gulf.

The Wall St. Journal has reported that state-owned oil companies in China are capitalizing on lower prices to fill that country's strategic petroleum reserve (SPR). The obvious question is whether the US should do the same, particularly since surging oil output from shale deposits is a major factor in the recent rebalancing of the oil market. If that means putting more oil into caverns on the Gulf Coast, the answer should be no. However, this could be an opportunity to begin creating strategic reserves for parts of the country like the West Coast that are poorly served by our 1970s-vintage SPR.

Superficially, $80 oil provides a tempting chance to turn a profit while replacing the 30 million barrels of oil the US government sold as part of a "coordinated release" with other International Energy Agency members during the Libyan revolution. Comparing the average WTI price in June 2011 to today's, the Department of Energy could pocket around $15 per barrel on the overall sale and repurchase. However, much has changed in the last three years.

When I examined this subject a year ago, the dramatic reduction in US oil imports resulting from the combination of resurgent production and lower consumption had roughly doubled the effective capacity of the SPR, in terms of the number of days of lost imports it could cover in a crisis. Since then, US crude oil imports have fallen by another 5% or so, increasing SPR coverage correspondingly--at least for the parts of the country to which it can easily deliver.

Yet as I noted in another post earlier this year, US oil imports aren't just falling; they are shifting in location. The West Coast, where domestic production has been declining, not growing, now accounts for about 15% of US crude oil imports. It has essentially no dedicated petroleum reserve, other than commercial inventories that are roughly 50% lower than when I traded oil for Texaco's refining and marketing subsidiary in the early 1990s. If oil prices fell much further, it might even make sense for west coast refiners to stock up, regardless of what official action the US government took.

With US oil production still increasing, demand stable or falling, oil imports shrinking, and imports from Canada growing in both absolute and relative terms, it is high time to reconsider holding nearly 700 million barrels of oil--$55 billion worth even at today's depressed prices--in a part of the country where production could soon surpass its 1972 peak. This seems like exactly the kind of overdue reform opportunity that a new Congress might be interested in taking up next year.

US Strategic Gasoline Reserve: Solution or Band-Aid?

• The new Northeast Gasoline Reserve addresses some of the shortcomings of the current, 39-year-old federal emergency crude oil reserve, or SPR.
• Whether or not the DOE considered other options, the upcoming Quadrennial Energy Review provides an ideal opportunity to rethink our strategic energy stockpiles.

The recent announcement that the US Department of Energy (DOE) would establish a strategic gasoline stockpile to serve the Northeast was at least partly a response to calls for such a reserve in the aftermath of the fuel distribution problems caused by “Superstorm” Sandy in 2012. Secretary Moniz also framed it as part of a broader effort to beef up US energy infrastructure.

Although it is encouraging to see the DOE recognize the limitations of the current US Strategic Petroleum Reserve (SPR), I was disappointed that the new stockpile appears merely to copy the Clinton-era Northeast Heating Oil Reserve, in both quantity and approximate location, rather than reflecting a thorough rethinking of the entire concept of strategic fuel inventories, involving all stakeholders.

As I noted in a post here last summer, the crude oil SPR and its Gulf Coast facilities were envisioned and stocked for a different world of falling domestic oil production, rising oil imports–mainly through Gulf Coast ports–and US refineries that supplied only domestic customers. Yet while the SPR’s roughly 700 million barrels in storage should now last much longer in an emergency than they would have done in the previous decade, the reserve’s other shortcomings have grown as the US energy situation has evolved in the last several years.

For starters, it holds too much light sweet crude oil. Once in short supply, the US now has such abundant supplies of this grade, thanks to the shale production in North Dakota and Texas, that US refineries may eventually not be able to refine it all, without expensive upgrades or under-utilization of their costly conversion hardware.

The SPR's oil is also increasingly in the wrong place. While oil imports into the Gulf Coast have been falling rapidly, California now imports more than half its crude oil needs, with half of those imports sourced from the Middle East. The existing Gulf Coast SPR provides virtually no coverage in the event of a disruption in California’s supplies.

Finally, as became apparent in the wake of Sandy and of 2005′s hurricanes Katrina and Rita, a crude oil SPR provides little benefit if the refineries necessary to process its oil have been shut down by storms, electricity outages, or other causes. And more recently, the emergence of the US as a major net exporter of petroleum products raises questions about the extent to which SPR oil might be used to produce fuel for non-US customers.

The announced Northeast Gasoline Reserve represents a step towards addressing these shortcomings, positioning refined products near major markets. That avoids the possibility that refinery capacity might not be available when required, and it circumvents at least part of the distribution infrastructure–pipelines and ports–that might fail in a future Sandy-like emergency.

The title of the DOE’s press release also hints that the Northeast reserve might be just the first, with others to follow. Additional locations should be chosen with regard not just to today’s vulnerabilities, but those under a variety of future scenarios. However, while this decision moves in the right direction in several ways, it does not even address all the vulnerabilities highlighted by Sandy.

Sandy presented governments and consumers in the Northeast with both a shortfall of supply, from local refineries and long-distance product pipelines, and a massive failure of local infrastructure. Many distribution terminals had product in their tanks that they couldn’t deliver due to power outages, flooding or closed roads, while numerous gas stations were shut due to a lack of power to operate pumps and payment systems, product to sell, or both. Without addressing these local distribution issues, it is conceivable that the new gasoline reserve might contribute no more in a future emergency than the Northeast Heating Oil Reserve did after Sandy, supplying mainly first responders. While still useful, that would fall well short of the consumer benefits that the Senators from New York and Massachusetts seemed to be touting.

I also can’t help wondering whether the team at DOE that devised this measure considered alternatives such as those in use in Europe. The EU requires each member country to maintain 90 days’ inventory of oil and refined products and gives countries latitude in how to provide for that. In the UK, and as I recall at least several other EU countries, the responsibility for maintaining strategic stocks falls on the fuels industry. That approach offers significant benefits.

Aside from avoiding the need for governments to maintain idle inventory at taxpayer expense for many years, this option would also disperse fuel stocks across a much larger number of locations. That would reduce the risk that the strategic reserve facility itself might be incapacitated by the same event that triggered a call on its stocks, or might end up on the wrong side of temporary distribution bottlenecks.  It should also reduce the likelihood of an offsetting reduction in commercial fuel inventories, such as appears to have occurred in New England following the establishment of the Heating Oil Reserve in late 2000.

Putting the reserve in commercial hands would also help to ensure that the product maintained in strategic storage always meets current specifications, without the need for a complete turnover of the stockpile that occurred when the Northeast Heating Oil Reserve had to switch from ordinary to ultra low-sulfur diesel a few years ago.

These advantages, when combined with a rigorous auditing and oversight system, should compensate for the distrust that many consumers might feel for the industry as custodian of such a strategic reserve. I hope this option was at least given careful consideration before the administration decided to implement another federally owned fuel reserve.

The US Strategic Petroleum Reserve has been in place for four decades, and the Northeast Heating Oil Reserve for nearly 14 years. Much has changed since these stockpiles were justified and planned, to such an extent that it seems highly improbable that we would wish to implement them in the same way today, particularly in the case of the crude oil SPR. What should a state-of-the-art system of strategic energy storage consist of in 2014 and beyond? That’s the question I would expect the DOE to address with input from a range of stakeholders, including broad representation from the companies that produce and distribute these fuels under normal circumstances.

The press release announcing the gasoline reserve also mentioned the upcoming Quadrennial Energy Review, with its initial focus on infrastructure and participation by many parties outside government. While the composition and charter of that effort don’t appear to align with the needs of a major reform of the SPR system, it should at least be able to assess the fit-for-purpose of the current approach. It even invites public comment.

A different version of this posting was previously published on Energy Trends Insider.

Energy Security Four Decades After the Arab Oil Embargo

• The Arab Oil Embargo of 1973-74 focused our attention on energy security and set in motion drastic changes in the way we produce, trade and consume energy.
• With US energy output approaching or exceeding 1970s levels, some experts now advocate prioritizing competition from non-petroleum fuels over reducing oil imports.

Forty years ago this month the United States and other Western countries experienced a new phenomenon as an embargo on oil deliveries from a group of the world’s largest oil exporters took effect. The embargo was a response to the military support that the US and some of its allies were providing to Israel during the Yom Kippur War then underway in the Middle East. A recent session hosted by the US Energy Security Council commemorating these events included a fascinating conversation between Ted Koppel and Dr. James Schlesinger, US Secretary of Defense at the time of the embargo and later the first US Energy Secretary.

The other, related purpose of the meeting was a presentation and discussion on the proposition that fuel competition provides a surer means of achieving energy security than our pursuit of energy independence for the next four decades following the Arab Oil Embargo. This idea warrants serious consideration, since energy independence, at least in the sense of no net imports from outside North America, is finally beginning to appear achievable.

The 1973-74 embargo was the first oil shock of a tumultuous decade, and it triggered a true crisis. The US had relied on oil costing around $3 per barrel (bbl), not just to fuel our transportation system, but also for 17% of our electricity generation and numerous other uses. The US was then one of the world’s largest oil producers but required imports comprising about one-third of supply to balance our growing demand. With the sudden loss of over a million barrels per day of oil imports from the Middle East, and lacking the sort of strategic petroleum reserve that was established a few years later, an economy already battling inflation was tipped into recession.

The embargo rattled more than the US economy; it challenged basic assumptions of American life, including our sense of entitlement to cheap and plentiful gasoline. Before the oil crisis, gasoline prices hovered around the mid-30-cent mark, with occasional local “gas wars” taking the price down to the high-20s--the inflation-adjusted equivalent of $1.60 per gallon now. Of course with average fuel economy around 13 miles per gallon, the effective real cost per mile wasn’t necessarily lower than today’s.

Within a year gas was over 50¢ at the pump, and by the end of the decade it passed $1.00/gal. for the first time. The gas lines that resulted from the unexpected supply shortfall and the federal government’s efforts to limit the ensuing increase in prices were an affront to drivers, a category that encompassed most of the over-16 population.

That first oil crisis and the subsequent energy crisis resulting from the Iranian Revolution in 1979 set in motion a number of important changes, including a sharply increased focus on energy efficiency, a deliberate effort to diversify our sources of imported oil, a pronounced shift away from oil in power generation — to the point that it now makes up less than 1% of US power plant fuel — and the beginnings of our search for affordable, renewable alternatives to oil.

The US Energy Security Council is an impressive group that includes many former government officials and captains of industry. They’ve clearly spent a lot of time studying this issue, and their report is worth reading. As I understand their conclusions and recommendations, they regard high oil prices as a bigger risk to the US economy than oil imports, per se, because of the impact of oil prices on consumer spending and the balance of trade. They have concluded that the most effective way to apply downward pressure on prices is not simply to reduce US oil imports, but to introduce meaningful fuel competition into transportation markets, where oil remains dominant with a share of around 93%.

The group doesn’t dismiss the benefits of increasing US oil production from sources such as the Bakken, Eagle Ford and other shale formations, but because these are relatively high-cost supplies, they have concluded that their leverage on global oil prices is limited. That means that higher US oil output couldn’t provide a path back to the price levels that prevailed before the Iraq War, when West Texas Intermediate crude averaged $26/bbl in 2002 and gasoline retailed for $1.35/gal.

This is a reasonable argument, though it’s worth considering that a return to $75/bbl might be feasible, if US production kept rising. That could yield US retail gasoline prices around $2.75/gal., equating to $2.15 in 2002 dollars. This isn’t as far-fetched as it might seem, because the global oil price is determined not by the entire 90 million bbl/day of world supply and demand, but by the last few million bbl/day of incremental supply, demand, and inventory changes.

The Council’s view also appears to emphasize the direct impact of oil prices on consumer spending without recognizing that rising production and falling imports shield the economy as a whole from the worst effects of high oil prices. With oil’s contribution to the trade deficit shrinking steadily, the main impact of higher oil prices is to divert money from consumers to shareholders of oil companies — of which I should disclose I am one. While exacerbating income inequality, that should at least result in a smaller impact on GDP and employment than the combination of rising oil prices and rising imports.

If the discussion had stopped at that point, the meeting would have been just another interesting Washington gabfest. However, the group’s analysis includes a set of actions it has identified as necessary for achieving their desired outcome: US energy security extending beyond the current US oil boom, underpinned by an expanding unconventional gas revolution that is widely expected to last for decades.

Their recommendations include giving fuels like methanol derived mainly from natural gas the chance to compete with gasoline made from oil, and with biofuels.They would start with revisions to the current US Corporate Average Fuel Economy standards to give carmakers incentives — not cash subsidies or mandates — to make at least half of all new vehicles fully fuel-flexible, capable of tolerating a wide range of blends of methanol, ethanol and gasoline. That seems like a no-regrets approach that could be achieved at a very low incremental cost per car. Even if you never bought a gallon of E85, M85, or M15, it could pay for itself by protecting your car from the damage that might result if you inadvertently filled up with gasoline containing more than the 10% of ethanol that carmakers believe is safe for non-flex-fuel cars. Other recommendations include easing regulations for retrofitting existing cars for flex-fuel and forming an alcohol-fuels alliance with China and Brazil.

Yet while I repeatedly heard that the group wasn’t promoting any single fuel, talk of methanol dominated the conversation. The moderator, Ann Korin, even joked that the session sounded like an “alcohol party.” As I later pointed out to her, there wasn’t a single mention of drop-in fuels — gasoline and diesel lookalikes derived from natural gas or biomass. I regard that as a crucial omission, because such fuels would be fully compatible with the billion cars already on the road, rather than just the 60 million or so new cars produced each year. They could provide greater leverage on oil prices by producing pipeline-ready products with which consumers are already familiar, from sources other than crude oil.

Part of the appeal of methanol seemed to be the potential for producing it from shale gas at a cost well below the cost of gasoline, even on an energy-equivalent basis — an important caveat, because a gallon of methanol contains half the energy of a gallon of gasoline. I hear the same argument in support of various pathways for producing jet fuel from non-oil sources, and it subscribes to the same fallacy: that market prices are set by manufacturing costs rather than supply and demand.

Fuel is a volume game. For a non-oil gasoline substitute to drive down oil prices –and thus motor fuel prices– as far as the Council apparently envisions, it would take at least several million barrels per day, on an oil-equivalent basis. Producing six million bbl/day of methanol from natural gas would consume 20 billion cubic feet per day of it. That’s 30% of last year’s US dry natural gas production, requiring 100% of the Energy Information Administration’s forecasted growth of US natural gas production through 2034. A number of other entities have their eyes on that same gas for other applications.

As many of the speakers at the Energy Security Council event reminded us, the world is a very different place than it was in 1973. Among other changes, US energy trends are headed in the right direction, with oil demand flat or declining, production rising and imports falling. That alone makes us more energy secure than we were, either five years ago or in 1972. Future oil supply disruptions are also unlikely to look much like the Arab Oil Embargo.

The Council is certainly correct that our unexpected shale gas bonanza, producing large quantities of new energy at a price equivalent to oil at $25 or less per barrel, provides a unique opportunity to weaken OPEC’s influence on oil prices. In pursuing that goal, however, it’s essential to remain flexible concerning the best pathways for gas to compete in transportation fuel markets, whether as CNG or LNG, or through conversion to electricity, methanol, or petroleum-product lookalikes. Consumer acceptance could prove to be the biggest uncertainty governing the ultimate outcome.

A different version of this posting was previously published on Energy Trends Insider. 

How Falling Oil Imports Doubled the US Strategic Petroleum Reserve

• Falling oil imports have greatly expanded the capability of the US Strategic Petroleum Reserve to replace oil imports in a crisis, although prices would still rise.

• The SPR remains an imperfect backstop. Post-Syria, it is high time for Congress and the White House to address its gaps after four decades of change.

Last week's deal between the US and Russia defused the threat of an attack on Syria's military installations, along with the risks of unintended consequences for Mideast oil exports. However, we shouldn't lose sight of an important energy-related observation in the Wall St. Journal's “Heard on the Street” column as the crisis was peaking. It concerned the extraordinary degree to which reviving US oil production and weaker US energy demand have boosted the effectiveness of US oil inventories, including the US Strategic Petroleum Reserve (SPR).

Without adding a drop — the SPR actually shrank a bit in 2011 — the reserve’s potential to replace daily oil imports in a crisis has soared as those imports have declined. This could prove extremely helpful should the complex talks over securing Syria's chemical weapons break down, and the US and France proceed with missile or air strikes. Longer term, it serves as a further reminder that the existing SPR was designed for another era and is overdue for a major rethink.

Having 700 million barrels of oil available in federal facilities along the Gulf Coast has tempted presidents and other politicians, who saw opportunities to benefit from using it to attempt to crush periodic gasoline price spikes. However, the recent situation came much closer to the scenarios the SPR was intended to address when it was begun during the Ford administration, to provide a backstop for our vital energy supplies in emergencies involving the physical interruption of supply. When it comes to uses of the SPR, I’ve always been a purist, perhaps because I can recall sitting in gas lines and participating involuntarily in the bizarre “odd-even” rationing-by-license-plate scheme introduced during the oil crisis following the Iranian Revolution in 1979.

Here’s how the benefits of tapping the SPR in an actual crisis have improved, based on the rapid recent drop in US oil imports. In 2007, the SPR could have replaced just over half of our crude oil imports from countries other than Canada or Mexico for 165 days, at its maximum draw-down rate of 4.25 million barrels per day. With its current inventory and this year’s average crude oil imports through June running at around 7.6 million barrels per day, the SPR could substitute for 100% of our non-North American imports for 163 days. The value of such an insurance policy is rarely appreciated until it is needed.

Of course in practice the situation would be more complicated, mainly for reasons that support the case for rethinking the current 1970s-vintage reserve. One problem is that the oil stored in caverns near the Gulf of Mexico wouldn’t provide much immediate assistance for east coast refineries or for the West Coast, which has become increasingly dependent on imports as production in both Alaska and California declined steadily. Then there’s the issue of quality. Nearly 40% of the SPR oil is light and sweet (low in sulfur), while much of the oil we still import is heavy and sour (higher sulfur), to match the requirements of current refinery configurations. With production of light sweet crude in Texas and North Dakota booming, releasing sweet crude from the SPR could compound regional imbalances and possibly result in reduced refinery utilization. Any redesign of the SPR should take these important shifts into account.

Oil prices jumped just at the thought of a cruise missile attack on Syria, so it’s worth recalling what a back-up supply from the SPR can and can’t do. It can buffer the US economy from the impact of a serious interruption in the flow of crude oil cargoes from the Middle East or elsewhere, for some months. US refineries would continue to operate, as would the planes, trains, trucks and ships they fuel, and on which commerce depends. However, consumers wouldn’t be insulated from the price increases that would accompany any major disruption in Middle East oil exports, because the SPR oil must be auctioned to refiners at market prices. The resulting situation at gas stations might look a lot like price-gouging, with social media rapidly spreading outrage and conspiracy theories. The fallout from that could be disruptive, too, if somewhat less so than widespread fuel shortages and “out of gas” signs.

A different version of this posting was previously published on Energy Trends Insider.

Exports Raise the Bar for US Strategic Petroleum Releases

I've seen a number of Tweets suggesting that the US will release oil from its Strategic Petroleum Reserve (SPR) sometime in the next month or two, perhaps in tandem with other member countries of the International Energy Agency.  Although circumstances might provide several possible rationales for such a release, including the implementation of tougher sanctions on Iran's oil sector and the possibility that Hurricane Isaac will disrupt some production in the Gulf Coast, it's hard to avoid a political interpretation, as well.  As we head into a close Presidential election, gas prices are rising again, and that's never good for an incumbent.  Selling oil from the SPR is one of the few levers available that might affect short-term energy prices.  However, much has changed since the Clinton administration released 30 million barrels (via exchange) in the lead-up to the 2000 election.  In particular, the country's switch from net importer to net exporter of petroleum products implies that a release in response to events other than a physical disruption in oil supplies could result in some of the benefit of such a release being exported, as well.

When it comes to uses of the SPR, I'm a purist, probably because I can recall sitting in gas lines and participating involuntarily in the bizarre "odd-even" rationing-by-license-plate scheme introduced during the oil crisis following the Iranian Revolution.  The SPR was designed to provide a backstop for our vital energy supplies in a true physical emergency, not as a tool for price manipulation.  I've also suggested for some time that the SPR is overdue for a comprehensive reassessment of its structure.  Our energy situation has changed significantly since the mid-1970s, when the present SPR was established, and we are in the midst of the biggest changes in US energy supply and demand patterns in decades.  We ought to invest the time and money required to bring this institution into the 21st century.  Earlier this year, I also suggested an alternative mechanism for leveraging SPR inventories without depleting them. These are tasks for after the election, whoever wins.  For now, we have what we have, and we should think carefully about the implications of using it in situations less compelling than a war in the Persian Gulf or an unanticipated disruption in North American or global supplies.

One of the changes that must be taken into account is our recent shift in refined product exports, about which I've written previously.  US refineries are capitalizing on the expansion of domestic oil production in a period of weak US demand to continue to operate at high utilization rates and export the resulting surplus output to growing economies in Latin America and elsewhere.  This is generally a good thing, because it helps preserve capacity that might otherwise no longer be available when our own economy eventually resumes healthier growth. It also sustains employment we would sorely miss in a terrible job market.  Furthermore, we have benefited greatly in reliability and flexibility from participating on both sides of the global market in refined products. Still, although I view our petroleum product exports as generally positive--just as I do Boeing's exports of jetliners--I wouldn't advocate using petroleum stockpiles purchased with tax dollars to drive down oil prices to give these refiners an even bigger export advantage.  Yet because of its temporary nature, in contrast to new pipelines or new production, that's exactly where at least some of the benefit of SPR oil released in the absence of a serious supply crisis would go now. 

That doesn't mean I regard rising oil or gasoline prices as harmless to the economy. Consumers are facing the highest pump prices heading into Labor Day weekend since 2008, and that could have a ripple effect throughout the economy.  But even if one ignores the longstanding bi-partisan principle that the SPR is intended only as a crisis-management tool, its effectiveness at moderating oil-price volatility is limited.  Last year's coordinated SPR release, prompted by the Libyan revolution, had little persistent effect on either oil or gasoline prices. A release now is likely to be no more effective when US refineries are already running above 90% utilization and the current 4-week averages show 3.6% of US gasoline production and 23% of diesel output being exported. None of these statistics suggest refiners are experiencing difficulties in obtaining feedstocks, other than on price.  Putting SPR oil into such a market might boost refiners' margins for a while, but it's doubtful it would do much for the product prices that matter to consumers. 

There are sharp differences between President Obama and Governor Romney, not least on energy policy. We're sure to hear more about energy from both campaigns in the weeks ahead, and I plan to analyze their positions closer to election day.  However, one factor this election doesn't need is a release of oil from the SPR that appears to be aimed at dampening gasoline prices that often decline after Labor Day without intervention, rather than being justified by a tangible threat to US oil supplies, and that fails to take into account the added complexity of net product exports. That wouldn't serve the interests of voters, taxpayers or consumers, and it would come at the expense of a little bit of our collective energy security. 

Can the US Military Afford More Biofuels?

Last week the US House of Representatives passed the fiscal 2013 National Defense Authorization Act by a wide, bi-partisan margin. It included two controversial provisions relating to energy that will presumably be debated when the Senate Armed Services Committee takes up the bill this week.  Sections 313 and 314 would exempt the Department of Defense from a provision of the Energy Independence and Security Act of 2007 (EISA) barring the government from purchasing alternative fuels with higher emissions than conventional fossil fuels, while prohibiting the purchase of any alternative fuel that costs more than the conventional fuel it would replace, except for testing and certification purposes.  If enacted, the bill would require drastic revisions to the current alternative energy strategies of the US military branches. 

It would be easier to attribute these provisions to partisan maneuvering, if our economic and fiscal circumstances hadn't changed so dramatically subsequent to the passage of EISA in 2007.  Although I don't dismiss the influence of election-year politics in such matters, we are now in the third full year of a recovery so weak that many Americans still think we're in a recession, and we face deficits and a ticking debt bomb that forced a reluctant Congress to agree to deep spending cuts starting next January.  Nearly $500 billion of those cuts are targeted at military spending.  Moreover, our perspective on US energy security has been altered by the emergence of shale gas and so-called "tight oil", and by our recent shift from net importer to net exporter of petroleum products--though certainly not of crude oil.  While it remains desirable for the US military to diversify its energy sources, the value of that diversification has arguably fallen.  Meanwhile, the biofuels industry, despite tremendous growth and advances, has been unable thus far to compete with petroleum-based fuels without either large subsidies or strict mandates, even with a global price of oil that has remained consistently above $100 per barrel since January 2011. 

Last year I had a couple of opportunities to question Defense Department officials about their alternative energy strategies, as part of an Army/Air Force energy forum and a subsequent Air Force media briefing at the Pentagon.  Although I was impressed by the changing military culture concerning energy and the methodical way they were approaching the introduction of new fuels, I was concerned that at some point the services' procurement of higher-cost renewable fuels would conflict with their other priorities, including the need to replace equipment worn out in Iraq and Afghanistan and to field the next generation of aircraft and naval vessels.  What I thought I heard very clearly from the Air Force Deputy Assistant Secretary for energy was that his service was not going into the fuel-production business, and would only buy renewable fuels--other than for certification with their fleet--if they were competitive with conventional fuels. That approach seems very different than the one embodied in the Navy's "Great Green Fleet" initiative.

The rationale behind the military's adoption of alternative fuels rests on many complex issues, including the vulnerability of military supply chains and budgets to potential disruptions in oil supplies and price spikes, consistency with the government's imposition of renewable energy mandates on the private sector, and the desirability of reducing the environmental footprint of the military's global activities.  There's also the human dimension of personnel put at risk delivering fuel to front-line units, although it's not clear how biofuels would alleviate that risk unless they were produced in forward locations. In any case, however, all these concerns must be reconciled with a realistic response to budget constraints. That looks extremely challenging, and it shouldn't be divorced from deeper questions about the evolving drivers for biofuels or other alternative fuels for the US military.

Consider the question of supply disruptions, for example.  US oil production looks set to continue increasing and oil imports to keep falling, while we now enjoy a refining surplus that is supporting new product exports.  We also have a Strategic Petroleum Reserve that could replace up to half of our net crude oil imports for up to 5 months, or a smaller disruption for much longer.  As a result of these factors, it's become more difficult to envision a scenario in which an oil market event affected the military's access to fuels in a manner that the present renewable energy industry could alleviate.  And with the cost of most alternatives still above even today's elevated prices for oil and its products, the investment required to develop an alternative fuel industry capable of making a meaningful dent in the military's needs under such a scenario would be very substantial.  Should the military make that investment, should someone else, or should it be left to the market?  And that doesn't begin to address the issues related to the non-renewable alternative fuels that would be enabled by Section 313, including synthetic fuels derived from natural gas or coal, though these would still be subject to the restriction that they must be price-competitive with conventional fuels. 

I suspect that the House bill will not be the last word on this subject, though I also imagine that in the new world of "sequestered" budgets and the fiscal challenges that lie ahead, the US military may need to rethink what can be achieved in this area without sacrificing readiness and combat capabilities. It's also important to note that the 2013 Defense Authorization Act's provisions on alternative fuels shouldn't affect the services' efforts to integrate renewable electricity generation, which looks like a real boon for some forward-deployed applications.

Is There A Better Way to Use Strategic Petroleum Reserve Oil Now?

With US gas prices rising rapidly to record levels for this time of year, it was inevitable that some politicians would start calling for a portion of the oil in the Strategic Petroleum Reserve (SPR) to be released in hopes of moderating high oil prices, which are mainly responsible for the current gas price spike. A narrow majority of Americans apparently agrees. This is a profoundly bad idea, for reasons of both actual US energy security and the uneven effectiveness of past releases. However, rather than railing against this proposal, it occurred to me that there might just be a better way, an alternative that could send the signals that those concerned about commodity speculation wish to send, but without draining oil that we would miss in an actual supply crisis. What if instead of instructing the Secretary of Energy to sell a certain quantity of oil from the SPR, the President told him to sell an equivalent volume of call options on SPR oil, on the condition that they that could only be executed in an actual emergency?

The SPR was established in the 1970s, and as I've noted on several occasions it's overdue for a major redesign to reflect the ways in which both the world and US energy consumption patterns and infrastructure have changed in the interim. However, this is clearly not the appropriate time for such an undertaking, with the very real prospect of a major disruption in the Middle East that might require the largest-ever SPR release to address.

The past history of SPR releases is well-documented. The two releases most relevant to the current situation include last year's release of 30 million barrels in coordination with other member countries of the International Energy Agency, to compensate for reduced exports from Libya resulting from the revolution that overturned Col. Gaddafi's regime. Although one could argue about the appropriateness of that response in the absence of a meaningful disruption in oil deliveries to the US, its outcome is now clear. The market impact of the release was small and quickly dissipated in the noise of market volatility. That stands in marked contrast to the SPR release announced at the start of hostilities in the Gulf War in 1991. Following the announcement of a 34 million barrel SPR sale, only half of which was ultimately delivered, oil prices fell by 33% literally overnight. I will never forget that, because I was trading petroleum products in London for Texaco at the time and the sudden shift in prices was stressful, to say the least. The lesson I take from these and other examples is that SPR releases are much more effective in an actual emergency than when they are perceived as merely attempts to manipulate the market.

But let's give those calling for a release now the benefit of the doubt that $125 oil and the resulting near-$4 gas prices might be at least partly the result of speculation--all the while recognizing that for every speculative buyer there must be a seller taking the opposite view of prices. If the Department of Energy were to sell options on SPR oil, instead of the oil itself, it could accomplish several useful things in this scenario. First, it would send a stronger signal to the market than the will-he-or-won't-he cloud that customarily hangs over such releases, conveying that the US is serious about covering a shortfall that might result from the manifestation of the various risks that have driven up oil prices by about 13% since the beginning of the year, notably focused on tensions with Iran. It would also generate a bit of revenue for the Treasury, in the amount of the option premiums collected. More importantly, it could significantly shorten the normal delay between the decision to hold an SPR sale and its actual execution, by identifying, pre-qualifying and contracting with specific buyers ahead of actual need. Hastening the flow of SPR oil in a crisis by a week or two could be very helpful. And the best feature from my perspective is that the whole time the oil would stay right where it should remain until it's really needed, in the SPR caverns on the Gulf Coast.

A number of crucial details would have to be worked out, including the careful specification of the precise circumstances under which the options could be triggered, how long they would remain active before expiring, who would be eligible to purchase them, and for what purposes. In order to be of value to buyers, the triggering event(s) would have to be objectively observable and not under the seller's control. Perhaps a specified reduction in exports through the Strait of Hormuz, or the outbreak of hostilities between Iran and Israel or the US would be the most suitable choices, since it is presumably such risks that have taken oil prices to their current level.

I don't know whether selling SPR options would be permissible under current statutes. If not, it might be hard to get a change like this through a deadlocked Congress, even though the idea of selling options rather than physical oil ahead of an actual emergency straddles the concerns of both parties. I'm also sure there would be unintended consequences, as well as a lot of finger-pointing after the fact if some trader or refiner made a fortune on one of these transactions. Still, it seems worth exploring as an alternative that might be useful, not just when we're facing high prices and a potential crisis but under more routine circumstances.

US Renewables Need A Fallback Plan

When I described some of the energy implications of the debt limit crisis last month, the most serious ones were associated with a default by the US government in the event the debt ceiling wasn't extended. That risk has been resolved, for now. But that doesn't mean that everything looks rosy, especially for renewables. Renewable energy technologies and projects are far more dependent on government assistance and policies than conventional energy. The fate of a wide range of federal energy incentives looks highly uncertain, and the impact of that uncertainty is matched by doubts about the health of the US economy and its growth prospects. With the pace of growth already slowing in some renewable energy sectors, any manufacturers or project developers that aren't thinking seriously about how they would manage without federal incentives could be setting themselves up to become roadkill.

Understanding why requires taking a closer look at the debt ceiling bill that Congress passed in the context of the federal budget baseline--never mind that the US Congress has not enacted a budget in more than two years. In April the Congressional Budget Office (CBO) published its assessment of what the economy would look like under the budget submitted by President Obama in February, as well as under the laws already on the books. The latter comprises the "March CBO Baseline" that was mentioned frequently during the debt limit talks and that formed the basis for comparing different proposals. (See Table 1-5 of the CBO report.) Without factoring in this week's debt limit agreement, the CBO projected a cumulative deficit for fiscal years 2012-21 of $6.7 trillion. That figure is important for several reasons.

First, it serves as a reminder that even after the $917 billion of cuts agreed up front and the $1.2-1.5 trillion of future cuts to be determined later this year, the US debt would still grow by more than $4 trillion over the next decade, mainly through increases in mandatory, or non-discretionary spending--entitlements and other untouchables. That won't change even under the deal done by the Senate and House this week; all of its pre-programmed cuts are to discretionary spending, the category into which most federal spending on renewable energy would fall.

But even that $4 trillion figure looks optimistic. As I understand it the CBO baseline assumes that next January 1 all of the Bush-era tax cuts will expire on schedule, resulting in substantial increases in taxes on both ordinary income and dividend income. And that's not just for those earning more than $200,000 per year, or whatever the threshold of "wealthy" is determined to be; it's for everyone. Nor would the Alternative Minimum Tax, which has been biting a growing number of middle class families every year, be indexed as proposed. It also assumes that the Social Security payroll tax will revert to its normal level of 6.2%, up from this year's 4.2%. Barring a dramatic improvement in the economy between now and the end of the year, it seems unlikely that all of those tax increases will be allowed to take effect. That means that the government's revenue through 2021 is likely to be significantly lower than the CBO forecast, because both growth and tax rates are likely to be lower. That translates into bigger deficits and more pressure for deficit reduction.

So the environment for continued support for renewables will be one in which the government's projected deficits continue as far as the eye can see, even after painful cuts, while its ability to continue borrowing on that scale looks suspect. With the main focus of budget cuts falling on the category that includes cash support for renewables, how likely is it that the Congress would extend the Treasury renewable energy cash grant program when it expires on December 31, 2011, or add new appropriations for the Department of Energy's Loan Guarantee Program? And if the Congressional super-committee's proposals include tax reform that would eliminate many "tax expenditures"--tax credits and deductions--then a host of programs such as the solar investment tax credit, the wind, biomass and geothermal energy production tax credit, various biofuel tax credits, and the electric vehicle purchase tax credit, could end up on the cutting block. In the coming scramble to avoid the budget knife, renewables will be competing with better-established programs with broader and more influential constituencies.

It has always been a risky proposition to build companies and industries, the economics of which depended on substantial government subsidies. Some folks could be on the verge of finding out just how risky. If we go down that path, it will probably also result in awkward questions being asked about some of the decisions made by the stewards of these government programs. They should be; I've never understood what kind of due diligence could have resulted in hundreds of millions of dollars in grants or "loans" going to to clean energy and automotive startups with minimal track records, when private investors weren't willing to bet on those risks at that scale. From a national energy policy and strategy perspective, our focus should not be on saving individual companies--no TARP for renewables, I suspect--but on preserving key capabilities essential to ensuring a long-term competitive US position in the global clean energy market.

What would that entail? First, as government funding for renewables becomes constrained it should be focused on R&D at the expense of deployment. Not only would the available money go much farther, but it would also create more options for the future. The next step should be to ensure that whatever the government does spend on deployment should go to projects that are close to being viable without help, or in the case of the military that enhance combat capabilities. That means, for example, focusing solar development assistance on sunny places like the southwest--preferably in proximity to existing transmission infrastructure--and putting an end to paying people to install utility and rooftop solar in places that receive less than about 5 "peak sun hours" (kWh/m2) per day, on average. Again, the money would go farther, and we'd be shoring up nearly viable operations, instead of trying to command the tide not to overwhelm the marginal ones. And finally, as I suggested last week, a greater emphasis on exports to developing country markets, where energy demand is growing at impressive rates and where renewables are becoming increasingly popular, would increase export earnings and employment while participating in volume-related unit cost reductions. And looking beyond renewable energy, the US government has a bird's nest on the ground in the form of the potential lease bid and royalty income from the substantial oil and gas resources that have been placed off limits for various reasons. Tapping those looks like a much smarter source of revenue--not to mention job creation--than selling off the Strategic Petroleum Reserve bit by bit.

If that sounds like a recipe for putting the US cleantech industry on life support after years of robust government-supported growth, then that's consistent with the severity of the fallback plan that could become necessary. The need for this would depend on the priorities set by the special Congressional deficit reduction committee established by the debt ceiling bill, and by the Congress as a whole, along with the subsequent efforts that will be necessary to prevent our long-term debt from growing beyond our ability to service it. Nor would it be quite the starvation diet it might appear, as long as states kept their renewable portfolio standards in place. This isn't a scenario the cleantech industry would willingly choose, but it's one that it can't ignore.

SPR Release Catches Market Napping

I see that the administration has decided to release 30 million barrels of oil from the US Strategic Petroleum Reserve, in coordination with a matched release from the strategic stocks of other OECD member countries of the International Energy Agency (IEA.) The release will be spaced over the next month, though it's not clear how soon it can begin, since it should take at least a few days to line up the requisite buyers, sign contracts, and schedule pipeline space. Politicians who have been calling for such a release to punish speculation in oil futures and alleviate pressure on consumers are crowing, and the oil markets have responded by dropping $5-6 dollars per barrel. As welcome as this will be for consumers, it is simultaneously a drop in the bucket and an unwelcome precedent for the future stewardship of these emergency reserves.

As I noted when I assessed the outcome of the recent OPEC meeting, oil inventories aren't unusually low, and the current shortfall in global production compared to demand will take a while to develop into a problem. I suspect the main concern behind the IEA's decision to release stocks now, rather than waiting for a true physical shortfall to materialize, is the mismatch between the quality of the Libyan and Middle Eastern oil that has been taken off the market as a result of the ongoing turmoil of the "Arab Spring" and that of the OPEC spare capacity available to fill in for it, mainly in Saudi Arabia. In this context, the US SPR release looks more like an expression of solidarity with its EU partners, for whom the Libyan shortfall is much more significant, than a direct assault on the market.

Nevertheless, the concerns I expressed in my posting of June 2nd regarding a smaller "operational" release from the SPR apply to this release, as well. The SPR doesn't exist to game the market, especially not for political purposes. It's there in case of a serious interruption in supply, the scenarios for which are numerous and unfortunately not very hard to imagine for either us or the potential perpetrators.

Perhaps an extra 2 million barrels per day will alter the psychology of the futures markets and catalyze a larger price drop than we've seen today. By itself, that seems unlikely. Because it's a temporary measure, the market will want to know what comes next, and that's the real problem. Unless the designers of this program have made a lucky choice and timed their release to coincide with a further easing of prices due to weakening demand, the calls for another release will start in a month, if prices remain at a level deemed high enough to threaten the economic recovery. Selling off 4% of the SPR in the absence of a real emergency--and with no clear plan for replacing it--might not be a big problem, but additional releases that added up to a substantial portion of the reserve would be. Let's hope we don't have cause to regret this.

Hedging the Risks of Selling Oil from the Strategic Petroleum Reserve

I see that the administration has asked Congress to approve a non-emergency sale of oil from the US Strategic Petroleum Reserve (SPR), in order to allow a storage cavern to be repaired before it starts to leak. That's fine, as far as it goes, though the article I read suggested this would be done as a net sale into the market, rather than an exchange for future oil, as has been done for many previous SPR releases. The distinction means that the government will either be exposed to buying the oil back at higher prices later, or would simply forgo refilling that portion of the reserve. The current shape of the oil futures market provides another alternative, though without the presumed political benefits of being seen to sell SPR oil when gasoline prices are high.

The sale in question was included in the administration's annual budget request and identified 6 million barrels to be sold "for operational purposes." That amounts to less than 1% of the 727 million barrels of oil currently in the SPR, equating to a little more than one day of import disruption insurance at the SPR's maximum output of 4.4 million barrels per day. Of course at current oil prices it would be worth over a half-billion bucks, so I can understand the appeal of doing this when federal finances are tight. However, the purpose of the reserve was never to speculate on the price of oil and harvest those gains when we came up short elsewhere; the oil is there to mitigate a serious disruption in the roughly 9 million barrels per day of oil imports on which our economy depends. Unless the administration now wants to undertake a comprehensive review of our SPR strategy--something I've advocated for several years--it is more or less obligated to replace the oil once the cavern has been fixed.

In that case, selling the oil, rather than offering it to refiners on a time-trade, will expose the government to a substantial amount of price risk while repairs are completed. For example, if they had sold this oil last fall and needed to buy it back now, the Department of Energy would have incurred a loss of up to $180 million, based on the increase in oil prices in general and the divergence of physical markets, which tend to track UK Brent Crude, from the futures market in West Texas Intermediate. Prices might fall in the meantime, but it is not the role of the DOE to bet on that prospect. The futures market offers a uniquely better alternative today.

Most of the time, the oil futures price curve is bent either up or down, in "contango" or "backwardation" in trader's terms, with oil for delivery several months or more from now selling for considerably more or less than for prompt delivery. That's usually an indication of expectations that the balance between supply and demand will be either tighter or looser in the months ahead, compared to today. The contango that prevailed until recently has flattened dramatically, so that if it acted quickly, the DOE could sell the oil from the caverns to refiners and lock in its future repurchase price on the futures market at only a dollar or two per barrel more than the sales price. Of course this would involve having the government participate in the dreaded futures market, even though it wouldn't be for the purpose of manipulation or stabilization, but for simple hedging of the kind that producers and refiners do every day of the week. (Backwardation would offer an even better deal, and the Brent market is currently mildly backwardated, but I can only imagine the hullabaloo if the US government hedged SPR oil on a European exchange.)

We would argue all day about which approach is riskier: hedging the oil sold from the SPR with futures contracts or waiting to buy back at whatever price prevailed later. In the larger scheme of things, neither looks as risky as emptying the cavern and not refilling it at all. Based on my experience and at least in this special case, hedging seems like a good way to ensure that the SPR cavern repair doesn't end up costing a lot more than the DOE expects, if its managers ignored oil-price risk.

Press Conference Confusion

After listening to the energy portions of the presidential press conference last Friday, I found myself confused about the administration's approach to energy. Although I heard the President defending certain US energy policies, they weren't mainly those of his administration, nor were many of the outcomes he highlighted the result of actions he has taken. What's odd about that is that this administration has pursued as clear a set of energy policies, explicit and implicit, as any administration in recent memory; they just happen to be focused on a very different set of goals than attempting "to boost domestic production of oil and gas". And while I haven't agreed with all of them, his administration's actual policies concerning energy are certainly defensible in the context of putting the highest national priority on concerns about climate change. Before looking at this in more detail, I want to share a few thoughts on the aftermath of the quake and tsunami in Japan.

Having spent many years in earthquake country, I have deep sympathy for what the people of northeastern Japan are experiencing. The cleanup and recovery will take years, and the tectonic and emotional aftershocks will persist for a long time. The aftershocks for energy are more difficult to assess. It seems premature to draw conclusions about the impact on Japan's nuclear reactor fleet and the future of the global nuclear power industry. However, if the damage to several reactors is as bad as reports suggest, then the Japanese power grid must make up for the lost generation using either spare capacity at fossil fuel plants or with new technology. That could affect global fuel markets and the global demand for quickly-deployed generation, including both photovoltaic power and conventional small generators. At the same time, the extent of disruption the quake has caused to the global supply chains for such technologies is not yet clear. I'll be watching for discernible trends on these concerns in the weeks and months ahead.

Now back to the press conference. Two years into this administration, it has a track record on energy. The President campaigned on a platform of refocusing the government's energy efforts on renewables and energy efficiency, and he has followed through on that. The stimulus bill enacted in February 2009 included nearly $17 billion for those areas and not a penny for oil and gas. The administration's latest budget proposes slashing funding for R&D on fossil energy technology and ending tax incentives for domestic oil and gas production, using the savings to increase support for renewables and efficiency, consistent with his State of the Union remarks about investing in tomorrow's energy instead of "yesterday's". The President also supported comprehensive energy legislation, the explicit purpose of which was to make energy derived from fossil fuels--especially oil--more expensive. Although I have disagreed with many of these measures because I thought they took too little cognizance of the realities of the energy sector that supports our economy and the length of time a transition to cleaner energy entails, there was at least an admirable--and defensible--consistency to them. I would not have expected the President to tack away from defending these policies the first time oil and gasoline prices seriously spiked since his inauguration.

Then there's the matter of appearing to take credit for the recent recovery in US oil production by citing it twice in his remarks. The increase is real enough, though most experts, including the administration's own Department of Energy expect it to be short-lived, as the lagged effects of the post-Deepwater Horizon deepwater drilling moratorium work their way through the system. In fact, lags are the key to the whole question. If you have had experience with large projects, and particularly oil projects, then you realize that it typically takes a lot longer than two years for them to go through all the stages from inception to first production, including leasing, exploration, permitting, procurement and construction. The last time I looked at this in detail for oil the average time lag involved was around 7 years.

What was happening seven or eight years ago? Well, oil prices were in the early stages of the long climb that peaked in July 2008 at $144. It's no coincidence that a wave of new projects should have been coming onstream over the last couple of years, because the attractiveness of investing in them increased tremendously when prices broke out of their long-standing $20-30 per barrel price range. Yet it can be no more than a coincidence that the resulting increase in production should appear during an administration that has put in place policies restricting access to oil & gas development, delaying permits, and in some cases rescinding previously awarded leases.

The President's statement about undeveloped oil leases is a further reflection of how short his administration is on staff with industry experience. Companies don't lease these tracts with the intention of letting them sit idle. Instead, they continually prioritize their drilling prospects and pursue the best ones first, adding new leases to their inventory when they appear to have higher potential than those in their backlog. This process benefits taxpayers as well as the companies involved by helping to maximize the production on which royalties are paid and displacing more imports. And in the meantime, the Department of Interior continues to collect rental payments on any undeveloped leases, having already pocketed the bid bonuses on the basis of which they were awarded in the first place.

President Obama isn't the first politician to take credit for the results of actions taken in another administration. Considering the blame presidents often receive for events over which they likewise had little control or responsibility, it might even be understandable. Still, I can't help being surprised when the leader of an administration that has focused 90% of its energy efforts on resources and technologies that account for about 5% of our energy consumption and treated oil and gas as a legacy of a previous, less enlightened era suddenly embraces rising oil output. Whatever the reason, the change is welcome. And he has certainly learned the lesson of not being overly specific in explaining the circumstances under which the Strategic Petroleum Reserve would be tapped. All that's needed now is a shift of emphasis to recognize both the large potential of the renewable energy technologies in which we are investing and the enormous contribution of the domestic oil and gas that supply 37% of our energy needs and can do even more in the medium term, under the right policies.

Are Strategic Inventories Adequate to Handle Another Oil Crisis?

In a thought-provoking op-ed, Michael Levi of the Council on Foreign Relations has provided a very timely reminder of the role that the strategic petroleum reserves of the US and other nations would play if the turmoil in North Africa and the Middle East spawned another oil crisis. Neither additional drilling nor an accelerated effort on renewable energy would make any near-term difference if oil exports from the Middle East were disrupted. Both strategies are important for our future needs, but the only two tools we have for dealing with an immediate oil crisis are the Strategic Petroleum Reserve (SPR) and old-fashioned conservation. Unfortunately, we've wasted the last couple of years of relative oil-market stability that could have been spent bringing the SPR into the 21st century.

The US government currently has 726 million barrels of oil stored in underground caverns around the Gulf Coast, for use in emergencies. At that level, the SPR is essentially full. The stored oil notionally equates to around 80 days of supply at our current rate of net crude oil imports, though in practice it would provide 165 days of drawdown at the SPR's maximum pumping rate of 4.4 million barrels per day. That is in addition to commercial supplies of crude oil and gasoline and other petroleum products, which currently stand at the equivalent of 24 and 28 days, respectively. However, commercial stocks aren't much of a backstop, because the difference between current levels and those at which the system would start to run out in places amounts to less than a week of normal consumption.

We needn't worry about relying on the SPR if exports from Libya dry up. As I noted in Tuesday's posting, OPEC has more than enough spare capacity to make up such a shortfall, although it's of different quality and might result in some tightness in global diesel markets. But if the current unrest spread and threatened exports from the big producers on the Arabian peninsula, the only thing standing between consumers and much higher oil and product prices would be the SPR and its counterparts in other consuming countries. With combined inventories of at least 1.6 billion barrels, these reserves are in good shape to respond to a drop in exports of a few million barrels per day for several months, though not necessarily a sustained curtailment or a much larger one. And any use of these reserves should be coordinated among consuming nations, as Mr. Levi pointed out in his op-ed.

This all sounds good in principle, and I have no doubt that even the announcement of the intent of the US and others to draw promptly on these stocks if the situation deteriorates further would do a lot to calm markets. At the same time, it's important to understand how much the world has changed since the SPR was first planned and implemented, as a result of the first oil crisis in 1973-74. As I commented three years ago:

"In addition to importing much larger volumes of crude oil, our refinery capacity hasn't kept pace with demand, resulting in steadily growing imports of gasoline and gasoline blending components. And in the interim, oil production in Alaska and California has fallen into deep decline, requiring crude and product imports into a maxed-out West Coast refining system.

So instead of a strategic reserve designed to provide a back-up supply of crude oil to Gulf Coast and Mid-continent refineries serving the entire US east of the Rockies, our needs have expanded to encompass oil and refined product imports on all three coasts. These altered circumstances suggest the need for a more diverse and dispersed SPR, perhaps modeled along the lines of the federal Northeast Heating Oil Reserve. Nor do I believe that the only practical model of such a reserve entails government ownership and custody of the hydrocarbons in question. Other countries achieve the same end with a requirement for oil companies to maintain mandatory minimum inventory levels at no direct cost to taxpayers."

That's as relevant today as when I wrote it, with the addition that the SPR's potential effectiveness has been further affected by the buildup of crude in the Mid-continent as a result of increased output from Canadian oil sands projects and the rapidly growing output of the Bakken Shale. This is one of the main reasons why West Texas Intermediate is trading at roughly $100 this morning, while UK Brent crude, which is normally within $2 of WTI, has spiked over $118. I also can't resist pointing out that the market is hitting us in the face with a two-by-four concerning the potential energy security value of US natural gas, which is still trading at an oil-equivalent price under $27 per barrel for all of 2011, despite the events in the Middle East.

I don't blame the last two administrations or Congress for not having made SPR reform a higher priority in the last three years. They had a few other things on their plate. However, even if the current crisis in Libya and the Middle East resolves itself quickly and without further impact on world oil supplies, it provides another unwelcome reminder that we live in a world in which the President and other world leaders might need to call on our strategic oil inventories on very short notice to prevent a catastrophic breakdown of the economy. In that context, redesigning our 1970s-vintage SPR to be more effective in a greatly altered landscape ought to rise to a similar priority as addressing other urgent concerns such as the deficit.

Leveraging the SPR

Election-year politics and prudent energy policy do not mix well. The combination is even worse when the election cycle coincides with a genuine energy crisis, and both parties seek to curry favor through short-sighted proposals aimed at producing votes, rather than BTUs or kilowatt-hours. We saw this earlier in the year with suggestions by Senator Clinton and Senator McCain to suspend the federal tax on motor fuels for the summer, and we are seeing it again in calls by the Speaker of the House and others to release oil from the Strategic Petroleum Reserve to drive down fuel prices.

It's remarkable how quickly the debate over the Strategic Petroleum Reserve (SPR) has shifted from halting additions to it, to draining it. The former was eminently sensible, in light of the cost of the program and the possibility that diverting small quantities of light, sweet crude into storage was having a disproportionate impact on the price of all oil. The balance of risks strongly favored suspending additions to the SPR; quite the contrary is true for using SPR oil to create a brief, convenient slump in the oil market, while diverting attention from the more serious discussion of increasing supply and reducing demand--both sides of which would be harmed by a non-emergency release from the SPR.

Make no mistake: the current SPR is a relic of the energy crisis of the 1970s that merits serious re-thinking about its fundamental purpose and the best way to achieve it in a very different economic and geopolitical environment. It is also possible to conceive of ways in which oil in the SPR could be used to speed up the contribution of production from new oil fields, once they are identified and under development, via SPR vs. reservoir exchanges. However, such considerations are quite different from simply dumping SPR oil into the market--volumes that under the policy passed by this Congress could not be replaced as long as oil remains expensive--for no purpose other than to provide some relief at the gas pump, where prices are already likely to fall by another 25-35 cents per gallon, based on the past week's drop in the crude oil and gasoline futures markets.

The problems with releasing SPR oil now are straightforward. Inventory is not production. The proposed draw-down is not sustainable, while the production that new drilling could add would contribute to our energy supplies for a generation. Moreover, oil prices are a classic stock-and-flow system, reflecting the current balance between actual supply and actual demand, and the difference between actual inventory and desired inventory. Although the flow of SPR oil into the market would create a temporary glut and drive down the price of oil for prompt delivery, the subsequent lower inventory levels--even for an emergency back-up such as the SPR--could result in even higher prices after the release program ended than before it began. At the same time, this signal--not just from lower current prices but also from the demonstrated willingness of the government to use the SPR to manipulate the market--would deter new energy projects, including those for alternative fuels that are more attractive when oil prices are high, while impeding our transition to more efficient vehicles.

The world has changed in many ways since the SPR was first opened, and some of those changes make it even more essential for the US to have quick access to large volumes of oil in extremis. Among other things, our net oil imports have doubled since President Ford signed the SPR into law in 1975. Although oil prices remain high, supply still meets demand. Yet it is far too easy to envision plausible scenarios in which that would not be the case, involving terrorism, expanded conflict in the Middle East, or the effects of Peak Oil. In any of those cases, we might find that the SPR's current 160 days of supply at its 4.4 million barrel per day maximum delivery rate are not nearly as ample as they seem.

Aside from expediency, the theory behind releasing SPR oil now is based on a flawed narrative involving a bubble in oil prices. If the evidence were clear that supply and demand would balance at a much lower oil price, and that speculators were responsible for a large fraction of the current oil price, then I could support using a brief release from the SPR to crush speculation. The reality appears much different. Oil prices have fallen since this debate started, largely because of the extraordinary reduction in demand that high prices and a weak economy have triggered--and not because the market sees a realistic prospect of a SPR release this year. Oil is trading today below $125 per barrel for delivery in September 2008, as well as for delivery in December of 2010, 2011 and 2012. That could change tomorrow, due to some event, but it suggests that the impact of speculation is more like the foam in a glass of beer than a steadily-inflating bubble. The interests of the nation would be better served by a Congressional commission on re-engineering the SPR for the 21st century, than by Congressional legislation to fritter away this $88 billion asset in the pursuit of short-term goals.