Tuesday, September 11, 2007

Practical Energy Security

Since 9/11/01 many of us have accepted the notion that energy security matters, and that it is risky for the US to rely on unstable countries and regions for large portions of our energy supplies. However, most of our preferred responses to that situation seem to be long-term in nature. Nor have we asked the large domestic oil & gas industry for help in shoring up our energy security in the meantime; if anything, we appear more interested in penalizing it for the profits created by high energy prices. But while stricter vehicle fuel economy standards and renewable fuel and electricity standards will take years to affect our dependence on OPEC, there's something that the oil industry could do quickly that would improve our energy security in the meantime, and it has to do with inventories.

US policies on strategic petroleum inventories--epitomized by the Strategic Petroleum Reserve--were set decades ago when the country had ample refining capacity and was not a consistent net importer of petroleum products. Storing up emergency supplies of crude oil seemed sufficient to our anticipated needs. Now, US refineries run close to capacity, and we import on average 1.5 million barrels per day of gasoline, diesel and jet fuel--imports we may not be able to rely on in a crisis. That makes product inventories the critical cushion between a disruption and widespread runouts, as we saw after Hurricane Katrina. But even after adding in the uncounted ethanol inventories I mentioned last week (9/5), US gasoline inventories from 2002 to the present have consistently averaged lower than they did in 2001, in terms of the number of days of supply they represent. That hardly seems prudent for a nation facing the possibility of another major terrorist attack, particularly if it involved our energy infrastructure.

Why have commercial gasoline inventories failed to keep up with growing demand? It has everything to do with the way inventories are treated for accounting and tax purposes. As long as companies see petroleum product inventories tying up capital, attracting taxes, and dragging down their return on capital employed statistics, they have no incentive to increase them beyond the bare minimum necessary for normal operations, let alone building a permanent buffer against a future supply shock or terrorist attack; quite the contrary.

So how could we remedy the situation? I see three possible solutions:
  1. We could create a federal strategic gasoline reserve, along the lines of the crude oil SPR.

  2. We could do what many European countries and other members of the International Energy Agency's emergency stocks program do: impose minimum compulsory stocks levels on the industry, set at a level to ensure some arbitrary number of days' supply on hand, typically between 60 and 90 days.

  3. We could eliminate the disincentives for companies to hold extra inventory. That would require the government to create special rules for inventory accounting and taxes, to render them neutral to the bottom line.

Of these options, the third makes the most sense to me. For all their perceived utility in a crisis, government-held strategic reserves create significant disincentives for holding commercial inventories, as I've discussed previously for the existing SPR. And the logistics of a federal gasoline SPR in a market made up of dozens of gasoline grades and environmentally-mandated formulations look extremely daunting. The second and third options share the virtue of maintaining dispersed inventories close to the point of demand, where it would be most useful in extremis. But requiring large compulsory stocks merely shifts a national strategic burden onto the backs of private companies, from which it would ultimately be passed to consumers. The third option would address the need for higher inventories at the least cost to consumers and taxpayers.

But let's be clear: the industry isn't asking for help on this, and as best I can tell they aren't remotely interested in pursuing it, at a time when there has been so much outcry over the industry-friendly provisions of the Energy Policy Act of 2005. The current Congress isn't motivated to do anything that might be interpreted as corporate welfare for a highly profitable industry. However, if we're serious about our desire to make the US more secure, including in energy terms, it's time to set aside our prejudices against this industry and begin to harness its capabilities, at least in this small way. The alternative is muddling along with the bare minimum of gasoline inventories, until some event exposes the folly of such a policy in the post-9/11 world, or until a recession punctures demand.

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