Friday, May 09, 2008

The SPR Debate

The ongoing oil price spike is attracting renewed attention to the government's policy of continuing to fill the Strategic Petroleum Reserve with extremely pricey oil, which I mentioned in Wednesday's posting. Members of Congress and various commentators are calling for a reassessment, as I've done since last October. We're also seeing suggestions such as the one in today's Wall Street Journal for ways to use the SPR not just as a hedge against catastrophic supply disruptions, but as a tool for managing oil prices. A new administration will take office in eight months, and energy is likely to be a key focus of its new policies. I can't imagine a better way to kick off a fresh look at the nation's energy problems than with a complete rethinking of the basis and design of our strategic oil inventories.

The op-ed in today's Journal applies a combination of common sense and questionable judgment to the problem. The author, the chief economist at a firm that supports independent financial planners, is right to point out that $120 oil is too dear to squirrel away against the low likelihood of a massive disruption in oil supplies, the likes of which we haven't seen since the SPR was created in the 1970s. Unfortunately, the rest of his proposal for reducing the scale of the SPR and using it to set a price ceiling for oil relies too much on economic theory and too little on the geopolitical and logistical realities of the situation in which we find ourselves. More importantly, it does not start with a fundamental reexamination of the challenges the SPR was intended to address, and how those have altered in the last three decades.

Consider that when the first barrel of oil went into the SPR's Gulf Coast storage caverns in 1977, the US was relatively self-sufficient in petroleum refining capacity. Crude oil imports accounted for only 45% of the supply to those refineries, compared to 66% last year. At the time, the West Coast was essentially autonomous in crude oil and refined products, with its refineries amply supplied by California's production, which would shortly peak at over one million barrels per day, along with the growing output from Alaska. Much has changed. 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 substantial 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. And with more of our domestic production shifting to the deep waters of the Outer Continental Shelf, the risks against which an SPR must insure us also include potential domestic supply disruptions. We saw that after hurricanes Katrina and Rita shut down much of our Gulf Coast production, and again when pipeline problems in 2006 idled half of the Alaskan North Slope field. These altered circumstances strongly 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.

Unfortunately, the risks we face have also evolved in the last thirty years, and that must be factored into our understanding of the necessity and nature of an effective SPR. No one expects his house to burn down in a given year, but most of us still buy fire insurance, because the consequences of that low-probability event would be so disastrous. An SPR works the same way. While Mr. Anderson looks to the pattern of past SPR releases to suggest that as little as 120 million barrels of oil might be adequate to cover any likely contingency, it is all too easy to imagine low-probability/high-impact scenarios that would require the SPR to cover a sudden shortfall exceeding two million barrels per day for longer than a month or two, at a time when global spare production capacity has shrunk to virtually nothing, or sits on the wrong side of a bottleneck. Full-scale civil war in Iraq, conflict with Iran, revolution in Venezuela or Nigeria, or a terrorist attack on the oil export facilities at Ras Tanura would do the trick.

It is high time to re-think the Strategic Petroleum Reserve, more than three decades after it was conceived. Global patterns of oil supply and demand have changed enormously, and so have the patterns of oil use within the US. The nature of the risks that an SPR should insure against have changed, too. We need a vigorous debate on all this, infused with new ideas and new options made possible by technology that didn't even exist in the 1970s. But we also need to be clear about the scope of such a debate, which should not include managing day-to-day oil prices, adding layers of complexity to the problem and a host of unintended consequences into the global energy market. So by all means, let's stop filling it, until we figure out the kind of SPR we really need. In the meantime, we must resist the temptation to expend these reserves on rash schemes to control the price of a commodity of which we only produce 10% of the world's supply.

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