Shhh, don’t tell Evan, I am going to post on the SPR

You only have to click here to see that I am not the resident SPR expert. But Evan is away on vacation this weekend, and I couldn’t let this go by:

Since current SPR additions are only 0.07 MBD (70,000 bbl/day), how much effect could foregoing them have on oil prices? Measured against 85 MBD, virtually none, but that’s not the relevant comparison. What really counts is the Mid-continent light sweet crude system.

…

With its three current royalty-in-kind swaps consisting of 58% sweet crude grades, according to a DOE spokesman I contacted this morning, the government has a 40,000 bbl/day lever with which to nudge the balance point of the physical WTI market by reselling the oil that would otherwise go into the SPR. Because that still only amounts to a few percent of actual WTI deliveries, I wouldn’t expect the market to drop by $10/bbl. But when you add the psychological impact of the government shifting its stance from buyer to seller–a net swing of 80,000 bbl/day–I wouldn’t be surprised to see a change in the speculative logic driving oil ever higher. That ought to be good for at least a few bucks per barrel, and a bit less exuberance going forward.

The basic argument as I read it is that the entire oil market is mostly resting on the back of the market for light sweet crude, and there is probably excessive speculation in the light sweet crude market. Pulling government support for even a tiny fraction of the market could scare off enough speculators to get prices to fall across the global oil market by more than you would initially suspect.

Also, Evan should get some credit. He has apparently leveraged his enormous influence through this blog to convince one of the presidential candidates to argue that we should suspend SPR purchases.

Support for SPR site dries up over river concerns

I’m posting, which these days means a story about the SPR must have come out. From Reuters:

The Department of Energy is boosting the reserve to 1 billion barrels, as Congress mandated, by adding Richton and expanding two existing sites. Richton was chosen because it is less vulnerable to hurricanes but close to a major pipeline system and the Gulf of Mexico for easy oil deliveries.

But many locals are horrified the government may drain 50 million gallons of water a day from the Pascagoula River for five years to dissolve the salt in the caverns. The resulting brine is to be carried away in a pipeline — which the Energy Department admits will probably leak many times — and dumped into the Gulf of Mexico not far from the state’s coastline.

Yep, we do actually need somewhere to put all that controversial SPR oil. Is it really surprising that leaching salt out of a cavern large enough to hold 160 million barrels of crude oil might have an adverse environmental impact? Not really, as was pointed out in the Canadian context about two months ago:

The report proposes a series of salt caverns in Lambdon County, Ontario, to cover that province’s allocation, but immediately notes that their excavation could be an environmental concern.

It’s also a bit disconcerting that the DOE is so freely admitting that the brine will likely “leak many times” (four dozen leaks in 5 years is the estimate) on its way to the Gulf. One wonders if this is the full extent of the potential damage, given that they’re so willing to concede the point. The brine issue is exacerbated by its extreme salinity (10 times that of the Gulf) and the nature of surrounding wetlands:

With some remote wetlands, leaks won’t likely be found for days and then the damage will be done. “Somebody is going to be out fishing and they’ll start seeing dead fish,” said Shepard.

With the net benefits of an expanded SPR so uncertain, decisions like this only add to the cost side of the balance.
H/T: Oil Drum

Independent truckin’: are their chips cashed in?

For all the talk I’ve heard about shipping costs going up with the price of fuel, I hadn’t really thought about the actual logistics of such a passthrough. In the trucking industry, it seems that owner-operators are paid by the mile, then expected to cover fuel and other costs. As diesel prices have shot up, independent drivers’ compensation has apparently not increased in kind, prompting a “loosely organized” informal slowdown/protest on major highways. Indeed, they have been footing the bill for the rest of us when it comes to rising fuel costs. From the Houston Chronicle:

“We can no longer haul their stuff for what they’re paying,” said David Santiago, 35, a trucker for the past 17 years. Santiago, like many of the more than 50 truckers gathered on a side street near the Port of Tampa, said he can’t support his family on what he makes. “If it wasn’t for my wife, we would have been bankrupt already,” he said.

Okay, understandable. So what can be done about it? Either companies are going to have to increase the price they pay independent operators, or fuel prices are going to have to decline somehow. Unfortunately, neither seems feasible at the moment:

Some other truckers, however, didn’t join the protests, saying they doubted a strike or mass demonstration would be effective because trucking companies are not on board and there is no central coordination.

“The oil company is the boss. What are we going to be able to do about it?” said Charles Rotenbarger, 49, a trucker from Columbus, Ohio, who was at a truck stop at Baldwin, Fla., about 20 miles west of Jacksonville. “The whole world economy is going to be controlled by the oil companies. There’s nothing we can do about it.”

Here we have a combination of collective action problems and lack of market power preventing the efficient passthrough of fuel costs to the consumer. The independent truckers apparently don’t have the coordination or sway to demand higher compensation as their costs go up. Marginal cost of supply went up, but market price isn’t rising in tandem as the oligopsonists hold it down.

So it looks like the only way to deal is to stabilize and even depress oil prices — that’ll stick it to the “boss”.

Some truckers, on CB radios and trucking Web sites, had called for a strike Tuesday to protest the high cost of diesel fuel, saying the action might pressure President Bush to stabilize prices by using the nation’s oil reserves.

It seems that America thinks the SPR can lower fuel prices, slice through marble, and strengthen your core in only 5 minutes a day for the low price of $99.99/barrel. No offense to Tony Little, Ron Popeil, and Byron Dorgan, but it probably can’t. Sadly, it’s a different world than it used to be, and the SPR just isn’t that big.

John Whitehead on the SPR

Responding to a claim by Congressional Democrats that (edit, left for posterity), John Whitehead over at EnvEcon thinks about the impact of the SPR fill and does a quick-and-dirty estimate of the drop in gas prices that would accompany a suspension of current policy. Key result:

Given the short run elasticity of .10, U.S. gas/oil consumption would need to fall by almost half to nudge gas prices down by $0.16/gallon.

In extremely vain fashion, here is a link to a very qualitative SPR post I wrote recently. John’s numbers back up my half-assed informal analysis and provide better context for scrutinizing simplistic anti-SPR arguments. As the GAO and I have pointed out, there are different reasons for re-examining current SPR fill policy that might hold more water (and less sweet crude).

GAO blasts DOE on SPR*

As the fill of the SPR is debated by Congress and the DOE, the GAO threw its hat in the ring. The Office’s report is critical of the cost-effectiveness of fill protocol. It makes three very reasonable suggestions:

1. Include some heavy crude in the SPR.

This is a complete no-brainer as far as I’m concerned. According to the report, around half of disruption-vulnerable U.S. refineries are incompatible with the light and medium crude currently held in the SPR. Running the wrong type of crude would result in about a 5% reduction in U.S. refining throughput, a significant loss during a supply disruption. Five percent is pretty bad, and certainly blunts the impact of any SPR release, but that’s for total refinery throughput. One refiner cited in the study claims that using exclusively SPR oil in its heavy crude unit would result in 11 percent less gasoline and 35 percent less diesel. To be fair, refineries are probably not going to be relying entirely on SPR crude, but you get the point.

There’s also the little matter that heavy crude costs about 10% less than light. So current policy has us buying more expensive crude oil that is only efficiently compatible with about 55% of likely affected U.S. refineries. Gold star for the GAO.

2. Use dollar-cost averaging to determine a purchase path instead of a constant quantity path.

The government has basically set a quantity and, as Sen. Dorgan is learning, is largely intractable regardless of market conditions. This means that even as prices soar above that magical $100 mark, the DOE is stubbornly purchasing the same monthly quantity as before. By using dollar-cost averaging, DOE basically gives itself a monthly SPR allowance. Thus, like a normal consumer, the DOE buys more oil when it’s cheap, and less when it’s expensive. This sounds good, but markets are tricky, and the oil market is quite volatile. So I quote the GAO:

We also ran simulations to estimate potential future cost savings from using a dollar-cost-averaging approach over 5 years and found that DOE could save money regardless of the price of oil as long as there is price volatility, and that the savings would be generally greater if oil prices were more volatile.

100 points to the GAO.

3. Purchase oil on the market instead of through royalty-in-kind arrangements.

First, this adds an unnecessary level of red tape to the SPR fill process. Since not all oil from RIK arrangements goes to the SPR, there is clearly already bureaucracy in place to sell RIK crude. But maybe selling off RIK crude and using the revenues to purchase the same amount of oil on the world market sounds inefficient and circuitous.

Well, unfortunately, the way the bid evaluation process works is not equivalent for market purchases versus RIK exchanges. Straight market purchases are considered conditional on general market trends, as well as the prices of SPR-suitable crude grades relative to other grades. In contrast, the RIK oil is exchanged for other oil for the SPR. The evaluation process focuses on whether DOE will receive oil of at least the same value as the RIK oil it is giving up. Thus, it ignores market trends and is vulnerable to exchanging at questionable times. The GAO report gives an example in which simultaneous bidding processes resulted in opposite outcomes: the cash process rejected Light Louisiana Sweet (LLS) at $67/bbl, whereas the exchange process bought LLS at a similar price. As you might have just concluded yourself, the cash process is also considerably more transparent. A for the GAO.

This report is quite readable, and well worth a look. But at first glance, it certainly seems that if the SPR fill process is to go on, the DOE and Interior would do well to implement the GAO’s suggestions. They would save money, improve the SPR’s effectiveness in the event of a disruption, and increase transparency.

Note: for great analysis of the fill/no fill debate, check out this post at Energy Outlook. Also read the post’s comments for some discussion of dollar-cost averaging by people who actually seem to know something about investment.

* I kind of wanted to see if I could write a title in which over 50% of the letters are in acronyms. Yes I could.

Should the US fill its SPR?

On the heels of yesterday’s post on a potential Canadian SPR, Sens. Dorgan and Wyden will introduce a bill to suspend fill of the SPR for one year or until oil prices fall to $50 or less (right…). According to Reuters:

Senate Democrats say the department’s plans are keeping U.S. crude oil and gasoline prices high, and on Wednesday will introduce legislation to delay plans to fill the SPR until prices fall.

The claim that the fill is keeping prices high is a bold one, as the fill plans to add 125,000 barrels/day, or 0.6% of the roughly 21 million barrels the US consumes daily. If we look at it as a share of total global consumption, it amounts to a less-than-whopping 0.15%.

Jeff Bingaman gave a different reason, but then fell back on the old faithful high price argument:

[Bingaman] told Energy Secretary Sam Bodman on Wednesday that it did not make sense to buy expensive oil for the emergency stockpile. “It seems odd to be spending a half-billion taxpayer dollars on activity that will help keep oil prices high,” Bingaman said at a hearing on the Energy Department budget.

The first half of the statement makes some sense. It is indeed more expensive to fill the SPR than it would have been in the recent past. However, making claims about the process significantly exacerbating the situation is either ignorant or disingenuous. I don’t honestly think we probably need to be increasing the size of the SPR to 1 billion barrels for some of the reasons I cited in the Canada post (e.g., crowd-out of private inventories), but it’s always alarming when politicians hijack economics to support whatever bill they’re pushing.

Should Canada build an SPR?

A joint report released this week by two think tanks called for Canada to establish its own SPR. As a net exporter of oil, Canada is not obligated to hold a particular level of stocks under the IEA emergency reserve program. However, the report argues that:

The IEA exemption for Canada is not warranted. NAFTA’s energy “proportionality clause” undercuts the logic behind the IEA’s exemption. Proportionality requires Canada, and Canada alone, to maintain its current share of energy exports to the United States, even if Canadians experience shortages. Mexico refused to sign this clause. Thus, until Canada demands, and gets, a “Mexican exemption” from the proportionality clause, not much oil from Western Canada and offshore Newfoundland can be redirected to meet Eastern Canadians’ needs.

This is an interesting argument, as Canada is exempt from requirements, despite the fact that most of its pipelines run North-South, thus leaving Eastern Canada vulnerable in the face of a short-term supply disruption. However, it jumps from proclaiming energy insecurity to touting the need for government stocks with few intermediate steps.

Many nations have set up reserves maintained by the private sector or via a quasi-governmental agency/corporation. This is generally done by requiring that all importers and/or refiners be required to hold a certain proportion of annual purchases or production in emergency stocks. These stocks are bound by law for release in the case of a declared supply emergency. This method is perhaps more efficient than a monolithic SPR (though there perhaps are economies of scale in storage), as it cuts out one more step in the process and also means that each refiner or importer can hold stocks of various refined products somewhat proportionally to production or purchase.

The cost-benefit balance of an SPR must account for the structure of the oil market. Oil is largely a fungible commodity, and stockdraw by any nation will have the desired effect on the world price for oil. Hence, coordinated draw under IEA and EU regulations will probably reduce the necessary size of a Canadian SPR. In addition, public stockholding might crowd private stockholding out of the market to some extent. If the private sector knows that the government will quell major supply disruptions, it has less incentive to hold inventories. Thus, putting a barrel of oil in a government SPR would probably increase total oil inventories by less than a full barrel. Finally, the effectiveness of emergency stocks is contingent on a government’s willingness and ability to release the oil at the right time. The mere presence of stocks probably stabilizes prices to some extent, but a drawdown has to happen quickly and convincingly in the event of a disruption.

Finally, an SPR must have proper infrastructure. One reason the U.S. SPR is somewhat feasible is because it is stored in underground salt caverns along the Gulf Coast in Texas and Louisiana (as well as proposed sites in Mississippi), near much of American refining capacity:

The report proposes a series of salt caverns in Lambdon County, Ontario, to cover that province’s allocation, but immediately notes that their excavation could be an environmental concern. In addition, any release from these caverns would probably not be able to travel far because of insufficient pipeline capacity and the costliness of shipping by rail. Also, due to political concerns, any SPR allocation for Quebec would likey have to be located within the province.

This is not to say that I think required Canadian emergency stocks are necessarily a bad idea. I just hope that if it comes to the planning stage, the government will take into account the factors I noted above. It’s easy to just fall into the meme of “energy security” without really thinking about how oil markets work. I appreciate that the purpose of this report is probably just to kickstart debate; however, a more thorough BCA should be undertaken before making any bold claims about a “need” for an SPR.