Strategic Petroleum Reserve: Options to Improve the Cost-Effectiveness of Filling the Reserve
Published: 2008-02-26T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The Strategic Petroleum Reserve (SPR) was created in 1975 to help insulate the U.S. economy from oil supply disruptions and currently holds about 700 million barrels of crude oil. The Energy Policy Act of 2005 directed the Department of Energy (DOE) to increase the SPR storage capacity from 727 million barrels to 1 billion barrels, which it plans to accomplish by 2018. Since 1999, oil for the SPR has generally been obtained through the royalty-in-kind program, whereby the government receives oil instead of cash for payment of royalties on leases of federal property. The Department of Interior's Minerals Management Service (MMS) collects the royalty oil and transfers it to DOE, which then trades it for oil suitable for the SPR. As DOE begins to expand the SPR, past experiences can help inform future efforts to fill the reserve in the most cost-effective manner. In that context, GAO's testimony today will focus on: (1) factors GAO recommends DOE consider when filling the SPR, and (2) the cost-effectiveness of using oil received through the royalty-in-kind program to fill the SPR. To address these issues, GAO relied on its 2006 report on the SPR, as well as its ongoing review of the royalty-in-kind program, where GAO interviewed officials at both DOE and MMS, and reviewed DOE's SPR policies and procedures. DOE provided comments on a draft of this testimony, which were incorporated where appropriate.
section_title: What GAO Found
paragraphs: To decrease the cost of filling the SPR and improve its efficiency, GAO recommended in previous work that DOE should include at least 10 percent heavy crude oils in the SPR. If DOE bought 100 million barrels of heavy crude oil during its expansion of the SPR it could save over $1 billion in nominal terms, assuming a price differential of $12 between the price of light crude oil and the lower price of heavy crude oil, the average differential over the last five years. Having heavy crude oil in the SPR would also make the SPR more compatible with many U.S. refineries, helping these refineries run more efficiently in the event that a supply disruption triggers use of the SPR. DOE indicated that, due to the planned SPR expansion, determinations of the amount of heavy oil to include in the SPR should wait until it prepares a new study of U.S. Gulf Coast refining requirements. In addition, we recommended that DOE consider acquiring a steady dollar value--rather than a steady volume--of oil over time when filling the SPR. This "dollar-cost-averaging" approach would allow DOE to acquire more oil when prices are low and less when prices are high. GAO found that if DOE had used this purchasing approach from October 2001 through August 2005, it would have saved approximately $590 million, or over 10 percent, in fill costs. GAO's simulations indicate that DOE could save money using this approach for future SPR fills, regardless of whether oil prices are trending up or down as long as there is price volatility. GAO also recommended that DOE consider giving companies participating in the royalty-in-kind program additional flexibility to defer oil deliveries in exchange for providing additional barrels of oil. DOE has granted limited deferrals in the past, and expanding their use could further decrease SPR fill costs. While DOE indicated that its November 2006 rule on SPR acquisition procedures addressed our recommendations, this rule does not specifically address how to implement a dollar-cost-averaging strategy. Purchasing oil to fill the SPR--as DOE did until 1994--is likely to be more cost-effective than exchanging oil from the royalty-in-kind program for other oil to fill the SPR. The latter method adds administrative complexity to the task of filling the SPR, increasing the potential for waste and inefficiency. A January 2008 DOE Inspector General report found that DOE is unable to ensure that it receives all of the royalty oil that MMS provides. In addition, we found that DOE's method for evaluating bids has been more robust for cash purchases than royalty-in-kind exchanges, increasing the likelihood that cash purchases are more cost-effective. For example, in April 2007, DOE solicited two different types of bids--one to purchase oil for the SPR in cash and one to exchange royalty oil for other oil to fill the SPR. DOE rejected offers to purchase oil when the spot price was about $69 per barrel, yet in the same month, DOE exchanged royalty-in-kind oil for other oil to put in the SPR at about the same price. Because the government would have otherwise sold this royalty-in-kind oil, DOE committed the government to pay, through foregone revenues to the U.S. Treasury, roughly the same price per barrel that DOE concluded was too high to purchase directly.

section_title: Letter
paragraphs: We are pleased to be here today to participate in the Committee’s hearing  on the Strategic Petroleum Reserve (SPR). Congress authorized the SPR in  1975 to protect the nation from oil supply disruptions following the Arab  oil embargo of 1973 and 1974 that led to sharp increases in oil prices. The  federal government owns the SPR, and the Department of Energy (DOE)  operates it. The SPR currently has the capacity to store up to 727 million  barrels of crude oil in salt caverns in Texas and Louisiana. As of February  19, 2008, current inventory of the SPR stood at 698.6 million barrels of oil,  which is roughly equivalent to 56 days of net oil imports. DOE made direct  purchases of crude oil until 1994, when purchases were suspended due to  the federal budget deficit, and in fiscal years 1996 and 1997 approximately  28 million barrels of oil were sold to reduce the deficit. Since DOE  resumed filling the SPR in 1999, it has obtained oil from the Department of  the Interior’s Minerals Management Service (MMS) “royalty-in-kind”  program. Through this program, the MMS receives oil instead of cash for  payments of royalties from companies that lease federal property for oil  and gas development. MMS contracts for some of this royalty oil to be  delivered to designated oil terminal locations or “market centers” where  DOE takes possession. Because the royalty oil often does not meet SPR  quality specifications, and because the market centers can be distant from  SPR storage sites, DOE generally awards contracts to exchange royalty oil  at the market center for SPR-quality oil delivered to SPR facilities.  Obtaining oil for the SPR through the royalty-in-kind program avoids the  need for Congress to make outlays to finance oil purchases, but the  foregone revenues associated with using royalty-in-kind oil to trade for  SPR oil imply an equivalent loss of revenue because MMS would otherwise  sell the oil and deposit the revenues with the U.S. Treasury. Interior  estimates that the forgone revenue attributable to using the royalty-in-kind  program to fill the SPR was $4.6 billion from fiscal year 2000 through fiscal  year 2007.
The Energy Policy Act of 2005 directed DOE to increase the SPR storage  capacity to 1 billion barrels and to fill it “as expeditiously as practicable  without incurring excessive cost or appreciably affecting the price of  petroleum products to consumers.” It required DOE to select sites to  expand the SPR’s storage capacity within 1 year of enactment, by August  2006. On February 14, 2007, Secretary of Energy Samuel Bodman  designated three sites for the expansion, including a 160 million barrel  facility in Richton, Mississippi, an 80 million barrel expansion of a facility  in Big Hill, Texas, and a 33 million barrel expansion of a facility in Bayou  Choctaw, Louisiana. In its June 2007 SPR plan, DOE anticipated these  expansions would begin in fiscal year 2008 and be complete in 2018.2, 3  DOE also indicated that it would prefer to continue using the royalty-in- kind program to fill the additional storage capacity. DOE estimates the  capital cost for the SPR expansion at approximately $3.67 billion, and  estimates the cost of operating and maintaining the expanded portion of  the SPR at $35 to $40 million per year.
As DOE begins to expand the SPR, past experiences may help inform  future efforts to fill the SPR in the most cost-effective manner. In that  context, our testimony today will focus on: (1) factors we recommend  DOE consider when filling the SPR, and (2) the cost-effectiveness of using  oil received through the royalty-in-kind program to fill the SPR.
DOE, Office of Petroleum Reserves, Strategic Petroleum Reserve Plan: Expansion to One  Billion Barrels (Washington, D.C.: June 2007).
In his State of the Union speech on January 23, 2007, President Bush proposed expanding  the SPR further to 1.5 billion barrels. Secretary of Energy Samuel Bodman indicated that  DOE’s goal was to have this expansion completed by 2027. kind program. We conducted our work on this testimony in January and  February 2008 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
To fill the SPR in a more cost-effective manner, we recommended in  previous work that DOE include in the SPR at least 10 percent heavy  crude oils, which are more compatible with many U.S. refiners and  generally cheaper to acquire than the lighter oils that comprise the  SPR’s volume. DOE indicated that, due to the planned SPR expansion,  such determinations should wait until it prepares a new study of U.S.  Gulf Coast heavy sour crude refining requirements. In addition, we  recommended that DOE consider acquiring a steady dollar value of oil  over time and allowing oil companies more flexibility to defer delivery  of royalty-in-kind exchanges to the SPR when prices are likely to  decline in return for additional deliveries in the future. In updating us  on the status of this recommendation, DOE indicated that its  November 8, 2006, rule on SPR acquisition procedures addressed our  recommendations; however, this rule does not specifically address  both how to implement a dollar-cost-averaging strategy and how to  provide industry with more deferral flexibility. In subsequent comment,  DOE noted that the November 8, 2006, acquisition procedures do not  address dollar-cost-averaging, but they do address flexibility of  purchasing and scheduling in volatile markets.
Filling the SPR with oil purchased in cash is likely to be more cost- effective than filling the SPR through the royalty-in-kind program for  several reasons. For example, the royalty-in-kind program adds a layer  of administrative complexity to the task of filling the SPR, increasing  the potential for waste or inefficiency. Moreover, DOE has evaluated  the cost of cash purchases more thoroughly than exchanges, increasing  the likelihood that cash purchases are more cost-effective. For  example, in May 2007, DOE rejected cash purchases for the SPR,  concluding that the current price of about $69 per barrel was unusually  high. However, in the same month, DOE entered into contracts to  exchange royalty oil, effectively committing the government to pay— through foregone revenues to the U.S. Treasury—about the same price  for oil that it concluded was too high to purchase directly. In  November, DOE entered into another exchange contract when oil was  about $96 per barrel.
subsections: section_title: DOE Could Improve the Cost-Effectiveness of Filling the SPR
paragraphs: For information on the composition of the SPR, see DOE, Office of the Assistant Secretary  for Fossil Energy, Strategic Petroleum Reserve: Annual Report for Calendar Year 2006. difference were to persist over the duration of the new fill period, DOE  would save about $1.2 billion in nominal terms by filling the SPR with 100  million barrels of heavy oil. The savings could be even larger if DOE  included more than 10 percent heavy oils in the SPR.
Including heavier oil would have the additional benefit of making the  composition of SPR oil more compatible with U.S. refineries. In recent  years, many refiners in the United States have upgraded their facilities so  they can process heavy oil. Our analysis of DOE’s Energy Information  Administration (EIA) data shows that, of the approximately 5.6 billion  barrels of oil that U.S. refiners accepted in 2006, approximately 40 percent  was heavier than that stored in the SPR. Refineries that process heavy oil  cannot operate at normal capacity if they run lighter oils. For instance,  DOE’s December 2005 study found that the types of oil currently stored in  the SPR would not be fully compatible with 36 of the 74 refineries  considered vulnerable to supply disruptions. DOE estimated that if these  36 refineries had to use SPR oil, U.S. refining throughput would decrease  by 735,000 barrels per day, or 5 percent, substantially reducing the  effectiveness of the SPR during an oil disruption, especially if the  disruption involved heavy oil. To improve the compatibility of SPR oil with  refineries in the United States, the DOE study concluded that the SPR  should contain about 10 percent heavy oil. However, our August 2006  report found that DOE may have underestimated how much heavy oil  should be in the SPR to maximize compatibility with refiners. We also  found DOE may have underestimated the potential impact of heavy oil  disruptions on gasoline production. Several refiners who process heavy oil  told us that they would be unable to maintain normal levels of gasoline  production if forced to rely on SPR oil as currently constituted. For  example, an official from one refinery stated that if it exclusively used SPR  oil in its heavy crude unit, it would produce 11 percent less gasoline and 35  percent less diesel. Representatives from other refineries told us they  might need to shut down portions of their facilities if they could not obtain  heavy oil. For these reasons, we recommended that DOE conduct a new  review of the optimal oil mix in the SPR and determine the maximum  volume of heavy oil that could be effectively put in the reserve.
In addition, we recommended that DOE consider filling the SPR by  acquiring a steady dollar value of oil over time, rather than a steady  volume of oil over time as has occurred in recent years. This “dollar-cost- averaging” approach would allow DOE to take advantage of fluctuations in  oil prices and ensure that more oil would be acquired when prices are low  and less when prices are high. In our 2006 report, we found that if DOE  had used this approach from October 2001 through August 2005, it could  have saved approximately $590 million in fill costs. 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.
We also recommended that DOE consider allowing oil companies  participating in the royalty-in-kind program more flexibility to defer their  deliveries to the SPR at times when filling would significantly tighten the  market or when prices are expected to decline. In return for these  deferrals, companies would provide additional barrels of oil when they  resumed deliveries. DOE has already approved some delivery deferrals at  companies’ requests, such as during the winter 2002-2003 oil workers’  strike in Venezuela. From October 2001 through August 2005, DOE  received an additional 4.6 million barrels of oil for the SPR valued at  approximately $110 million as payment for these delivery deferrals.  However, DOE has denied some deferral requests and experts have noted  that there is room to expand the use of deferrals. Experts noted DOE  would need to exercise its authority to deny deferrals at times when it is in  the national interest. Nonetheless, given that the SPR currently holds  roughly 56 days of net imports, we believe there is sufficient inventory for  some flexibility in allowing deferrals.
In updating us on the status of recommendations we made to DOE in our  August 2006 report, DOE indicated that its November 8, 2006, rule on SPR  acquisition procedures addressed our recommendations on dollar-cost- averaging and deferrals. However, the new acquisition rule does not  specifically address our recommendations to study both how to implement  a dollar-cost-averaging strategy and how to provide industry with more  deferral flexibility. In subsequent comment, DOE noted that the November  8, 2006, acquisition procedures do not address dollar-cost-averaging, but  they do address flexibility of purchasing and scheduling in volatile  markets. As to our recommendation on the optimal mix of oil in the SPR,  DOE indicated that, due to the planned SPR expansion, such  determinations should wait until it prepares a new study of U.S. Gulf Coast  heavy sour crude refining requirements. We believe the SPR expansion  offers DOE an ideal opportunity to change the SPR’s oil mix to include  heavier oils that are less costly to acquire and better match U.S. refining  capacity. We look forward to DOE completing its new study of U.S. Gulf  Coast heavy crude refining requirements and believe such a study will find  that DOE should include at least 10 percent heavy oils in the SPR.
section_title: Purchasing Oil to Fill the SPR May Be More Cost-Effective Than Current Royalty-in- Kind Program
paragraphs: There are several reasons that purchasing oil—as DOE did until 1994— may be more cost-effective than filling the SPR using the current royalty- in-kind program. For instance, there may be fewer bidders for the royalty  oil under the current exchange system than a direct cash purchase system,  which in turn may limit competition and the exchange deals that DOE can  negotiate. In the exchange process, a single company must be able to and  interested in both accepting oil at the designated market centers and  delivering other oil with specific characteristics to the SPR. This may limit  the number of companies interested in bidding on exchange contracts. In  contrast, if DOE purchased oil, many additional companies may be  interested in selling their oil, increasing competition and lowering prices.  In 2007, the then Deputy Assistant Secretary for Petroleum Reserves, who  directed activities of the SPR, told us that he agrees with this reasoning.  The inherent limits of exchanging versus direct purchases are  compounded by the fact that DOE and Interior have not systematically  analyzed where to send royalty oil in a way that maximizes the value of the  exchanges. The value of exchanges is a function of both the costs to  deliver oil to market centers and the deals that DOE can negotiate at  particular market centers. The informal process that DOE and Interior  currently use to identify market centers does not systematically analyze  the tradeoffs between these two factors to identify market centers that  optimize net value to the government.
In addition, royalty-in-kind exchanges add a layer of administrative  complexity to the task of filling the SPR, increasing the potential for waste  or inefficiency. In a January 2008 report, the DOE Inspector General  concluded that DOE does not have an effective control system over  receipts of royalty oil from Interior at the market centers. Specifically,  the Inspector General found that DOE did not have adequate controls to  ensure that the volumes of oil that contractors reported to have received  from Interior at the market centers matched scheduled deliveries. As a  result, DOE did not have assurance that it received all of the oil that  Interior shipped, raising concerns that DOE may not have received its full  entitled deliveries to the SPR. If DOE purchased all of its oil, it would no  longer need to exchange oil at designated market centers and would not  need to coordinate with Interior. Moreover, rather than diverting a fraction  of the oil collected through the royalty-in-kind program to fill the SPR,  Interior could sell that fraction in competitive sales, as it currently does  for the other oil it receives through the royalty-in-kind program. A senior  Interior official said that selling the royalty oil would be simpler for  Interior to administer than the current exchanges.
Further, DOE’s method for evaluating bids is more robust for cash  purchases than royalty-in-kind exchanges, increasing the likelihood that  cash purchases are more cost-effective. In November 2006, DOE issued a  final rule that describes how DOE will evaluate offers when it is  purchasing oil and when it is exchanging royalty oil for other oil for the  SPR. This rule provides DOE with considerable flexibility in the degree of  analysis it can conduct when evaluating offers, and, in practice, DOE’s  method for evaluating bids for cash purchases has been more robust than  it has for exchanges. For example, in April 2007, DOE solicited two  different types of bids—one to purchase oil for the SPR in cash and one to  exchange royalty oil for other oil to fill the SPR. In deciding whether to  purchase oil, DOE evaluated the bids it received in the context of overall  market trends. It concluded that the offers it received from sellers were  priced too high, in part because the price of oil was generally high and  because the prices of the specific type of oil DOE sought to purchase were  unusually high relative to other oil types. As a result, DOE rejected offers  to purchase oil when the spot price for Light Louisiana Sweet (LLS)—a  commonly used benchmark for Gulf Coast oil—was about $69 per barrel  and decided to delay purchasing any oil until at least the end of the  summer driving season. In contrast, DOE’s method for evaluating bids for  exchanging royalty oil focused on whether the oil DOE would receive  would be at least the same value as the oil it would exchange. It did not  include an analysis of whether overall market conditions indicated that it  would be more profitable for the federal government to stop or delay  exchanges and have Interior sell the royalty oil for cash instead. In this  case, in the same month, DOE entered into royalty oil exchange contracts  when the spot price of LLS was about $67 a barrel, effectively committing  the government to pay—through foregone revenues to the U.S. Treasury— roughly the same price for oil that DOE concluded was too high to  purchase. Moreover, in November, it awarded additional exchange  contracts when the spot price of LLS had reached $96 a barrel.
It should also be noted that the current exchange method is less  transparent than direct purchases because the primarily cash-based  federal budget does not account for noncash transactions. Interior  estimates that the royalty-in-kind program cost the federal government in  total foregone revenue $4.6 billion from fiscal year 2000 through fiscal year  2007. This foregone revenue was not reflected in the federal budget since  no federal cash flows were involved. Congressional budget  decisionmakers therefore have not had the opportunity to consider  whether the value of the transferred oil could be reallocated to other  competing resource needs.
Importantly, the royalty-in-kind effort to fill the SPR creates, essentially, a  “blind spot” where neither DOE nor Interior, the two agencies responsible  for running the joint program, systematically examines whether exchanges  of millions of barrels of royalty oil have been a cost-effective approach to  filling the reserve. DOE does conduct a prospective analysis to estimate  whether the value of the oil it will receive in the exchanges will be at least  as valuable as the royalty oil it will exchange. However, DOE enters into  exchange agreements that can last 6 months, and DOE’s initial estimates  of the values of the different oil types may not hold over the duration of  the contracts. DOE has not analyzed any of the completed exchanges to  determine whether those exchanges performed as well as expected.  Similarly, when evaluating the performance of the royalty-in-kind program  overall, Interior does not analyze whether the royalty oil transfers to DOE  are a cost-effective means to fill the reserve. The 60.7 million barrels of  oil that Interior transferred to DOE from fiscal year 2004 to 2005  accounted for 58 percent of all the royalty-in-kind oil that Interior  collected during that time. While Interior reports to Congress each year on  the financial performance of its royalty-in-kind program, these reports  have not included a measure of the cost-effectiveness of using royalty oil  to fill the SPR.
section_title: Conclusions
paragraphs: Because the SPR has reached sufficient size to address near-term supply  disruptions, decisions about future fill practices can be made in a more  flexible, cost-effective manner without unduly hurting our ability to  respond to such disruptions. With oil prices recently exceeding $100 a  barrel, there should be greater interest in finding ways to reduce fill costs.  If it is to reach its goal of filling the expanded SPR by 2018, DOE will have  to, in some combination, purchase or receive through royalty-in-kind  transfers roughly 300 million barrels of oil. Our work shows that  substantial cost savings could be achieved through increased purchasing  of heavy oil, a dollar-cost-averaging purchasing strategy, more flexibility in  the timing of oil purchases and deliveries, and greater attention paid to the  opportunity costs of filling the SPR with royalty oil. Based on our past  estimates of the cost savings potential of dollar cost averaging and the  significantly lower cost of heavier oils, DOE could save well over 10  percent of the costs of filling the SPR to the currently authorized level—an  amount that is likely well in excess of $1 billion. During this era of dire  national long-term fiscal challenges, it is all the more important that DOE  make fill decisions in a cost-effective manner.
Mr. Chairman, this concludes my prepared statement. I would be pleased  to respond to any questions that you or other members of the Committee  may have at this time.
section_title: GAO Contact and Staff Acknowledgements
paragraphs: For further information about this testimony, please contact me, Frank  Rusco, at 202-512-3841 or ruscof@gao.gov. Contact points for our Offices  of Congressional Relations and Public Affairs may be found on the last  page of this statement. Contributors to this testimony include Ben Bolitzer,  Chase Huntley, Heather Hill, Jon Ludwigson, Tim Minelli, Michelle Munn,  Alison O’Neill, G. Greg Peterson, and Barbara Timmerman.
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