Bulk Fuel Pricing: DOD Needs to Reevaluate Its Approach to Better Manage the Effect of Market Fluctuations
Released: 2014-07-08T00:00:00


Highlights: section_title: Why GAO Did This Study
paragraphs: DOD purchases bulk fuel and sells it to customers, including the military services. Each fiscal year, DOD sets a standard price for budgeting purposes, endeavoring to closely approximate the price it will pay when it buys the fuel almost a year later. If this price is different than the standard price, DOD may need to take actions to manage its working capital funds—funds used to purchase fuel and other commodities that are reimbursed through sales.

Senate Report 113-44, accompanying a bill for the National Defense Authorization Act for FY 2014, mandated GAO to review DOD's approach for establishing its bulk fuel pricing. This report discusses, among other things, (1) how estimated bulk fuel costs have compared to actual costs since FY 2009 and the factors that have contributed to any differences; and (2) the extent to which DOD has considered options for adjusting its approach to estimating bulk fuel costs and managing working capital funds in light of any differences between estimated and actual fuel costs. GAO compared estimated and actual fuel costs for FY 2009 through 2013 and analyzed DOD actions to manage working capital funds.

section_title: What GAO Found
paragraphs: During fiscal years 2009 through 2013, the Department of Defense's (DOD) actual costs for bulk fuel differed considerably from its budget estimates, largely because of fluctuations in fuel price in the open market. During this period, DOD underestimated its costs for 3 years and overestimated them for 2 years as shown below. GAO identified two factors that contributed to the differences between estimated and actual costs—(1) fuel price fluctuations and (2) differences between the military services' estimated fuel requirements and their actual fuel consumption. GAO's analysis showed that the differences between the price DOD paid for fuel and the price it charged its fuel customers—the standard price—accounted for, on average, 74 percent of the difference between estimated and actual costs. Specifically, of the three components of the standard price that DOD sets each fiscal year—crude oil, refinement markup, and nonproduct costs, such as transportation and facilities maintenance costs—differences in the price of crude oil accounted for most of the difference between estimated and actual fuel costs in fiscal years 2009 and 2010. In fiscal years 2011 through 2013, the refinement markup accounted for most of the difference. Differences between the services' estimated fuel requirements and actual fuel consumption accounted for an average of 26 percent of the difference between estimated and actual fuel costs.

Since 2004, DOD has conducted reviews of aspects of its bulk fuel program to determine whether adjustments should be made, including managing acquisition strategies, managing working capital funds, and budgeting for cost fluctuations. However, it has not updated its approach to reflect current market conditions or documented its rationale for the assumptions it uses in estimating the standard price. GAO's Cost Estimating and Assessment Guide and Office of Management and Budget guidance state that a cost estimate should be updated regularly to reflect changes to assumptions and actual costs, so that it always reflects current conditions. Furthermore, cost estimates should be supported by detailed documentation that describes how they were derived. Reevaluating its approach for estimating the standard price would allow DOD to develop more informed estimates and better position it to minimize risks and uncertainty resulting from changing market conditions. Further, documenting the rationale for its assumptions would provide greater transparency and clarify for fuel customers and decision makers the process DOD uses to set the standard price.

section_title: What GAO Recommends
paragraphs: GAO recommends that DOD reevaluate its approach for estimating the components of the standard price and document the rationale for its assumptions. DOD agreed with the first recommendation and partially agreed with the second stating there is a closely-monitored, formal process. GAO continues to believe the recommendation remains valid as discussed in the report.

section_title: Letter
paragraphs: For each fiscal year, the Department of Defense (DOD) sets a standard  price per barrel that it will charge the military services and other  customers for fuel. In setting this standard price, DOD endeavors to  closely approximate the actual price it will pay for the fuel during the year  of budget execution. However, due to the timing of DOD’s budget  process, the department estimates this price almost a year in advance of  when it will actually purchase the fuel at the current market rate. Because  of the volatility of world petroleum prices, the standard price DOD  establishes for a barrel of fuel may be lower or higher than the price it will  have to pay on the world market. For example, in fiscal year 2013, the  price DOD paid for fuel ranged from around $140 to $164 per barrel—a  difference of $24 per barrel. If the actual market price of fuel is higher  than the price DOD is charging its customers, DOD will have to pay more  for fuel than it is being reimbursed. If the actual price is lower than the  standard price, DOD will have more cash than it anticipated. Since fiscal  year 2009, the military services have purchased an average of  approximately 110 million barrels per year from DOD. Therefore, a  standard price increase of even $1 per barrel would result in a $110  million difference from their budget requests.

To manage these price fluctuations, DOD uses the Defense-wide  Working Capital Fund (the fund), which covers DOD’s costs for  purchasing various commodities, including bulk fuel, and is reimbursed  through DOD’s sale of these commodities to the military services and  other customers, such as other federal agencies and foreign military  sales. The fund is intended to insulate the military services and DOD’s  other fuel customers from the volatility of the market by allowing DOD to  charge them a consistent standard price. In some instances, DOD may  need to respond to fluctuations in world fuel prices by increasing or  decreasing its standard price or by transferring funds from other accounts  into its Defense-wide Working Capital Fund in order to maintain a  sufficient cash balance in the fund.

The Senate report accompanying a bill for the fiscal year 2014 National  Defense Authorization Act mandated that we review DOD’s approach for  establishing its bulk fuel pricing. This report discusses (1) how estimated  bulk fuel costs have compared with actual costs since fiscal year 2009  and the factors that have contributed to any differences; (2) the extent to  which DOD has taken actions to manage the effect of any differences  between estimated and actual fuel costs; and (3) the extent to which DOD  has considered options for adjusting its approach to estimating bulk fuel  costs and managing working capital funds in the light of any differences in  recent years between estimated and actual fuel costs.

To address these objectives we focused our analysis on fiscal years 2009  through 2013. We focused on these years because this period covered  the most recent complete year of fuel sales and provided 5 years of cost  data to analyze any trends. To determine the reliability of the data  provided to us by DOD, we obtained information on how the data were  collected, managed, and used through interviews with and questionnaires  to relevant officials and determined that the data presented in our findings  were sufficiently reliable for the purposes of this report.

To determine how estimated bulk fuel costs have compared with actual  costs since fiscal year 2009 and the factors that contributed to any  differences, we compared the estimated costs for fuel against actual  costs in the budget year of execution to identify any differences. For these  differences, we determined the percentage of the difference explained by  either fuel price fluctuations or differences in fuel consumption compared  with budgeted consumption levels. We then compared each of the three  components of the standard price (crude oil price, refinement markup,  and nonproduct costs—such as transportation and facilities maintenance  costs) against the actual costs for each component to determine which  contributed most to the difference.

To determine the extent to which DOD has taken actions to manage the  effect of any differences between estimated and actual fuel costs, we  reviewed monthly cash balances in the Defense-wide Working Capital  Fund for fiscal years 2009 through 2013 to examine the effect that bulk  fuel purchases and sales had on those balances. We also obtained  information on the number and amount of approved transfer actions  related to fuel into and out of the Defense-wide Working Capital Fund  during this period. In addition, we identified all changes to the standard  price DOD charged to customers and identified any fuel-related  supplemental appropriations received into the fund since fiscal year 2009.

To determine the extent to which DOD has considered options for  adjusting its approach for estimating bulk fuel costs and managing  working capital funds, we reviewed documentation, including budget  justification materials and DOD reports, that describes DOD’s current  process for estimating bulk fuel costs and compared it with cost- estimating practices and Office of Management and Budget (OMB) and  DOD guidance. We also performed analysis on the relationship of the  West Texas Intermediate (WTI) crude oil benchmark with other crude oil  pricing benchmarks to determine whether DOD’s approach to setting its  standard price reflects current market conditions. We reviewed related  studies and recommendations that we identified through interviews with  DOD officials and literature searches that discuss options available to  DOD to adjust its approach to managing bulk fuel costs and working  capital funds. For this review we focused on relevant studies that have  been conducted since 2004. We also interviewed DOD officials  responsible for managing DOD’s bulk fuel program, economic policy and  budget officials from OMB, and officials from the Department of Energy’s  Energy Information Administration, which is the federal government’s  primary authority on energy statistics and analysis. Appendix I provides a  more detailed discussion of our scope and methodology.

We conducted this performance audit from November 2013 to July 2014  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.
subsections: section_title: Background
paragraphs: In each fiscal year, DOD establishes a standard price per barrel to be  charged to its fuel customers. The Office of the Under Secretary of  Defense (Comptroller), in coordination with the Defense Logistics Agency  (DLA), estimates and sets a standard price for its fuel and other fuel- related commodities that endeavors to closely approximate the actual per  barrel price during budget execution, which occurs almost a year later.  The Office of the Under Secretary of Defense (Comptroller) sets the  standard price annually based on three components.

Crude Oil—The baseline for setting the standard price is the  forecasted price for crude oil, which is provided to DOD by OMB. To  estimate the cost of crude oil, the Council of Economic Advisors, the  Department of the Treasury, and OMB—referred to as the Troika— jointly prepare a set of economic assumptions for agencies to use in  preparing their overall budgets. In developing the crude oil price  projections, the Troika uses oil price projections coming from the  prices in the futures market for both West Texas Intermediate (WTI)  and Brent crude oil prices. DOD uses the WTI projection as its  baseline. According to OMB Circular A-11, all baseline estimates used  in the budget must be consistent with the economic assumptions  provided by OMB.

Refinement Markup—DOD adds a markup for the cost of refining the  crude oil. Because DOD and its customers use refined oil products— such as jet fuel and diesel fuel—DOD has to include the additional  cost of refining the fuel in its standard price. This refinement markup  is estimated based on the historical price relationship between WTI  crude oil and refined product prices.

Nonproduct Costs—DOD adds an estimate for nonproduct costs  associated with DLA’s overhead, including facilities sustainment,  restoration, and modernization; transportation; and storage costs.  Other nonproduct costs include an estimate of product losses and  may include cost recovery adjustments for prior year fund losses to  the Defense-wide Working Capital Fund, legal judgments, and  rounding.

Figure 1 identifies each of the price components as a percentage of the  total standard price for fiscal year 2013.

In developing their annual operation and maintenance budget requests,  the military services use the standard price and their estimated fuel  requirements based on activity levels (such as flying hours, steaming  days, tank miles, and base operations). For example, the Air Force as the  largest DOD customer for fuel, purchased approximately 49 million  barrels in fiscal year 2013, representing 53 percent of all sales to the  military services. In determining its Operation and Maintenance funding  needs, the Air Force provided an estimate for fuel in its budget request  based on an analysis of each aircraft’s fuel usage and future programmed  flying hours. Figure 2 below generally illustrates the process and the main  organizations involved in budgeting for fuel.

DOD utilizes its Defense-wide Working Capital Fund to purchase bulk fuel  for customers. According to DOD’s Financial Management Regulation,  working capital funds were established to satisfy recurring DOD  requirements using a businesslike buyer-and-seller approach. The  Defense-wide Working Capital Fund is the Working Capital Fund  managed by the defense agencies. The fund consists of six activity  groups. Three of these activity groups are operated by DLA, two by the  Defense Information Systems Agency, and one by the Defense Finance  and Accounting Service. The activity group related to DOD’s bulk fuel  program is the DLA Energy Management Activity group, which provides  worldwide energy support including bulk fuel purchasing, transportation,  and storage for the military services and other customers.

The fund covers DLA’s costs for purchasing bulk fuel and is reimbursed  through its sale of fuel to the military services and other customers at a  standard price. The standard price is intended to remain unchanged until  the next budget year. This helps to shield the military services from  market price volatility by allowing the cash balance in the fund to absorb  minor fuel price fluctuations. According to DOD’s Financial Management  Regulation, the goal of the fund is to remain revenue-neutral, allowing the  fund to break even over time—that is, to neither make a gain nor incur a  loss. During the year the budget is executed, the actual price for a barrel  of fuel on the world market may be higher or lower than DOD’s standard  price. If the actual price is higher, the cash balance in the Defense-wide  Working Capital Fund will go down. If the actual price is lower, the cash  balance in the fund will go up. These fluctuations in the cash balance are  known as a net outlay. To correct for these fluctuations, DOD may adjust  the standard price for the following year. For example, DOD may increase  the standard price to make up for losses in the previous year and bolster  the cash balance in the fund. Alternatively, DOD may decrease the  standard price to reimburse the services, which had paid a higher price  the previous year. DOD can also cover fund losses during the execution  year by obtaining an appropriation from Congress, transferring funds from  another DOD account into the fund, or adjusting the standard price out of  cycle.

section_title: DOD’s Actual Costs Differed Considerably from Budget Estimates since Fiscal Year 2009, Due Largely to Fluctuations in Fuel Price
paragraphs: During fiscal years 2009 through 2013, DOD’s actual costs for bulk fuel  differed considerably from its budget estimates, due largely to fluctuations  in fuel price. During those years, DOD either under- or overestimated  what it would have to pay for bulk fuel. The differences between  estimated and actual fuel costs were accounted for primarily by  fluctuations in the market price for fuel.
subsections: section_title: DOD’s Actual Fuel Costs Differed from Its Budget Estimates
paragraphs: In each of fiscal years 2010, 2011, and 2012, DOD underestimated its  bulk fuel costs by about $3 billion. In 2009, DOD overestimated these  costs by about $3 billion and in 2013 by about $2 billion. Table 1 shows  the total difference between DOD’s estimated and actual fuel costs for  fiscal years 2009 through 2013.

section_title: Differences between Estimated and Actual Fuel Costs Were Largely Due to Fuel Price Fluctuations
paragraphs: We identified two primary factors that accounted for the difference  between estimated and actual costs—(1) fluctuations in the market price  of fuel and (2) differences between the services’ estimated and actual fuel  consumption. Our analysis showed that from fiscal years 2009 through  2013, the differences between the price DOD paid for fuel and the price it  charged its fuel customers—the standard price—accounted for, on  average, 74 percent of the difference between estimated and actual  costs. In fiscal year 2012, for example, DOD estimated a standard price  of $131.04 per barrel. DOD’s actual costs during that year averaged  $167.33 per barrel—an underestimate of $36.29 per barrel—which  represented 85 percent of the underestimate for fiscal year 2012.

Figure 3 compares the actual price DLA paid for fuel with the standard  price DOD used to calculate its budget estimates.

Of the three components that constitute the standard price, crude oil  prices and refinement markup costs accounted for most of the difference  between the estimated standard price and actual fuel costs during fiscal  years 2009 through 2013. In fiscal years 2009 and 2010, differences in  the price of crude oil accounted for most of the difference between the  estimated and actual prices—in 2009 for 95 percent of the difference and  in 2010 for 72 percent. However, during fiscal years 2011 through 2013,  the refinement markup became the main driver of the difference,  accounting for between 65 and 79 percent of the difference, as shown in  table 2.

For fiscal years 2009 through 2012, DOD added a markup of 30 percent  over the price of WTI to account for refinement costs in setting the  standard price. According to DOD officials, the 30 percent markup over  the WTI crude oil price had been a generally accurate predictive indicator  for the price of DOD’s actual refined fuel costs. However, in fiscal year  2011, actual fuel costs exceeded the price of WTI by an average of 49  percent and in 2012 by an average of 60 percent. Therefore, DOD set the  refinement markup too low in those years. According to DOD officials, to  account for these differences, DOD increased the markup for refinement  costs from 30 percent to 50 percent of the WTI price when developing the  standard price for fiscal year 2013.

Although fluctuations in fuel prices were, on average, the primary driver of  the differences between estimated and actual fuel costs in fiscal years  2009 through 2013, differences between the services’ estimated and  actual fuel consumption levels also contributed to the overall difference.  These differences accounted for, on average, 26 percent of the difference  between DOD’s estimated and actual fuel costs. In fiscal years 2009  through 2012, the military services’ estimated fuel requirements were  within 5 percent of their actual consumption, as shown in figure 4.  However, in fiscal year 2013, we found that differences between  estimated and actual fuel consumption levels became the main driver of  the total difference between estimated and actual fuel costs. In that year,  DOD underestimated the cost of fuel but overestimated its consumption  by approximately 19 million barrels, or 17 percent. According to DOD  officials, actual consumption was much lower as a result of actions DOD  took to address sequestration. In November 2013, we reported that for  fiscal year 2013, DOD’s Operation and Maintenance accounts were  reduced by approximately $20 billion, or 7.2 percent, due to sequestration  reductions. We identified several actions DOD took to address these  budgetary reductions. For example, in fiscal year 2013, the Air Force  initially ceased flight operations from April through June for about one- third of active-duty combat Air Force units. Also, the Army curtailed  training for all units except those deployed, preparing to deploy, or  stationed overseas, and the Navy limited flight training for nondeploying  units.

section_title: DOD Has Taken Various Actions to Manage the Effect of Differences between Estimated and Actual Fuel Costs
paragraphs: DOD has taken actions to manage fluctuations in the cash balance of the  Defense-wide Working Capital Fund caused by differences between its  estimated and actual fuel costs. These actions included transferring funds  into the Defense-wide Working Capital Fund from other accounts and  adjusting the standard price DOD charged to its fuel customers.
subsections: section_title: Cash Balances in the Defense-Wide Working Capital Fund Fluctuate Due to Changing Fuel Prices
paragraphs: The Defense-wide Working Capital Fund provides the cash balance that  is used to fund the day-to-day operations for six defense-wide activity  groups, including DLA Energy, which provides, among other things,  worldwide energy support to the military services and other authorized  customers for bulk fuel purchasing, transportation, and storage.  According to a DOD report, the volatility of fuel prices has historically  posed a challenge to managing the cash balance of the fund. When  DLA pays more or less for fuel than the standard price it charges its  customers, the cash balance in the Defense-wide Working Capital Fund  will go down or up. For instance, if fuel market prices rise significantly  relative to the standard price, the cash balance in the fund will go down.  On the other hand, if fuel market prices decrease relative to the standard  price, the fund will generate excess cash and the balance will go up. In  fiscal years 2009 through 2013, the fluctuations in the cash balance of the  Defense-wide Working Capital Fund were partially driven by these net  outlays for fuel, as shown in figure 5.

section_title: DOD Used Fund Transfers and Adjustments to Its Standard Price to Manage Working Capital Fund Balances
paragraphs: The Defense-wide Working Capital Fund is intended to provide DOD with  the flexibility to absorb some fluctuation in fuel prices. However, in some  instances, DOD has sought to manage the fluctuations in the fund’s cash  balance by transferring money into or out of the fund or by adjusting its  standard price. For example, in fiscal years 2012 and 2013, DOD  transferred funds into the Defense-wide Working Capital Fund. In 2012,  DOD transferred $1 billion into the fund from the Afghanistan Security  Forces Fund and in 2013 another $1.4 billion from various accounts,  including the Foreign Currency Fluctuations account, to mitigate the cash  shortfall caused by an increase in fuel costs over the standard price. DOD  also transferred cash out of the fund during the period of our review.  Specifically, in fiscal year 2011, Congress reduced funding for several  DOD operation and maintenance accounts by about $2 billion to reflect  excess cash balances in the Defense-wide Working Capital Fund. In  response, DOD transferred almost $1.3 billion out of the Defense-wide  Working Capital Fund to fund the reduced operation and maintenance  accounts. We found that these transfers into or out of the fund can affect  adjustments to the standard price. For example, according to DOD  officials, the fiscal year 2013 transfer allowed DOD to maintain the same  standard price throughout that year even though actual fuel costs  exceeded the standard price. A DOD study noted that the fiscal year 2011  transfer out of the fund required DOD to increase its standard price by  almost $40 per barrel because the cash balance in the Defense-wide  Working Capital Fund was no longer sufficient to mitigate the increased  costs of fuel in that year.

DOD also used changes to the standard price to manage the cash  balance in the Defense-wide Working Capital Fund. From the beginning  of fiscal year 2009 through end of fiscal year 2013, DOD adjusted its  standard price 13 times—increasing it 6 times and decreasing it 7 times.  According to DOD, these price changes were due to changing product  costs, approved transfers, and the availability of cash balances in the  fund. For example, the fiscal year 2012 President’s Budget estimated a  standard price of $131.04. However, in October 2011, DOD raised the  standard price to $165.90. It then lowered the price to $160.44 in January  2012, to $151.20 in June 2012 and finally to $97.02 in July 2012, where  the price remained for the rest of the fiscal year. Figure 6 shows the  transfers and standard prices during fiscal years 2009 through 2013 and  the cash balances in the Defense-wide Working Capital Fund.

Standard price adjustments affect the military services. According to DOD  officials, an adjustment to the standard price is not their preferred option  for managing the fund’s cash balances because of the potential strain it  places on the services’ budgets. For example, a Navy official told us that  when the standard price is increased, the Navy must either reduce  consumption by curtailing training or request additional funding. Fiscal  year 2013 was the first year since 2004 during which DOD maintained its  standard price for the entire year.

section_title: DOD Has Conducted Studies on Its Management of Working Capital Funds, but Has Not Reevaluated Its Approach or Documented Its Assumptions for Estimating Fuel Costs
paragraphs: DOD has studied various aspects of its bulk fuel program since 2004, but  it has not updated its current approach for setting the standard price to  reflect current market conditions or documented its rationale for the  assumptions it uses in estimating the standard price—even though the  differences between its estimated and actual costs have been  considerable since that time.
subsections: section_title: DOD Has Conducted Various Studies on Its Bulk Fuel Program, Including Management of Working Capital Funds
paragraphs: Since 2004, DOD has completed a number of studies reviewing various  aspects of its bulk fuel program, including studies of its management of  working capital funds. We identified six studies related to DOD bulk fuel  pricing and management of the Defense-wide Working Capital Fund. See  appendix II for a description of the purpose of the studies and any  identified findings, including the status on any proposed  recommendations.

The John Warner National Defense Authorization Act for Fiscal Year  2007 required the Secretary of Defense to submit a report on fuel rate  and the cost projections used in the DOD budget presentation. In  response, DOD completed a study in February 2007 that compared the  crude oil forecast provided by OMB with crude oil forecasts developed by  the Department of Energy and 38 private forecasting companies. Based  on its analysis, DOD elected to maintain its current approach—using  OMB’s WTI forecast as its preferred baseline—because the study  concluded that OMB’s forecasts were comparable to or better at  estimating the actual crude oil price than the alternative forecasts it  evaluated.

More recently, in January 2012, in response to the Ike Skelton National  Defense Authorization Act for Fiscal Year 2011, the Office of the Under  Secretary of Defense (Comptroller) reviewed alternatives for managing  the balances of the Defense-wide Working Capital Fund. The study found  that fuel cost volatility poses a major threat to the fund’s solvency. As a  result, the study concluded that DOD may need to request funding  transfers that could disrupt investment programs or threaten readiness.  The study recommended two alternatives for managing working capital  funds. The first would allow DOD to transfer expiring unobligated  balances from other appropriation accounts into the fund to build a cash  reserve. The study noted that this alternative is similar to authorities  provided to other federal agencies’ working capital funds, but that it would  require statutory authorization. The second alternative would allow the  fund to accumulate and reserve funds in times of positive cash flow—up  to $12.5 billion, or two times the largest cash shortfall on record. The  Office of the Under Secretary of Defense (Comptroller) identified several  concerns with this alternative. For example, according to the study, DOD  would need congressional authorization to accumulate positive operating  results. Additionally, the study noted that maintaining a large cash  balance in the fund to mitigate potential price risk is not a productive use  of resources. According to DOD officials, DOD’s Financial Management  Regulation is currently being updated with an estimated issuance of  summer 2014 to allow for greater flexibility in developing cash balance  targets for the Defense-wide Working Capital Fund.

The 2012 study also listed other alternatives for managing working capital  fund balances, which it did not recommend due to certain limitations,  risks, and costs. These included some alternatives that had previously  been studied and recommended by the Defense Business Board. For  example, the Defense Business Board had previously studied the  feasibility of hedging fuel on the open market, which includes purchasing  financial instruments to minimize risk in future prices. However,  according to the study, DOD has elected not to pursue hedging for a  number of reasons including that it is outside of DOD’s current authority,  would incur management fees that would increase total costs, and poses  additional political and economic risk. The 2012 study also rejected the  Defense Business Board’s recommendations to implement firm-fixed- price fuel contracts and to partner with the Department of the Interior to  access additional funds when fuel costs increase. The study noted that  firm-fixed-price contracts would shift pricing risk to the supplier, which  would be likely to result in DOD paying a premium for the contracts.

section_title: DOD Has Not Reevaluated Its Approach or Documented its Assumptions for Setting the Standard Price
paragraphs: According to GAO’s Cost Estimating and Assessment Guide, a cost  estimate should be updated regularly to reflect significant changes—such  as changes to assumptions—and actual costs, so that it always reflects  current conditions. Also, according to the guide, major assumptions  should be assessed to determine how sensitive they are to changes, and  risk and uncertainty analysis should be performed to determine the level  of risk associated with the estimate. Further, OMB guidance states that  agencies should consider the effect that demographic, economic, or other  changes can have on assumptions for program levels beyond the budget  year. However, the assumptions that DOD uses for setting the crude oil  component of the standard price do not reflect current market conditions.  Specifically, DOD’s assumptions do not consider (1) differences between  crude oil benchmarks, (2) differences between domestic and international  crude oil prices, and (3) the decreasing relationship between crude oil  and refined prices.

DOD’s approach for establishing the standard price has not accounted for  changes in market conditions for crude oil. As discussed earlier in this  report, DOD’s process of adding a refinement markup to the price of WTI  in setting the standard price has resulted in estimated fuel costs that have  been considerably lower than actual fuel costs. We found that, from fiscal  years 2010 through 2013, the price for WTI diverged from other crude oil  pricing benchmarks. According to a report from the Energy Information  Administration, WTI was selling during this period for less than other  crude oil pricing benchmarks, such as Brent—a commonly used crude oil  benchmark. The price spread between WTI and Brent reached a high of  $27 per barrel in September 2011, as shown in figure 7. Energy  Information Administration officials also told us that, although the price  spread between Brent and WTI has narrowed recently, they believe that  the relationship between the pricing of Brent and WTI may remain volatile  and that a price spread between the two benchmarks will likely continue.  In its April 2014 Short-Term Energy Outlook, the Energy Information  Administration estimates that in calendar year 2015 the price of WTI will  be about $11 per barrel less than the price of Brent.

Recognizing this market change, other federal agencies have adjusted  their crude oil benchmarks for estimating energy prices because of this  price spread. For example, in its 2013 Annual Energy Outlook, the Energy  Information Administration shifted from WTI to Brent for estimating energy  prices. According to officials from the Energy Information Administration,  Brent crude oil prices have become the primary international crude oil  benchmark. Furthermore, these officials noted that worldwide petroleum  product prices—including in the United States—are typically based on  Brent prices. This is consistent with DLA’s analysis, which found that  domestic refined fuel products are more closely related with Brent than  with WTI prices.

OMB has also accounted for other crude oil benchmarks in its annual  economic assumptions that are provided to federal agencies for  budgeting purposes. According to officials from DOD and OMB, beginning  with the fiscal year 2014 budget cycle, OMB began providing DOD and  other federal agencies with forecasted Brent prices in addition to WTI  prices. OMB officials told us that although OMB Circular A-11 requires  that federal agencies’ budget estimates be consistent with OMB’s  economic assumptions, DOD has discretion over which economic  assumptions, such as an appropriate crude oil benchmark, to apply in  developing its bulk fuel estimates.

We identified other market conditions that DOD has not accounted for  with its current approach to determining the crude oil component of the  standard price. For example, DLA purchases about half of its fuel from  overseas refiners. From fiscal years 2009 through 2013, DLA purchased,  on average, 48 percent of its fuel from overseas sources. However, WTI  is a pricing benchmark only for domestic crude oil. Because DOD uses  WTI, its baseline for setting the standard price does not account for any  potential price differences between domestic and overseas purchases.  Furthermore, officials at DOD also expressed concerns that crude oil may  no longer be a good indicator for refined product prices. According to an  official from the Office of the Under Secretary of Defense (Comptroller), in  recent years the relationship between crude oil prices and the price of  DOD refined products has not been as closely related as it has in the  past. This is consistent with our own analysis. Specifically, for fiscal years  2009 through 2013 we compared the actual price DLA paid for fuel with  the actual price of other fuel products—including WTI crude oil, Brent  crude oil, and commercial jet fuel—to determine the relationship among  these prices. Based on our analysis of data from the Energy Information  Administration, we found that in each year the prices DLA paid for fuel  had a closer relationship with commercial jet fuel prices than with either  WTI or Brent crude oil prices.

To compensate for the limitations in its crude oil baseline, DOD has  adjusted other components of its standard price. For example, as  discussed earlier in this report, beginning in fiscal year 2013, DOD  increased the refinement markup component of the standard price from  30 percent to 50 percent to account for the divergence between WTI and  other crude oil pricing benchmarks. DOD has continued to use the 50  percent refinement markup in setting its standard price for fiscal years  2014 and 2015. This practice means that DOD is using the markup not  only to account for refinement costs, but to cover the price spread  between WTI and other crude oil pricing benchmarks. By using the  increased refinement markup to compensate for the price spread, DOD is  not addressing the underlying limitations with its crude oil baseline.

Rather, DOD is adding further risk and uncertainty concerning its  estimate, because the estimate must now account for additional price  variables.

Even though in recent years its methodology has been producing  estimates that differ significantly from actual costs, DOD has not  reevaluated its approach or documented the rationale behind the  assumptions it uses for setting the standard price. DOD’s 2007 study  found that its forecasting methodology produced results as good as or  better than the forecasting models the study compared it with. However,  that study focused exclusively on the crude oil component of the standard  price. It did not evaluate the accuracy of the standard price methodology  as a whole against other potential approaches. Moreover, since that time,  DOD has not reevaluated whether using WTI as its baseline  assumption—with the corresponding refinement markup—is still  appropriate given recent market changes. Further, DOD has not  considered whether a crude oil baseline is still reasonable at all. Officials  from the Office of the Under Secretary of Defense (Comptroller) told us  that they have held internal discussions regarding changing the crude oil  pricing baseline used in the standard price, but no final decision has been  made.

Furthermore, DOD has not fully documented its rationale and  assumptions for establishing each component of the standard price.  GAO’s Cost Estimating and Assessment Guide states that a cost  estimate should be supported by detailed documentation that describes  how it was derived. According to the guide, the documentation should  include, among other things, the estimating methodology used to derive  the costs for each element of the cost estimate, and it should also discuss  any limitations of the data or assumptions. Further, a well-documented  methodology allows decision makers to understand and evaluate the  budget request and make proper determinations. According to an official  from the Office of the Under Secretary of Defense (Comptroller)  responsible for overseeing DOD’s bulk fuel program, DOD’s Financial  Management Regulation provides overarching guidance on establishing  prices for working capital fund products, including fuel. Specifically, the  Financial Management Regulation provides that all business areas of the  fund are required to set their prices based upon full cost recovery,  including general and administrative support provided by others. This  official noted that DOD’s process for setting the standard price is based  on this full cost recovery, as described in specific guidance in the  Financial Management Regulation. Additionally, federal guidance also  governs aspects of the rate-setting process. For example, OMB’s A-11  Circular requires DOD’s budget estimates for fuel to be consistent with  OMB’s economic assumptions. For this reason the official stated that the  establishment of a more specific methodology could be potentially  redundant to the existing process, and could add additional administrative  hurdles that may not add value.

However, while DOD’s Financial Management Regulation provides  overall principles for working capital funds, it does not require DOD to  document its methodology for setting the standard price in a step-by-step  process. Therefore, DOD does not have detailed documentation that  describes the rationale for the assumptions it uses. For example, DOD  has not documented its rationale for continuing to select WTI as a crude  oil benchmark in establishing the standard price although OMB now  provides more than WTI crude oil forecasts in its economic assumptions.  Also, according to the Office of the Under Secretary of Defense  (Comptroller) official, DOD determines its refinement markup to account  for the fact that DLA purchases refined product and does not buy crude  oil and that this factor is developed based on current commodity market  experience balanced against DOD priorities. However, DOD has not  documented its rationale or assumptions for determining these trade-offs.  Reevaluating its approach for estimating the components of the standard  price would allow DOD to develop more informed estimates and better  position DOD to minimize risks and uncertainty resulting from changing  market conditions. Further, documenting the rationale for its assumptions  would provide greater transparency and clarify for fuel customers and  decision makers the process DOD uses to set the standard price.

section_title: Conclusions
paragraphs: DOD has faced challenges in setting a standard price that closely  approximates its actual fuel costs, and in recent years its estimated fuel  prices have differed considerably from its actual costs. Actual prices have  differed from DOD’s estimates largely because changes in fuel market  conditions have not been reflected in the standard price. Additionally,  DOD has not documented its rationale for continuing to use the same  assumptions. The Defense-wide Working Capital Fund, designed to  absorb the effects of price fluctuations, has been insufficient to absorb the  significant net outlays for fuel. This has led to large transfers into the fund  from other DOD accounts and adjustments to the standard price DOD  charges to customers—disrupting other DOD programs and straining the  military services’ budgets. Despite the recurring need for these transfers  and price adjustments, DOD has not reevaluated its approach to setting  the standard price since 2007. Until DOD has reevaluated its approach  and documented its assumptions for setting the standard price, it may not  be certain that its price reflects current conditions.

section_title: Recommendations for Executive Action
paragraphs: To improve DOD’s process for setting its standard fuel price, we  recommend that the Secretary of Defense direct the Office of the Under  Secretary of Defense (Comptroller), in coordination with the Defense  Logistics Agency (DLA), to take the following two actions:  reevaluate the approach for estimating the components of the  standard price and document its assumptions, including providing detailed rationale for  how it estimates each of these components.

section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of this report to DOD, OMB, and the Energy  Information Administration for review and comment. DOD provided written  comments, which are summarized below and reprinted in appendix III. In  its comments, DOD concurred with the first recommendation and partially  concurred with the second recommendation. OMB and the Energy  Information Administration did not provide comments on the draft report.

DOD concurred with the first recommendation that the Secretary of  Defense direct the Under Secretary of Defense (Comptroller), in  coordination with DLA, to reevaluate DOD’s approach for estimating the  components of the standard price. In its comments, DOD stated that this  is an ongoing effort within the department and that the Office of the Under  Secretary of Defense (Comptroller) and DLA are continually evaluating  methods to better estimate the price of fuel. DOD stated that this is a  challenge because the rate-setting process takes place a budget cycle in  advance of execution. DOD noted that fuel-market volatility affects the  Working Capital Fund’s ability to budget for, and customers’ ability to buy,  fuel at a stabilized price. Additionally, in its comments, DOD stated that  the department does not have the storage capacity to hold a year’s worth  of fuel in advance, so fuel is purchased in real time throughout the  execution year and sold at a price set 18 months prior. We agree that the  rate-setting process is challenging, given the timing of DOD’s budget  process and when the department actually purchases fuel. However, as  stated in the report, DOD’s current approach for establishing the standard  price has not accounted for changes in market conditions for crude oil,  such as the decreasing relationship between crude oil and refined prices,  even though its methodology has been producing estimates that differ  greatly from actual costs. Although DOD noted in its comments that it is  continually evaluating methods to better estimate the price of fuel, it did  not specify any specific initiatives to that end. Moreover, the report did not  identify any studies that DOD has undertaken since 2004 that constitute a  reevaluation of the department’s approach for estimating the components  of the standard price. Reevaluating its approach for estimating the  components of the standard price would allow DOD to develop more- informed estimates and better position the department to minimize risks  and uncertainty resulting from changing market conditions.

DOD partially concurred with the second recommendation that the  Secretary of Defense direct the Under Secretary of Defense  (Comptroller), in coordination with DLA, to document its assumptions,  including providing a detailed rationale for how it estimates each of the  standard price components. In its comments, DOD stated that the  department does not have a “documented” specific, step-by-step process  to develop the fuel price. DOD further stated that it prices fuel by using a  formal process that has been presented to the department’s leadership,  briefed to congressional staffers, discussed with the administration, and  reproduced in various instructional and informational briefings and  papers. In its comments, DOD stated that the process for setting the fuel  price is similar to other Working Capital Fund products and follows the  intent of DOD’s Financial Management Regulation and congressional  implementing language for full cost recovery. We stated in the report that  DOD’s Financial Management Regulation provides overall principles for  working capital funds, but it does not require DOD to document its  methodology for setting the standard price in a step-by-step process.  Therefore, DOD does not have detailed documentation that describes the  rationale for the assumptions it uses, such as its rationale for selecting  one crude oil benchmark over another benchmark or the factors and other  tradeoffs that it considers when establishing the refinement markup.  GAO’s Cost Estimating and Assessment Guide states that a cost  estimate should be supported by detailed documentation that describes  how it was derived. According to the guide, the documentation should  include, among other things, the estimating methodology used to derive  the costs for each element of the cost estimate, and it should also discuss  any limitations of the data or assumptions. Documenting DOD’s  assumptions, including the rationale for each component of the standard  price, would provide greater transparency and clarify for fuel customers  and decision makers the process DOD uses to set the standard price.

We are sending copies of this report to appropriate congressional  committees and the Secretary of Defense; the Under Secretary of  Defense (Comptroller); the Director of DLA; the Director of OMB; and the  Administrator of the Energy Information Administration. In addition, this  report is available at no charge on GAO’s website at http://www.gao.gov.

If you or your staff have questions about this report, please contact Cary  Russell at (202) 512-5431 or russellc@gao.gov, or Asif A. Khan at (202)  512-9869 or khana@gao.gov. Contact points for our Offices of  Congressional Relations and Public Affairs may be found on the last page  of this report. GAO staff who made key contributors to this report are  listed in appendix IV.

section_title: Appendix I: Scope and Methodology
paragraphs: To address our objectives, we focused our analysis on fiscal years 2009  through 2013. We focused on these years because this period covered  the most recent complete year of the Department of Defense’s (DOD) fuel  sales and provided 5 years of cost data to analyze any trends. To  determine how estimated bulk fuel costs have compared with actual costs  since fiscal year 2009 and identify the factors that contributed to any  differences, we compared the estimated budget costs for fuel against  actual costs in the budget year of execution and identified any  differences. We calculated DOD’s estimated fuel costs by multiplying the  standard price per barrel by the number of barrels the military services  estimated they would consume. To calculate DOD’s actual fuel costs, we  multiplied the actual purchase price per barrel by the number of barrels  sold to the military services. We then determined which factors  contributed to the overall differences. Specifically, we calculated the  percentage of the overall difference explained by either fuel price  fluctuations or differences between estimated fuel consumption and  actual consumption. Next, we compared each of the three components of  the standard price (crude oil price, refinement markup, and nonproduct  costs—such as transportation and facilities maintenance) against the  actual costs for each component to determine which one contributed most  to the difference between the standard price and actual fuel costs. We  also interviewed officials from the Office of the Under Secretary of  Defense (Comptroller), the Defense Logistics Agency (DLA), the military  services, and the Department of Energy’s Energy Information  Administration to discuss the factors that contributed to these  differences.

To determine the extent to which DOD has taken actions to manage the  effect of any differences between estimated and actual fuel costs, we  reviewed monthly cash balances in the Defense-wide Working Capital  Fund for the period October 2008 through September 2013 and  determined the effect of bulk fuel purchases and sales on those balances.  In doing so, we determined net outlays from the Defense-wide Working  Capital Fund and compared them with the cash balance in the fund. We  analyzed DOD financial management documents for this same period to  determine the number and amount of approved transfer actions related to  fuel into and out of the Defense-wide Working Capital Fund and any fuel- related supplemental appropriations received into the fund. In addition,  we analyzed DOD budget-justification materials and other documentation  to identify all changes to DOD’s standard price. We also interviewed  officials from DOD and the military services to determine the effect on the  services’ budgets of transfers and changes to the standard price.

To determine the extent to which DOD has considered options for  adjusting its approach for estimating bulk fuel costs and managing  working capital funds, we reviewed related studies and recommendations  that we identified through interviews with DOD officials and literature  searches that discuss options available to DOD to adjust its approach to  managing bulk fuel costs and working capital funds. For this review we  focused on relevant studies that have been conducted since 2004. We  interviewed DOD officials to determine the status of any findings and  recommendations from these studies related to DOD’s bulk fuel pricing or  management of the Defense-wide Working Capital Fund. We also  reviewed documentation that describes DOD’s current approach for  estimating bulk fuel costs, including budget-justification materials and  DOD reports, and discussed the department’s approach with officials from  the Office of the Under Secretary of Defense (Comptroller), DLA, and the  Office of Management and Budget. We compared this information with  cost-estimating practices established in GAO’s Cost Estimating and  Assessment Guide and Office of Management and Budget and DOD  guidance. We also interviewed officials from DOD, the Office of  Management and Budget, and the Department of Energy to discuss  current fuel market conditions and alternative approaches to estimating  bulk fuel costs and reviewed Department of Energy reports describing  current fuel market conditions. To better understand the fuel market  conditions, we reviewed DLA fuel purchase data for fiscal years 2009  through 2013 and compared the amount of domestic fuel purchases with  the amount of international fuel purchases. We also performed analysis  on the relationship of the West Texas Intermediate (WTI) crude oil  benchmark with other crude oil pricing benchmarks to determine whether  DOD’s approach to setting its standard price reflects current market  conditions. Further, we conducted an analysis on the relationship of crude  oil prices with refined product costs, including the cost of commercial jet  fuel.

To determine the reliability of the fuel cost data provided to us by DOD,  we obtained information on how the data were collected, managed, and  used through interviews with and questionnaires to relevant officials. We  assessed the reliability of the data collected by analyzing questionnaire  responses from Office of the Under Secretary of Defense (Comptroller)  and DLA officials, which included information on their data system  management, data quality-assurance processes, and potential sources of  errors and mitigations of those errors. To determine the reliability of  monthly cash balances in the Defense-wide Working Capital Fund, we (1)  obtained and analyzed reports containing detailed data on transactions  affecting the Working Capital Fund cash balance including collections,  disbursements, direct appropriations to the fund, and funds transferred  into and out of the fund; (2) reconciled year-end cash balances between  DOD reports and Department of the Treasury records; and (3) obtained  and analyzed documentation supporting the amount of funds transferred  in and out of the Working Capital Fund. To determine the reliability of DLA  fuel purchase data, we compared DLA domestic and international fuel  purchases against fuel purchase data provided in DOD’s budget- justification materials. To determine the reliability of the Energy  Information Administration’s data on Brent, WTI, and commercial jet fuel  prices, we reviewed information on its methodology and data quality  guidelines in accordance with GAO guidance on assessing data from  federal statistical databases. Based on our review of the data, we  determined that the data presented in our findings were sufficiently  reliable for the purposes of this report.

We interviewed officials, and where appropriate obtained documentation,  at the following DOD locations:

Office of the Under Secretary of Defense (Comptroller);

Office of the Assistant Secretary of Defense for Operational Energy

Defense Logistics Agency, Energy Management Activity Group;

Air Force Petroleum Agency;

Office of the Secretary of the Air Force, Financial Management and

Army Petroleum Center;

Naval Supply Systems Command; and

Headquarters, Marine Corps, Programs and Resources, Operations  and Maintenance Budget Formulations Branch.

We also interviewed other officials from the following federal agencies  and other organizations:

Office of Management and Budget;

Department of Energy, Energy Information Administration; and

Institute for Defense Analyses.

We conducted this performance audit from November 2013 to July 2014,  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 the  evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.

section_title: Appendix II: Studies on Department of Defense Bulk Fuel Pricing and Management of the Defense-Wide Working Capital Fund
paragraphs: This appendix contains a list of six studies conducted since 2004 on the  Department of Defense’s (DOD) bulk fuel pricing and management of the  Defense-wide Working Capital Fund. Table 3 provides information on  each study’s name and purpose, as well as any findings and  recommendations, and DOD’s response to the recommendations or  status of their implementation. Some of the studies listed below included  information outside the scope of our review; however, we have only  included findings and recommendations related to DOD’s bulk fuel pricing  or management of the Defense-wide Working Capital Fund.

section_title: Appendix III: Comments from the Department of Defense

section_title: Appendix IV: GAO Contacts and Staff Acknowledgments
subsections: section_title: GAO Contacts

section_title: Staff Acknowledgments
paragraphs: In addition to the contacts named above, Gregory Pugnetti, Assistant  Director; Matthew Ullengren, Assistant Director; Pedro Almoguera;  Russell Bryan; Virginia Chanley; Stephen Donahue; Adam Hatton;  Joanne Landesman; Amie Steele; and Michael Willems made key  contributions to this report.


Question-summary annotations: questions: question: Why has the DOD conducted reviews on its bulk fuel program?
answer: Since 2004, DOD has conducted reviews of aspects of its bulk fuel program to determine whether adjustments should be made, including managing acquisition strategies, managing working capital funds, and budgeting for cost fluctuations.
child_questions: question: What have these reviews omitted?
answer: However, it has not updated its approach to reflect current market conditions or documented its rationale for the assumptions it uses in estimating the standard price.

question: What does GAO state about cost estimates?
answer: GAO's Cost Estimating and Assessment Guide and Office of Management and Budget guidance state that a cost estimate should be updated regularly to reflect changes to assumptions and actual costs, so that it always reflects current conditions. Furthermore, cost estimates should be supported by detailed documentation that describes how they were derived.

question: How will reevaluating its approach help DOD?
answer: Reevaluating its approach for estimating the standard price would allow DOD to develop more informed estimates and better position it to minimize risks and uncertainty resulting from changing market conditions. Further, documenting the rationale for its assumptions would provide greater transparency and clarify for fuel customers and decision makers the process DOD uses to set the standard price.

questions: question: What is DOD's fuel practice?
answer: DOD purchases bulk fuel and sells it to customers, including the military services.
child_questions: question: How does DOD set its fuel price?
answer: Each fiscal year, DOD sets a standard price for budgeting purposes, endeavoring to closely approximate the price it will pay when it buys the fuel almost a year later.
child_questions: question: What may occur if this price is different than the standard price?
answer: If this price is different than the standard price, DOD may need to take actions to manage its working capital funds—funds used to purchase fuel and other commodities that are reimbursed through sales.

questions: question: What did Senate Report 113-44 mandate?
answer: Senate Report 113-44, accompanying a bill for the National Defense Authorization Act for FY 2014, mandated GAO to review DOD's approach for establishing its bulk fuel pricing.

question: What is specifically discussed by the report?
answer: This report discusses, among other things, (1) how estimated bulk fuel costs have compared to actual costs since FY 2009 and the factors that have contributed to any differences; and (2) the extent to which DOD has considered options for adjusting its approach to estimating bulk fuel costs and managing working capital funds in light of any differences between estimated and actual fuel costs.

question: How did GAO conduct its analysis?
answer: GAO compared estimated and actual fuel costs for FY 2009 through 2013 and analyzed DOD actions to manage working capital funds.