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Government Mismanages the Strategic Petroleum Reserve November 13, 2007

Posted by federalist in Economic Policy, Finance, Government Spending, Taxation.
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Here’s another way government can replace taxes with the astute stewardship of public assets: David Henderson notes that the U.S. government is in a unique position to arbitrage commodities market. Since it stockpiles massive quantities of commodities it could take risk-free profits in a backwardated market — while helping to mitigate a transient supply crunch (which is what a backwardated market indicates). For example, right now it can sell oil from the Strategic Petroleum Reserve at $96/barrel, while buying contracts to refill the SPR in one year at only $87/barrel.

My cynical side suspects that this is such an obvious win for both commodities consumers and taxpayers that we can almost guarantee it won’t happen.  [Sure enough, Nov 14, WSJ notes, “Last week, the Department of Energy announced plans to continuing buying crude oil to fill the 694-million-barrel Strategic Petroleum Reserve, noting that the reserve’s purpose is to cope with oil supply disruptions — not to manipulate prices.”  So if a backwardated market doesn’t indicate a supply disruption, what does?]

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1. federalist - November 15, 2007

The President should define explicit rules for employing the Strategic Petroleum Reserve (SPR). As the Federal Reserve has recently concluded, greater transparency always benefits our national economy when it comes to market-moving government and regulatory intervention.

The SPR was created by the Energy Policy and Conservation Act to mitigate the impact of temporary supply disruptions on our nation’s access to crude oil. To this point the use of the SPR has relied upon the discretion of the President to declare an emergency supply disruption and affirmatively act to draw from the SPR. The fact that this has become a discretionary and political decision has reduced the effectiveness of the SPR, and has caused our country to miss clear opportunities to constructively employ the SPR. SPR drawdowns should instead be triggered and governed by explicit rules.

There is a large and active futures market for crude oil that clearly indicates when supply disruptions are underway: When the price for future delivery of oil is lower than the price to buy oil now, then there is (by definition) a temporary shortage. This is known in the markets as “backwardation.”

We do not need to rely on the discretion of anyone in the executive branch to identify a supply shortage: The futures markets can tell us. The SPR should always sell oil in backwardated markets because it will produce two positive effects:
1. The supply shortage will be alleviated.
2. The SPR can lock in a guaranteed profit by selling at the spot price and buying oil on the futures market to replace the drawdown.

For example, the oil markets are presently backwardated: The spot price for crude oil has risen above $96/barrel, while oil for delivery in one year has been almost $10/barrel cheaper. In this circumstance the SPR should begin to sell oil and buy futures. The consequences of this action would be as follows:
1. The spot price for oil would begin to decrease as the current supply is enhanced from the SPR. I.e., the temporary shortage would be alleviated.
2. The futures price for oil would begin to increase as the SPR contracts to refill the reserves following the shortage.
3. The SPR would lock in a profit for each barrel of oil – a guaranteed profit as high as $10/barrel in this scenario.
4. Within one year the SPR would be completely replenished, based on its futures contracts.

The SPR is in a unique position to smooth out supply disruptions. No other entity has the capacity to instantaneously unleash market-moving supplies of oil on this continent. The President should not wait for a politically compelling event to employ the SPR in this fashion. Simply following a rule of drawing down the SPR when futures markets are backwardated, and simultaneously contracting through the futures markets to refill it after the shortage is mitigated will guarantee both profits for the government and the best possible economic performance for our oil-driven economy.


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