The Strategic Petroleum Reserve: Possible Effects on Gasoline Prices of Selected Fill Policies

CRS Report for Congress
The Strategic Petroleum Reserve:
Possible Effects on Gasoline Prices
of Selected Fill Policies
Updated September 27, 2004
Robert Bamberger
Specialist in Energy Policy
Resources, Science, and Industry Division
Robert Pirog
Specialist in Energy Economics and Policy
Resources, Science, and Industry Division


Congressional Research Service ˜ The Library of Congress

The Strategic Petroleum Reserve: Possible Effects on
Gasoline Prices of Selected Fill Policies
Summary
The Strategic Petroleum Reserve (SPR), authorized by the Energy Policy and
Conservation Act (P.L. 94-163), was originally intended to provide a domestic stock
of crude oil to be used in emergency situations when the supply of crude oil to the
United States is disrupted. In November 2001, President Bush ordered that the SPR
be filled to its current capacity with royalty-in-kind (RIK) oil, the government’s share
of oil produced from federal leases. In the face of high prices for crude oil and
gasoline, the policy has been challenged as a contributing cause of higher prices.
Some policymakers have been urging suspension of RIK deliveries to the reserve,
arguing that it would help to lower the cost of gasoline. RIK deliveries are currently
scheduled through April 2005, notwithstanding loans of some crude to refiners
adversely affected by Hurricane Ivan in September 2004.
This report examines the factors that are currently influencing crude oil and
gasoline prices, and reviews the extent to which prices might be correlated with SPR
fill policy. If RIK oil were released to the market, gasoline prices might be affected.
Since crude oil is a raw material in the production of gasoline, a reduction in the
price of oil might pass through to the price of gasoline. To the extent that the
capacity to refine additional barrels of crude directed to the market exists, and the
diverted RIK oil is not offset by reduced crude oil imports, consumers might benefit.
However, the amount of RIK oil, relative to the total market when it is operating
normally, is small, and when coupled with other market dynamics, the effect of
changes in SPR fill policy on crude and product prices could be only minimal. In
instances where there is an actual interruption in deliveries — as experienced by
some refineries in the Gulf Coast in the wake of Hurricane Ivan — the effect of SPR
use may be different.
Conditions in the gasoline market, including strong demand, high refinery
capacity utilization rates, fragmented regional gasoline specifications, and scarce,
high-cost imports, as well as the need to build inventories, point to the continuation
of high gasoline prices even if oil prices decline somewhat. Although the price of oil
influences, and is a component of, the price of gasoline, a complex interaction of
many factors determines price.
A drawdown of the SPR — in addition to a deferral of RIK fill — is a further
policy option, but is not analyzed in depth here. Benefits might vary, depending upon
the ability of refineries to absorb additional crude, and the amount of additional crude
made available. However, if one considers that refining capacity is already strained
and unlikely to benefit from extra crude supply, any softening in oil prices from a
drawdown would be unlikely to be passed along in full to consumers. This report
will be updated as events warrant.



Contents
SPR Background..............................................1
Oil Markets and Price..........................................3
Gasoline Markets and Price......................................6
Conclusion ...................................................8



The Strategic Petroleum Reserve:
Possible Effects on Gasoline Prices of
Selected Fill Policies
The price of gasoline reached nominal record levels in May 2004. The price of
crude oil surged to over $49 per barrel in August 2004, before receding during the
first weeks of September 2004. During the week of September 20, prices rose to over
$48 per barrel on news of a sharp decline in crude oil inventories, at least partly
attributed to interruptions in crude deliveries owing to the effects of a hurricane in
the Gulf of Mexico. These high prices continue to raise concern among consumers
and policy makers. Crude oil prices are an important component of gasoline prices,
but not the only one. Conditions within the gasoline market itself, including strong
demand, as well as supply restrictions, are also adding upward pressure to the price.
This report analyzes one strategy that has entered public debate as a possible way to
mitigate gasoline prices: the diverting of scheduled deliveries of royalty-in-kind
(RIK) oil from the SPR.
SPR Background
Congress authorized the Strategic Petroleum Reserve (SPR) in the Energy
Policy and Conservation Act (EPCA, P.L. 94-163) to help prevent a repetition of the
economic dislocation caused by the 1973-74 Arab oil embargo. Physically, the SPR
comprises five underground storage facilities, hollowed out from naturally occurring
salt domes, located in Texas and Louisiana. Although authorized to a level of one
billion barrels, current storage capacity is 700 million barrels, and current fill levels
are approximately 670 million barrels.
Until 1995, Congress appropriated funds for purchase of SPR oil, and what was
then known as the Defense Fuel Supply Center contracted for deliveries. Crude oil
from Mexico and the United Kingdom accounted for roughly 65% of purchases from
1978 to 1995. Volumes and fill rates varied over the years, reaching a peak
exceeding 300,000 barrels per day (b/d) during the Reagan Administration. The
urgency attached to the SPR program during the 1980s and 1990s often tracked
broader energy concerns. Periods of volatility in energy prices drew a focus on SPR
fill policies. During times of relatively low prices and adequate supply, the SPR fill
rate declined, or was even suspended. Congress and the Clinton Administration
agreed to suspend purchases after FY1994.
From 1995 until the latter part of 1998, sale of SPR oil, not acquisition, was at
the center of debate. There were three sales of SPR oil initiated during 1996, totaling
28.1 million barrels. The first of these sales was for the purpose of financing the
decommissioning of the SPR storage site at Weeks Island. Other sales were directed
by Congress for the purpose of budget deficit reduction. By the late 1990s, following



a reduction of the annual federal budget deficit, and a major drop in crude oil prices,
there was new interest in replenishing the SPR to further energy security objectives,
and as a possible means of providing price support to domestic producers who were
struggling to keep higher-cost, marginal production in service. Secretary of Energy
Bill Richardson requested that the Office of Management and Budget (OMB) include
$100 million in the FY2000 budget request for oil purchases. The proposal was
rejected.
When OMB turned down the Department of Energy’s (DOE’s) request to fund
purchases for SPR oil in FY1999, DOE suggested as an alternative that a portion of
the royalties owed to the government from oil leases in the Gulf of Mexico be
accepted “in kind” (in the form of oil) rather than as cash payments. The Department
of the Interior (DOI) was reported to be unfavorably disposed to the royalty in kind
(RIK) proposal, but a plan to proceed with such an arrangement was announced on
February 11, 1999. The intention was to replace the 28 million barrels sold in the
mid-1990s. It was estimated that, at a rate of 100,000 b/d, it would take about 10
months to replace this volume. At its inception, the RIK plan was greeted by the oil
industry as a well-intended and helpful first step.
The initial contracts were signed at the end of March 1999 with Texaco, Shell,
and BP-Amoco for a total of 3.5 million barrels, and they provided for an adjusted
volume of oil reflecting the quality differential between the oil to be delivered and
the oil produced from the lease tracts. Competitive bids were invited for a second
round, and contracts were awarded in mid-June 1999 for an additional 9.3 million
barrels.
The terrorist attacks on the United States on September 11, 2001 accelerated
interest in acquiring crude for the SPR. Some thought that, depending on the nature
of the U.S. response and potential reprisals, the possibility existed that a politically
driven interruption in oil exports bound for the United States might occur. On
November 13, 2001, President Bush ordered the filling of the SPR to its full capacity
of 700 million barrels, relying on RIK oil. During 2002, nearly 40 million barrels of
oil were delivered to the SPR, some of which was oil returned under the terms of a
“swap” in the fall of 2000.1
Deposit of 40 million barrels into the SPR during 2002 was criticized in a report
released on March 3, 2003, by Senator Levin, prepared by the minority staff of the
U.S. Senate Permanent Committee on Investigations. The study argued that this
increment of SPR fill had been a major contributor to oil price increases during that


1 Stocks of home heating oil were low as the end of summer 2000 approached, and there was
concern about the fresh pressure that escalating crude prices, colder weather, and anticipated
refinery maintenance might have on home heating price and supply during the winter. On
September 22, 2000, President Clinton announced a swap of 30 million barrels of oil from
the SPR, and contracts were awarded on October 4, 2000. Interested parties bid to borrow
quantities of not less than 1 million barrels. Contracts were awarded on the basis of how
much oil bidders offered to return to the SPR.

year.2 A number of industry analysts dismissed the study, arguing that the quantity
of SPR fill was not significant enough to have driven the market.3
However, in light of tightness in world oil markets and increasing prices (due
in some measure to an interruption in roughly 1.5 million b/d in oil exports from
Venezuela), the Bush Administration agreed to delay deliveries scheduled for late
2002 and the first months of 2003. The Administration had intended to accept a total
of 3.9 million barrels of RIK crude oil during April 2003, an average of 130,000 b/d.
On March 4, 2003, DOE delayed delivery of all but 15,000 b/d. With the end of the
initial phase of the war in Iraq and little effect on oil markets, deliveries of RIK oil
were resumed in the spring of 2003, as was delivery of oil still owed from the swap
in 2000.4 In early August 2003, Senator Levin reiterated his charges in a letter to
Secretary of Energy Abraham, requesting that DOE suspend purchases for the SPR
until crude oil prices declined.5 The Administration has indicated that it is continuing
with RIK fill, and deliveries are currently scheduled through April 2005, generally
at a rate of 2.5 to 3.5 million barrels monthly.6
However, there have been three efforts in Congress during 2004 to suspend RIK
fill. On March 11, 2004, during debate on the FY2005 budget resolution, the Senate
called for a suspension of deliveries and a sale, instead, of 53 million barrels of RIK
oil.7 Proceeds (estimated at $1.7 billion) would be used for deficit reduction and
increased homeland security funding for states. Another effort to suspend deliveries
to the SPR of RIK oil occurred on September 14, 2004, during debate on H.R. 4567,
the FY2005 Department of Homeland Security appropriations bill. Senator Byrd
proposed suspension of RIK fill in order to provide $470 million in additional
funding for homeland security purposes. The amendment was set aside.
Oil Markets and Price
Determining whether the cancellation, delay, or market sale of the scheduled
delivery of approximately 25 million barrels of RIK crude oil to the SPR between
October 2004 and April 2005 might have an effect on gasoline prices requires
analysis of the link between the price and supply of crude, as well as the link between
crude oil and gasoline prices in U.S. markets.


2 U.S. Congress. Senate. U.S. Strategic Petroleum Reserve: Recent Policy Has Increased
Costs To Consumers But Not Overall U.S. Energy Security. Report prepared by the
Permanent Subcommittee on Investigations. Committee on Governmental Affairs. S.Rept.

108-18. March 5, 2003. p. 2.


3 See, for example: Petroleum Industry Research Foundation, Inc. The SPR, the Royalty in
Kind Program, and Oil Prices. August 2003.
4 Obligations to the SPR from the “swap” were completely covered by January 2004.
5 Platts Inside Energy, August 11, 2003, p. 3.
6 The current delivery schedule may be monitored at [http://www.fe.doe.gov/programs/
reserves/] under the link for “Current Inventory.”
7 This is roughly the volume of oil yet to be delivered to the SPR to reach capacity.

Net imports of petroleum to the United States averaged an estimated 11.2
million barrels per day (mbd) during 2003, while total daily petroleum consumption
exceeded 20 million barrels.8 While daily volumes will fluctuate, scheduled
deliveries of RIK oil to the SPR between October 2004 and April 2005 will average
roughly 135,000 b/d. If diverted to the market, this would represent less than 1% of
U.S. demand for oil. The amount of oil potentially entering the market, relative to
the size of the market, is the reason that some analysts discount the practical
importance of altering the planned SPR fill.9
Other analysts have made broader assertions that stockpiling and policies
governing drawdown of the SPR — along with strategic stocks held elsewhere in the
world — have added to the price of oil in world markets. In a statement before a
California panel discussion on gasoline prices, Philip Verleger estimated that SPR
fill policy had raised crude oil prices between $5-$10/barrel by the end of 2003.10
The March 2003 study by the minority staff of the Permanent Subcommittee on
Investigations, of the relationship between SPR fill policy and price argued that the
addition of 25 million barrels to the SPR during late 2001 and early 2002 contributed
to oil price increases. During a one-month period in mid-2002, the study concludes,
crude oil price increases stemming from deposits to the SPR imposed an additional
energy price burden on consumers ranging between 500 million and one billion
dollars.11 The study predicted that maintenance of the Administration’s fill policy
would contribute to higher prices in 2003 as well.
Consistency between links in the oil supply chain, from the oil market, to the
refineries, to the gasoline market, might also be important in determining the extent
to which oil, and ultimately gasoline, prices would be affected by rescheduling RIK
deliveries to the SPR. For example, if refining capacity were not readily available
to process released oil, because refineries were near maximum capacity, the result
might be that U.S. imports of crude oil would decline as refiners substitute RIK oil,
yielding no additional new product supply on the market.
The other side of these arguments is that in a tight oil market, even a relatively
small change in supply could have a disproportionate effect on price. The
Organization of Petroleum Exporting Countries (OPEC) however, asserts that the
market is not experiencing supply tightness. They point to plentiful supplies of


8 U.S. Department of Energy. Energy Information Administration. Monthly Energy Review.
March 2004.
9 American Petroleum Institute, “API Update to Congress on Fuel Supplies, Market
Conditions.” April 2, 2004.
10 Goldman-Sachs Commodities Weekly, January 16, 2004, p. 5. Philip K. Verleger, Jr.,
“Statement for Attorney General Lockyer’s Panel Discussion on California Gasoline
Prices.” March 11, 2004. Verleger asserts that SPR policy since the fall of 2001 has resulted
in increases in crude oil prices of as much as $8 per barrel.
11 U.S. Congress. Senate. U.S. Strategic Petroleum Reserve: Recent Policy Has Increased
Costs To Consumers But Not Overall U.S. Energy Security, p. 2.

heavy, sour crude, the type sold by many OPEC producers, while recognizing the
market for light, sweet crude oil is tighter.12
Isolating the effect of any single causal factor in the workings of the oil market
is difficult. The market is characterized by complex multi-causality that reflects both
long and short run influences. Daily market price perturbations suggest that it is
likely that any change in energy policy, including one on SPR fill rates, could have
some immediate effect on the price of crude oil, due to the price sensitivity of spot
and near term futures prices to changing expectations. Whether the initial price
response would last long enough to translate into a change in gasoline prices for
consumers would depend on whether the underlying demand and supply
fundamentals were tipped in the direction of excess supply. But, it would also be
difficult to separate out the effect of other developments during the same period that
also may have had some bearing on oil and product prices.
The events of March 31, 2004, provide a good example of the complex, and
sometimes contradictory, short term effects of changing market forces on price. On
March 31, 2004, the price of oil, measured by the May delivery, light, sweet crude
futures contract traded on the New York Mercantile Exchange (NYMEX), closed
lower by $0.49 per barrel, or a decline of about 1.5%, at $35.76. On the same day,
OPEC ministers, meeting in Vienna, reaffirmed their intent to lower their production
limit to 23.5 million barrels per day on April 1, a decline of 1 million barrels per day,
which, if effective, might tighten oil supply and push prices upward. However, other
factors also affected the market that day. The EIA announced that stocks of crude oil
held by refiners unexpectedly rose by 5.7 million barrels, to 294.3 million barrels, for
the week ended March 26, the highest value attained since August 2002. This news
seemed to offset the OPEC actions, yielding the fall in price.13
Longer term demand and supply factors also filter into the price setting process.
The persistently high price of crude oil in 2004, above the stated OPEC target price
range of $22 to $28 per barrel, has been widely attributed to demand growth that has
exceeded forecasts, especially in the United States and China.
Expectations and psychological factors also play a role in price formation. When
the Senate passed a bipartisan sense-of-the-Senate resolution (sponsored by Senators
Levin and Collins) to the 2005 budget resolution that would direct the government
to cancel delivery of RIK oil and divert 53 million barrels to the market, the price of
crude oil futures fell $0.59/barrel. The futures price then rose $0.40/barrel only a
week later on the day that the administration announced that it intended to keep
filling the SPR as planned, even though prices were at a near record high level. How
much of these price movements should be attributed to the Senate action or the
Administration response is arguable in light of the many other factors cited here that
may bear on daily movements in market prices.


12 Oil Daily, “Opec Looks Set to Stick to April Target.” Vol. 54, No. 61, March 31, 2004.
p.1.
13 Some also argue that speculation plays some part in the movement of crude and product
prices, and that these observed prices may not always be a strict measure of current or
anticipated supply.

A more recent example where other market factors overwhelmed discussion
occurred on September 24, 2004, when Energy Secretary Spencer Abraham
announced that DOE had reached agreement to make limited quantities of SPR oil
available to refiners in the Gulf Coast whose supply of crude oil had been disrupted
by Hurricane Ivan. The released oil, totaling less than 2 million barrels, would be
replaced by contracting companies when supply conditions returned to normal. The
quantity of oil to be released is small relative to U.S. imports, and because it is
replacing temporarily lost production, its effect on oil, and ultimately gasoline, prices
is likely to be small and difficult to discern. The day after Secretary Abraham’s
announcement, crude oil for November 2004 delivery traded at over $48.50, close to
recent peak values. The Administration did not agree to the swap as a market-
calming measure, but as a limited, and focused, swap to address a temporary,
measurable physical disruption of supply.14
A drawdown of the SPR — in addition to a deferral of RIK fill — is a further
policy option, but one not analyzed in depth here. Depending upon the ability of
refineries to absorb additional crude, and the volume of the drawdown, the benefits
might vary. However, it could be argued that refining capacity is already strained
and unlikely to benefit from a deferral in SPR fill. Thus, in this circumstance, any
softening in the price of crude from a drawdown is unlikely to be passed along in full
to consumers. At the same time, if use of SPR oil is expected to replenish crude
inventories — which fell during the week after Hurricane Ivan — it is possible that
there could be some small market-calming effect. Once again, other external factors
might offset the use of SPR crude even for this purpose.
Gasoline Markets and Price
According to the Energy Information Administration (EIA), crude oil accounts
for approximately 40% of the cost of gasoline at the pump.15 The remaining
components of the price per gallon are federal and state taxes (about 30%),
distribution and marketing costs (about 13%), with refining costs and profits
accounting for a variable residual. Along with the price of crude oil, refining profit
margins and costs have been volatile in recent years.16 Conditions may now exist in
the gasoline market that would tend to keep prices high, independent of crude oil
pri ces. 17
Since no new refinery has been built in the United States in over 25 years,
expansion of capacity to meet growing product demand has come from incremental
expansion of existing facilities and increasing the rate of capacity utilization. Over


14 “DOE Signs SPR Loan Deals With Refiners,” Oil Daily, Vol. 54, No. 185, Monday,
September 27, 2004, p. 1-2.
15 Energy Information Administration, “Primer on Gasoline Prices.” September 2003. p 2.
16 See CRS Report RL32248, Petroleum Refining: Economic Performance and Challenges
for the Future, March 1, 2004, for a more complete analysis of the refining industry.
17 For a more detailed treatment of the factors and dynamics affecting gasoline prices, see
CRS Report RL32343, Gasoline Price Surge: Revisited Crude Oil and Refinery Issues, by
Lawrence Kumins and Robert Bamberger.

the past decade, capacity utilization, on average, has been greater than 90%. The
most recent monthly data for 2004 show capacity utilization averaging 96% in May
and 95% in June 2004, higher values than the 95.8% and 94.7% for May and June
2003.18 Weekly data estimates suggest that capacity utilization remained at 95% or
more through July and August 2004.19 High utilization rates imply very little
flexibility in the system to expand production if a bottleneck appears anywhere else
in the supply chain or if market supply of crude oil increases.
If RIK crude oil entered the market and did not displace supply from other
sources, and if refinery capacity were available to produce more gasoline for the
market, it is likely that consumers would gain. Increased supply would likely help
reduce price, and this additional supply could be used to replace high cost imported
gasoline.
Adding to the tightness in regional gasoline markets is the specialized nature of
gasoline specifications. The variety of gasoline blends makes it difficult to transfer
product from areas of available supply to those in shortage. Importing fuel also
becomes more expensive because a foreign refinery has to tailor a relatively small run
of product for a regional U.S. market. In some cases, relatively small product
volumes and lower profit expectations may induce foreign refiners not to invest in
the processes necessary to produce specific blends for U.S. regional markets. If this
outcome were to occur it might mean localized price spikes and shortages.
Imports of gasoline and gasoline blending components account for about 10%
of total gasoline supply on the U.S. market.20 Because of more stringent
requirements on sulfur content, additives such as MTBE, and vapor pressure,
obtaining gasoline on the international market that meets U.S. and state fuel
specifications, and is competitively priced, has become more difficult. As a result,
it may be that the more expensive import component of gasoline supply is raising the
price of gasoline in the U.S. market. This is likely to happen if the price of gasoline
is determined by the cost of acquiring the incremental supply necessary to meet
market demand and avoid market disruptions.
Low inventories of both crude oil and gasoline products have also influenced
near-term futures prices, as well as prices faced by consumers. The level of total
motor gasoline inventories maintained during the course of the year have been
declining in recent years. It has been estimated that a minimum stock level of 185
million barrels of gasoline is needed simply to keep the distribution system running.
However, gasoline stocks averaged about 211 million barrels in 2002. They declined
further to about 202 million barrels on average in 2003, a 4.5% decline from the 2002
level. Estimates for the first six months of 2004 show gasoline inventory levels


18 Energy Information Administration, “Weekly Petroleum Status Report.” September 17,

2004. Table 2, p. 2.


19 Ibid.
20 Ibid. Table 8, p. 14.

declined by 0.7% compared to 2003.21 Although U.S. motor gasoline supplied to the
market has averaged about 9 million barrels per day, an inventory level of slightly
above 200 million barrels translates into available supply of less than two days’
consumption when the necessary volumes required to keep the system flowing are
factored into the analysis.22
Conclusion
Crude oil is an input into a production process that yields motor gasoline as a
retail product. For the suspension of RIK deliveries of crude oil to the SPR to have
an effect on gasoline prices this oil would have to alter the demand and supply
balance in the production process. At least two obstacles exist that might prevent the
RIK oil from having a significant effect. First, the amount of oil is small, less than
1%, of U.S. requirements, and even less of the world market. If any other oil
producer chose to reverse the effect of the RIK oil on the market, that could be
accomplished with an offsetting reduction in supply. Second, refineries in the United
States, the link between the crude oil and the gasoline markets, are operating at nearly
full capacity, making it unlikely that additional supplies of crude oil, in the form of
the RIK volumes, could be refined and distributed as a net increase in motor gasoline.
High crude oil prices in the world market are influenced by political as well as
economic forces. The high gasoline prices facing U.S. consumers reflect those high
world crude oil prices and are sustained by a number of conditions in the gasoline
market. The high utilization rate of refineries, the fragmented specification of
regional gasoline blends, the low inventory balances, and the scarcity and high cost
of conforming imported gasolines suggest that the gasoline market might remain tight
even if additional crude oil appeared on the market.


21 Ibid. Table 4, p. 6.
22 Energy Information Administration, “Petroleum Supply Monthly.” August 2004, Table
S4, p. 17.