Strategic Petroleum Reserve: Available Oil Can Provide Significant Benefits, but Many Factors Should Influence Future Decisions about Fill, Use, and Expansion

Strategic Petroleum Reserve: Available Oil Can Provide
Significant Benefits, but Many Factors Should Influence Future
Decisions about Fill, Use, and Expansion (24-AUG-06, GAO-06-872).

Congress authorized the Strategic Petroleum Reserve (SPR),
operated by the Department of Energy (DOE), to release oil to the
market during supply disruptions and protect the U.S. economy
from damage. The reserve can store up to 727 million barrels of
crude oil, and currently contains enough oil to offset 59 days of
U.S. oil imports. GAO answered the following questions: (1) What
factors do experts recommend be considered when filling and using
the SPR? (2) To what extent can the SPR protect the U.S. economy
from damage during oil supply disruptions? (3) Under what
circumstances would an SPR larger than its current size be
warranted? As part of this study, GAO developed oil supply
disruption scenarios, used models to estimate potential economic
harm, and convened 13 experts in conjunction with the National
Academy of Sciences.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-06-872
ACCNO: A59404
TITLE: Strategic Petroleum Reserve: Available Oil Can Provide
Significant Benefits, but Many Factors Should Influence Future
Decisions about Fill, Use, and Expansion
DATE: 08/24/2006
SUBJECT: Crude oil
Energy consumption
Energy planning
Energy shortages
International organizations
Oil resources
Petroleum industry
Energy supplies
Supply and demand
Strategic Petroleum Reserve

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GAO-06-872

* Report to Congressional Requesters
* August 2006
* STRATEGIC PETROLEUM RESERVE
* Available Oil Can Provide Significant Benefits, but Many Factors
Should Influence Future Decisions about Fill, Use, and Expansion
* Contents
* Results in Brief
* Background
* Based on Historical Experience, Experts Suggested Alternative
Practices for SPR Fill and Points to Consider for Use
* Experts Suggested Practices to Reduce the Cost of Filling
the SPR
* Early Fill Activity Was Generally Focused on Making the
SPR Large Enough to Respond to Disruptions
* Experts Generally Agreed That Recent SPR Acquisitions
Caused Minimal Increase in Oil Prices, and Suggested
Practices to Reduce the Future Cost of SPR Fill
* Experts Suggested Several Points to Consider When Deciding
on SPR Use
* SPR Legislation Allows Broad Presidential Discretion
* Members of our Expert Group Disagreed about Past SPR
Use Decisions
* Experts Suggested Several Points to Consider When
Making Decisions about SPR Use
* SPR Use during Disruptions Can Provide Substantial Benefits, but
the Magnitude of These Benefits Is Uncertain
* SPR and International Reserves at Their Current Size Can
Replace the Oil Lost in All but the Most Catastrophic
Disruptions
* SPR Use during Disruptions Can Prevent Substantial Economic
Damage
* DOE Models Yield Significantly Different Estimates of the
Economic Damage Avoided by Using the SPR
* Other Factors, in Addition to the SPR's Ability to Replace
Oil, May Affect the Extent to Which the SPR Can Protect the
U.S. Economy from Damage
* Transport of Oil to Refineries May Be Difficult during
Some Disruptions
* SPR Oil Is Not Fully Compatible with Some Refineries
* Releasing Oil from the SPR Is Less Helpful If U.S.
Refining Capacity Is Damaged
* SPR Can Provide Benefits to the U.S. Economy Without
Releasing Oil
* A Larger SPR Is Warranted If Demand for Oil Grows as Expected
* Oil Demand Projections Support a Larger SPR
* DOE Estimates That Long- term Benefits of SPR Expansion to
1.5 Billion Barrels Exceed Costs
* Factors Influencing the SPR's Ideal Size Are Likely to
Change Over Time
* Conclusions
* Recommendations for Executive Action
* Agency Comments and Our Evaluation
* Scope and Methodology
* Economic Modeling of Oil Supply Disruptions
* Oil Supply Disruption Scenarios
* Modeling of Economic Impacts
* EIA Model
* Office of Petroleum Reserves' Model
* Similarities and Differences between the EIA Model and
Office of Petroleum Reserves' Model
* Comments from the Department of Energy
* GAO Contact and Staff Acknowledgments

Report to Congressional Requesters

August 2006

STRATEGIC PETROLEUM RESERVE

Available Oil Can Provide Significant Benefits, but Many Factors Should
Influence Future Decisions about Fill, Use, and Expansion

Figures

August 24, 2006Letter

The Honorable Susan M. Collins Chairman Committee on Homeland Security and
Governmental Affairs United States Senate

The Honorable Carl Levin Ranking Minority Member Permanent Subcommittee on
Investigations Committee on Homeland Security and Governmental Affairs
United States Senate

Oil is the world's most important energy resource. The world consumes
approximately 83 million barrels of oil per day, accounting for nearly 40
percent of world energy consumption. In 2004, the most recent year for
which data are available, 40 percent of the energy used in the United
States and 96 percent of the energy used in the U.S. transportation sector
were derived from oil, the majority of which was imported. In 2004, the
United States imported 65 percent of its crude oil supply, or
approximately 10 million barrels per day. Supply and demand for oil are in
tight balance today, with only about 1 million barrels per day of spare
oil production capacity, meaning that even small disruptions in supply can
cause large increases in prices. Unusually high prices for petroleum
products due to a strike at Venezuela's national oil company in 2002 to
2003 and Hurricanes Katrina and Rita in 2005 demonstrated this effect.

Because of the central role that oil plays in the U.S. economy, sudden
increases in its price can cause economic damage. Increases in crude oil
price are reflected in the prices of products made from crude oil, such as
gasoline, diesel, home heating oil, and petrochemicals such as fertilizer.
Furthermore, because petroleum products are an important part of the
production of many goods and services, the prices of these goods and
services also increase. These price increases can reduce the total amount
of goods and services that consumers can afford, thus reducing economic
activity. Past studies have shown that oil price shocks can cause hundreds
of billions of dollars of damage to the U.S. economy.

To help protect the U.S. economy from damage caused by oil supply
disruptions, Congress authorized the Strategic Petroleum Reserve (SPR) in
1975, following the Arab oil embargo of 1973 to 1974. The SPR is owned by
the federal government and operated by the Department of Energy (DOE). It
can store up to 727 million barrels of crude oil in salt caverns located
at sites in Texas and Louisiana. Since 1976, the United States has spent
about $45.2 billion in 2005 dollars to build, maintain, fill, and manage
the SPR. In addition, the United States and 25 other nations that are
members of the International Energy Agency have agreed to maintain
reserves of oil or petroleum products equaling 90 days of net imports and
to release these reserves and reduce demand during oil supply
disruptions.1 In June 2006, the SPR contained about 689 million barrels,
equal to 59 days of U.S. oil imports. In addition to government reserves,
private industry inventory varies over time, but DOE estimates that
private inventory contains an amount equal to an additional 59 days of
U.S. oil imports. Thus, at the current level of oil demand, the SPR
combined with private industry holdings contains enough oil to exceed the
United States' 90-day reserve requirement.

Under conditions prescribed by the Energy Policy and Conservation Act, as
amended, the President and the Secretary of Energy have discretion to
authorize release of the oil in the SPR to minimize significant supply
disruptions.2 In the event of an oil supply disruption, the SPR can
provide supply to the market-by selling stored crude oil or trading this
oil in exchange for a larger amount of oil to be returned later. When oil
is released from the SPR, it flows through commercial pipelines or on
waterborne vessels to refineries, where it is converted into gasoline and
other petroleum products, then transported to distribution centers for
sale to the public.

Refineries are configured to refine specific types of crude oil. Crude oil
is generally classified according to two parameters: density and sulfur
content. Less dense crudes are known as "light," while denser crudes are
known as "heavy." 3 Crudes with relatively low sulfur content are known
as

"sweet," while crudes with higher sulfur content are known as "sour." 4
In general, heavier and more sour crudes require more complex and
expensive refineries to process the oil into usable products, but are less
expensive to purchase than light sweet crudes. Many refiners in the United
States have upgraded their facilities in recent years to process heavy
sour crude. The SPR contains about 40 percent sweet crude and 60 percent
sour crude, stored in separate caverns. Both crude types in the SPR are
considered "light."

Oil markets have changed substantially in the 31 years since the
establishment of the SPR. At the time of the Arab oil embargo, price
controls in the United States prevented the prices of oil and petroleum
products from increasing as much as they otherwise might have,
contributing to a physical oil shortage that caused long lines at gasoline
stations throughout the United States. Now that the oil market is global,
the price of oil is determined in the world market primarily on the basis
of supply and demand. In the absence of price controls, scarcity is
generally expressed in the form of higher prices, as purchasers are free
to bid as high as they want to secure oil supply. In a global market, an
oil supply disruption anywhere in the world raises prices everywhere.
Releasing oil reserves during a disruption provides a global benefit by
reducing oil prices in the world market.

Use of the SPR during an oil supply disruption mitigates damage to the
economy by replacing the oil lost, thereby reducing the price spike and
the resulting economic damage. Such damage is typically reflected in a
temporary reduction in gross domestic product (GDP), the total market
value of all goods and services produced in the U.S. economy in a given
year, compared with what it would have been without the disruption. The
reduction in GDP caused by an oil supply disruption and the resulting
price increases depends on several factors, including the size and
duration of the disruption; the availability of oil market "cushions,"
such as excess oil production capacity and private inventories; and the
importance of oil to economic activities. Severe oil supply disruptions in
the past, such as the Arab oil embargo, caused sudden spikes in oil prices
accompanied by economic losses of billions of dollars in the United States
and other major oil-consuming economies. More recent disruptions, such as
the Venezuelan strike in 2002 to 2003, have involved smaller quantities of
oil for shorter durations and caused less economic damage. Two offices
within DOE-the Office of Petroleum Reserves and the Energy Information
Administration (EIA)-use models to analyze the effects of oil supply
disruptions and SPR use on the economy. The Office of Petroleum Reserves
is in charge of the day-to-day operations of the SPR, and it uses a model
to calculate the effects of oil supply disruptions and SPR use as part of
a study of the net benefits of expanding the reserve. EIA is a statistical
agency that uses a separate model to estimate the impact of oil supply
disruptions and to advise officials about their potential consequences.

From 1977 to 1992, Congress appropriated money to purchase oil from the
market to fill the SPR. Since 1999, oil for the SPR has been obtained
through the royalty-in-kind program. Through this program, the government
receives oil instead of cash for payment of royalties on leases of federal
land in the Gulf of Mexico. Because oil produced in the Gulf generally
does not meet the specifications to be stored in the SPR, DOE trades this
oil with contractors who provide oil that can be stored in the SPR.
Recently, the Energy Policy Act of 2005 directed DOE to increase the SPR
inventory to 1 billion barrels and required DOE to select sites for the
expansion to accommodate the inventory no later than 1 year after
enactment, or by August 2006.

Historically, DOE has added oil to the SPR in response to specific
concerns about oil supply security. For example, when DOE acquired oil for
the SPR after the Arab oil embargo of 1973 to 1974 and the Iranian
revolution in 1979, the goal was to rapidly create a reserve large enough
to be useful in case of a severe oil supply disruption. During the mid- to
late-1990s when oil prices were relatively low, there were no significant
oil security concerns and little oil was added to the SPR. In contrast,
following the terrorist attacks of September 11, 2001, the President
directed that oil be added to the SPR, even though it already contained
enough oil to meet potential near-term supply disruptions. The stated goal
was to maximize long-term protection against oil supply disruptions. Some
have criticized filling the SPR at that time because they believe doing so
increased the price of oil.

The President has the primary authority to decide when to use the SPR.
Additionally, the Secretary of Energy is authorized to carry out exchanges
from the SPR and test drawdowns to evaluate SPR procedures. Presidents
have twice ordered that oil be sold from the SPR in response to oil supply
disruptions: that is, in response to the 1990-1991 Persian Gulf War and
Hurricane Katrina in 2005. Additionally, the SPR has sold or exchanged oil
on several other occasions, including providing small quantities of oil to
refiners to help them through short-term localized oil shortages.

In conducting our review, we answered the following questions: (1) Based
on past experience, what factors do experts recommend be considered when
filling and using the SPR? (2) To what extent can the SPR protect the U.S.
economy from damage during oil supply disruptions? (3) Under what
circumstances would an SPR larger than its current size be warranted?

In addressing these questions, we developed six hypothetical oil supply
disruption scenarios. These scenarios are set in today's oil market, with
global crude oil demand of approximately 83 million barrels per day and
U.S. demand of approximately 21 million barrels per day. The scenarios are
as follows:

o A hurricane in the U.S. Gulf Coast disrupts oil supplies by up to 1.5
million barrels per day for 6 months, similar to the disruptions caused by
Hurricanes Katrina and Rita in 2005.

o A strike among oil workers in Venezuela disrupts oil production by up to
2.2 million barrels per day over 5 months, similar to a strike that
occurred in 2002 to 2003.5 Production then remains 0.2 million barrels per
day below its prestrike level for an additional 19 months.

o Iran stops exporting oil for 18 months, removing 2.7 million barrels per
day from the market.

o A terrorism event at an oil facility in Saudi Arabia disrupts up to 6
million barrels per day over 8 months.

o Closure of the Strait of Hormuz, which is a vital oil shipping lane
located at the entrance to the Persian Gulf, disrupts 17 million barrels
per day for 1 month. Supply then recovers over the next 2 months.

o Saudi Arabia stops oil production, removing 10 million barrels per day
from the market for 18 months. Production then recovers over the following
6 months.

We selected these hypothetical scenarios to illustrate the potential
benefits of strategic reserves in a wide range of different situations,
not because we consider these scenarios likely.

To collect expert opinions on the impacts of past SPR fill and use and
recommendations for the future, we convened a group of experts in
conjunction with the National Academy of Sciences6 and interviewed experts
from industry and academia. We convened the group to allow the experts to
exchange and challenge ideas, but the group was not designed to reach
consensus on the issues discussed. We also reviewed records and reports
from DOE and the International Energy Agency and interviewed officials
from these agencies and other oil industry experts.

To analyze the ability of the SPR to reduce economic damage caused by oil
supply disruptions, we reviewed the economic literature on the impact of
oil supply disruptions and used two DOE simulation models to estimate the
reduction of harm to U.S. GDP that would result from releasing oil from
the SPR and international reserves during our oil supply disruption
scenarios. These two models estimate the increase in oil prices and the
reduction in GDP that are likely to occur during an oil supply disruption
of a given size. Although the models provide useful information, they make
assumptions and do not include some factors that could influence the
reserve's operation, such as the compatibility of SPR oil with U.S.
refineries. Therefore, we interviewed oil industry experts, members of our
group of experts, and representatives from companies that comprise 76
percent of the refining capacity of the United States to learn about
issues with SPR operation not included in the models that affect the
extent to which the SPR can protect the economy.

To learn about the circumstances under which a larger SPR would be
warranted, we reviewed U.S. stockholding obligations to the International
Energy Agency, estimates of future U.S. oil demand, and a 2005 study
performed by a contractor for DOE that analyzed the expected costs and
benefits of expanding the SPR.7 We also reviewed studies and interviewed
members of our National Academy of Science group of experts and other oil
market experts about factors that influence the ideal size of the SPR. Our
intent was to present useful information and discussion of key
considerations about expanding the SPR, not to make recommendations about
whether the SPR should be expanded.

We did not independently verify information about security, drawdown
rates, or other operational factors reported by the Office of Petroleum
Reserves, nor did we analyze or verify strategic reserves held by other
countries that belong to the International Energy Agency. A more detailed
description of our scope and methodology is included in appendix I. We
performed our work between March 2005 and July 2006 in accordance with
generally accepted government auditing standards.

Results in Brief

The group of experts with whom we consulted recommended a number of
factors to be considered for filling and using the SPR. With regard to
filling the SPR, although recent fill activity during a time of tight
supply and demand conditions raised some concerns that filling the SPR was
increasing world oil prices, experts generally agreed that the nearly
steady acquisitions of oil for the SPR from late 2001 through 2005 caused
minimal increase in world oil prices. To reduce the cost of filling the
reserve, experts in our group and others recommended acquiring a steady
dollar value of oil over time-that is, a dollar-cost-averaging approach-to
ensure that more oil is acquired when prices are low and less oil is
acquired when prices are high. We estimated that if DOE had followed a
dollar-cost-averaging approach when filling the SPR from October 2001
through August 2005, it could have saved approximately $590 million while
acquiring the same amount of oil. Simulations we performed of this
approach under various potential oil market conditions, including
scenarios of rising and falling prices and periods of smaller and larger
price volatility, showed that this approach would likely save money in the
future as well. Some experts also suggested that DOE should allow oil
producers to delay oil delivery to the SPR when supply and demand are in
tight balance. Producers could provide additional oil to the SPR to pay
for the privilege of delaying delivery. With regard to using the SPR,
experts generally supported providing broad discretion about when to use
the reserve, although they questioned some past presidential decisions
about SPR use. Experts also described several key factors to consider when
making future decisions about using the SPR, including using the SPR
without delay when it is needed to minimize economic damage.

The SPR is an extremely valuable asset, and releasing oil from the reserve
during oil supply disruptions could greatly reduce the damage to the U.S.
economy, as measured by losses in GDP. According to DOE, the SPR can
currently release up to 4.4 million barrels of oil per day-about 44
percent of U.S. daily oil imports-for 90 days, and can release a
diminishing amount of oil for an additional 90 days. This level alone is
sufficient to completely replace oil lost in the Gulf Coast hurricane and
Venezuelan strike scenarios we evaluated and, when combined with
international reserves, can completely replace the losses from our Iranian
embargo and Saudi terrorism scenarios. However, world reserves are
inadequate to fully replace the oil lost in our most catastrophic
scenarios: that is, the closure of the Strait of Hormuz and the loss of
Saudi oil production. DOE uses one model to estimate the net benefits of
expanding the SPR and another model to estimate the economic effect of oil
supply disruptions. These models rely on different assumptions,
particularly about the effect of oil price increases on GDP. Both models
show a positive effect from using SPR, although the results are very
different in magnitude. For example, for our Gulf Coast hurricane
scenario, the Office of Petroleum Reserves and EIA models estimate avoided
GDP damage of $7 billion and up to $400 million, respectively; in our
Saudi shutdown scenario, the models estimate avoided GDP damage of $170
billion and up to $66 billion, respectively. The substantial differences
between the results of these two models could lead offices within DOE to
provide inconsistent advice about expanding and using the SPR.
Additionally, several factors beyond the SPR's ability to replace oil
could decrease or increase the economic benefit of the reserve. For
example, the crude oil in the SPR is not compatible with all U.S.
refineries. During a disruption of heavy crude oil supply, refineries
configured to use this type of crude oil would have to reduce production
of some petroleum products if they processed the lighter oil stored in the
SPR. This decrease in production could raise prices for these products and
decrease the SPR's effectiveness in reducing economic damage.

If demand for oil in the United States increases as expected, a larger SPR
would be necessary and desirable to maintain the economy's existing level
of protection. EIA recently projected increases in U.S. demand for
petroleum products of approximately 12 percent by 2015 and 24 percent by
2025, compared with the 2005 level. Using these demand projections, DOE
estimates that the United States will drop below its stockholding
obligation to the International Energy Agency by 2025. Additionally, a
2005 study prepared for DOE finds that the benefits of expanding the SPR
to 1.5 billion barrels exceed the costs over a range of future conditions.
However, factors that influence the SPR's ideal size are likely to change
over time. For example, although projections show increasing oil demand in
the United States and world, the level of oil demand depends on many
factors, including rates of economic growth, the price of oil, future
policy choices related to increasing conservation and availability of
alternative energy sources, and technology changes. As the world oil
market changes over time, periodic reassessments by DOE of the appropriate
size of the SPR could be helpful as part of the nation's long-term energy
security planning.

We are making four recommendations to the Secretary of Energy to improve
the operation of the SPR and to improve decisions surrounding the SPR's
use and expansion. Specifically, we are recommending that the Secretary
should (1) study how to best implement experts' suggestions to fill the
SPR more cost-effectively, including acquiring a steady dollar value of
oil for the SPR over the long term and providing industry with more
flexibility in the royalty-in-kind program to delay oil delivery to the
SPR; (2) conduct a new review to examine the maximum amount of heavy oil
that should be held in the SPR and ensure that DOE implements its own
recommendation to hold at least 10 percent heavy oil in the SPR; (3)
clarify the differences in structure and assumptions between the models
used by the Office of Petroleum Reserves and EIA and clarify to
policymakers how the models are used; and (4) periodically reassess the
appropriate size of the SPR in light of changing oil supply and demand in
the United States and the world. In commenting on a draft of this report,
DOE generally agreed with the report and recommendations.

Background

Oil is vitally important to the world and U.S. economy, accounting for
nearly 40 percent of world primary energy consumption.8 As shown in figure
1, although world oil consumption has increased significantly over the
past 20 years, oil's share of primary energy consumption has remained
fairly constant. EIA projects similar trends for the next 20 years, with
total world energy consumption increasing 2 percent annually through 2025
and oil comprising about 38 percent of all energy consumption in 2025.9

Figure 1: World Primary Energy Consumption

Note: Percentage shares may not add to 100 percent due to rounding.

Oil is also the largest primary source of energy in the United States,
accounting for about 40 percent of all energy consumed in 2004. As shown
in figure 2, two-thirds of the oil consumed in the United States is used
for transportation. About 96 percent of energy used for transportation in
the United States comes from oil. The transportation sector is almost
exclusively dependent on oil because there are no significant competitive
alternatives. EIA projects that transportation will comprise an even
larger part of U.S. oil use in the future, about 72 percent in 2030,
because it expects the growth in demand for transportation to far exceed
increases in fuel efficiency.10

Figure 2: U.S. Oil Consumption, by Sector, 2004

As shown in figure 3, the United States' demand for imported crude oil
increased rapidly after 1970, when domestic crude oil production peaked.
Although the percentage of imported crude oil decreased from about 45
percent in 1977 to about 26 percent in 1985 due to a reduction in demand
for oil, imported crude oil increased again to 65 percent by 2004 due to a
combination of increases in consumption and decreases in domestic
production.

Figure 3: United States' Use of Domestic and Imported Crude Oil

The United States created the SPR because the country's reliance on oil
imports makes it vulnerable to disruptions in oil supply. Strategic oil
reserves like the SPR are particularly important now because oil market
cushions, such as excess oil production capacity and private inventories,
have decreased in recent years. Although estimates of spare production
capacity are uncertain, experts believe that spare production capacity
dropped to around 1 million barrels per day in 2004, close to a 20-year
low. Additionally, private inventories of oil and oil products have been
on a long-term declining trend, in part because of a trend toward
just-in-time inventory. The absence of these market cushions means that
less oil is available in the market to mitigate price spikes during oil
supply disruptions. Thus, a supply disruption that takes even a small
amount of oil off the market could cause the price of oil to rise
dramatically.

One factor limiting excess oil production capacity is recent steep
increases in world consumption of oil. Together, the United States and
Western Europe accounted for 44 percent of the 80 million barrels of oil
per day of
world oil consumption in 2003.11 The United States is the world's largest
oil consumer, accounting for about 25 percent of the world's oil
consumption, despite having only 5 percent of the world's population. In
addition to the high levels of consumption in the United States and
Western Europe, oil consumption has also been rising rapidly in Asia and
Oceania, as shown in figure 4. For example, according to a recent study by
the International Monetary Fund, China and India accounted for 35 percent
of incremental oil consumption between 1993 and 2003, even though they
accounted for only 15 percent of world economic output over the period.12
China has overtaken Japan as the second largest oil consumer in the world,
second to the United States.

Figure 4: World Oil Consumption, by Region

Since 1976, the United States has spent about $26.3 billion-$45.2 billion
when valued in year 2005 dollars-to build, maintain, fill, and manage the
SPR. The largest cost has been the cost of filling the reserve. Since
filling began in 1977, $20.0 billion has been spent to obtain oil ($35.1
billion in 2005 dollars).13 This amount includes $15.7 billion of oil
purchased with funds appropriated from 1977 through 1992, and $4.3 billion
of oil received in lieu of government royalty payments since 1999.

Since 1999, oil for the SPR has been obtained through the royalty-in-kind
transfer program, in which royalties from government oil leases in the
Gulf of Mexico are taken in the form of oil, rather than in cash. The
Department of the Interior's Minerals Management Service, which collects
the royalties, contracts for delivery of the royalty oil to designated
market centers. Because the oil delivered to these market centers often
does not meet SPR quality specifications and is distant from the SPR
storage sites, DOE awards complementary contracts to exchange royalty oil
at the market center for SPR-quality oil delivered to the SPR facilities.
However, the logistics of Gulf of Mexico oil production from federal
leases limits the rate at which royalty oil can be economically delivered
to the SPR sites.

The SPR oil is stored in salt caverns at the following four facilities:
Bayou Choctaw and West Hackberry in Louisiana, and Big Hill and Bryan
Mound in Texas. These caverns range in size from 6 million to 35 million
barrels and were created by solution mining, in which water injected into
an underground salt formation dissolves the salt and creates a cavern.
According to DOE, salt caverns offer the lowest cost, most environmentally
secure way to store crude oil for long periods of time. Storing oil in
aboveground tanks generally costs 5 to 10 times as much. Also, because the
salt caverns are 2,000 to 4,000 feet below the surface, geologic pressure
will seal any crack that develops in the salt formation, ensuring that no
crude oil leaks from the cavern. An additional benefit is the natural
temperature difference between the top of the caverns and the bottom,
which keeps the crude oil continuously circulating in the caverns,
ensuring that the oil in the cavern is of consistent quality.

Areas near the Gulf of Mexico were a logical choice for locating the SPR.
In addition to the more than 500 salt domes concentrated along the Gulf
Coast, many U.S. refineries and distribution points for tankers, barges,
and pipelines are available. The four SPR storage areas are connected via
pipelines to the Gulf Coast and the Midwest refining regions. Oil can be
transferred via tanker to the Louisiana Offshore Oil Port, which is a
major facility in the Gulf of Mexico that is connected via pipeline to
over 50 percent of the United States refining capacity. The location of
the SPR is less advantageous for distributing oil to or receiving it from
the western United States.

Past drawdowns of the SPR have occurred for a wide variety of reasons. The
SPR has sold oil twice under emergency conditions, 17.3 million barrels in
1991 at the beginning of Operation Desert Storm and 11.0 million barrels
in 2005 after Hurricane Katrina. In response to problems ranging from a
blocked pipeline to a potential shortage of commercial heating oil stocks,
exchanges of crude oil from the SPR with private companies have occurred
eight times, ranging in size from 500,000 barrels to 30 million barrels.
The largest exchange occurred in the fall of 2000 in response to concerns
about low inventories of heating oil in the Northeast. In these exchanges,
the borrowing parties returned the amount of oil borrowed plus additional
volumes of oil as interest. In two cases, conducted for operational
reasons, the SPR exchanged 11.0 million barrels of lower quality oil for
8.5 million barrels of higher quality oil and 2.7 million barrels of crude
oil for 2.0 million barrels of heating oil. DOE has also conducted two
test sales to demonstrate the readiness of the SPR, in 1985 and 1990. In
addition, sales to reduce the federal deficit occurred mainly in 1996.

Based on Historical Experience, Experts Suggested Alternative Practices
for SPR Fill and Points to Consider for Use

Recent concerns about filling the SPR and long-standing concerns about its
use can be addressed in ways that improve SPR effectiveness, according to
numerous energy and oil market experts. A number of persons have raised
questions because they believe that recent efforts to fill the SPR during
tight oil supply conditions put upward pressure on oil prices. Others have
expressed concerns that the SPR has not been used in disruptions where its
use was warranted and, when used, has not been used early enough after a
disruption has occurred. In addressing these concerns, experts with whom
we spoke suggested alternative practices to consider when filling the SPR
to reduce fill costs, as well as various points to consider when deciding
whether to use the SPR.

Experts Suggested Practices to Reduce the Cost of Filling the SPR

While early SPR fill activity focused on establishing an oil reserve large
enough to be useful during a supply disruption, more recent fill activity
has focused on maximizing long-term protection against disruptions.
Although several oil analysts and experts believe that filling the SPR
from late 2001 through 2005 during a time of tight supply and demand
conditions caused the price of oil to increase by several dollars per
barrel, most of the experts with whom we spoke believe that filling the
SPR at that time had minimal impact on oil prices because the volume was
so small compared with world oil demand. Experts suggested SPR fill
practices that could reduce the cost of filling the SPR. They recommended
that DOE acquire a fixed dollar value of oil per time period, rather than
a fixed volume of oil per time period, and allow industry more flexibility
in the timing of oil deliveries to the SPR.

Early Fill Activity Was Generally Focused on Making the SPR Large Enough
to Respond to Disruptions

Prior to 1984, several pieces of legislation set forth minimum fill rates
for the SPR, in an effort to increase the volume of the reserve to a level
large enough to be useful during an oil supply disruption. However, the
actual rate of fill often fell short of these goals. Several studies
completed around this time reported that, given the SPR's small size, it
should be reserved for severe disruptions since it is a one-time source of
crude oil, which must be replenished after a drawdown. They advised that
only after the SPR contained a minimum of 250 million to 500 million
barrels of oil would it be advisable to use it. In a September 1981
report, we echoed this concern, believing that DOE should not suspend SPR
fill, except during severe disruptions, until the SPR reached a minimum
threshold size.14 Furthermore, we stated that, given the importance of the
SPR, filling it should be considered a part of U.S. base demand and should
not be cut back under tight market conditions.

Figure 5 shows the progress in filling the SPR since its inception in
1975. Fill was suspended from September 1979 to September 1980 when oil
supplies were disrupted following the Iranian Revolution. The SPR reached
a volume of about 500 million barrels in 1985, and filling the reserve
slowed considerably after that time. SPR fill was again suspended in 1990
after the Iraqi invasion of Kuwait. The size of the SPR did not
significantly increase again until after the September 11 terrorist
attacks, when the President ordered DOE to fill the SPR to its 700 million
barrel capacity to maximize the long-term protection against potential oil
supply disruptions.15 The President's statement accompanying the fill
order indicated that, although current strategic inventories in the United
States and other countries were sufficient to meet any potential near-term
supply disruption, filling the SPR to capacity would strengthen the
long-term energy security of the United States. The President directed
that the SPR be filled in a deliberate and cost-effective manner,
principally through royalty-in-kind transfers. From April 2002 to August
2005, DOE added 138 million barrels to the SPR at a
cost of $4.3 billion.16 The SPR received oil from the royalty-in-kind
program at average rates varying from about 60,000 to 116,000 barrels per
day, although fill was suspended twice during this period, including
January to April 2003 in response to the disruption of crude oil supplies
from Venezuela.

Figure 5: SPR Inventory Over Time

Note: Congress authorized the SPR in 1975, but filling the reserve did not
begin until 1977.

Experts Generally Agreed That Recent SPR Acquisitions Caused Minimal
Increase in Oil Prices, and Suggested Practices to Reduce the Future Cost
of SPR Fill

The President's directive to fill SPR in 2001 became controversial.
Several oil analysts and experts believe that filling the reserve at that
time caused the world price of oil to increase by several dollars per
barrel. Most of the oil experts with whom we spoke, however, believe that
filling the SPR had minimal impact on oil prices, because the volume of
oil going to the SPR was very small, less than one-quarter of 1 percent of
total world demand.

To decrease the cost of filling the SPR, many experts recommend changes in
SPR practices, including more flexible timing of oil acquisition.
Generally, all fill options must balance the cost of adding oil to the SPR
now against the benefits that the additional oil will provide in the
future. During the initial filling of the SPR, it was clear that the
benefits of adding oil outweighed the immediate costs of doing so.
However, now that the SPR holds nearly 700 million barrels of oil, there
is a greater interest in finding ways to reduce the acquisition costs.

Several experts suggested that DOE should use a predictable, transparent
long-term process to acquire oil for the SPR. For example, some experts
suggested a dollar-cost-averaging approach, where DOE would acquire a
steady dollar value of oil per time period (e.g., day or month) instead of
a relatively steady volume, as has generally been the case in recent
years. A dollar-cost-averaging approach would take advantage of
fluctuations in oil prices, since the same dollar amount will purchase
more oil when prices are low than when prices are high. To evaluate the
effect of a dollar-cost-averaging approach on SPR fill cost, we estimated
the potential savings of this approach had it been used from October 2001
through August 2005. Our results showed that if DOE had followed a
dollar-cost-averaging approach when filling the SPR during that time, it
could have saved approximately $590 million while acquiring the same
amount of oil. We also ran simulations to estimate potential future cost
savings from using a dollar-cost-averaging approach over 5 years. The
simulations showed that dollar cost averaging is likely to save money over
a range of plausible paths of future oil prices, whether prices are rising
or falling and whether price volatility is small or large. The savings due
to dollar cost averaging were generally greater when oil prices were more
volatile.

As an additional measure, some experts suggested that DOE exercise
flexibility and react to market conditions when filling the SPR. They said
that DOE should not fill the SPR when the oil market is tight or when
doing so would significantly tighten the market. DOE officials told us
that the department has approved some delivery deferrals that contractors
have requested, in particular after the oil workers' strike in Venezuela,
but DOE has also turned down some requests. In return for these deferrals,
DOE received additional barrels of oil as a premium. From October 2001
through August 2005, payment for deferrals added 4.6 million barrels of
oil to the SPR, with a value of approximately $110 million. Some experts
suggested that DOE could expand the use of deferrals by allowing oil
producers to
delay oil delivery to the SPR when they believe that supply and demand are
in tight balance and current prices are higher than expected future
prices.17 Under these conditions, it is financially advantageous for oil
producers to delay delivery, and producers could provide additional oil to
the SPR to pay for the privilege of delaying delivery. Experts noted that
there may be considerations beyond the oil market, such as national
security concerns, that would necessitate the delivery of oil to the SPR
at a particular time, therefore, DOE would want to exercise its authority
to disallow deferrals at times when it is in the national interest that
oil deliveries not be delayed.

Experts Suggested Several Points to Consider When Deciding on SPR Use

The law allows broad presidential discretion and provides only general
guidance for the SPR's use, making use of the SPR a matter of judgment by
the President. SPR use decisions are largely a matter of judgment, and
members of our group of experts disagreed about the appropriateness of
past use decisions. Past drawdowns have been for widely varying purposes,
including emergency responses, test sales, and deficit reduction. In
addressing use-related issues, experts suggested several points to
consider when deciding whether to use the SPR.

SPR Legislation Allows Broad Presidential Discretion

The President has the primary authority to decide when to use the SPR. The
Energy Policy and Conservation Act authorizes the President to use the SPR
in the event of a severe energy supply disruption or when required to meet
the obligations of the United States to the International Energy Agency.18
Amendments to this act in 1990 gave the President additional authority to
use the SPR in reaction to a circumstance that constitutes or is likely to
become a significant shortage, and where action taken would assist in
preventing or reducing the adverse impact and would not impair national
security. These amendments allow for only limited use of the SPR-no more
than 30 million barrels may be sold over 60 days, and no sales may be made
if the SPR is below 500 million barrels.

In addition to presidential authority, the Secretary of Energy is
authorized to carry out test drawdowns and sales or exchanges from the SPR
to evaluate the drawdown and sale procedures. The Secretary may not
release more than 5 million barrels of oil during such a test. DOE
officials pointed out that they follow a series of progressive steps in
responding to a disruption. They can (1) identify relevant inventories and
evaluate market impacts (with the help of EIA); (2) defer any ongoing
deliveries to the SPR, thereby making this oil available to the market;
(3) make exchanges in response to requests from individual companies
facing problems; and (4) arrange for competitive exchanges, whereby
companies bid for oil from the SPR by promising to replace it with a
greater volume of oil at a specified date in the future. DOE officials
believe that this graduated approach allows them a flexible and measured
response appropriate to the size of the disruption.

While the President's discretion over the release of oil introduces some
uncertainty into the market, it also has certain advantages. Members of
our group of experts told us that uncertainty around SPR use can be
valuable. For example, the President can use the SPR as a bargaining tool
in diplomatic negotiations during energy crises, enabling him to encourage
behavior by oil-producing nations that could be beneficial to the United
States.

Members of our Expert Group Disagreed about Past SPR Use Decisions

Members of our group of experts disagreed about the appropriateness of
past SPR use decisions. Since the decision about whether the SPR should be
used to ameliorate a situation is generally a matter of judgment, experts
tend to view past decisions from the perspective of hindsight. For
example, several members of our group told us that they believed the oil
workers' strike in Venezuela in 2002 to 2003 was a clear case in which SPR
use was appropriate, although the reserve was not used in response to the
strike. However, DOE officials stated that oil from the SPR was not needed
during the strike. They noted that other oil-producing nations had agreed
to increase production, and that the U.S. government allowed oil companies
to delay delivery of oil to the SPR-which together added significant
quantities of oil to the market.

Members of our group of experts held a range of views about the timeliness
of past use, including the SPR's first emergency use during the Gulf War
in 1991. While some said that reserve use in this instance was timely and
showed the market that supply would be available, others contended that
the United States did not use the SPR soon enough, when it could have
dampened oil price increases and prevented the U.S. economy from slipping
into a recession. However, these experts acknowledged the difficulty of
disentangling the effects of the war from the effects of the SPR release
on oil prices.

Group members were generally supportive of SPR use in response to
Hurricane Katrina in 2005. Several experts agreed that this use of SPR
demonstrated that the government understood its role as one of
complementing rather than competing with the market.

Experts Suggested Several Points to Consider When Making Decisions about
SPR Use

Despite the lack of clear consensus regarding previous decisions to use
the SPR, experts in our group suggested several points that policymakers
should consider when deciding whether to use the SPR: (1) that recent
increases in the size of the SPR should result in a greater willingness to
use it during a disruption, (2) that more extensive experience with the
SPR during oil supply disruptions may enable better understanding of the
features of each disruption that determine whether SPR use is warranted,
and (3) that using the SPR without delay when it is needed will minimize
economic damage. DOE officials told us that, while they do not have a
formal checklist, they consider all relevant features when considering SPR
use during a disruption, including the features noted by our group of
experts.

First, experts in our group and in interviews noted that the SPR is much
larger today than in the past, and that this change allows the SPR to be
used with less concern about keeping enough oil in the reserve for future
disruptions. Members of our expert group pointed out that today's larger
reserve diminishes the value of holding oil back during a disruption as a
hedge against possible future disruptions, and they noted greater
willingness to use reserves in response to disruptions now than in the
past.

Second, more extensive experience with the SPR during past disruptions may
enable better understanding of the unique features of future oil
disruptions that warrant a release of oil from the SPR. In a 1993
report,19 we stated that U.S. policy emphasized initially relying on free
market forces in oil supply disruptions. However, the report observed that
this policy provides little specific guidance on how long market forces
should be allowed to operate before the SPR is used or what conditions
should dictate its use. Experts in our group agreed that the SPR should be
used to supply oil during disruptions where the market cannot make up for
lost supply. Experts also identified a variety of specific features of
disruptions that could help determine when SPR use is warranted. These
features included the volume of oil disrupted, the type of oil disrupted,
the availability of spare oil production capacity, the source of the
disruption and its distance from the United States, and the time of year
that the disruption occurs (with implications for gasoline supplies in the
summer and heating oil in the winter).

Economic experts have described additional points to consider when making
decisions about using the SPR during a disruption.

o Experts noted that not all oil price increases are equally damaging to
the economy. Economic research shows that rapid oil price increases, or
price shocks, are much more harmful to the economy than oil price
increases along a steady upward path. For example, one expert noted that
although average world crude oil prices increased by more than $30 per
barrel between 2001 and 2005, there was no price shock, and the U.S.
economy remained strong, growing at about 3.5 percent annually during this
period.

o Under some conditions, decision makers could use monetary policy to
partially offset economic damage from an oil price shock. The Federal
Reserve might be able to prevent some economic damage by allowing a
one-time increase in the money supply to stimulate spending and spur GDP
growth. However, not all economists agree that monetary policy would be
effective, or that monetary policy could offset the impacts of a
disruption without having other negative impacts on the economy.

Third, avoiding delay in using the SPR when its use is warranted will
minimize economic damage. Expert group members encouraged early use of the
SPR as a first line of defense against oil supply disruptions, noting that
recent changes in the oil industry-including diminished spare crude oil
production capacity, refining capacity, and product inventories-have
removed sources of supply security that have covered short-term supply
losses in the past. Additionally, some experts believe that much of the
harm to the U.S. economy occurs in the early phases of a disruption,
before the economy has a chance to adjust to higher prices.

Avoiding delay in SPR use is also important because even when spare
production capacity is available in the world to take the place of
disrupted oil supply, this oil will take time to reach the United States.
EIA estimates that the majority of the world's spare oil production
capacity is located in Saudi Arabia and takes about 30 to 40 days to reach
the United States. For this reason, experts told us that spare capacity
would be unlikely to mitigate the early stages of a domestic disruption or
a disruption affecting a nearby oil supplier, such as Venezuela, whose oil
takes about 5 to 7 days to reach the Gulf Coast of the United States.

SPR Use during Disruptions Can Provide Substantial Benefits, but the
Magnitude of These Benefits Is Uncertain

At their current capacities, the SPR and international reserves can
replace the oil lost in all but the most catastrophic disruptions. Doing
so protects the economy from significant damage, according to the results
of two DOE models, although these models disagree about the magnitude of
the avoided damage. Additionally, several factors beyond the SPR's ability
to replace oil could decrease or increase the economic benefit of the
reserve, such as the compatibility of SPR oil with some U.S. refineries.

SPR and International Reserves at Their Current Size Can Replace the Oil
Lost in All but the Most Catastrophic Disruptions

In June 2006, the SPR contained 689 million barrels of oil that can be
released at a maximum initial rate of 4.4 million barrels a day, a rate
that can replace about 44 percent of U.S. oil imports. As shown in figure
6, the maximum drawdown rate gradually decreases after 90 days as the
storage caverns are emptied. If the SPR is drawn down more slowly, it
could release a million barrels of oil per day for nearly 1 1/2 years, or
at smaller rates for an even longer period.

Figure 6: SPR Maximum Drawdown Capability

In addition to the reserves in the United States, members of the
International Energy Agency have about 2.7 billion barrels of public and
industry reserves, of which about 700 million barrels are
government-controlled for emergency purposes.20 These
government-controlled reserves can release a maximum of about 8.5 million
barrels of oil and petroleum products per day, diminishing quickly to
about 4.5 million barrels per day after 30 days, about 3.5 million barrels
per day after 60 days, and slightly more than 1 million barrels per day
after 90 days. Reserves of refined petroleum products, such as gasoline or
diesel, can be useful during oil supply disruptions, but they are more
expensive to store than crude
oil.21 We did not independently verify the potential drawdown rates of
international reserves.

The SPR, either alone or in combination with these international reserves,
can replace the oil lost in four of the six hypothetical disruption
scenarios that we developed for this review. The six scenarios are (1) a
hurricane in the U.S. Gulf Coast, (2) a strike among oil workers in
Venezuela, (3) an embargo of Iranian oil supply, (4) a terrorism event at
an oil facility in Saudi Arabia, (5) closure of the Strait of Hormuz, and
(6) a shutdown of Saudi Arabian oil production. For each scenario, we
assume that world excess crude oil production capacity and world
fuel-switching capabilities, which together total 850,000 barrels per day,
are available immediately to help offset a disruption.22 We also assume
that private inventories of crude oil are neutral during a
disruption-holders of private inventory neither draw down their
inventories nor hoard oil. (See app. II for a more detailed description of
our scenarios.)

As shown in table 1, the SPR is large enough and has enough drawdown
capacity to completely replace the oil lost during our Gulf Coast
hurricane and Venezuelan strike scenarios, which reduce world oil supply
by 155 million barrels over 6 months and 307 million barrels of oil over
24 months, respectively. The SPR could eliminate these hypothetical
disruptions by releasing 24 million and 87 million barrels of oil,
respectively, and world spare capacity and fuel switching would make up
the remaining 131 million and 220 million barrels.

Table 1: Ability of the SPR and International Reserves to Replace Oil

Barrels in
millions
Release Release from
from the SPR and
the SPR international
alone reserves
Hypothetical Disruption Disruption Excess Can Volume Can Volume
oil supply length size capacity replace of replace of
disruption (months) and fuel oil? release oil? release
scenario switching
Gulf Coast 6 155 131 Yes 24 Yes 24
hurricane
Venezuelan 5 307 220 Yes 87 Yes 87
strike
Iran embargo 18 1,478 465 No 684 Yes 1,013
Saudi 8 882 207 No 650 Yes 675
terrorism
Strait of 3 882 78 No 344 No 688
Hormuz
closure
Saudi 24 6,205 620 No 684 No 1,461
shutdown

Source: GAO assumptions and analysis of data from Leiby, Paul N. and David
W. Bowman, "Disruption Scenarios and the Avoided Costs Due to SPR Use,"
Oak Ridge National Laboratory Working Paper (Jan. 19, 2006).

The SPR alone is not large enough to replace all of the oil lost in our
Iranian embargo scenario, and it does not have enough drawdown capacity to
completely replace the oil lost during our Saudi terrorism scenario. Our
Iranian embargo scenario assumes a disruption of almost 1.5 billion
barrels of oil over 18 months. Even if the United States were to release
all of the oil in the SPR and if excess production capacity and fuel
switching were available in the amount assumed here, there would still be
a net disruption of slightly more than 300 million barrels. In our Saudi
terrorism scenario, the drawdown capacity of the SPR would be insufficient
to replace the oil lost during the 1st month of the disruption. For the
SPR to replace the oil during the 1st month with no assistance from
international reserves, maximum SPR drawdown capacity would need to be
increased by almost 1 million barrels per day, to a total drawdown
capacity of approximately 5.2 million barrels per day. In both of these
cases, however, a coordinated international response could replace all of
the disrupted oil.

Even with a coordinated response, the SPR and international oil reserves
are not adequate to replace the disrupted oil from our catastrophic Strait
of Hormuz closure and Saudi shutdown scenarios. The drawdown capacity of
international reserves is inadequate to replace the very large amount of
oil that could be disrupted if the Strait of Hormuz were closed. We assume
that a closure of the Strait of Hormuz could disrupt 17 million barrels of
oil per day during the 1st month-more than 12 million barrels per day
beyond what the SPR could release on its own and more than 4 million
barrels per
day beyond what could be released during a coordinated international
response. In contrast, the volume of oil in international reserves is
inadequate to replace the oil lost during our Saudi shutdown scenario.
Even if all of the oil in the SPR were used in a unilateral response, the
net disruption would still be more than 4.9 billion barrels over 2 years,
an amount equal to about 16 percent of the crude oil consumed in the world
in 2004. Assuming a coordinated international response, the net disruption
would still be over 4.1 billion barrels over 2 years, an amount equal to
more than 13 percent of the crude oil consumed in the world in 2004.

SPR Use during Disruptions Can Prevent Substantial Economic Damage

The SPR can reduce economic damage during oil supply disruptions by
replacing some or all of the disrupted oil, moderating the resulting oil
price increase and its negative effect on U.S. economic activity, as
measured by GDP. As previously noted, DOE uses two different economic
models to estimate the impact of oil supply disruptions on oil prices and
GDP: one used by the Office of Petroleum Reserves and one used by EIA. We
used both of these models to estimate the reduction in economic damage
(avoided damage) that could result from releasing oil from the SPR and
international reserves during our six hypothetical disruption scenarios.
(See app. II for additional description of these models and the
assumptions used in our analysis.)

Table 2 shows the oil price increases that the Office of Petroleum
Reserves' model estimates for our six disruption scenarios if reserves
were not used, if the SPR were used alone, and if the SPR were used as
part of a coordinated international response. This model estimates oil
prices each month during a disruption and assumes that completely
replacing the oil lost in a disruption eliminates the resulting price
increase. Thus, this model predicts no price increase in situations where
the SPR or international reserves can completely replace the disrupted
oil, although experts told us that a price increase would likely occur in
this instance due to market psychology. For those scenarios where some,
but not all, of the oil can be replaced, the model estimates smaller oil
price increases than if reserves were not used. For example, the model
estimates that oil prices could rise by up to $47 per barrel during our
Saudi terrorism scenario if reserves were not used.23 However, if SPR oil
were released into the market, the estimated maximum price increase would
be only $7 per barrel. If oil from international reserves were also
released into the market, the model estimates there would be no price
increase, because the reserve oil would completely replace the disrupted
oil.

Table 2: Maximum Monthly Increases in Oil Price, According to the Office
of Petroleum Reserves' Model

Dollars per barrel
Maximum monthly
oil price
increase
Hypothetical oil supply No release SPR release SPR and
disruption scenarios international
release
Gulf Coast hurricane $5 $0 $0
Venezuelan strike 11 0 0
Iranian embargo 16 5 0
Saudi terrorism 47 7 0
Strait of Hormuz closurea 175 121 34
Saudi shutdown 89 77 63

Source: GAO analysis of data from Leiby, Paul N. and David W. Bowman,
"Disruption Scenarios and the Avoided Costs Due to SPR Use," Oak Ridge
National Laboratory Working Paper (Jan. 19, 2006).

aThis model shows a very large maximum oil price increase in the 1st month
of the Strait of Hormuz closure because the disruption volume in this
month is the largest of any of the scenarios, even though the volume of
the disruption as a whole is smaller.

To estimate how much economic damage could be avoided by using the SPR and
international reserves during our oil supply disruption scenarios, we
first estimated the damage that would occur if no reserves were used. We
then estimated the damage to GDP, if any, from the disruptions if the SPR
were used, either alone or in conjunction with international reserves. The
difference between the estimates with and without reserve use is the
avoided damage to GDP resulting from use of the reserve. As shown in table
3, the Office of Petroleum Reserves' model estimates that the ability of
the SPR alone to curb rising oil prices reduces damage to GDP by a range
of $7 billion for our 6-month Gulf Coast hurricane scenario to $142
billion for our 8-month Saudi terrorism scenario. In all but the two
smallest scenarios, the model shows that a coordinated international
response can provide a greater reduction in damage, ranging from $118
billion for the 3-month closure of the Strait of Hormuz to $201 billion
for our 18-month Iranian embargo scenario. In our 24-month Saudi shutdown
scenario, the model shows that economic damage of approximately $662
billion occurs even if international reserves were used in response to the
disruption.

The damage caused by each disruption and the portion of that damage that
can be avoided by releasing reserves depend on the nature of the
disruption. For example, the SPR and international reserves cannot
eliminate all of the economic damage that could be caused by our Strait of
Hormuz closure scenario because, even though the duration is short, it
involves a disruption of a very large quantity of oil that the reserves
cannot replace. Additionally, the models show that replacement of a
portion of the oil lost in the Saudi Arabian shutdown scenario results in
less benefit to the economy than completely replacing the oil lost in the
smaller Iranian embargo scenario.

Table 3: Ability of the SPR and International Reserves to Reduce Damage to
GDP, According to the Office of Petroleum Reserves' Model

Dollars in billions
Hypothetical oil GDP damage GDP damage that can be
supply disruption caused by eliminated by reserves
scenarios disruption SPR alone SPR and
international
reserves
Gulf Coast hurricane $7 $7 $7
Venezuelan strike 23 23 23
Iranian embargo 201 132 201
Saudi terrorism 149 142 149
Strait of Hormuz 146 56 118
closure
Saudi shutdown 832 77 170

Source: GAO analysis of data from Leiby, Paul N. and David W. Bowman,
"Disruption Scenarios and the Avoided Costs Due to SPR Use," Oak Ridge
National Laboratory Working Paper (Jan. 19, 2006).

The way in which oil is released from the reserves also impacts how
effective the reserves are in preventing damage to GDP. In each scenario,
the results previously described include the assumption that release
begins immediately and occurs at a steady rate for the entire length of
the disruption. The results also include the assumption that the rate of
release either completely replaces the oil lost or is the maximum
sustainable rate for the entire disruption. Delaying the release of
reserves in response to a disruption is harmful in every scenario, and the
harm is greater the longer release is delayed. This effect is particularly
large in scenarios where more oil is lost at the beginning of the
disruption, such as the closure of the Strait of Hormuz or the Saudi
terrorism scenarios. Replacing the oil lost during the disruption at the
maximum rate possible instead of a steady rate gives a different result
only in our largest disruption scenario, the Saudi shutdown. The maximum
release strategy is advantageous in this scenario because the model
assumes that the economic damage from the disruption is worse at the
beginning, before the economy has had a chance to adjust. Since
international reserves are emptied to respond to this scenario, releasing
more oil at the beginning provides more benefit than releasing at a steady
rate.

Table 4 shows the oil price increases that the EIA model estimates for our
six oil supply disruption scenarios for the same three circumstances
described for the Office of Petroleum Reserves' model: if reserves were
not used, if the SPR were used alone, and if the SPR were used as part of
a coordinated international response. The EIA model estimates a range of
price impacts for each quarter of the disruption, rather than a single
value for each month as in the Office of Petroleum Reserves' model. Both
models consider the amount of oil disrupted when calculating oil price
increases, but the EIA model also estimates the impact of the disruption
on market psychology. For example, an EIA official stated that disruptions
caused by violent events would have larger price impacts than disruptions
caused by peaceful events, such as a strike or natural disaster.
Furthermore, the EIA model assumes that even if reserves can replace all
of the oil lost in a disruption, oil prices may still increase because of`
market psychology. For these reasons, in some cases, the EIA model
predicts larger price increases when reserves are used than the Office of
Petroleum Reserves' model. For example, for the Saudi terrorism scenario,
the EIA model predicts a price increase of $18 to $39 if the SPR were used
alone (see table 4), while the Office of Petroleum Reserves' model
predicts a maximum price increase of only $7 (see table 2).

Table 4: Maximum Quarterly Increases in Oil Price, According to the EIA
Model

Dollars per barrel
Maximum quarterly
oil price increase
Hypothetical oil supply No release SPR release SPR and
disruption scenarios international
release
Gulf Coast hurricane $1 - $2 $0 $0
Venezuelan strike 9 - 13 0 - 2 0 - 2
Iranian embargo 19 - 28 11 - 17 6 - 11
Saudi terrorism 39 - 67 18 - 39 15 - 35
Strait of Hormuz closure 54 - 82 32 - 52 11 - 24
Saudi shutdown 66 - 104 60 - 96 54 - 87

Source: GAO analysis using the EIA model.

Note: For each scenario, we assume that world excess crude oil production
capacity and world fuel-switching capabilities, which together total
850,000 barrels per day, are available immediately to help offset a
disruption. Oil price increases are modeled for each quarter of the
disruption, rather than each month as in the previous model, meaning that
the price increases are not directly comparable.

As shown in table 5, the EIA model estimates that the ability of the SPR
alone to mitigate increases in oil prices reduces damage to GDP by $0.4
billion to $1.0 billion for our Gulf Coast hurricane scenario up to $15
billion to $38 billion for our Iranian embargo scenario. As with the
Office of Petroleum Reserves' model, the EIA model also shows that a
coordinated international response reduces more economic harm in each
scenario, except those where the SPR can replace the oil alone. As it does
with oil price increases, the EIA model estimates a range of GDP damage
for each scenario, rather than the single value that the Office of
Petroleum Reserves' model produces.

Table 5: Ability of the SPR and International Reserves to Reduce Damage to
GDP, According to the EIA Model

Dollars in billions
Hypothetical oil supply GDP damage Damage that can
disruption scenarios caused by be eliminated by
disruption reserves
SPR alone SPR and
international
reserves
Gulf Coast hurricane $0.4 - $1.0 $0.4 - $1.0 $0.4 - $1.0
Venezuelan strike 2.6 - 7.5 2.6 - 6.3 2.6 - 6.3
Iranian embargo 34 - 99 15 - 38 23 - 60
Saudi terrorism 21 - 71 13 - 34 15 - 38
Strait of Hormuz closure 16 - 48 6.9 - 17 13 - 34
Saudi shutdown 137 - 442 11 - 31 24 - 66

Source: GAO analysis using the EIA model.

DOE Models Yield Significantly Different Estimates of the Economic Damage
Avoided by Using the SPR

Under every scenario, the EIA model predicts much smaller avoided harm to
GDP than the Office of Petroleum Reserves' model. For example, in the
Iranian embargo scenario, the Office of Petroleum Reserves' model
estimates that using international reserves could prevent $201 billion in
economic harm, while the EIA Model predicts $23 billion to $60 billion in
avoided harm. This difference occurs primarily because the EIA model
assumes that oil price increases cause less harm to GDP, meaning that
there is less economic harm for the SPR and other reserves to mitigate.
The estimates of the effect of oil price spikes on GDP from the Office of
Petroleum Reserves and EIA models are, respectively, near the high end and
low end of the spectrum of such estimates in the economic literature.
Officials from the Office of Petroleum Reserves and EIA acknowledged that
they hold different views about how oil supply disruptions impact the
economy. An EIA official also told us that EIA is currently updating its
model, although the assumptions about how oil price changes impact GDP
have not changed substantially.24

This discrepancy in results between the two models is potentially
problematic because the results of the two models are used to support
different decisions about the SPR. The Office of Petroleum Reserves' model
has been used to estimate the net benefits of expanding the SPR, as
described in the following section of this report. The larger economic
impacts predicted by the Office of Petroleum Reserves' model would justify
a larger SPR than if the model predicted smaller economic impacts. The EIA
model is used to estimate the impact of oil supply disruptions and to
advise officials about their potential consequences. The smaller economic
impacts predicted by the EIA model could lead to recommendations that the
SPR not be used as often or for as many oil supply disruptions as would be
the case if the model found larger economic impacts. The results of these
two models pull decision makers in opposite directions, making it
important to clarify the differences between the two models and to ensure
that policymakers are aware of the different views within DOE.

Other Factors, in Addition to the SPR's Ability to Replace Oil, May Affect
the Extent to Which the SPR Can Protect the U.S. Economy from Damage

The purpose of the SPR is to protect the economy from harm during oil
supply disruptions by replacing the disrupted oil. However, factors beyond
the amount of oil that SPR can replace affect the extent to which SPR can
protect the U.S. economy from damage. For example, during some situations,
such as a hurricane, typical transportation routes for oil could be
blocked, reducing the benefits of releasing SPR oil. Also, the benefits of
releasing SPR oil could also diminish if the type of oil in the SPR is not
a good substitute for the disrupted oil, or if refining capacity is
damaged. On the other hand, the SPR can provide economic benefits to the
United States when it is used as a tool for diplomacy and as a deterrent
against intentional disruptions, even when no oil is released.

Transport of Oil to Refineries May Be Difficult during Some Disruptions

During a drawdown, SPR oil is shipped through marine terminals or
pipelines. Shipping time from the SPR to different parts of the country
varies, as shown in table 6. The oil pipeline network and marine shipping
allow SPR oil to reach every region of the United States, except for the
Rocky Mountains. Canada provides the only imported oil to the Rocky
Mountain region, and DOE believes that a disruption of Canadian oil is
unlikely.25

Table 6: Consumption of Imported Oil and Shipping Time for SPR Oil to
Various Regions

Regiona 2004 crude oil imports (millions of Days to reach
barrels per day)b region
1 - East Coast 1,370 6 - 8
2 - Midwest 519 5 - 9
3 - Gulf Coast 5,445 <1
4 - Rocky Mountain 0 N/A
5 - West Coast 864 16 - 18

Source: GAO analysis of DOE data.

aDOE divides the United States into five Petroleum Administration for
Defense Districts for planning purposes. The result is a geographic
aggregation of the 50 states and the District of Columbia into five
districts.

bThis table does not include data on imports from Canada.

The ability of the SPR to reduce economic damage may be impaired if
transport of oil to refineries is delayed. For example, the SPR was large
enough to replace the oil lost from recent Hurricanes Katrina and Rita,
but petroleum product prices still increased dramatically following the
hurricanes, in part because power outages shut down pipelines that
refineries depend upon to supply their crude oil and to transport their
refined petroleum products to consumers. For example, Colonial Pipeline,
which transports petroleum products to the Southeast and much of the East
Coast, was not fully operational for a week after Hurricane Katrina.
Consequently, short-term gasoline shortages occurred in some places, and
the media reported gasoline prices greater than $5 per gallon in Georgia.

SPR Oil Is Not Fully Compatible with Some Refineries

The crude oils stored in the SPR are compatible with many refineries in
the United States. However, some U.S. refineries process crude oils
heavier than those stored in the SPR. Of the 8.3 million barrels of
non-Canadian oil imported into the United States per day in 2004, 3.5
million barrels, or about 40 percent, were heavy oil.26 Refineries that
process heavy oil may have difficulty operating at normal capacity if
their supply of heavy oil is disrupted. A December 2005 DOE report
identified 74 refineries that are connected to the SPR that receive
non-Canadian imports of oil, and the report found that the types of oil
currently stored in the SPR would not be fully compatible with 36 of those
refineries, or slightly less than 50 percent.28 DOE estimated that if
these refineries had to use SPR oil, U.S. 27, refining throughput would
decrease by 735,000 barrels per day, or 5 percent. DOE estimated that
production of distillate fuels, such as diesel and jet fuel, would
decrease substantially from heavy oil refineries, but DOE estimated that
production of gasoline would increase.

To improve the compatibility of SPR oil with refineries in the United
States, the DOE study concluded that the SPR should contain about 10
percent heavy oil. However, DOE may have underestimated how much heavy oil
should be in the SPR to maximize compatibility with refiners and minimize
oil acquisition cost. First, DOE determined the least amount of heavy oil
that could be added to improve the compatibility of the SPR oil inventory
with U.S. refineries. However, because heavy oil is less expensive to
purchase than the lighter oils currently stored in the SPR, a cost-benefit
analysis may show that a larger amount of heavy oil is beneficial, while
still maintaining compatibility with U.S. refining capacity.29 Second, the
DOE report may have underestimated the potential impact of heavy oil
disruptions on gasoline production. Several refiners who process heavy oil
told us that they would be unable to maintain normal levels of gasoline
production if they used only SPR oil. For example, an official from one
refinery stated that if it used solely SPR oil in its heavy crude unit, it
would produce 11 percent less gasoline and 35 percent less diesel.
Representatives from other refineries said that they might need to shut
down portions of their facilities if they could not obtain heavy oil. A
refining industry expert explained that a reduction in gasoline production
would likely occur when some heavy oil refineries processed light oil,
because the light oil would not provide enough feed to units designed to
convert heavier products into gasoline.

Releasing Oil from the SPR Is Less Helpful If U.S. Refining Capacity Is
Damaged

In addition to disrupting crude oil supplies, disasters such as hurricanes
and terrorist acts can disrupt supplies of petroleum products by damaging
refineries. Crude oil must be processed in refineries to be useful.
Following Hurricanes Katrina and Rita, nearly 30 percent of the refining
capacity in the United States was shut down, disrupting supplies of
gasoline and other products. Because the SPR contains only crude oil, it
cannot replace petroleum products if a disruption in refining occurs.
However, some countries in the International Energy Agency hold petroleum
products in their reserves, and they released these products after
Hurricanes Katrina and Rita. DOE reported that these releases of petroleum
products helped reduce prices for gasoline and diesel after the
hurricanes.

SPR Can Provide Benefits to the U.S. Economy Without Releasing Oil

Several members of our group of experts and other experts noted that the
SPR has value to the United States economy in addition to physically
replacing oil during supply disruptions. First, the ability of the SPR to
replace supply during disruptions may deter adverse behavior on the part
of oil-producing nations. Since the SPR can replace a large amount of
disrupted oil, cutting off supply would not have the intended negative
economic consequence. Second, the SPR could be used as a negotiation tool
to encourage producers to increase oil production when needed. Third,
experts told us that they believe the SPR may reduce oil prices by
lowering the risk premium sometimes included in the price of oil. Oil
prices can increase because of fear of a disruption, and some experts told
us that the existence of the SPR may quell this fear.

A Larger SPR Is Warranted If Demand for Oil Grows as Expected

If demand for oil in the United States increases as expected, a larger SPR
will be necessary to maintain the economy's present level of protection
from oil supply disruptions. Expansion of the SPR could also be required
under the U.S. agreement with the International Energy Agency. In
addition, a recent study prepared for DOE shows that the benefits of
expanding the SPR to as much as 1.5 billion barrels would exceed the costs
over a range of future conditions, although expanding the reserve to this
size would take approximately 18 years. However, factors influencing the
SPR's ideal size are likely to change over time, including factors such as
oil demand and the likelihood of oil supply disruptions.

Oil Demand Projections Support a Larger SPR

Future oil demand in the United States has an important impact on the
benefits of expanding the SPR, and current projections support the
interest in a larger SPR. Under the base case in the EIA's most recent
Annual Energy Outlook, published in February 2006, U.S. demand for
petroleum will rise from 21.1 million barrels per day in 2005 to 23.6
million barrels per day in 2015 and 26.1 million barrels per day in 2025,
increases of 12 percent and 24 percent, respectively.30 As a result, the
volume of imported oil and petroleum products is projected to increase
over time to meet this demand, from 12.5 million barrels per day in 2005
to 13.2 million barrels per day in 2015 and 15.7 million barrels per day
in 2025.

The amount of protection that the SPR provides to the U.S. economy is
generally measured in days of net import protection. The SPR contained
enough crude oil in 2005 to offset about 58 days of imports. Using the
most recent EIA forecast, we calculate that the net import protection that
the SPR provides at its current size will decrease to 53 days in 2015 and
45 days in 2025.

The United States' agreement with the International Energy Agency could
also require an expanded SPR as imports of oil and oil products increase,
if private inventories do not increase enough to cover the difference in
demand. As we previously mentioned, the United States agrees to hold
inventories of oil and petroleum products totaling 90 days of net imports
as part of its obligation to the International Energy Agency, and the
United States meets its obligation with a combination of public and
private inventories. Privately held inventories of oil and petroleum
products vary, but in 2005 DOE assumed these inventories could offset 58
days of imports. In total, the SPR and private inventories could offset
127 days of imports in 2005. As shown in figure 7, DOE estimates that
without SPR or private inventory expansion, the United States will drop
below its 90-day stockholding obligation in 2025. With the expansion of
the SPR to 1 billion barrels included in the Energy Policy Act of 2005,
DOE estimates that the United States will remain in compliance with its
90-day obligation through 2030.31 As figure 7 shows, the number of days of
net import protection provided by private inventory of oil and petroleum
products has generally decreased since the mid-1980s, and DOE officials
expect this trend to continue. Holding inventory is costly to private
companies, so they have an incentive to keep their inventory as low as
possible.

Figure 7: United States' Current and Estimated Compliance with
International Energy Agency Obligation to Hold Reserves

DOE Estimates That Long-term Benefits of SPR Expansion to 1.5 Billion
Barrels Exceed Costs

To evaluate the costs and benefits of expanding the SPR to a capacity of
up to 1.5 billion barrels, DOE's Oak Ridge National Laboratory (ORNL)
prepared a study for DOE in late 2005.32 This study relies on the same
model that the Office of Petroleum Reserves used, as discussed in the
previous section, to estimate the reduction in economic damage from using
the SPR during oil supply disruptions. The study shows that the benefits
of expanding the reserve to 1.5 billion barrels exceed the costs over a
45-year horizon. The study estimates the costs and benefits of SPR
expansion through 2050 because of the long construction time for
additional SPR capacity and the large up-front investment required. The
costs of constructing and filling the additional capacity dominate the
analysis until 2020, while benefits of the additional capacity accrue from
2021 through the end of the analysis in 2050. The study uses EIA forecasts
of oil price and demand through 2025, and a linear extrapolation of these
forecasts from 2025 through 2050. Any analysis of costs and benefits so
far in the future is inherently uncertain. However, this study is the only
one of its kind to analyze the future net benefits of SPR expansion.

The costs of expanding the SPR to 1.5 billion barrels consist of capital
costs to acquire and construct the facilities, the cost of crude oil to
fill the new capacity, and ongoing maintenance and security costs for the
additional facilities. DOE estimates that expanding the physical structure
of the SPR to 1.5 billion barrels would take approximately 18 years and
cost approximately $5.4 billion, in 2004 dollars. DOE assumed that
expanding the reserve to this size would involve purchasing or
constructing additional storage capacity at three existing SPR sites: West
Hackberry and Bayou Choctaw in Louisiana, and Big Hill in Texas. The
remaining expansion would be accomplished by constructing new storage
sites at three sites selected from five potential sites in Texas,
Louisiana, and Mississippi. The ORNL study's authors estimate the cost of
filling the additional SPR capacity at $23.0 billion, in 2004 dollars.
This estimate is based on the base-case oil price forecast from the 2005
Annual Energy Outlook because the 2006 volume was not yet published when
the ORNL study was completed. The 2006 Outlook forecasts higher crude oil
prices than the 2005 Outlook. Using the most recent base-case forecast,
the ORNL authors estimated a fill cost of $36.2 billion in 2004 dollars.
These calculations assume that the new SPR capacity is filled as it is
completed at a maximum fill rate of 100,000 barrels per day, a fill rate
achievable using the royalty-in-kind program.

The ORNL study does not separately consider the costs and benefits of the
expansion to 1 billion barrels authorized in the Energy Policy Act of
2005. DOE estimates that expanding to this size would take approximately
15 years and cost at least $1.3 billion, in 2004 dollars, based on
selection of the lowest-cost expansion options. This cost includes, as we
previously described, purchasing or constructing additional capacity at
three existing SPR sites and constructing a new storage site at one of the
five potential locations. We estimate that filling the additional capacity
would cost approximately $13.4 billion in 2004 dollars, using the
base-case cost estimate in the 2006 Annual Energy Outlook.

The ORNL study estimates that the benefits of expanding the reserve to 1.5
billion barrels exceed the costs over a range of assumptions about future
demand and oil prices. Expanding the SPR to 1.5 billion barrels is
estimated to be cost-beneficial for each of the demand and world oil price
forecasts in EIA's 2005 Annual Energy Outlook. The 2005 Outlook contains
four forecasts of the world oil market: a base-case forecast, a
lower-price forecast, and two higher-price forecasts.33 A different level
of oil demand is associated with each of these price forecasts. The
estimated net benefits of expanding the SPR are greatest in the EIA
forecast when oil demand is highest and oil prices are lowest, and least
when oil demand is lowest and prices are highest. The ORNL study used the
2005 forecasts because, as we previously mentioned, it was completed
before the 2006 Outlook was published. The 2005 Outlook forecasts higher
oil demand and lower oil prices than the 2006 edition, but the author of
the ORNL study noted that the highest-price case included in the 2005
report closely resembles the 2006 base case. Thus, SPR expansion appears
to be cost-beneficial for the 2006 base-case forecast, but the study does
not include oil prices as high as those in the 2006 high-price forecast,
which would tend to decrease the benefits of a larger reserve.

Beyond assumptions about future oil demand and price, the ORNL study makes
a number of additional assumptions, including important assumptions about
the probability of disruptions and the impact of oil price increases on
GDP.

o The likelihood of oil supply disruptions in the future is uncertain and
difficult to assess. The ORNL study considers two different estimates of
the probability of oil supply disruptions: one that DOE created in 1990
and a second that the Stanford Energy Modeling Forum created in 2005.34
The benefits of expanding the SPR to 1.5 million barrels exceed the costs
for both disruption probability estimates, but the benefits are larger for
the 2005 Stanford Energy Modeling Forum estimate because this estimate (1)
considers longer disruptions than those considered in the 1990 estimate
and (2) recognizes that excess capacity will not be available from a part
of the world where supply is disrupted.

o The measure of how much a given increase in oil price reduces GDP is
known as the GDP elasticity of oil price. GDP loss avoided when the SPR is
used during oil supply disruptions is a measure of the benefit of the SPR.
The ORNL study used a range of GDP elasticity estimates and the results of
the model runs indicate that, over that range, expanding the SPR is
cost-beneficial. Some economists, however, believe that the GDP elasticity
is lower than the bottom of the range of elasticity estimates used by the
ORNL study. For example, the model we described in the previous section
that EIA uses to estimate the impacts of oil supply disruptions uses
values for this GDP elasticity derived from the Global Insight
Macroeconomic Model that are one-quarter to one-half the size of the
smallest value considered in the ORNL study. A smaller value for the GDP
elasticity would reduce the calculated benefits of expanding the SPR.

Factors Influencing the SPR's Ideal Size Are Likely to Change Over Time

Many factors influence the ideal size of the SPR, including world demand
for oil and the probability and potential size of oil supply disruptions.
Although current projections anticipate increasing future demand for oil
in the United States and world, future oil demand conditions are
uncertain. Predicting future demand is difficult because it depends on
many factors, including the rates of economic growth, the price of oil,
policy choices, and technology changes.

The rate of world economic growth strongly influences oil demand. Strong
economic growth in China has increased its demand for oil and petroleum
products, contributing to rising world oil prices since 2004. In that
year, China became the world's second largest consumer of oil, behind the
United States, and its demand for oil grew at an annual rate of 15
percent. Conversely, the financial crisis in Asia in mid-1997 dramatically
slowed the rate of oil demand growth in the region at that time, and oil
demand even decreased between 1997 and 1998 in some countries. This change
in demand contributed to lower oil prices in 1998 and early 1999,
according to some experts.

Future demand for oil will also depend on its price. As we previously
described, crude oil prices are set in the world marketplace, and are
largely outside the control of U.S. policymakers. High oil prices can
encourage conservation and investment in fuel-efficient technologies and
alternative fuels, reducing demand, while low oil prices can have the
opposite effect.

Members of our group of experts suggested several policy choices that
might diminish growth in U.S. demand for oil. First, they suggested that
research and investment in alternative fuels might reduce the growth of
future U.S. oil demand. Vehicles that use alternative fuels, including
ethanol, biodiesel, liquefied coal, and fuels made from natural gas, are
now generally more expensive or less convenient to own than conventional
vehicles, because of higher vehicle and fuel costs and a lack of refueling
infrastructure. Alternative-fuel vehicles could become more viable in the
marketplace if their costs and fuel delivery infrastructure become more
comparable to vehicles fueled by petroleum products. Second, expert group
members suggested that greater use of advanced fuel-efficient vehicles,
such as hybrid electric and advanced diesel cars and trucks, could reduce
U.S. oil demand. The Energy Policy Act of 2005 directs the Secretary of
Energy to establish a program that includes grants to automobile
manufacturers to encourage domestic production of these vehicles. Third,
several members of our group of experts suggested improving the Corporate
Average Fuel Economy (CAFE) standards to curb demand for petroleum fuels
in the United States. After these standards were established in 1975, the
average fuel economy of new light-duty vehicles improved from 13.1 miles
per gallon in 1975 to a peak of 22.1 miles
per gallon in 1987.35 More recently, the fuel economy of new vehicles in
the United States has stagnated at approximately 21 miles per gallon. New
CAFE standards for light trucks, including minivans and sport-utility
vehicles, were announced by the administration in March 2006, which
include larger vehicles that were not regulated under past standards.
Other experts have questioned the need for enhanced CAFE standards, noting
that today's higher gasoline prices will bring about more efficient use of
gasoline. Additionally, studies from the Congressional Budget Office
suggest that a tax on gasoline could reduce demand at lower cost to the
economy than enhanced CAFE standards.36

The size of the SPR needed to protect the U.S. economy also depends on the
likelihood of oil supply disruptions. A number of factors in today's
energy market cause particular concern, including a reduction in global
surplus oil production capacity in recent years, the fact that much of the
world's supply of oil is produced in relatively unstable regions, and
rapid growth in world oil demand that has led to a tight balance between
demand and supply. However, factors influencing disruption probability are
likely to change over time.

As we described in the previous section, international reserves augment
the SPR's ability to replace oil during supply disruptions. Since a
release of oil anywhere in the world during a disruption can lower oil
prices everywhere, strategic reserves in other countries are beneficial to
the United States and influence the SPR's ideal size. Along these lines,
some members of our group of experts stressed the importance of
international reserves to U.S. oil security and suggested that the United
States and the International Energy Agency should encourage construction
of strategic reserves abroad to be used during oil supply disruptions and
should offer technical assistance to countries that want to construct such
reserves. Officials from DOE and the International Energy Agency described
efforts to support construction of reserves in other countries, including
sponsoring workshops and providing other assistance. Experts pointed out
that encouraging the construction of strategic reserves is particularly
important in developing countries that are significant oil consumers and
that are not currently members of the International Energy Agency, such as
China. EIA forecasts that through 2025, demand in China will increase at a
much faster rate than demand in more developed countries.

Projections of future oil demand and oil market conditions are inherently
uncertain, but these projections are key to any estimate of the optimal or
necessary size of the SPR. If demand for oil grows as projected, keeping
the SPR at its current size may put the economy at greater risk from the
negative effects of oil supply disruptions. However, the estimates of
world oil demand used in current studies could be too high or too low,
resulting in high or low estimates of the SPR's optimal size. Therefore,
as time passes and oil markets change, periodic reassessments by DOE of
the appropriate size of the SPR could be helpful as part of the nation's
long-term energy security planning.

Conclusions

The SPR is a valuable asset for protecting the U.S. economy, providing
benefits as a source of oil during supply disruptions and as a tool of
diplomacy in foreign policy discussions. Our work shows that the SPR,
particularly in conjunction with reserves held by the other countries of
the International Energy Agency, can replace the oil lost during all but
the most catastrophic disruption scenarios and, thus, can reduce the
negative consequences of oil supply disruptions on the U.S. economy.
However, our work also describes issues that could impact the cost and
effectiveness of the SPR, including the conditions under which the reserve
is filled, how DOE estimates the economic impacts of using the reserve,
and the type of crude oil in the reserve. Expanding the reserve makes
sense and will be necessary to maintain the economy's present level of
protection if demand for oil in the United States increases as expected.
However, factors that influence the ideal size of the SPR are likely to
change over time and will warrant periodic reassessments.

Since the SPR's inception, it has been filled and used in response to
world events and changing conditions. Although some experts claimed that
acquiring oil for the SPR after the terrorism events of September 2001
caused substantial increases in oil prices, the majority of experts we
talked with believe that this increase was minimal because the volume of
oil going to the SPR was very small relative to world oil demand. Experts
believe that changes in SPR practices-including following a
"dollar-cost-averaging" approach, where the government acquires a fixed
dollar value of oil for the SPR over a specified time period, and allowing
oil producers more flexibility in the timing of delivery for oil acquired
for the SPR-could reduce the future cost of filling the SPR.

Different parts of DOE have very different opinions on the amount of
economic harm oil supply disruptions can cause and, thus, implicitly about
the ideal size and use of the SPR. The estimates of the effect of price
spikes on GDP that these different parts of DOE use are, respectively,
near the high end and low end of the spectrum of such estimates in the
economic literature. The two models have been used to support different
kinds of decisions-the Office of Petroleum Reserves' model has been used
to support decisions about whether to expand the SPR, while the EIA model
has been used to advise policymakers about the potential economic
consequences of oil supply disruptions. Clarifying the differences between
these models and how the models are used to provide policy advice would
help ensure that DOE provides consistent transparent advice about the size
and use of the SPR.

The SPR protects the economy during oil supply disruptions by replacing
the oil lost. For the SPR to be most effective, refiners need to be able
to efficiently use the oil in the reserve in the absence of other sources
of supply. The two types of crude oil currently stored in the SPR can be
effectively used by most refineries during a supply disruption, but the
lack of heavy sour oil in the SPR poses problems to refiners who use this
type of oil. Adding some heavy sour oil to the SPR could provide a source
of supply to these refiners during a disruption, while still leaving
enough oil of other types for other refiners. A 2005 DOE study supports
this finding, concluding that separately storing approximately 10 percent
heavy sour crude in the SPR could provide oil supply to refiners who
process heavy sour oil during a disruption and better protect the economy.
Additionally, adding some heavy sour oil to the SPR could decrease the
cost of filling the SPR, since this oil is generally less expensive than
the lighter grades currently stored in the reserve.

Although another 2005 study for DOE shows that expanding the SPR could be
warranted, factors influencing the ideal size of the SPR are likely to
change over time. Many factors influence the ideal size of the SPR,
including oil demand levels and the likelihood of oil supply disruptions.
Because these factors are very dynamic, decisions about expanding the SPR
will always be made under uncertainty. Nonetheless, as the world changes,
periodically revisiting decisions about SPR size would allow policymakers
to use new information to refine their views on the SPR's proper size.

Recommendations for Executive Action

The Secretary of Energy should take the following four steps to improve
the operation of the current SPR and to improve decisions surrounding the
SPR's use and expansion. Specifically, the Secretary should:

o Study how to best implement experts' suggestions to fill the SPR more
cost-effectively, including

o acquiring a steady dollar value of oil for the SPR over the long term,
rather than a steady volume, to ensure a greater volume of fill when
prices are low and a lesser volume of fill when prices are high and

o providing industry with more flexibility in the royalty-in-kind program
to delay oil delivery to the SPR during times when supply and demand are
in tight balance and current prices are higher than expected future
prices.

o Conduct a new review about the optimal oil mix in the SPR that would
examine the maximum amount of heavy sour oil that should be held in the
SPR, in addition to the minimum amount determined in DOE's prior report.
The Secretary should ensure that DOE, at a minimum, implements its own
recommendation to have at least 10 percent heavy sour oil in the SPR.

o Clarify the differences in structure and assumptions between the models
used by the Office of Petroleum Reserves and EIA and clarify to
policymakers how the models are used when providing advice to Congress and
the executive branch.

o Periodically reassess the appropriate size of the SPR in light of
changing oil supply and demand in the United States and the world.

Agency Comments and Our Evaluation

We provided a draft of this report to DOE for review and comment. DOE
generally agreed with the conclusions and recommendations presented in the
draft report, but provided additional information regarding the
implementation of two of our recommendations. Additionally, DOE explained
EIA's efforts to update its model of the economic impacts of oil supply
disruptions. In reviewing our draft report, DOE also provided technical
and clarifying comments, which we incorporated as appropriate. DOE's
written comments are reproduced in appendix III.

In response to our recommendation to study how to implement experts'
suggestions to fill the SPR more cost effectively, DOE noted that
decisions on when to acquire oil are extremely complex and subject to many
strategic and tactical considerations in addition to cost. We agree that
SPR oil acquisition decisions must consider cost, market conditions,
national security concerns, and other issues. DOE also stated that dollar
cost averaging as a means to improve the cost-effectiveness of SPR fill
could be employed only when DOE is purchasing oil, and noted that recent
oil acquisition has been accomplished by the transfer of royalty oil from
the Interior Department. However, we believe that dollar cost averaging
when acquiring oil through the royalty-in-kind program is possible,
although it would require that DOE vary the amount of oil it accepts from
royalties and perhaps purchase some oil at times of low prices. Because of
the potential for cost savings, we continue to believe that DOE should
study such an approach. Finally, regarding this recommendation, DOE stated
that it believes that the value of deferring oil deliveries to the SPR
during the period of 2002 to 2004 would have been less than $590 million.
To clarify, we did not attempt to value deferrals that DOE might have
approved during this time period. Instead, the $590 million of potential
savings referred to in the report reflects the potential savings from
applying a dollar-cost-averaging approach from October 2001 through August
2005, not to the savings that could have occurred from deferring oil
delivery.

In response to our recommendation to consider storing heavy sour oil in
the SPR, DOE stated that it does not believe the advantages of holding a
heavier crude stream would justify replacing any of the current inventory.
Instead, it believes that studying and implementing this recommendation
should wait until the SPR is expanded. Neither our work nor DOE's recent
study explored the costs and benefits of adding heavy sour oil to the SPR.
We believe that DOE should study the costs and benefits of adding heavy
sour oil with and without SPR expansion. Without such analysis, DOE does
not have data to determine whether replacing of any of the current
inventory with heavy sour oil is economically justified.

Regarding the last two recommendations, DOE agreed that officials will
work together to better articulate the different approaches and
perspectives contained in their modeling of the effects of oil supply
disruptions on the economy, and committed to periodic reassessments of the
SPR's ideal size. DOE also described an ongoing update of the EIA model
for assessing the impacts of supply disruptions. The new model is more
complex than the older model, but according to EIA, its estimates of the
GDP impacts of supply disruptions will remain smaller than those estimated
by the Office of Petroleum Reserves' model.

As agreed with your offices, unless you publicly announce the contents of
this report earlier, we plan no further distribution of it until 21 days
from the report date. At that time, we will send copies of this report to
interested congressional committees, the Secretary of Energy, and other
parties. We will also make copies available to others upon request. In
addition, the report will be available at no charge on the GAO Web site at
h ttp://www.gao.gov.

If you or your staffs have any questions about this report or need
additional information, please contact me at (202) 512-6877 or
[email protected] . Contact points for our Offices of Congressional Relations
and Public Affairs may be found on the last page of this report. GAO staff
who have made major contributions to this report are listed in appendix
IV.

Jim Wells Director, Natural Resources and Environment

Appendix I

Scope and Methodology

We addressed the following questions during our review: (1) Based on past
experience, what factors do experts recommend be considered when filling
and using the Strategic Petroleum Reserve (SPR)? (2) To what extent can
the SPR protect the U.S. economy from damage during oil supply
disruptions? (3) Under what circumstances would an SPR larger than its
current size be warranted?

In addressing these objectives, we conducted a comprehensive literature
review of economic and public policy material relevant to the SPR's fill
and use, and to its ability to provide energy security for the U.S.
economy. To identify articles for our literature review, we searched
databases using key terms. We also obtained recommended reading lists of
studies from several experts on issues related to the questions we
addressed. We considered the methodological soundness of the articles and
studies included in our literature review and determined that the findings
of these studies were sufficiently reliable for our purposes. In addition,
we conducted interviews with academics and experts, as well as industry
representatives and officials from several offices within the Department
of Energy (DOE), including the Energy Information Administration (EIA) and
the Office of Petroleum Reserves. We also conducted interviews with
academics and experts at institutes that study energy security issues. We
selected these individuals on the basis of their expertise in energy
security and SPR policy as represented by their presentations or
publications. We present data and forecasts from EIA that have been deemed
sufficiently reliable for our purposes.

Additionally, we contracted with the National Academy of Sciences1 to
convene a group of experts to collect opinions on the impacts of past SPR
fill and use and on recommendations for the future, as well as on the
benefit of the SPR in reducing economic losses in the event of oil supply
disruptions. We worked closely with the National Academies to identify and
select 13 group members (see table 7) who could adequately respond to our
general and specific questions about current practices for filling and
using the SPR and about the economic benefit the SPR could provide at its
current size and at a larger size. In keeping with National Academies'
policy, the group members were invited to provide their individual views,
and the group was not designed to reach a consensus on the issues that we
asked them to discuss. The group members convened at the National
Academies in Washington, D.C., on December 1, 2005. The views expressed by
the group members do not necessarily represent the views of GAO or the
National Academies. After the group of experts met, we analyzed a
transcript of the discussion to identify principal themes and group
members' views. Although we were able to secure the participation of a
balanced, highly qualified group of experts, the group was not
representative of all potential views. Nevertheless, it provided a rich
dialogue on current practices for filling and using the SPR and on what
considerations are pertinent to identifying the best fill and use
policies, as well as on how the SPR, at its current size and at a larger
size, can protect the economy from significant losses in the event of oil
supply disruptions.

Table 7: Members of the Group of Experts Compiled by GAO and the National
Academies

Name Affiliation
Robert Hirsch (moderator) Senior Energy Program Advisor, SAIC
Joseph E. Aldy Fellow, Resources for the Future
Kyle M. Cooper Vice President, Futures/Fixed Income, Citigroup
Global Markets, Inc.
Leonidas Drollas Deputy Executive Director and Chief Economist,
Centre for Global Energy Studies
Robert Ebel Chairman, Energy Program, Center for Strategic
and International Studies
Lawrence J. Goldstein President, PIRA Energy Group
David L. Goldwyn President, Goldwyn International Strategies, LLC
Les Harding Senior Manager, Trading, Valero Energy Corp.
Hillard G. Huntington Executive Director, Stanford Energy Modeling
Forum, Stanford University
Klaus Jacoby Head, Emergency Planning and Preparations
Division, International Energy Agency
Paul Leiby Science and Technology Policy Group,
Environmental Sciences Division, Oak Ridge
National Laboratory
John A. (Jack) Riggs Executive Director, Program on Energy, the
Environment and the Economy, The Aspen Institute
John Shages Deputy Assistant Secretary, Petroleum Reserves,
Department of Energy

Source: GAO.

To learn what factors experts recommend be considered when making
decisions about SPR fill and use, we reviewed records and reports from DOE
and the International Energy Agency. We also reviewed available literature
on the political and economic implications of various ways of filling and
using the SPR, and interviewed experts from government, academia, and
private industry on issues of SPR fill and use.

To estimate the potential savings of using a dollar-cost-averaging
approach to fill the SPR, we calculated the cost of using this approach
for SPR oil acquisitions between October 2001 and August 2005. In
addition, we ran simulations to project potential savings from a
dollar-cost-averaging approach going forward over 5 years. Specifically,
we evaluated 12 possible paths that future oil prices may take. First,
starting from an initial price of $70 per barrel, we allowed prices to
increase or decrease on average by varying degrees-the price paths
increased or decreased at average rates of 1, 5, and 10 percent per year.
Second, for each of these 6 possible price paths, we allowed prices to
fluctuate to account for potential price volatility-for each of the 6
possible price paths, we allowed for a low- and high-price volatility
case. Specifically, prices for each month were drawn randomly from a
normal distribution, with standard deviations of $15 for the low
volatility case and $50 for the high case. For each of these 12 scenarios,
we then simulated future prices for 60 months and compared the average
price per barrel under dollar cost averaging versus acquiring oil at a
steady rate. We ran 1,000 simulations for each of the 12 scenarios and
found that in all but 10 of the resulting 12,000 simulations, dollar cost
averaging saved money. These simulations are not intended to measure the
magnitude of savings. To do so would require using actual projections of
oil prices and price volatility, something that was beyond the scope of
this report.

We did not independently verify information about security, drawdown
rates, or other operational factors of the SPR or other strategic reserves
held by countries that belong to the International Energy Agency.

To analyze the ability of the SPR to reduce economic damage caused by oil
supply disruptions, we present the results of two DOE models used to
estimate the reduction of harm to U.S. gross domestic product (GDP) that
would result from releasing oil from the SPR and international reserves
during six hypothetical oil supply disruption scenarios. Oak Ridge
National Laboratory (ORNL) produced one of these models under contract
with DOE's Office of Petroleum Reserves. ORNL officials produced model
results for us. EIA produced the second model. We produced model results
using the EIA model, and then verified these results with EIA officials.
(See app. II for a more detailed discussion of the hypothetical oil supply
disruption scenarios and the economic modeling effort.) Additionally, we
conducted semistructured interviews with representatives from the refining
industry. We spoke with representatives from companies that comprise 76
percent of the refining capacity of the United States to learn about their
views on SPR operations. We also reviewed studies of the potential for oil
supply disruptions to occur and to reduce U.S. GDP.

To learn about the circumstances under which an SPR larger than its
current size could provide additional energy security benefits, we
reviewed an ORNL study that analyzed the expected costs and benefits of
expanding the SPR, U.S. stockholding obligations to the International
Energy Agency, and estimates of future U.S. oil demand. Finally, we also
reviewed studies and interviewed expert group members and other oil market
experts about factors that influence future demand for oil in the United
States and alternatives for reducing U.S. economic losses in the event of
oil supply disruptions.

Appendix II

Economic Modeling of Oil Supply Disruptions

We present in this appendix the results of models that economists at ORNL
and EIA created to simulate the effects of six hypothetical oil disruption
scenarios. These scenarios illustrate the impacts of a variety of oil
supply disruptions and the extent to which the SPR and international
reserves could replace oil and protect the economy from losses. Both
models make a number of assumptions in simulating the effects of
disruptions on the economy, and some of these assumptions differ between
models.

Oil Supply Disruption Scenarios

To study the capabilities of the SPR and international reserves to replace
oil and prevent economic damage during oil supply disruptions, we
developed six hypothetical oil supply disruption scenarios. The six
scenarios are as follows:

o A hurricane along the United States Gulf Coast decreases domestic oil
production. This scenario is closely based on Hurricanes Katrina and Rita,
which struck the U.S. Gulf Coast in August and September, 2005, and
temporarily stopped a large percentage of the offshore crude oil
production in the Gulf of Mexico. The disruption in production continued
for several months as damaged offshore production platforms, pipelines,
and onshore facilities were repaired.

o A strike occurs among oil workers in Venezuela. This scenario is based
on the oil worker strike that occurred in Venezuela in 2002 to 2003.
Although that strike lasted only 63 days, oil production was well below
normal for several months and did not recover to its prestrike level.

o Iran stops exporting oil for 18 months. Although none of Iran's 2.7
million barrels per day of exported crude oil go directly to the United
States, removing this oil from the market would raise prices everywhere,
thus impacting the U.S. economy.

o Terrorists attack the Abqaiq oil-processing facility in Saudi Arabia,
which handles more than half of Saudi Arabia's 10.4 million barrels per
day of oil output. This facility is the largest oil-processing plant in
the world, removing water, gas, sulfur, and other impurities before the
oil is exported. This scenario assumes that a terrorist attack cripples
the facility for 1 month, and then production recovers over 7 additional
months as the facility is repaired. Terrorists attempted to attack this
facility in February 2006, but security forces turned back the attack.

o Terrorist or military action closes the Strait of Hormuz, which connects
the Persian Gulf with the Arabian Sea. Our scenario assumes that military
action closes the Strait completely for 1 month, removing 17 million
barrels per day of crude oil from the market. Oil supply then recovers
over 2 months as the Strait is cleared and oil reaches the market through
alternate routes.

o A catastrophic loss of oil production in Saudi Arabia occurs,
eliminating exports of oil for 18 months. Oil production then recovers
over the next 6 months. Since Saudi Arabia is the world's largest exporter
of crude oil, this is nearly a worst-case scenario for world oil supplies.

For each scenario, table 8 shows the amount of crude oil disrupted during
each month over a 2-year period.

Table 8: Amount of Crude Oil Disrupted over a 2-Year Period, by
Hypothetical Scenario

Barrels in
millions
Oil supply
disrupted per
day, by
hypothetical
scenario
Month of Gulf Coast Venezuelan Iranian Saudi Strait Saudi
disruption hurricane strike embargo terrorism of shutdown
Hormuz
closure
1st 1.5 1.8 2.7 6.0 17.0 10.0
2nd 1.0 2.2 2.7 4.0 8.0 10.0
3rd 0.8 1.4 2.7 4.0 4.0 10.0
4th 0.8 0.5 2.7 4.0 0 10.0
5th 0.5 0.4 2.7 4.0 0 10.0
6th 0.5 0.2 2.7 4.0 0 10.0
7th 0 0.2 2.7 2.0 0 10.0
8th 0 0.2 2.7 1.0 0 10.0
9th 0 0.2 2.7 0 0 10.0
10th 0 0.2 2.7 0 0 10.0
11th 0 0.2 2.7 0 0 10.0
12th 0 0.2 2.7 0 0 10.0
13th 0 0.2 2.7 0 0 10.0
14th 0 0.2 2.7 0 0 10.0
15th 0 0.2 2.7 0 0 10.0
16th 0 0.2 2.7 0 0 10.0
17th 0 0.2 2.7 0 0 10.0
18th 0 0.2 2.7 0 0 10.0
19th 0 0.2 0 0 0 8.0
20th 0 0.2 0 0 0 6.0
21st 0 0.2 0 0 0 4.0
22nd 0 0.2 0 0 0 2.0
23rd 0 0.2 0 0 0 2.0
24th 0 0.2 0 0 0 1.0

Source: GAO.

We selected these scenarios to illustrate the potential benefits of
strategic reserves in disruptions of different size and duration, not
because they are likely to occur. These scenarios are set in today's oil
market, with global crude oil demand of approximately 83 million barrels
per day and U.S. demand of approximately 21 million barrels per day.

Modeling of Economic Impacts

We used two DOE models to estimate the economic effects of our six
disruption scenarios. EIA developed one model and economists at ORNL
developed the other, under contract to DOE's Office of Petroleum Reserves.
Both models estimate U.S. GDP loss from oil supply disruptions by linking
disruptions to oil price spikes and linking price spikes to GDP losses. We
used both models to estimate the economic effects of our hypothetical
disruptions under three conditions: that is, no reserves are used in
response to the disruption, the SPR is used alone, and the SPR is used in
conjunction with international reserves.

In both models, we assumed that world excess crude oil production capacity
and world fuel-switching capabilities, together totaling 850,000 barrels
per day, are available immediately to help offset a disruption. We also
assumed that private inventories of crude oil are neutral during a
disruption-holders of private inventory neither draw down their
inventories nor hoard oil. Finally, we assumed that SPR and international
reserves are used immediately at their maximum sustainable rate or at a
rate large enough to replace disrupted oil supply.

EIA Model

EIA's Division of Energy Markets and Contingency Information has developed
"rules of thumb" for estimating the oil price and U.S. macroeconomic
impacts of oil supply disruptions, based on simulations from the Global
Insight Macroeconomic Model of the U.S economy. The assumptions relating
disruptions to oil price spikes are summarized in the "price rules of
thumb" and the assumptions relating price spikes to GDP losses are
summarized in the "economic rules of thumb."

EIA measures the response of world oil prices to a hypothetical supply
disruption as the projected quarterly average increase in the price of
West Texas Intermediate oil. EIA's oil market analysis is based on
competitive forces producing a market price on the basis of market
fundamentals and market psychology during an oil supply disruption. The
"price rules of thumb" are based on net disruption sizes and the current
and expected future oil price level before the disruption. These rules of
thumb provide a range of oil prices around an average price, and do not
try to quantify the size of price spikes that could occur during
disruptions. EIA estimates that a supply disruption when the price of oil
is around $40 per barrel results in an oil price increase of between $4
and $6 per barrel for each 1 million barrels per day of oil that is
disrupted. However, if the price of oil is about $50 per barrel, EIA
estimates a price increase of between $5 and $7 per barrel for each 1
million barrels per day of oil that is disrupted. For a disruption of a
given size, the higher the predisruption oil price, the bigger the price
increase needed to balance supply and demand after the disruption.
Additionally, EIA adds a "market psychology price premium" to the price
calculated using the rules of thumb in situations where it believes market
psychology will further increase the price.

To translate oil price increases into GDP losses, EIA uses "economic rules
of thumb," based on simulations from the Global Insight Macroeconomic
Model of the U.S. economy. These rules estimate that a sustained increase
of 10 percent in the price of oil could result in a 0.05 to 0.l percent
reduction in real U.S. GDP relative to its baseline value (the forecasted
GDP without an oil disruption). EIA states that, for price increases
greater than 10 percent, the GDP impacts would increase linearly with the
price impacts, so that a doubling of the price impacts would result in a
doubling of the GDP impacts. The EIA model's GDP responsiveness estimates
are derived from the Global Insight model that EIA uses for its long-run
forecasts of energy market and overall economic activity. EIA notes that
additional factors, such as the effect of high oil prices on the rest of
the world's economy, the reaction of the Federal Reserve to ameliorate the
economic damage of high oil prices, and the change in the value of the
dollar against foreign currencies, may also influence the economic impact
of an oil price spike.

Office of Petroleum Reserves' Model

Economists at ORNL, under contract to DOE's Office of Petroleum Reserves,
developed a model to estimate the costs and benefits of expanding the size
and drawdown capability of the SPR. Economists at ORNL used a portion of
this model to estimate the GDP impacts of our oil supply disruption
scenarios. The model estimates the economic impacts of oil supply
disruptions by first calculating the remaining oil shortfall after world
excess oil production capacity has been utilized. Then the model assumes
that world oil price increases sufficiently for world oil demand to
contract enough to equal the now-reduced supply. On the basis of a review
of the literature, the modelers assume a short-run price elasticity of
demand for oil between -0.10 to -0.25. The elasticity gets larger as the

duration of the supply shock gets larger and longer.1 The short-run oil
demand elasticities then are used to determine the increase in the world
price of oil. The GDP elasticity of oil price is then used to infer the
losses in economic output that would follow a sudden, unanticipated oil
price shock. The modelers draw on results from econometric studies of the
sensitivity of the U.S. economy to oil price spikes to select a GDP
elasticity, expressed in percentage terms, of -5.4 percent for a 100
percent spike in oil price.

To estimate the benefits of expanding the size and drawdown capability of
the SPR, the model simulates the impact of oil supply disruptions against
DOE's baseline paths for oil prices, world oil demands, U.S oil demands,
and U.S. oil supplies. The primary benefit from the SPR is the GDP loss
avoided when it is used to prevent or lessen the effects of oil price
spikes. Their cost-benefit approach uses a simple model of the oil market
and the U.S. economy to (1) assess the potential causes and likelihood
that oil supply disruptions will occur, (2) account for the size of
existing strategic oil stocks and expected degree of international
cooperation on their use, (3) estimate the cost to the U.S. economy of oil
supply disruptions and the incremental ability of additional SPR stocks
and drawdown capability to reduce these costs, (4) estimate the costs of
buying and storing oil in the SPR, and (5) determine the net benefit and
efficient size of the SPR. The model uses a Monte Carlo simulation of the
world oil market over the next several decades to model the likelihood of
future oil supply disruptions.2

Similarities and Differences between the EIA Model and Office of Petroleum
Reserves' Model

In assessing the economic costs of disruptions, the Office of Petroleum
Reserves' model makes a number of assumptions similar to those made by
EIA, in particular, assumptions about the responsiveness of oil price to
supply disruptions. However, the Office of Petroleum Reserves' model
assumes a considerably greater degree of responsiveness of the
macroeconomy to oil price spikes than the EIA model. The Office of
Petroleum Reserves' model assumes for its base case that a sudden doubling
in the price of oil could reduce GDP in the following year by about 5.4
percentage points below what it otherwise would have been. This contrasts
with the EIA model result that a sudden doubling of the price of oil would
cause about a 0.5 to 1.0 percent reduction in the level of real GDP
relative to its value if an oil price increase did not occur.

Some experts have suggested that the EIA model and Office of Petroleum
Reserves' model have assumptions that could be responsible for differences
in their estimates of the responsiveness of GDP to disruptions. In the
Office of Petroleum Reserves' model, the responsiveness of GDP to an oil
price shock incorporates a controversial assumption, that U.S. monetary
authorities would not intervene and increase the money supply to
accommodate the price shock. Some experts have suggested that, by
increasing the money supply, monetary authorities could restore consumers'
purchasing power to its predisruption level and eliminate or moderate the
GDP loss. Experts have also suggested deficiencies in the model that EIA
uses for its estimates of the responsiveness of GDP to oil price shocks. A
number of experts believe that large-scale macroeconomic models, such as
the EIA model, underestimate the effects of oil price shocks on the
economy. They question whether these models can distinguish between a
price shock and a more gradual price increase. In contrast, the
econometrically based estimates used by Office of Petroleum Reserves'
model and others are derived from models of oil price shocks.

Appendix III

Comments from the Department of Energy

Appendix IV

GAO Contact and Staff Acknowledgments

GAO Contact

Jim Wells, (202) 512-6877

Staff Acknowledgments

In addition to the individual named above, Dan Haas, Assistant Director;
Dennis Carroll; Samantha Gross; Mike Kaufman; Marietta Mayfield; Cynthia
Norris; Alison O'Neill; Paul Pansini; Jena Sinkfield; Anne Stevens; and
Barbara Timmerman made key contributions to this report.

(360565)

www.gao.gov/cgi-bin/getrpt? GAO-06-872 .

To view the full product, including the scope
and methodology, click on the link above.

For more information, contact Jim Wells at (202) 512-6877 or
[email protected].

Highlights of GAO-06-872 , a report to congressional requesters

August 2006

STRATEGIC PETROLEUM RESERVE

Available Oil Can Provide Significant Benefits, but Many Factors Should
Influence Future Decisions about Fill, Use, and Expansion

What GAO Recommends

GAO is recommending that the Secretary of Energy (1) assess the
effectiveness of experts' proposals to use dollar cost averaging when
filling the SPR and allow delays in SPR fill; (2) to better serve users,
store some heavy sour oil in the SPR; (3) clarify the difference in
assumptions and purposes of two models DOE uses to estimate the impact of
using the SPR; and (4) periodically reassess the ideal size of the SPR in
light of changing oil market conditions. DOE generally agreed with the
report and recommendations.

The group of experts recommended a number of factors to be considered when
filling and using the SPR. They generally agreed that filling the reserve
by acquiring a steady dollar value of oil over time, rather than a steady
volume of oil over time as has occurred in recent years, would ensure that
more oil will be acquired when prices are low and less when prices are
high. Experts also suggested allowing oil producers to defer delivery of
oil to the reserve at times when supply and demand are in tight balance,
with oil producers providing additional oil to the SPR to pay for the
delay. Regarding use of the SPR, experts described several factors to
consider when making future use decisions, including using the reserve
without delay when it is needed to minimize economic damage.

During oil supply disruptions, releasing oil from the SPR could greatly
reduce damage to the U.S. economy, based on our analyses and expert
opinions. Particularly when used in conjunction with reserves in other
countries, the SPR can replace the oil lost in all but the most
catastrophic oil disruption scenarios we considered, lasting from 3 months
to 2 years. DOE uses one model to estimate the optimal size of the SPR and
another to estimate the economic effects of oil supply disruptions. Both
models predict positive effects from using the SPR, but the magnitude of
such benefits differ. The substantial differences between the results of
these two models could lead DOE to provide inconsistent advice about
expanding and using the reserve. Furthermore, factors beyond the SPR's
ability to replace oil affect the extent to which the SPR can protect the
U.S. economy from damage. For example, SPR crude is not compatible with
all U.S. refineries. During a disruption of heavy sour crude oil,
refineries configured to use this type of oil would have to reduce
production of some petroleum products when refining the lighter oil in the
SPR, decreasing the reserve's effectiveness at preventing economic damage.

If demand for oil increases as expected, a larger SPR would be necessary
to maintain the existing level of protection for the U.S. economy. The
Energy Information Administration recently projected increases in U.S.
demand for petroleum of approximately 12 percent by 2015 and 24 percent by
2025, compared with the 2005 level. In this regard, a 2005 study prepared
for DOE found that the benefits of expanding the reserve to 1.5 billion
barrels exceed the costs over a range of future conditions. However, many
factors that influence the SPR's ideal size are likely to change over
time. For example, although projections show increasing oil demand, the
level of demand depends on many factors, including rates of economic
growth, the price of oil, policy choices related to alternatives to oil,
and technology changes. Consequently, periodic reassessments of the SPR's
size in light of new information could be helpful as part of the nation's
energy security planning.
*** End of document. ***