	DOE Could Improve the Cost-Effectiveness of Filling the SPR

For information on the composition of the SPR, see DOE, Office of the Assistant Secretary  for Fossil Energy, Strategic Petroleum Reserve: Annual Report for Calendar Year 2006. difference were to persist over the duration of the new fill period, DOE  would save about $1.2 billion in nominal terms by filling the SPR with 100  million barrels of heavy oil. Including heavier oil would have the additional benefit of making the  composition of SPR oil more compatible with U.S. refineries. For these reasons, we recommended that DOE conduct a new  review of the optimal oil mix in the SPR and determine the maximum  volume of heavy oil that could be effectively put in the reserve. In addition, we recommended that DOE consider filling the SPR by  acquiring a steady dollar value of oil over time, rather than a steady  volume of oil over time as has occurred in recent years. This “dollar-cost- averaging” approach would allow DOE to take advantage of fluctuations in  oil prices and ensure that more oil would be acquired when prices are low  and less when prices are high. In our 2006 report, we found that if DOE  had used this approach from October 2001 through August 2005, it could  have saved approximately $590 million in fill costs. We also ran  simulations to estimate potential future cost savings from using a dollar- cost-averaging approach over 5 years and found that DOE could save  money regardless of the price of oil as long as there is price volatility, and  that the savings would be generally greater if oil prices were more volatile. We also recommended that DOE consider allowing oil companies  participating in the royalty-in-kind program more flexibility to defer their  deliveries to the SPR at times when filling would significantly tighten the  market or when prices are expected to decline. In updating us on the status of recommendations we made to DOE in our  August 2006 report, DOE indicated that its November 8, 2006, rule on SPR  acquisition procedures addressed our recommendations on dollar-cost- averaging and deferrals. As to our recommendation on the optimal mix of oil in the SPR,  DOE indicated that, due to the planned SPR expansion, such  determinations should wait until it prepares a new study of U.S. Gulf Coast  heavy sour crude refining requirements. We look forward to DOE completing its new study of U.S. Gulf  Coast heavy crude refining requirements and believe such a study will find  that DOE should include at least 10 percent heavy oils in the SPR. Purchasing Oil to Fill the SPR May Be More Cost-Effective Than Current Royalty-in- Kind Program

There are several reasons that purchasing oil—as DOE did until 1994— may be more cost-effective than filling the SPR using the current royalty- in-kind program. In addition, royalty-in-kind exchanges add a layer of administrative  complexity to the task of filling the SPR, increasing the potential for waste  or inefficiency. In a January 2008 report, the DOE Inspector General  concluded that DOE does not have an effective control system over  receipts of royalty oil from Interior at the market centers. Moreover, rather than diverting a fraction  of the oil collected through the royalty-in-kind program to fill the SPR,  Interior could sell that fraction in competitive sales, as it currently does  for the other oil it receives through the royalty-in-kind program. Further, DOE’s method for evaluating bids is more robust for cash  purchases than royalty-in-kind exchanges, increasing the likelihood that  cash purchases are more cost-effective. In November 2006, DOE issued a  final rule that describes how DOE will evaluate offers when it is  purchasing oil and when it is exchanging royalty oil for other oil for the  SPR. For example, in April 2007, DOE solicited two  different types of bids—one to purchase oil for the SPR in cash and one to  exchange royalty oil for other oil to fill the SPR. In deciding whether to  purchase oil, DOE evaluated the bids it received in the context of overall  market trends. In this  case, in the same month, DOE entered into royalty oil exchange contracts  when the spot price of LLS was about $67 a barrel, effectively committing  the government to pay—through foregone revenues to the U.S. Treasury— roughly the same price for oil that DOE concluded was too high to  purchase. Based on our past  estimates of the cost savings potential of dollar cost averaging and the  significantly lower cost of heavier oils, DOE could save well over 10  percent of the costs of filling the SPR to the currently authorized level—an  amount that is likely well in excess of $1 billion.
Why GAO Did This Study

The Strategic Petroleum Reserve (SPR) was created in 1975 to help insulate the U.S. economy from oil supply disruptions and currently holds about 700 million barrels of crude oil. The Energy Policy Act of 2005 directed the Department of Energy (DOE) to increase the SPR storage capacity from 727 million barrels to 1 billion barrels, which it plans to accomplish by 2018. Since 1999, oil for the SPR has generally been obtained through the royalty-in-kind program, whereby the government receives oil instead of cash for payment of royalties on leases of federal property. The Department of Interior's Minerals Management Service (MMS) collects the royalty oil and transfers it to DOE, which then trades it for oil suitable for the SPR. As DOE begins to expand the SPR, past experiences can help inform future efforts to fill the reserve in the most cost-effective manner. In that context, GAO's testimony today will focus on: (1) factors GAO recommends DOE consider when filling the SPR, and (2) the cost-effectiveness of using oil received through the royalty-in-kind program to fill the SPR. To address these issues, GAO relied on its 2006 report on the SPR, as well as its ongoing review of the royalty-in-kind program, where GAO interviewed officials at both DOE and MMS, and reviewed DOE's SPR policies and procedures. DOE provided comments on a draft of this testimony, which were incorporated where appropriate.

What GAO Found

To decrease the cost of filling the SPR and improve its efficiency, GAO recommended in previous work that DOE should include at least 10 percent heavy crude oils in the SPR. If DOE bought 100 million barrels of heavy crude oil during its expansion of the SPR it could save over $1 billion in nominal terms, assuming a price differential of $12 between the price of light crude oil and the lower price of heavy crude oil, the average differential over the last five years. Having heavy crude oil in the SPR would also make the SPR more compatible with many U.S. refineries, helping these refineries run more efficiently in the event that a supply disruption triggers use of the SPR. DOE indicated that, due to the planned SPR expansion, determinations of the amount of heavy oil to include in the SPR should wait until it prepares a new study of U.S. Gulf Coast refining requirements. In addition, we recommended that DOE consider acquiring a steady dollar value--rather than a steady volume--of oil over time when filling the SPR. This "dollar-cost-averaging" approach would allow DOE to acquire more oil when prices are low and less when prices are high. GAO found that if DOE had used this purchasing approach from October 2001 through August 2005, it would have saved approximately $590 million, or over 10 percent, in fill costs. GAO's simulations indicate that DOE could save money using this approach for future SPR fills, regardless of whether oil prices are trending up or down as long as there is price volatility. GAO also recommended that DOE consider giving companies participating in the royalty-in-kind program additional flexibility to defer oil deliveries in exchange for providing additional barrels of oil. DOE has granted limited deferrals in the past, and expanding their use could further decrease SPR fill costs. While DOE indicated that its November 2006 rule on SPR acquisition procedures addressed our recommendations, this rule does not specifically address how to implement a dollar-cost-averaging strategy. Purchasing oil to fill the SPR--as DOE did until 1994--is likely to be more cost-effective than exchanging oil from the royalty-in-kind program for other oil to fill the SPR. The latter method adds administrative complexity to the task of filling the SPR, increasing the potential for waste and inefficiency. A January 2008 DOE Inspector General report found that DOE is unable to ensure that it receives all of the royalty oil that MMS provides. In addition, we found that DOE's method for evaluating bids has been more robust for cash purchases than royalty-in-kind exchanges, increasing the likelihood that cash purchases are more cost-effective. For example, in April 2007, DOE solicited two different types of bids--one to purchase oil for the SPR in cash and one to exchange royalty oil for other oil to fill the SPR. DOE rejected offers to purchase oil when the spot price was about $69 per barrel, yet in the same month, DOE exchanged royalty-in-kind oil for other oil to put in the SPR at about the same price. Because the government would have otherwise sold this royalty-in-kind oil, DOE committed the government to pay, through foregone revenues to the U.S. Treasury, roughly the same price per barrel that DOE concluded was too high to purchase directly.