Manipulating The Oil Reserve

Thomas I. Palley
January 26, 2007

Thomas Palley runs the Economics for Democratic and Open Societies Project. He is the author of Plenty of Nothing: The Downsizing of the American Dream and the Case for Structural Keynesianism. His weekly economic policy blog is at www.thomaspalley.com.

2006 was the year that oil prices came close to breaching $80 per barrel. This was despite the fact that there were no significant supply interruptions and oil demand actually fell in industrialized countries. That raises the question of what caused the spike.

It turns out there is good reason to believe that record oil prices may be due to our own strategic oil reserve, which the Bush administration may have been manipulating to drive up prices for the benefit of its clients. This is something Congress must investigate, and here is some preliminary evidence.

Any finding of manipulation would go far beyond corruption and be close to economic treason, because when oil prices increase America must pay more for its imported oil. That, in turn, increases the trade deficit and our foreign debt. Alternatively, one can think of price manipulation as the equivalent of a tax increase on American families that is paid to foreign governments, including Iran. While some small energy scandals are under investigation by Congress, the big enchilada is the strategic oil reserve, which may have been “strategically” manipulated to drive up oil prices. The key to understanding this manipulation is demand and supply and oil storage capacity.

The last three years have seen rapidly rising oil prices, and a tight oil market has meant that even small increases in demand have had large price impacts. During this period the Bush administration purposely expanded inventories of the strategic oil reserve, which rose from 600 million barrels in May 2003 to 700 million barrels in August 2005. The administration therefore increased demand by 125,000 barrels per day, and oil prices rose from 30 dollars per barrel to 70 dollars.

As oil prices rose, Wall Street became increasingly engaged in commodity speculation (the destructive effects of which is a story for another day), and this is where storage matters. As speculators entered the market the spot price of crude oil rose above the futures price. However, buying spot oil means taking delivery, which requires storage capacity. By adding to the strategic reserve, the administration not only increased oil demand but also increased storage capacity because the oil it bought was stored in the strategic reserve’s caverns. That helped speculators by adding storage capacity vital for cornering the market.

That brings us to today. Over the last month spot oil prices have been tumbling. The reason is that the market has finally run out of storage capacity, which means that all oil produced must now be immediately sold—and that has driven oil prices down. This suggests there has never been a supply shortage warranting seventy-five dollar oil, and absent the administration’s dealings, oil prices might not have risen as they did.

The story does not end here. With private sector oil storage capacity exhausted, the administration has now announced its intention to double the size of the strategic oil reserve from 700 million barrels to 1.5 billion barrels, and it plans to start purchasing 100,000 barrels of oil per day.

The result has been predictable, with the price of oil jumping from $50 to $55 per barrel over the last week (01/19- 01/24). Not only will these purchases increase oil demand, they will also provide new storage capacity needed to re-corner the market.

One last piece of evidence concerns Hurricane Katrina and the oil loan program. Following Katrina, gulf oil production was interrupted causing shortages of crude for refineries. The administration’s response was to loan crude to refiners who were to pay it back in kind. That was a huge gift to refiners who got the oil they wanted and then made a killing on the processed gasoline that was in short supply after Katrina. The proper way to handle the situation would have been to auction the oil, in which case taxpayers would have got the windfall disaster rent (excess profit) resulting from Katrina. This is because refiners would have been willing to pay a high price knowing that gas prices were high.

But there’s yet more damage. If government had auctioned the oil, it could have chosen when to buy it back. Instead, companies paid it back in kind in late 2005 and early 2006, and these payments tightened the market demand and also freed up private storage capacity facilitating further market cornering.

The oil market is full of smoke that provides perfect cover for corruption. Every price blip calls forth explanations in terms of Chinese demand, more violence in Nigeria’s delta region, cold weather, threats from Venezuela’s Hugo Chavez or heightened tensions over Iran’s nuclear program. The strategic reserve is the perfect vehicle for corruption since transactions can be cloaked in the veil of national defense. But the situation is clear. A motive exists, the bad character of the administration is known and the circumstantial evidence is strong.

Congress must investigate the strategic oil reserve, how it has been managed and what its purpose is. The recently announced expansion serves no real national security function (though that will be the justification) and will only drive up oil prices and add to the budget deficit and national debt.

One last factoid. A recent IMF study documented that oil prices in the U.S. appear to be politically manipulated, falling prior to elections—as they did in 2002, 2004 and 2006. If you are an economist you ask how that is done. The answer is the strategic oil reserve.