At a time when consumers are paying high prices for gasoline, the federal government is refilling stocks.
While the recent filling of the U.S. Strategic Petroleum Reserve has not become a major national issue yet, it is stirring controversy.
Consumers think gasoline prices are high, which is the case compared to a few years ago. At the same time, the federal government is putting large amounts of crude oil into salt domes along the Gulf Coast for the reserve.
Some people are outraged that government would do anything that exacerbates consumer energy prices at this time. The federal government established the reserve in 1975 in the wake of the 1973 Arab oil embargo. Many people thought this embargo severely damaged the U.S. economy. Some feared that oil import interruptions would become more frequent and more severe.
Congress passed legislation authorizing the purchase and storage of up to 1 billion barrels of crude oil as a strategic reserve that could be tapped to smooth out any future supply interruptions. At that time, we imported about 2 billion barrels of oil and used about 6 billion annually. The new reserve thus would hold about six months’ worth of imports.
In any case, the U.S. Department of Energy acquired capacity to store only 700 million barrels and over several years actually stored some 600 million. In 28 years, the United States has taken oil out of the reserve just once — in January 1991 during the first Gulf War. Less than 18 million barrels were removed, or about 3 percent of the total available.
Two months after the Sept. 11, 2001, attacks, President George W. Bush authorized filling the unused 100 million barrels to capacity. This is going on right now at a rate of about 130,000 barrels per day.
PUMP PRESSURE
Is this enough to drive up prices?
This is the sort of question that economists love to assign to their microeconomics students because it deals with a fundamental idea: How does a market price respond to changes in the quantity available?
The technical term for this response is “elasticity of demand.”
Elasticity usually is couched in terms of how a change in price affects the quantity consumers are willing to buy.
If a higher price results in a large decrease in purchases, demand is elastic. On the other hand, if a higher price does not reduce the quantity purchased very much, demand is inelastic.
The same relationships are true when prices fall.
If a drop in prices results in a large increase in quantity purchased, demand is elastic. If the response is a small quantity change, demand is inelastic.
In mathematical terms, elasticity of demand is a number calculated by taking a percentage change in quantity over the related change in price. Numbers for different products typically run from -0.3 to -1.2 or so.
While most elasticity problems are framed in terms of how quantity responds to a price change, the same techniques can be used to estimate what will happen to price if some outside force changes the quantity available.
We flip the little division over and look at percentage change in price associated with a given change in quantity. Technically, we now have a “flexibility” coefficient instead of elasticity, but in practice we lump the two terms together because one is just the inverse of the other.
Elasticity is higher in the long run than in the short run. That makes sense. If oil prices go up, you can add insulation to your house and buy a cheaper car over a period of months or years. You cannot do much from one day or week to the next.
Demand for gasoline tends to be inelastic, especially in the short run, because we use it in ways that are hard to change overnight. In the very short run, a 10 percent increase in gas prices may cut gallons purchased by only 2 percent. The coefficient would be -0.2.
If we flip the relationship over — with this elasticity of -0.2, any given percentage decrease in quantity available would increase prices by a factor of five. Thus, in the short term a modest decrease in quantity can have big effects on prices. This is the primary reason that gasoline prices are volatile in a way that rutabaga prices are not.
Have we found our culprit for high gas prices? Are federal additions to the Strategic Petroleum Reserve pushing up our driving costs?
BARRELING AHEAD
To answer that, we need to look at the size of these additions relative to total crude consumption. As noted, about 130,000 barrels of oil are going into the reserve every day as a result of the president’s order to fill it to capacity.
This sounds like a lot of oil, but not when you consider that our nation uses about 20 million barrels a day.
Writing those relative quantities out to the last zero helps answer our question. Oil pumped into the reserve amounts to only two-thirds of 1 percent of daily usage.
If we assume the factor of five, this storage could increase gas prices by 3 cents or 4 cents per gallon.
While this is not negligible, it is only a fraction of the increases we have seen in the last two years.
Looking at all the numbers does raise the broader question of whether we need a reserve that we have drawn on only once in the last quarter century.
The purpose of the reserve is “strategic” — for use in true national emergencies and not as a device to keep gasoline or crude oil prices low or high.
The world oil market is, however, far larger and more diverse than it was in 1975. The reserve may be a safeguard that we really don’t need.
© 2003 Edward Lotterman
Chanarambie Consulting, Inc.