Strategic Petroleum Reserve: Improving the Cost-Effectiveness of 
Filling the Reserve (24-APR-08, GAO-08-726T).			 
                                                                 
The Strategic Petroleum Reserve (SPR) was created in 1975 to help
protect 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 we incorporated where appropriate.		 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-08-726T					        
    ACCNO:   A81872						        
  TITLE:     Strategic Petroleum Reserve: Improving the 	      
Cost-Effectiveness of Filling the Reserve			 
     DATE:   04/24/2008 
  SUBJECT:   Bid evaluation					 
	     Cost analysis					 
	     Cost effectiveness analysis			 
	     Crude oil						 
	     Energy consumption 				 
	     Energy costs					 
	     Energy demand					 
	     Energy management					 
	     Energy planning					 
	     Energy shortages					 
	     Energy supplies					 
	     Evaluation methods 				 
	     International organizations			 
	     International relations				 
	     Oil importing					 
	     Oil resources					 
	     Petroleum industry 				 
	     Petroleum refining facilities			 
	     Procurement evaluation				 
	     Program evaluation 				 
	     Royalty payments					 
	     Supply and demand					 
	     Strategic Petroleum Reserve			 

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GAO-08-726T

   

     * [1]In summary
     * [2]DOE Could Improve the Cost-Effectiveness of Filling the SPR
     * [3]Purchasing Oil to Fill the SPR May Be More Cost-Effective Th
     * [4]Conclusions
     * [5]GAO Contact and Staff Acknowledgments
     * [6]GAO's Mission
     * [7]Obtaining Copies of GAO Reports and Testimony

          * [8]Order by Mail or Phone

     * [9]To Report Fraud, Waste, and Abuse in Federal Programs
     * [10]Congressional Relations
     * [11]Public Affairs

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Testimony:

Before the Select Committee on Energy Independence and Global Warming, 
House of Representatives:

United States Government Accountability Office: 
GAO:

For Release on Delivery: 
Expected at 10:00 a.m. EDT:
Thursday, April 24, 2008:

Strategic Petroleum Reserve:

Improving the Cost-Effectiveness of Filling the Reserve:

Statement of Frank Rusco: 
Acting Director: 
Natural Resources and Environment: 

GAO-08-726T: 

GAO Highlights:

Highlights of GAO-08-726T, a testimony before the Select Committee on 
Energy Independence and Global Warming, House of Representatives. 

Why GAO Did This Study:

The Strategic Petroleum Reserve (SPR) was created in 1975 to help 
protect 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 Interiorï¿½s 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, GAOï¿½s 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 DOEï¿½s SPR 
policies and procedures. DOE provided comments on a draft of this 
testimony, which we incorporated where appropriate.

What GAO Found:

To decrease the cost of filling the reserve 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 valueï¿½rather 
than a steady volumeï¿½of oil over time when filling the SPR. This 
ï¿½dollar-cost-averagingï¿½ 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 between October 2001 through 
August 2005, it could have saved approximately $590 million, or over 10 
percent, in fill costs. GAOï¿½s 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 recommends 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 SPRï¿½as DOE did until 1994ï¿½is 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 DOEï¿½s 
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 bidsï¿½one 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.

To view the full product, including the scope and methodology, click on 
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-08-726T]. For more 
information, contact Frank Rusco at (202) 512-3841 or [email protected]. 

[End of section] 

Mr. Chairman and Members of the Committee:

We are pleased to be here today to participate in the Committee's 
hearing on the Strategic Petroleum Reserve (SPR). Congress authorized 
the SPR in 1975 to protect the nation from oil supply disruptions 
following the Arab oil embargo of 1973 and 1974 that led to sharp 
increases in oil prices. The federal government owns the SPR, and the 
Department of Energy (DOE) operates it. The SPR currently has the 
capacity to store up to 727 million barrels of crude oil in salt 
caverns in Texas and Louisiana. As of April 21, 2008, current inventory 
of the SPR stood at 701.3 million barrels of oil, which is roughly 
equivalent to 58 days of net oil imports. DOE made direct purchases of 
crude oil until 1994, when purchases were suspended due to the federal 
budget deficit, and in fiscal years 1996 and 1997 approximately 28 
million barrels of oil were sold to reduce the deficit. Since DOE 
resumed filling the SPR in 1999, it has obtained oil from the 
Department of the Interior's Minerals Management Service (MMS) "royalty-
in-kind" program. Through this program, the MMS receives oil instead of 
cash for payments of royalties from companies that lease federal 
property for oil and gas development. MMS contracts for some of this 
royalty oil to be delivered to designated oil terminal locations or 
"market centers" where DOE takes possession. Because the royalty oil 
often does not meet SPR quality specifications, and because the market 
centers can be distant from SPR storage sites, DOE generally awards 
contracts to exchange royalty oil at the market center for SPR-quality 
oil delivered to SPR facilities. Obtaining oil for the SPR through the 
royalty-in-kind program avoids the need for Congress to make outlays to 
finance oil purchases, but the foregone revenues associated with using 
royalty-in-kind oil to trade for SPR oil imply an equivalent loss of 
revenue because MMS would otherwise sell the oil and deposit the 
revenues with the U.S. Treasury. Interior estimates that the forgone 
revenue attributable to using the royalty-in-kind program to fill the 
SPR were $4.6 billion from fiscal year 2000 through fiscal year 2007.

The Energy Policy Act of 2005 directed DOE to increase the SPR storage 
capacity to 1 billion barrels and to fill it "as expeditiously as 
practicable without incurring excessive cost or appreciably affecting 
the price of petroleum products to consumers."[Footnote 1] It required 
DOE to select sites to expand the SPR's storage capacity within 1 year 
of enactment, by August 2006. On February 14, 2007, Secretary of Energy 
William Bodman designated three sites for the expansion, including a 
160 million barrel facility in Richton, Mississippi, an 80 million 
barrel expansion of a facility in Big Hill, Texas, and a 33 million 
barrel expansion of a facility in Bayou Choctaw, Louisiana. In its June 
2007 SPR plan, DOE anticipated these expansions would begin in fiscal 
year 2008 and be complete in 2018.[Footnote 2],[Footnote 3] DOE also 
indicated that it would prefer to continue using the royalty-in-kind 
program to fill the additional storage capacity. DOE estimates the 
capital cost for the SPR expansion at approximately $3.67 billion, and 
estimates the cost of operating and maintaining the expanded portion of 
the SPR at $35 to $40 million per year.

As DOE begins to expand the SPR, past experiences may help inform 
future efforts to fill the SPR in the most cost-effective manner. In 
that context, our testimony today will focus on: (1) factors we 
recommend 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, we are summarizing work from our August 2006 
report on the SPR and our ongoing review of the royalty-in-kind 
program.[Footnote 4] For our August 2006 report, we contracted with the 
National Academy of Sciences to convene a group of 13 industry, 
academic, governmental, and nongovernmental experts to collect opinions 
on the impacts of past SPR fill and use and on recommendations for the 
future. We also reviewed records and reports from DOE and the 
International Energy Agency. In addition, for our ongoing review of the 
royalty-in-kind program for this committee and others, we identified 
and reviewed applicable laws and documentation on DOE policies and 
procedures for evaluating SPR purchase and exchange bids, and 
interviewed officials at both Interior and DOE. We have also drawn upon 
previous GAO reports on the royalty-in-kind program.[Footnote 5] We 
conducted our work on this testimony from January to April 2008 in 
accordance with generally accepted government auditing standards. Those 
standards require that we plan and perform the audit to obtain 
sufficient, appropriate evidence to provide a reasonable basis for our 
findings and conclusions based on our audit objectives. We believe that 
the evidence obtained provides a reasonable basis for our findings and 
conclusions based on our audit objectives.

In summary:

* To fill the SPR in a more cost-effective manner, we recommended in 
previous work that DOE include in the SPR at least 10 percent heavy 
crude oils, which are more compatible with many U.S. refiners and 
generally cheaper to acquire than the lighter oils that comprise the 
SPR's volume. 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. In addition, we 
recommended that DOE consider acquiring a steady dollar value of oil 
over time and allowing oil companies more flexibility to defer delivery 
of royalty-in-kind exchanges to the SPR when prices are likely to 
decline in return for additional deliveries in the future. In updating 
us on the status of this recommendation, DOE indicated that its 
November 8, 2006, rule on SPR acquisition procedures addressed our 
recommendations; however, this rule does not specifically address both 
how to implement a dollar-cost-averaging strategy and how to provide 
industry with more deferral flexibility. In subsequent comment, DOE 
noted that the November 8, 2006, acquisition procedures do not address 
dollar-cost-averaging, but they do address flexibility of purchasing 
and scheduling in volatile markets.

* Filling the SPR with oil purchased in cash is likely to be more cost- 
effective than filling the SPR through the royalty-in-kind program for 
several reasons. For example, the royalty-in-kind program adds a layer 
of administrative complexity to the task of filling the SPR, increasing 
the potential for waste or inefficiency. Moreover, DOE has evaluated 
the cost of cash purchases more thoroughly than exchanges, increasing 
the likelihood that cash purchases are more cost-effective. For 
example, in May 2007, DOE rejected cash purchases for the SPR, 
concluding that the current price of about $69 per barrel was unusually 
high. However, in the same month, DOE entered into contracts to 
exchange royalty oil, effectively committing the government to pay-- 
through foregone revenues to the U.S. Treasury--about the same price 
for oil that it concluded was too high to purchase directly. In 
November, DOE entered into another exchange contract when oil was about 
$96 per barrel.

DOE Could Improve the Cost-Effectiveness of Filling the SPR:

To decrease the cost of filling the SPR and improve its efficiency, we 
have recommended in our previous work that DOE: (1) include at least 10 
percent heavy crude oil in the SPR, (2) consider acquiring a steady 
dollar value of oil, and (3) consider allowing oil companies additional 
flexibility to defer deliveries in exchange for delivering additional 
barrels of oil at a later date. The current composition of the SPR is 
entirely of medium to light grades of oil.[Footnote 6],[Footnote 7] 
Including heavier oil in the SPR could significantly reduce fill costs 
because heavier oil is generally less expensive than lighter grades. We 
recommended in our August 2006 report that DOE, at a minimum, implement 
its own recommendation made in a 2005 study to have at least 10 percent 
heavy oil in the SPR.[Footnote 8] In addition, we found that DOE may 
have underestimated how much heavy oil should be in the SPR to minimize 
oil acquisition costs. Therefore, we further recommended that DOE 
examine the maximum amount of heavy oil that should be held in the SPR. 
To illustrate the potential magnitude of savings from including heavy 
crude oil in the SPR, we have done some simple calculations. If DOE 
included 10 percent heavy oil in the SPR as it expands to 1 billion 
barrels, that would require DOE to add 100 million barrels of heavy 
oil, or about one-third of the total new fill. From 2003 through 2007, 
Maya--a common heavy crude oil--has traded for about $12 less per 
barrel on average than West Texas Intermediate--a common light crude 
oil. If this price 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.[Footnote 9] The 
savings could be even larger if DOE included more than 10 percent 
heavier oils in the SPR. Alternatively, DOE could add heavy oil to the 
SPR by exchanging the light oil in one or more of the caverns for 
heavier oil. DOE has the legal authority to exchange one type of oil 
for another and has done so before. For example, in 1998, DOE exchanged 
11 million barrels of heavy crude oil stored in the Bryan Mound site 
for 8.5 million barrels of other higher value light crude oil.

Including heavier oil would have the additional benefit of making the 
composition of SPR oil more compatible with U.S. refineries. In recent 
years, many refiners in the United States have upgraded their 
facilities so they can process heavy oil. Our analysis of DOE's Energy 
Information Administration (EIA) data shows that, of the approximately 
5.6 billion barrels of oil that U.S. refiners accepted in 2006, 
approximately 40 percent was heavier than that stored in the 
SPR.[Footnote 10] Refineries that process heavy oil cannot operate at 
normal capacity if they run lighter oils. For instance, DOE's December 
2005 found that the types of oil currently stored in the SPR would not 
be fully compatible with 36 of the 74 refineries considered vulnerable 
to supply disruptions. DOE estimated that if these 36 refineries had to 
use SPR oil, U.S. refining throughput would decrease by 735,000 barrels 
per day, or 5 percent, substantially reducing the effectiveness of the 
SPR during an oil disruption, especially if the disruption involved 
heavy oil. 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, our August 2006 report found that 
DOE may have underestimated how much heavy oil should be in the SPR to 
maximize compatibility with refiners. We also found DOE 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 forced to rely on SPR oil as currently constituted. For 
example, an official from one refinery stated that if it exclusively 
used SPR oil in its heavy crude unit, it would produce 11 percent less 
gasoline and 35 percent less diesel. Representatives from other 
refineries told us they might need to shut down portions of their 
facilities if they could not obtain heavy oil. 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.[Footnote 11] 
In return for these deferrals, companies would provide additional 
barrels of oil when they resumed deliveries. DOE has already approved 
some delivery deferrals at companies' requests, such as during the 
winter 2002-2003 oil workers' strike in Venezuela. From October 2001 
through August 2005, DOE received an additional 4.6 million barrels of 
oil for the SPR valued at approximately $110 million as payment for 
these delivery deferrals. However, DOE has denied some deferral 
requests and experts have noted that there is room to expand the use of 
deferrals. Experts noted DOE would need to exercise its authority to 
deny deferrals at times when it is in the national interest. 
Nonetheless, given that the SPR currently holds roughly 58 days of net 
imports, we believe there is sufficient inventory for some flexibility 
in allowing deferrals.

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. However, the new acquisition rule does 
not specifically address our recommendations to study both how to 
implement a dollar-cost-averaging strategy and how to provide industry 
with more deferral flexibility. Unless DOE addresses and adopts these 
recommendations, it will not be filling the reserve in the most cost- 
effective manner. 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 believe the SPR 
expansion offers DOE an ideal opportunity to change the SPR's oil mix 
to include heavier oils that are less costly to acquire and better 
match U.S. refining capacity. 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 more than 10 percent 
heavier 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. For instance, there may be fewer bidders for 
the royalty oil under the current exchange system than a direct cash 
purchase system, which in turn may limit competition and the exchange 
deals that DOE can negotiate. In the exchange process, a single company 
must be able to and interested in both accepting oil at the designated 
market centers and delivering other oil with specific characteristics 
to the SPR. This may limit the number of companies interested in 
bidding on exchange contracts. In contrast, if DOE purchased oil, many 
additional companies may be interested in selling their oil, increasing 
competition and lowering prices.[Footnote 12] In 2007, the then Deputy 
Assistant Secretary for Petroleum Reserves, who directed activities of 
the SPR, told us that he agrees with this reasoning. The inherent 
limits of exchanging versus direct purchases are compounded by the fact 
that DOE and Interior have not systematically analyzed where to send 
royalty oil in a way that maximizes the value of the exchanges. The 
value of exchanges is a function of both the costs to deliver oil to 
market centers and the deals that DOE can negotiate at particular 
market centers. The informal process that Interior and DOE currently 
use to identify market centers does not systematically analyze the 
tradeoffs between these two factors to identify market centers that 
optimize net value to the government.

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. 
[Footnote 13] Specifically, the Inspector General found that DOE did 
not have adequate controls to ensure that the volumes of oil that 
contractors reported to have received from Interior at the market 
centers matched scheduled deliveries. As a result, DOE did not have 
assurance that it received all of the oil that Interior shipped, 
raising concerns that DOE may not have received its full entitled 
deliveries to the SPR. If DOE purchased all of its oil, it would no 
longer need to exchange oil at designated market centers and would not 
need to coordinate with Interior. 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. A senior Interior official said that selling the 
royalty oil would be simpler for Interior to administer than the 
current exchanges.

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.[Footnote 14] This rule provides DOE with considerable 
flexibility in the degree of analysis it can conduct when evaluating 
offers, and, in practice, DOE's method for evaluating bids for cash 
purchases has been more robust than it has for exchanges. 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.[Footnote 15] In deciding whether to purchase 
oil, DOE evaluated the bids it received in the context of overall 
market trends. It concluded that the offers it received from sellers 
were priced too high, in part because the price of oil was generally 
high and because the prices of the specific type of oil DOE sought to 
purchase were unusually high relative to other oil types. As a result, 
DOE rejected offers to purchase oil when the spot price for Light 
Louisiana Sweet (LLS)--a commonly used benchmark for Gulf Coast oil-- 
was about $69 per barrel and decided to delay purchasing any oil until 
at least the end of the summer driving season.[Footnote 16] In 
contrast, DOE's method for evaluating bids for exchanging royalty oil 
focused on whether the oil DOE would receive would be at least the same 
value as the oil it would exchange. It did not include an analysis of 
whether overall market conditions indicated that it would be more 
profitable for the federal government to stop or delay exchanges and 
have Interior sell the royalty oil for cash instead. 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. Moreover, in November, it awarded additional exchange 
contracts when the spot price of LLS had reached $96 a barrel.[Footnote 
17]

It should also be noted that the current exchange method is less 
transparent than direct purchases because the primarily cash-based 
federal budget does not account for noncash transactions. Interior 
estimates that the royalty-in-kind program cost the federal government 
in total foregone revenue $4.6 billion from fiscal year 2000 through 
fiscal year 2007. This foregone revenue was not reflected in the 
federal budget since no federal cash flows were involved. Congressional 
budget decisionmakers therefore have not had the opportunity to 
consider whether the value of the transferred oil could be reallocated 
to other competing resource needs.

Importantly, the royalty-in-kind effort to fill the SPR creates, 
essentially, a "blind spot" where neither DOE nor Interior, the two 
agencies responsible for running the joint program, systematically 
examines whether exchanges of millions of barrels of royalty oil have 
been a cost-effective approach to filling the reserve. DOE does conduct 
a prospective analysis to estimate whether the value of the oil it will 
receive in the exchanges will be at least as valuable as the royalty 
oil it will exchange. However, DOE enters into exchange agreements that 
can last 6 months, and DOE's initial estimates of the values of the 
different oil types may not hold over the duration of the contracts. 
DOE has not analyzed any of the completed exchanges to determine 
whether those exchanges performed as well as expected. Similarly, when 
evaluating the performance of the royalty-in-kind program overall, 
Interior does not analyze whether the royalty oil transfers to DOE are 
a cost-effective means to fill the reserve.[Footnote 18] The 60.7 
million barrels of oil that Interior transferred to DOE from fiscal 
year 2004 to 2005 accounted for 58 percent of all the royalty-in-kind 
oil that Interior collected during that time. While Interior reports to 
Congress each year on the financial performance of its royalty-in-kind 
program, these reports have not included a measure of the cost- 
effectiveness of using royalty oil to fill the SPR.

Conclusions:

Because the SPR has reached sufficient size to address near-term supply 
disruptions, decisions about future fill practices can be made in a 
more flexible, cost-effective manner without unduly hurting our ability 
to respond to such disruptions. With oil prices recently exceeding $117 
a barrel, there should be greater interest in finding ways to reduce 
fill costs. If it is to reach its goal of filling the expanded SPR by 
2018, DOE will have to, in some combination, purchase or receive 
through royalty-in-kind transfers roughly 300 million barrels of oil. 
Our work shows that substantial cost savings could be achieved through 
increased purchasing of heavy oil, a dollar-cost-averaging purchasing 
strategy, more flexibility in the timing of oil purchases and 
deliveries, and greater attention paid to the opportunity costs of 
filling the SPR with royalty oil. 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. During this era of dire 
national long-term fiscal challenges, it is all the more important that 
DOE make fill decisions in a cost-effective manner.

Mr. Chairman, this concludes my prepared statement. I would be pleased 
to respond to any questions that you or other members of the Committee 
may have at this time.

GAO Contact and Staff Acknowledgments:

For further information about this testimony, please contact me, Frank 
Rusco, at 202-512-3841 or [email protected]. Contact points for our 
Offices of Congressional Relations and Public Affairs may be found on 
the last page of this statement. Contributors to this testimony include 
Ben Bolitzer, Chase Huntley, Heather Hill, Michael Kendix, Jon 
Ludwigson, Tim Minelli, Michelle Munn, Alison O'Neill, G. Greg 
Peterson, and Barbara Timmerman. 

[End of section] 

Footnotes:

[1] Pub. L. No. 109-58 (2005). The Energy Policy and Conservation Act, 
Pub. L. No. 94-163 (1975), created the SPR and authorized storage of up 
to one billion barrels of petroleum products.

[2] DOE, Office of Petroleum Reserves, Strategic Petroleum Reserve 
Plan: Expansion to One Billion Barrels (Washington, D.C.: June 2007).

[3] In his State of the Union speech on January 23, 2007, President 
Bush proposed expanding the SPR further to 1.5 billion barrels. 
Secretary of Energy William Bodman indicated that DOE's goal was to 
have this expansion completed by 2027.

[4] GAO, Strategic Petroleum Reserve: Available Oil Can Provide 
Significant Benefits, but Many Factors Should Influence Future 
Decisions about Fill, Use, and Expansion, [hyperlink, 
http://www.gao.gov/cgi-bin/getrpt?GAO-06-872] (Washington, D.C.: 
Aug. 24, 2006).

[5] GAO, Royalties Collection: Ongoing Problems with Interior's Efforts 
to Ensure a Fair Return for Taxpayers Require Attention, [hyperlink, 
http://www.gao.gov/cgi-bin/getrpt?GAO-07-682T] (Washington, D.C.: 
Mar. 28, 2007). 

GAO, Mineral Revenues: Cost and Revenue Information Needed to Compare 
Different Approaches for Collecting Federal Oil and Gas Royalties, 
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-04-448] 
(Washington, D.C.: Apr. 16, 2004). 

GAO, Mineral Revenues: A More Systematic Evaluation of the Royalty-in- 
Kind Pilots is Needed, [hyperlink, 
http://www.gao.gov/cgi-bin/getrpt?GAO-03-296] (Washington, D.C.: 
Jan. 9, 2003).

[6] 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. 

[7] The weight of oil is measured by its gravity index. According to 
DOE's EIA, light oil is greater than 38 degrees gravity, while 
intermediate oils, such as those in the SPR, are 22 to 38 degrees 
gravity.

[8] See DOE, Office of the Deputy Assistant Secretary for Petroleum 
Reserves, Strategic Petroleum Reserve Crude Compatibility Study 
(December 2005).

[9] This calculation is intended to illustrate the magnitude of 
potential savings, and is not meant to be a projection of actual 
savings. The actual price difference between light and heavy oil over 
the course of the new fill could be smaller or larger than over the 
past 5 years, which would either reduce or increase the savings, 
respectively.

[10] According to DOE's EIA, heavy oil has a gravity index of 22 
degrees or below. According to EIA 2006 data, about 10 percent of the 
oil accepted by U.S. refiners has this gravity index and are considered 
heavy oils. An additional 30 percent of oil accepted by U.S. refiners 
was 22 to 30 degrees gravity, however, according to DOE, all oils 
stored in the SPR range from approximately 30 to 37 degrees gravity.

[11] For example, this situation could occur if futures prices are 
lower than current prices. Futures prices of oil reflect the cost of 
delivery at a specified place, price, and time in the future.

[12] We note that including heavier oils in addition to lighter oils 
would also increase the number of potential suppliers of oil for the 
SPR.

[13] DOE Office of Inspector General, Audit Report: Department of 
Energy's Receipt of Royalty Oil, DOE/IG-0786 (Washington, D.C.: Jan. 
2008).

[14] 10 C.F.R Part 626.

[15] DOE's solicitations to purchase oil were part of a plan to replace 
11 million barrels of SPR oil that DOE sold in the fall of 2005 after 
Hurricane Katrina disrupted refinery supplies.

[16] The spot price reflects the price for immediate settlement of oil 
purchases. 

[17] By itself, the spot price does not determine how many barrels of 
oil the government will receive through royalty exchanges. Rather, this 
is determined by the relative value--the price of the grade of oil that 
DOE has to exchange (the oil it receives from Interior) versus the 
price of the grade of oil that it wishes to exchange for. This means 
that the government could receive the same number of barrels of SPR oil 
through its exchanges when spots prices are low or high. However, from 
a broader federal perspective, it would be more cost-effective if the 
federal government deferred royalty exchanges when oil prices were high 
and sold the royalty oil for cash. It could then purchase oil when oil 
prices were lower, acquiring more of the desired grade of oil for the 
same amount of money.

[18] Interior does, however, have procedures in place to ensure that it 
pays a reasonable rate to transport oil from the offshore federal 
leases, where the oil is produced, to the market centers where DOE 
takes possession of the oil. 

[End of section] 

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