by Thomas I. Palley / January 30, 2007

“Last year 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 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 have been due to our own strategic oil reserve, which the Bush
administration may have been manipulating to drive up prices for the
benefit of its supporters. This is something Congress must
investigate, and here is some preliminary evidence.

Any finding of manipulation would be economic treason. When global oil
prices increase, Americans must pay more for imported oil. That
increases the U.S. trade deficit. Alternatively, one can think of
price manipulation as the equivalent of a tax increase on American
families paid to foreign governments.

While some energy scandals in the Department of the Interior are
already under investigation by Congress, the big enchilada is the
strategic oil reserve. The key to understanding any 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 may 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 in
that same time period.

As oil prices rose, Wall Street became increasingly engaged in
commodity speculation, and this is where storage matters. As
speculators entered the market, the spot price of crude oil rose
significantly above the futures price in late 2003.

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

Over the past month, spot crude oil prices have been tumbling. The
reason is that the market has 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 $75 oil, and absent the administration’s dealings,
oil prices might not have risen as high as they did.

The story does not end here. With private-sector oil storage capacity
exhausted, the president in his State of the Union address has now
announced his intention to double the size of the strategic oil
reserve from 700 million barrels to 1.5 billion barrels. The Bush
administration plans to start purchasing 100,000 barrels of oil per

The result has been predictable, with the futures price of oil jumping
from $50 to $54 per barrel between Jan. 19 and Jan. 24. Not only will
these government 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 of Mexico 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.

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 repayments tightened market demand and also
freed up private storage capacity, thus facilitating further cornering
of the market.

Every price blip in the oil market calls forth explanations in terms
of Chinese demand, more violence in Nigeria’s delta region, cold
weather, threats from Venezuela’s president, Hugo Chavez, or
heightened tensions over Iran’s nuclear program. The strategic reserve
is the perfect vehicle for subterfuge corruption because its
transactions can be cloaked in the veil of national defense. But a
motive exists and the circumstantial evidence is troubling.

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.

One last factoid. A recent working paper posted by the International
Monetary Fund documented that oil prices in the United States appear
to be politically manipulated, falling prior to elections. If you are
an economist, you ask how that is done. The answer is the strategic
oil reserve.”


Dr. Thomas Palley is an economist living in Washington DC. He holds a
B.A. degree from Oxford University, and a M.A. degree in International
Relations and Ph.D. in Economics, both from Yale University.

He has published in numerous academic journals, and written for The
Atlantic Monthly, American Prospect and Nation magazines.

Dr . Palley has recently started a project, Economics for Democratic &
Open Societies. The goal of the project is to stimulate public
discussion about what kinds of economic arrangements and conditions
are needed to promote democracy and open society.

Dr . Palley was formerly Chief Economist with the US – China Economic
and Security Review Commission. Prior to joining the Commission he was
Director of the Open Society Institute’s Globalization Reform Project,
and before that he was Assistant Director of Public Policy at the AFL-

Thomas Palley
1900 Lamont St. NW
Washington DC 20010
phone: (202) 374-3951
mail [at] thomaspalley [dot] com

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