TCS Daily

Sell High, Buy Low! (Actually, Don't Buy at All)

By David R. Henderson - May 28, 2004 12:00 AM

"A simplistic quick fix," according to the May 19 New York Times. "Political theater," says the May 20 Wall Street Journal. The editors of these august newspapers were referring to a proposal to sell oil from the U.S. government's Strategic Petroleum Reserve. When editors of the establishment newspapers of the left and right agree that a proposal is a bad idea, it must be bad, right? And when you learn that the idea was proposed by 20 Senate Democrats, well, then that's the trifecta. Except for one thing. The idea makes sense.

In fact, I first proposed selling reserves in April 2000, when oil prices were quite high (see David R. Henderson, "America's Free Lunch: Selling Oil From the Strategic Petroleum Reserve," Investor's Business Daily, April 17, 2000) and the Clinton administration, shortly after that, began to do so. The same reasoning I used then for selling reserves applies equally today.

If you want to build a long-run reserve of some item and you can buy it today for $41 but next year for $35, when would it be best to buy it? Next year, right? After all, you would save $6 per unit. And what if you have a lot of that good now that you could sell for today's price of $41, with the understanding that you can buy it a year from now for $35? That's even sweeter, because you can make $41 now and spend $35, for a net gain of $6 per unit, with no long-run reduction in your number of units.

Well, that's the choice the U.S. government faces. Right now, it's buying about 170,000 barrels of oil a day to add to its oil reserves of about 650 million barrels and paying the market price of about $41. The government could, instead, quit buying oil at a high price and wait until the price falls. It could even sell oil at a high price and replace the oil with barrels it buys later at a low price.

Ah, you say, but what if the price doesn't fall later and the government has to pay even more than $41 in the future? This is where futures markets come in. One of the beauties of the free market is that on certain widely-traded commodities, you can hedge against risk of future price changes by buying futures contracts. Oil is such a commodity. And the futures market is telling us, as of May 25, that the price of light sweet crude oil in July 2005 is only $35.10, or about $6 below its current price, often called the spot price. So the government could sell oil now at about $41 and simultaneously enter the futures market and buy for delivery in July 2005 at $35.10, making a cool $6 a barrel minus transactions costs.

The government can pump as much as 2 million barrels per day (mbd) of the SPR oil. But say it pumped only 1 mbd. Then it could make about $6 million a day or $545 million in three months. Now I know this is a rounding error on government waste, let alone on government spending, but some of us would like to reduce government waste by $545 million.

And waste is exactly what the government is creating by keeping oil in the reserve when it's valuable rather than selling it. That's just as wasteful as buying corn or Cameros and dumping them in the ocean.

Actually, I've simplified a little. Because the very act of selling 1 mbd would bring down world prices. Current world supply is about 80 mbd and so 1 mbd would increase the supply by 1.25 percent. That small increase could reduce the world price by as much as 12.5 percent, or about $5. Why so much? Because in the short run, the demand for oil is highly inelastic; small percentage changes in output cause substantially larger percentage changes in price. So then the government wouldn't make as much money, but we oil consumers would pay $5 less per barrel. That would translate at the gas pumps into a saving of about 12 cents a gallon.

The Wall Street Journal's editors do have one legitimate objection. They argue that "Releasing oil for political purposes would make matters worse by removing the incentive for private companies to carry inventories." That's true. And that's why there's an even better reform. There was never much justification for the Strategic Petroleum Reserve in the first place. Private holders of oil have the right incentive to hold inventories if the government can't undercut them by selling when prices are high. But the very existence of the SPR means that inventory holders always have to second-guess the government. There's only way to solve this problem: have the government sell the oil until there's none left. Then the government could reduce the debt by about $16.3 billion (assuming conservatively that it gets an average price of $25 a barrel on its 650 million barrels), bring the price of oil down by $5 a barrel at least, and avoid messing up future incentives for private firms to hold oil reserves. Now there's the right trifecta.

David R. Henderson is a research fellow with the Hoover Institution and an economics professor at the Naval Postgraduate School in Monterey, California. He was the senior economist for energy policy with President Reagan's Council of Economic Advisers from August 1983 to July 1984. He is also author of The Joy of Freedom: An Economist's Odyssey and editor of The Concise Encyclopedia of Economics. ( He can be reached at


TCS Daily Archives