Developing a market-based approach to managing the US strategic petroleum reserve

The Strategic Petroleum Reserve has not been used effectively to manage the consequences of oil shocks in the United States. The main reason is that political decision makers tend to hoard the reserves during crises and bureaucratic processes delay the sale of the reserves. Also, the enabling legislation focused on ameliorating shortages whereas disruptions result price spikes rather than shortages. We develop a Markov game of the buildup and drawdown of the reserve in which a public player aims to maximize consumer welfare at the same time private holders of inventory maximize their profit. The methodological contribution in this paper is the development of financial options to implement the public player's optimal policy. We use the solution of this game to calculate the number and value of options necessary for the private marketplace to trigger the optimal buildup and drawdown of the reserve. (C) 2010 Elsevier B.V. All rights reserved.