The case for offshore drilling in the outer continental shelf of the United States
I have to confess as I start off the article that I am certainly not an expert on the issue, and consequently, I will not attempt an elaborate explanation of all the benefits and costs of offshore drilling off the coast of the United States. Rather the principal intention of the post is to clarify a point that often is not clear during the course of our regular conversation on the topic as to why supply of oil and natural gas that may not take place till well into the future, can still cause a decline in prices today.
But before I attempt to launch into a discussion of the topic, let us get some of the very basic facts and concepts in order. First of all, what is the Outer Continental Shelf? This is how the Minerals Management Service, (henceforth MMS) of the U.S. department of Interior defines it. “The Outer Continental Shelf (OCS) consists of the submerged lands, subsoil, and seabed, lying between the seaward extent of the States' jurisdiction and the seaward extent of Federal jurisdiction. The continental shelf is the gently sloping undersea plain between a continent and the deep ocean.” 1 Now why should an arcane term that I can barely remember from my geography books be of any interest to either you or me? Well the answer is quite simple. It is oil and natural gas. In case you haven’t been paying any attention lately, oil has been trading at $145 per barrel, with some analysts believing it could hit as high as $200 per barrel per year. 2 The question then becomes how much of oil and natural gas might we expect if we were to allow off shore drilling in the outer continental shelf of the United States, some thing that is prohibited under current federal regulation. Current mean estimates from MMS place the technically recoverable resources currently off limits in the OCS of the lower 48 states (excluding Alaska and Hawaii, and by extension EXCLUDING any reserves from the Arctic National Wildlife Refuge, or ANWR) total 18 billion barrels of crude oil and 77 trillion cubic feet of natural gas. 3 Thus a casual inspection will tell you that even if the prices for both oil and natural gas stay at where they are, a highly optimistic assumption, availing the oil and natural gas through offshore drilling would prove a blessing to the U.S. economy and reduce oil imports from the Middle East and Venezuela.
However the main objective of my present post is not to make a comprehensive case for offshore drilling but simply to dispel a myth that as production from these reserves will not start till say 2015 (estimates vary; some put it at as late as 2030), it is futile to engage in exploration and production activities to tap into these reserves. The biggest flaw in the logic is that it assumes that anticipated production of a resource that will not be available till some time in the future does not impact prices as of today. Applying basic economic principles suggests a different result. For a second, assume that the ruling prince of Saudi Arabia is deciding whether it is in his nation’s best interests to drill more oil and feed the American and the Chinese monsters in their growing appetite for oil or whether he should leave the oil in the ground for future generations to tap into, when the prices rise still higher. His decision would be influenced not just by today’s price but also by how high he would expect prices to go into the future. The fundamental economic insight that is relevant here is this: Owners of a natural resource will adjust their production and stock piles until the price of that resource is expected to rise at the rate of interest, appropriately adjusted for risk. If the price of our natural resource of interest here, oil, is expected to rise faster in the future, then it pays for the Crown Prince to keep the oil in the ground. This would cause today’s supply to decrease and not surprisingly, today’s prices to also increase. In contrast, if the price of oil is not expected to rise as fast as the rate of interest, then it pays to extract more today and invest the proceeds in the best investment opportunities that are available to him.
To make matters concrete, let us work with some simple numbers under the highly simplifying assumption that the costs of extracting oil from the ground are negligible. Let us assume that the only investment opportunity available to the Crown Prince is to invest all of his money into 10-year U.S. treasury notes, which provide him a fixed interest of 3% per year. (A U.S. treasury note is a government bond issued by the United States Department of the Treasury promising to pay the bond holder a fixed rate of interest, much in the same way that you may obtain a certificate of deposit (CD) or a fixed deposit (FD) from a bank.) In that case, if you are helping him decide on the production levels for today, then you ought to take the future price levels of crude oil into consideration. For instance, if the price of crude oil in 2018, 10 years from today, is expected to be more than $195 (= $145 * ((1+0.03)^10)), then it would pay him to reduce the production level as of today. The consequent reduction in supply would cause prices today to increase till the anticipated price rise between today and 2018 yields the same returns as what he could get by investing his proceeds in U.S. treasuries. Thus if he expects prices in 2018 to $240, say, then he would choose to cut production which would raise prices on the world market to $180/ barrel. On the other hand, if he expected that oil prices in 2018 would be only $175/ barrel, instead of $195/ barrel, then he would drill more and expand production today, which in turn would cause the world prices today to drop to $130/ barrel bringing the anticipated price increase to 3% per year, same as the rate of interest that would be available to him by investing in U.S. treasuries.
Now bringing it back to our question of how and why drilling in the outer continental shelf might be expected to help out today, it is precisely this: the expectation of a reduction in crude oil prices, as much as 10 years into the future, would still cause today’s prices to drop. The Crown Prince of Saudi Arabia (and other producers of crude oil around the world) react and respond to incentives that are offered to them and hence while drilling in the OCS would not cause an immediate increase in supply of crude on the world market, it would nevertheless cause prices today to drop at the pump by changing the incentives at the margin. If that is not another reason to go for drilling in the OCS, what is?
Sources: 1 http://www.gomr.mms.gov/homepg/whoismms/whatsocs.html
2 http://www.independent.ie/business/world/betting-surges-on-oil-costing-200-by-year-end-1427566.html
3 http://www.eia.doe.gov/oiaf/aeo/otheranalysis/ongr.html
All sites accessed 7th July, 2008
Credits: The blog was inspired by an article in the Wall Street Journal by Martin Feldstein of Harvard Feldstein, “We Can Lower Oil Prices Now.” Sections of the blog are reproduced from the author’s original text. For a reading of the original article, follow the link http://www.collegejournal.com/article/SB121486800837317581.html
But before I attempt to launch into a discussion of the topic, let us get some of the very basic facts and concepts in order. First of all, what is the Outer Continental Shelf? This is how the Minerals Management Service, (henceforth MMS) of the U.S. department of Interior defines it. “The Outer Continental Shelf (OCS) consists of the submerged lands, subsoil, and seabed, lying between the seaward extent of the States' jurisdiction and the seaward extent of Federal jurisdiction. The continental shelf is the gently sloping undersea plain between a continent and the deep ocean.” 1 Now why should an arcane term that I can barely remember from my geography books be of any interest to either you or me? Well the answer is quite simple. It is oil and natural gas. In case you haven’t been paying any attention lately, oil has been trading at $145 per barrel, with some analysts believing it could hit as high as $200 per barrel per year. 2 The question then becomes how much of oil and natural gas might we expect if we were to allow off shore drilling in the outer continental shelf of the United States, some thing that is prohibited under current federal regulation. Current mean estimates from MMS place the technically recoverable resources currently off limits in the OCS of the lower 48 states (excluding Alaska and Hawaii, and by extension EXCLUDING any reserves from the Arctic National Wildlife Refuge, or ANWR) total 18 billion barrels of crude oil and 77 trillion cubic feet of natural gas. 3 Thus a casual inspection will tell you that even if the prices for both oil and natural gas stay at where they are, a highly optimistic assumption, availing the oil and natural gas through offshore drilling would prove a blessing to the U.S. economy and reduce oil imports from the Middle East and Venezuela.
However the main objective of my present post is not to make a comprehensive case for offshore drilling but simply to dispel a myth that as production from these reserves will not start till say 2015 (estimates vary; some put it at as late as 2030), it is futile to engage in exploration and production activities to tap into these reserves. The biggest flaw in the logic is that it assumes that anticipated production of a resource that will not be available till some time in the future does not impact prices as of today. Applying basic economic principles suggests a different result. For a second, assume that the ruling prince of Saudi Arabia is deciding whether it is in his nation’s best interests to drill more oil and feed the American and the Chinese monsters in their growing appetite for oil or whether he should leave the oil in the ground for future generations to tap into, when the prices rise still higher. His decision would be influenced not just by today’s price but also by how high he would expect prices to go into the future. The fundamental economic insight that is relevant here is this: Owners of a natural resource will adjust their production and stock piles until the price of that resource is expected to rise at the rate of interest, appropriately adjusted for risk. If the price of our natural resource of interest here, oil, is expected to rise faster in the future, then it pays for the Crown Prince to keep the oil in the ground. This would cause today’s supply to decrease and not surprisingly, today’s prices to also increase. In contrast, if the price of oil is not expected to rise as fast as the rate of interest, then it pays to extract more today and invest the proceeds in the best investment opportunities that are available to him.
To make matters concrete, let us work with some simple numbers under the highly simplifying assumption that the costs of extracting oil from the ground are negligible. Let us assume that the only investment opportunity available to the Crown Prince is to invest all of his money into 10-year U.S. treasury notes, which provide him a fixed interest of 3% per year. (A U.S. treasury note is a government bond issued by the United States Department of the Treasury promising to pay the bond holder a fixed rate of interest, much in the same way that you may obtain a certificate of deposit (CD) or a fixed deposit (FD) from a bank.) In that case, if you are helping him decide on the production levels for today, then you ought to take the future price levels of crude oil into consideration. For instance, if the price of crude oil in 2018, 10 years from today, is expected to be more than $195 (= $145 * ((1+0.03)^10)), then it would pay him to reduce the production level as of today. The consequent reduction in supply would cause prices today to increase till the anticipated price rise between today and 2018 yields the same returns as what he could get by investing his proceeds in U.S. treasuries. Thus if he expects prices in 2018 to $240, say, then he would choose to cut production which would raise prices on the world market to $180/ barrel. On the other hand, if he expected that oil prices in 2018 would be only $175/ barrel, instead of $195/ barrel, then he would drill more and expand production today, which in turn would cause the world prices today to drop to $130/ barrel bringing the anticipated price increase to 3% per year, same as the rate of interest that would be available to him by investing in U.S. treasuries.
Now bringing it back to our question of how and why drilling in the outer continental shelf might be expected to help out today, it is precisely this: the expectation of a reduction in crude oil prices, as much as 10 years into the future, would still cause today’s prices to drop. The Crown Prince of Saudi Arabia (and other producers of crude oil around the world) react and respond to incentives that are offered to them and hence while drilling in the OCS would not cause an immediate increase in supply of crude on the world market, it would nevertheless cause prices today to drop at the pump by changing the incentives at the margin. If that is not another reason to go for drilling in the OCS, what is?
Sources: 1 http://www.gomr.mms.gov/homepg/whoismms/whatsocs.html
2 http://www.independent.ie/business/world/betting-surges-on-oil-costing-200-by-year-end-1427566.html
3 http://www.eia.doe.gov/oiaf/aeo/otheranalysis/ongr.html
All sites accessed 7th July, 2008
Credits: The blog was inspired by an article in the Wall Street Journal by Martin Feldstein of Harvard Feldstein, “We Can Lower Oil Prices Now.” Sections of the blog are reproduced from the author’s original text. For a reading of the original article, follow the link http://www.collegejournal.com/article/SB121486800837317581.html
Labels: high gas prices, natural resource extraction, offshore drilling, Outer Continental Shelf
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