18 July 2008

The Economic Impact Of Domestic Oil Production

The Wilderness Society has gathered up a number of briefing sheets at their website about the environmental impacts of oil shale development, which is a hot issue in the debates over Colorado oil and gas development in environmentally sensitive areas. Not surprisingly, gathering up oil shale resources is bad for the localized natural areas and residents, and separating oil from oil shale involves energy use that produces lots of greenhouse gases and air pollution generally.

One of the blurbs they pick out of their story, which is that "Experts generally agree that more drilling will not lower gasoline prices," is almost certainly not true.

Increased supply reduces prices, and oil drilling increases the supply of oil. (The oil and gas industry wouldn't be interested in more drilling if it didn't increase supply.) This is about as fundamental a principle as one gets in economics. Indeed, by claiming otherwise (even though it requires lengthy nuance to state a more accurate message), the Wilderness Society triggers an immediate rejections of their overall message, which is still basically on target, in the same way that they might turn off a physicist by claiming to have a perpetual motion machine. At best, to the extent this statement is true, it is deceptive. Gasoline prices may be up in absolute terms because the forces pushing up gasoline prices are greater in magnitude than the economic impact of additional drilling.

For example, the impact of opening up the Arctic National Wildlife Reserve to drilling and ending legal prohibitions on drilling oil on the coastal shelves of the United States combined has been estimated by government economists to take years to have an impact, and at their peak might reduce prices at the pump by a few pennies a gallon, at the same time that other forces in the world market may overshadow these impacts to the point where the impact is hard to parse out of the overall price. Thus, more drilling may simply make gasoline prices lower than they otherwise would have been without more drilling, but gasoline prices will still rise due to other factors.

But, I seriously doubt that many economists are actually arguing that increasing domestic oil supplies by opening up ANWAR for drilling and allowing offshore drilling on U.S. Coasts would not have any downward impact on world oil prices at all. It may be a drop in the bucket, but it still contributes to the world supply of oil.

The magnitude of the impact more domestic oil and gas drilling in environmentally sensitive areas would have on oil prices is quite another thing. As the Wilderness Society rightly notes:

At current consumption levels, U.S. resources are inadequate to achieve energy independence. The United States contains 2.5% of the world's oil resources and 3% of world natural gas resources. But we account for 24% of total world consumption of oil and 22% of natural gas consumption.

The point these statistics try to make is true, despite a few important technical niggles that I identify below about them. The U.S. has ceased to be a very important player in the world oil production market. Even substantial increases and decreases in domestic oil supplies have only a modest impact on the overall petroleum market. The magnitude of the economic impact of U.S. production on world oil prices, and hence on domestic gasoline prices, is quite modest.

For example, about 8% of U.S. vehicle fuels come from biofuels, mostly corn based ethanol (per a NPR story I heard in the past week or so), which is on an order of magnitude comparable in market price importance to or more important than any possible changes in domestic oil production. Producers are souring on the economic viability of corn based ethanol, even with substantial government subsidies, but the example of corned based ethanol shows that biofuels can have an economic impact on domestic vehicle fuel supplies comparable to or greater than major changes in domestic oil production.

Likewise, fairly modest single digit percentage reductions in consumption from fuel efficiency and conservation efforts can have impacts on oil prices comparable in magnitude to increased domestic oil and gas production in economically sensitive areas.

Of course, even the statistics on the U.S. share of world oil resources, come with caveats. First, the number are current numbers. But, countries where oil is cheaper and easier to drill, like those in the Middle East, Nigeria and Venezuela, are using up their supplies at a faster rate than the U.S. is right now.

Second, the U.S. imports natural gas mostly from geographically close and politically stable places like Mexico and Canada. And, a good share of our imported oil also comes from these geographically close, politically stable neighbors. But, since oil travels better than natural gas, oil prices are more strongly driven by the world market, rather than the local market, and oil in the world petroleum market comes mostly from places with questionable government much further from home.

Third, when one talks about world "oil resources" and "gas resources" one is using shorthand for the real number referred to, which is economically exploitable oil resources and gas resources. Many reserves that are not economically exploitable when oil prices are in the $20-$40 2008 dollars a barrel range where they have been for most of the past century, may be economically exploitable in an age of $140 a barrel or more oil.

Terms like "Peak oil" do not refer to the point at which the world runs out of oil. Indeed, it probably never will run out of oil. It refers to the point at which the amount of oil produced in a given time period (typically a year) reaches its peak. After that, annual oil production is expected to decline gradually, while demand is expects to continue to rise in the face of developing world economic growth and population growth. These twin forces are expected, more or less inevitably, to drive up oil prices to the kind of shockingly high levels we see now and to get higher and higher over time.

Eventually, of course, this will end the "oil age" of the world economy which replaced the "steam age" (a euphemism of a coal based economy) that preceded it, although what combination of natural gas, coal, nuclear power and renewables will replace petroleum is very much up a question still in the process of being resolved.

It is also worth noting that while natural gas is not running out as fast as petroleum (i.e. annual consumption is a smaller percentage of known reserves), Peak Natural Gas is expected to follow Peak Oil by a decade or two, and the natural gas market is likely to start looking more like the petroleum market over the next couple of decades, because the technology for transportation natural gas over long distances by ship, rather than via pipelines, is advancing. This will turn the natural gas market into a true world market, rather than several regional ones, and will permit natural gas to be diverted from natural gas rich locations without enough economic development to use it, to places that have exhausted or never had natural gas resources but have economies that could use more of the cleanest fossil fuel.

One of the reason that the oil industry hasn't fought terribly hard about U.S. environmental restrictions on off shore drilling along the U.S. Coasts, and drilling in environmentally sensitive places from Alaska to Colorado on federal property, is that the environmentally sensitive domestic oil supply (particularly oil shale which requires more work to extra than liquid oil reserves in which a finished product can simply be pumped out of underground pools of oil in the ground), is that environmentally sensitive domestic oil reserves are mostly expensive to exploit relative to oil reserves elsewhere in the world market.

Indeed, I wouldn't be at all surprised if, in the long run, it turned out to be cheaper to chemically convert vast American coal reserves into liquid fuels that are a close substitute for petroleum from mineral sources (and into syngas that is a close substitute for natural gas), than it is to exploit Colorado's oil shale reserves. The break points for economically viable oil share and coal to oil conversions in the last 1970s and early 1980s, before the oil shale bust wiped out Grand Junction, Western Colorado more generally, and seriously maimed the entire Colorado economy, were within a few dollars of each other, and the technology to covert coal to a liquid fuel backed most prominently by Montana's Governor seems to have advanced more rapidly than oil shale technology, whose biggest fan these days is probably Republican U.S. Senate candidate Bob Schaffer.

A more honest pitch would be to explain that the amount of oil produced in ANWAR and other environmentally sensitive places is a drop in the bucket that comes at a great price to our nation's treasures.

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