Will Deciding to Drill Lower Oil Prices?

Over the last couple of weeks the price of oil has dropped around $20 per barrel. Some observers have been quick to credit President Bush, who rescinded the executive ban on exploration and drilling in the Outer Continental Shelf, and Congressional Republicans, who have kept up pressure on Democrats to allow exploitation of our domestic resources. But is this realistic? Certainly producing more oil would reduce the price, but if the market merely believes that the U.S. is likely to expand production in the future, would that expectation really reduce oil prices today?

For answers to these questions I turned to my friend Bob Cunningham, who spent twenty years in corporate finance, working for major financial institutions. Bob did transaction origination, structuring and credit and financial analysis for energy projects, including large equipment, project and nuclear fuel financings. Here are his answers to the above questions:

The left/Dems insist that there can be no immediate effect from “drilling now, drilling here” because there would noa actual oil produced for years. Is this correct? What would be the effect on oil prices if we were to announce that we would now permit exploration and drilling where it is currently prohibited — ANWR and the Outer Continental Shelf? Would futures traders take notice? Would the effect be felt immediately?

The short answer: I believe it would…But the question is how much?…and it is not so much the futures aspect of the price…what really is in play, I believe, is the “scarcity rent” component of both spot and futures prices. That’s a fancy name for taking account of the fact that if you pump it today, you obviously will not have it tomorrow. Because oil is an exhaustible resource you have to take account of the opportunity cost of consumption today vs. leaving it in the ground for tomorrow’s consumption and factor that cost into today’s price. If the markets’ expectation about future reserves and demand fundamentals is of some combination of influences that results in less scarce future reserves, net of today’s consumption, that opportunity cost (“user cost” it is called) will be less and oil prices today should decline.

Obviously, increased supply, i.e., increased reserves, other things being equal, puts downward pressure on prices; but note that INFLATION (in dollar terms) has a huge effect as well: if the financial assets a resource owner receives for production today are being systematically debased, then expectations of future inflation can lead to the same effect on “user cost” as a lack of replacement reserves: leave the gunk in the ground unless you get a higher (real) price for it.

Net, net?….other things being equal an increase in drilling should have the effect of lowering prices today because the nearly certain expectation of increased reserves lowers (theoretically) “scarcity rent” to the extent that it is currently priced in (which most observers believe it is). In assessing the “How much” question, however, there are big unknowns:…inflation…is the government going to “monetize” the overhang of debt it is about to guarantee?….how much ARE the reserves anyway (partly a geological/technological question and partly dependent on price)?….and what is the timing of any actual production?…and, crucially, what will be the offsetting actions of MUCH bigger resource owners, like OPEC, in response….In other words, will they reduce production to maintain a price point? (They can easily afford to do so and have a potentially huge impact on pricing. For OPEC to cut 1 mmbpd is trivial and could offset the effect of new domestic E&P.)…and whatever war risk premium might be priced in.

But…whatever the magnitude of offsetting forces, increasing reserves through more drilling by itself would lower prices below what they otherwise would be. The market would sort all this out — the expected addition of reserves from drilling here and drilling now would be added to the mix and almost certainly would lower today’s price by reducing “scarcity rent”. Exploration certainly should be a no brainer — let’s find out exactly what we’ve got at least. The market pricing will then tell us the extent to which we ought to drill here and now — or leave it in the ground as a rational hedge against future scarcity while we consume others’ oil.

From which I conclude that it probably overstates the case to credit anything Republicans have done so far with a significant impact on current oil prices, but if the federal government really does adopt a pro-production policy, there will be some immediate impact on pricing, the magnitude of which is impossible to predict.

I would also note that it is not true that it will take years for any new oil production to reach the market. While that is true of major development projects like ANWR and Rocky Mountain shale oil, there are areas now foreclosed to drilling where, if the ban were lifted, oil could be flowing in months, not years. But that is a subject for another day.

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