Will More Drilling Lower Fuel Prices?

On Wednesday, April 25, 2012, The Tulsa World published an op-ed piece headlined “Why more drilling won’t lower fuel prices”.  The piece was written by Rafael Corredoria, an assistant professor of management and organization at the University of Maryland.  It was written originally for the Baltimore Sun.  The article is not balanced nor accurate.  The Tulsa World headline,which is worse, picks up on the general tenor of the article, but is not really supported by the article if one reads the article closely.  Even so, the article contains both errors of omission and commission.

Mr. Corredoira’s thrust is to say that increased US drilling will not result in a decrease in US gasoline prices at the pump.  His reasons are the existence of OPEC and the fact that oil markets are international.  As a cartel OPEC will control the international price of oil he asserts.   And so even if the US increases its production to the point that it is self-sufficient the US oil could be sold abroad at any higher international price.  The only way to isolate the US market would be through government export controls, which he doesn’t think would ever happen. He goes on to say that “if something was learned from the aftermath of the 1973 oil crises, it is that higher oil prices lead to technological solutions, reducing the dependence on oil at a global level (e.g., conservation, development of alternative energy sources, opening of new oil reserves).”  As a result, he says, “some OPEC members have been concerned about high oil prices prompting conservation and development of alternative energy sources.”  So, he concludes that the good news is that OPEC will not let gasoline prices go above $5 per gallon.

So what are the difficulties here?  Let’s start with the behavior of cartels.  Prior to the oil embargo of 1973, there had not been much economic study of cartels since they were illegal in the US and most developed countries.  What research existed indicated that while cartels were effective at setting initial production quotas that would result in a desired price, they were not good at lowering production to maintain prices.  Indeed, OPEC has had this problem.  There was cheating on production quotas almost from the beginning.  As it happened, the embargo started at a time when the US, the principle non-OPEC producer, was experiencing declining production.  So absolute adherence to initial production quotas did not prevent crude prices rising from less than $5 per barrel to over $35 per barrel in the space of a few years.  Part of the difficulty in 1973 was that because of the high level of cheap OPEC production, there had not been enough economic incentive for companies to drill in non-OPEC areas to develop reserves.  $35 per barrel provided more than enough incentive, but the resources – trained men and equipment – were not available for a rapid increase in drilling.  We were having a problem with natural gas supplies at the same time for many of the same reasons.  In 1978, many people thought we would be out of natural gas by 1985.

So what happened?  At the time there were energy economist who believed that increasing non-OPEC production would eventually put enough pressure on OPEC to break the price.  In 1980 non-OPEC (and non-US) world-wide  production was starting to increase.  Did OPEC cut production quotas for all members?  Yes.  Did they cut actual production – only the Saudi’s made significant cuts in production.  The Saudi’s were probably in the best position to make cuts.  They had more reserves and production than the other members and less population and less government spending.  But by 1985 they were producing about half what they had been in 1979, and the decrease in revenue had begun to cause pain.  No one else had really made any cuts, so the Saudi’s opened the valves.  Oil prices went from the mid $30s to under $10 per barrel.  But the low prices were effective in getting other OPEC members to reduce production, and the price was allowed to rise to about $20 per barrel for the next 15 years or more.  $20 was a price that allowed some drilling of higher return prospects but not another drilling boom.  The US daily average rig count of active drilling rigs went from over 4,000 in 1980 to around 400 by the mid 90s.

So what should we have learned?  That the end of that high-priced oil was mainly the result of successful international drilling in non-OPEC areas.  Mr. Corredoira is correct that conservation and attempts to development sources had the effect of dampening demand growth, but it was not sufficient to cause prices to decline. Also the cartel did not act cohesively to reduce production to maintain the price.  Only Saudi Arabia did that.  Would the Saudi’s do it again?  Hard to say, but my guess would be not to the same degree that they did in the early 80s.  This time around there is no reason to believe that conservation and alternate energy development will be any more effective than 30 years ago.  Will US drilling cause lower fuel prices alone.  No.  Mr. Corredoira is also correct that we have an international oil market.  So it’s not US production alone, but total world non-OPEC production that will have an effect.  But the US is a major world, non-OPEC oil producer, so drilling here has got to help.

The better question is: Will more drilling keep fuel prices below what they would be otherwise?  That depends on if and how much additional drilling adds to the international production totals.  ( To his credit, he cites the “opening of new oil reserves” as a possible way to put downward pressure on prices, but we haven’t yet found a good way to open and produce “new oil reserves” without drilling.)  Some believe that we have passed the point of “peak oil” production in the history of the world.  Maybe so, but the only way to know is by continuing to drill.  Anything that we find to maintain production levels will help.  In the absence to drilling, production is guaranteed to decline and prices to rise more rapidly.

In the documentary film “spOILed”,  director/producer Mark Mathis provides well documented reasons why it will be difficult to impossible to replace oil in the near future and maintain our current life style and standard of living.

A few final thoughts:

  • I’m not one who thinks that we have passed the period of peak oil in the world.  I don’t know if that is wrong.  But I do know that since the beginning of the oil industry, we have periodically had people who believed that we were running out of oil, and so far they have been wrong.  We didn’t run out of natural gas in 1985. When drilling rates increased, we had another 20 years of conventional production and now with horizontal drilling techniques, we believe we have another 100 years left.  Will oil be the same story?  Only time and drilling will tell.
  • The $5 per gallon gasoline price is an interesting benchmark.  I’m not sure where Mr.  Corredoira gets that number.  A couple of years ago, some US Economists suggested that $4 per gallon was the point that we would see US drivers changing their driving habits.  That seems to have held up, but that is not necessarily what it will take to stimulate serious conservation and development of (unsubsidized) alternate energy sources.  On a trip to Europe 10 years ago, we paid more than $5 per gallon. I believe that most of the world all ready has greater than $5 per gallon prices.
  • The question,  “Should the US have secure crude oil sources (i.e North American sources)?”  is a different question than the question of  whether drilling will reduce prices.  But that is subject for another time.

About tjc13

BE - Chem Engineering, Vanderbilt Univ, MBA, University of Tulsa - Worked for an energy and chemical company for many years and then started a management consulting business working for both for-profit and not-for-profit organizations.
This entry was posted in Economics and tagged , , , . Bookmark the permalink.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s