The Simple Economics of Offshore Drilling

Professor Tom Lyon

Professor Andy Hoffman

by Andrew J. Hoffman and Thomas P. Lyon.

Yesterday, President Obama expanding offshore oil and natural gas drilling along the nation’s coasts. And now, pundits on both sides of the issue are clambering to criticize or congratulate the President on this bold move. But, much like the debate over health care, much of this public debate is full of lots of political gimmickry and little sound economics.

Let’s consider the facts and be honest about the ultimate results of offshore drilling.  First and foremost, contrary to what many are arguing, it will not lower gasoline prices.  It will transfer wealth from oil producers like Chavez, Putin and the Saudis to the oil companies that develop these offshore assets.  This can have some benefits.  It may help us reduce the flow of funds to terrorist organizations and it will certainly help investors in the oil companies that exploit our domestic oil resources. But American consumers will never see benefits at the pump.

Consider the simple economics of oil pricing.  If Exxon-Mobil, Chevron, BP, Shell, Total or some other oil company is given the rights to drill oil off the Atlantic coast  or the Gulf of Mexico, does anyone really believe they will sell that oil at a discount to the American consumer?  No, that oil will be sold at the prevailing price on global markets. Oil drilled in US waters is indistinguishable from Saudi or Russian oil of comparable quality.  Oil prices are determined by global supply and demand, and there is a single market-clearing price for oil of a given quality.  There simply is not enough domestic oil offshore to make a meaningful dent in oil prices.

Further more, the U.S. Department of Energy issued a report on offshore drilling in 2007, which found that “access to the Pacific, Atlantic, and eastern Gulf regions would not have a significant impact on domestic crude oil and natural gas production or prices before 2030. Leasing would begin no sooner than 2012, and production would not be expected to start before 2017.” It concluded, “Because oil prices are determined on the international market, however, any impact on average wellhead prices is expected to be insignificant.” And that report is now three years old; change 2012 to 2015 and we have virtually the same situation.

Although offshore drilling won’t bring down gas prices, it would at least allow us to divert some oil dollars away from OPEC and into the pockets of investors who own shares of western oil companies.  (Since most American retirement portfolios include oil stocks, this benefit is widely shared.)  In addition, to the extent that OPEC countries are financing the teaching of virulent anti-Western ideas, this could have a small positive effect in reducing the risk of terrorism and enhancing national security.  Strangely, these benefits have been largely omitted from the political debate.

Whether these financial gains are worth the environmental (and aesthetic) costs of offshore drilling has also been largely omitted from the debate.  Oil transport is getting safer, and oil spills as a percentage of that increasing transport is dropping.  But spills still happen, and they cause real environmental and economic harm. The ITOPF estimates that there were 3.3 spills per year over 700 tons.  This volume conjures up images of Santa Barbara oil spill in 1969 (3 million gallons) and the Exxon Valdez in 1989 (11 million gallons).  Smaller spills are more than 5 times that amount and cause serious problems. In July 2008, over 400,000 gallons of oil were spilled in the Mississippi river, forcing a closure of 100 miles of the river.

We find it ironic that the environmental and aesthetic impacts can be ignored in the push to place oil rigs off our coasts while opposition to offshore wind mills occupying similar real estate remains strong. Windmills have no similar environmental impacts and the aesthetics are in the eye of the beholder. One reason for this opposition may be that wind has the annoying habit of showing up off the coast line of wealthier Americans in places like Nantucket Sound and the West Coast of Michigan.

Rational people can disagree about whether offshore drilling is a good idea, but let’s get the debate focused on the true issues.  At heart, this is an issue that pits environmental protection against financial gain.  And it is a tired contest, one that has been paraded in front of the American people since the 1970 OPEC oil embargo in order to protect oil company interests. It will have at most a trivial impact on gasoline prices for the consumer.

In the end, oil prices will fall in one of two ways.  The first is if supply increases in a significant way. The world consumed 43 billion barrels of crude oil in 2006, and the US Department of Energy estimates that increased offshore drilling in the US might increase total global supplies by 18 billion barrels of oil, spread out over a period of decades.  Overall, it is just a drop in the bucket.

The second way that prices can drop is if demand decreases.  That can happen as consumers adopt innovative energy-efficient technologies, such as hybrid cars.  Demand can also decrease through good old-fashioned competition.  This fact is understood by most Americans.  When there are viable alternatives to oil, demand will drop and so will the margins that companies can charge for this singular resource.  If we want to talk seriously about opening up the energy reserves of this country, we need to talk about diversification – another concept understood by most Americans

Only when this country gets serious about all forms of energy as ways to give consumers options at the pump and the electric meter can we hope to solve the energy problems we face.  On that count, Obama is making the right point.  But we need to develop the right market signals to stimulate development in forms of energy that move us away from oil. These signals come from policies like a carbon prices, gas taxes, renewable portfolio standards, energy standards, CAFÉ standards.  By unlocking American ingenuity in fields that directly compete with oil, we can and will find a way out of this predicament.  The truth is that venture capital is pouring into alternative energy with the likes of T. Boone Pickens, Kleiner Perkins and others seeing the way out through innovation. Some estimate that annual combined revenue for solar photovoltaics, wind power, biofuels and fuel cells were between $55 billion and $71 billion in 2006. The global wind energy market alone is growing the fastest, with China and Germany pouring money into developing their own domestic industries.

And with numbers like these, investment dollars are flowing and companies and governments are scrambling to capitalize. A Pew Charitable Trusts study found that clean energy investments hit $18.6 billion in 2009, while China’s investment reached $34.6 billion. Five years ago, China’s investments in clean energy totaled just $2.5 billion.

Some politicians fear the government “intrusion” into the market with energy related policies.  Why can’t they share the same faith and hope in the American can-do spirit?  We cannot solve this problem using the same thinking and the same technology that got us into the mess in the first place.  We are poised for an energy renaissance in this country, if only our political leaders don’t get in the way.

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One Response to The Simple Economics of Offshore Drilling

  1. […] Expanding offshore oil and natural gas drilling along U.S. coasts will not lower gas prices, write Andrew Hoffman and Thomas Lyon in an April 2 opinion piece titled “The Simple Economics of Offshore Drilling.” […]

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