Monday, August 25, 2008

Now Comes Driller Time

I've heard that people want $2-a-gallon gas again, and I'm willing to bet that the presidential candidate who promises to deliver it is going to do well in the election. Now, putting aside the myriad of conspiracy theories that one can (and many do) spin out regarding what's happened to the price of crude oil over the last couple of years, we can certainly agree that three big factors in the run-up in prices are (1) a demand-shift brought about by higher consumption patterns in emerging economies, notably China and India, (2) a downward supply-shift brought about by the war in Iraq, and (3) weakening of the US dollar. We can't fix #1; it will take a lot of time and money to fix #2; and there's so much at work behind #3 that there's not really a short-run fix.

Is it any surprise, then, that the terms of the political debate have shifted to something that is unlikely to do anything at all in the foreseeable future? I write, of course, of deep-water drilling on the outer continental shelf. So here's a little discussion and a modest proposal.

First the discussion. The US actually does a pretty good job of supplying its own net energy needs, although the allocation is not so great. In other words, in terms of BTUs, we're nearly self-sufficient, but we've got a lot of extra coal, so we export a lot of it, and we don't have enough oil, so we import a lot of it. We use more than 7 billion barrels of oil a year; we produce a little less than 2 billion barrels a year. Of the 2 billion barrels we produce, about 500 million barrels comes from drilling in federal offshore tracts, so offshore drilling represents a big portion of what we produce, but a small portion of what we consume. But here's the problem: when our refiners go into the marketplace to buy crude oil to refine into gasoline, they're looking for 5 billion barrels a year at whatever the world price happens to be. If by some miracle we were able to drill offshore and double our production tomorrow morning, our refiners would have to go into the world marketplace and look for 4.5 billion barrels a year, and they'll be paying world market prices for that oil.

Now, let's imagine that anyone who wanted to could go and poke a hole in the Gulf of Mexico and suck out as much crude oil as he wanted to without paying for it, with the only restriction being that neither the crude oil nor the refined product could be exported. Would the price of refined product be zero? Obviously not. First, there's a cost associated with the extraction, refining and sale which would need to be recouped. Second (and more important), the price of the other refined product in the market would come down a little bit, while the price of the magic product would equilibrate at some market-clearing level. Bringing the magic, free oil doesn't do much to bring down the price of refined product.

And by the way, I haven't mentioned the law part, which is my justification for blogging. Producers aren't allowed to suck out as much as they want for free. Instead, under the Outer Continental Shelf Land Act, producers have to bid for the right to drill, and the Secretary of the Interior has to accept the highest responsible bid. So, if two oil producers bid for a lease on the same offshore tract, the bidder who projects the price of oil at $140 can formulate a higher winning bid than the bidder who projects the price at $70. (The high bidder may guess wrong, but the Secretary of the Interior can't take the lower bid.) The OCSLA has about a dozen different bidding methods that are authorized, but they're all designed to maximize revenue to the federal and state governments; none gives away something for nothing, and none gives any weight at all to what consumers pay at the pump.

Now the proposal. How do we get cheap gasoline by drilling on the outer continental shelf? We can't, so let's call the bluff. Introduce a bid with a penalty, in which the pump price of gasoline is pegged at whatever level is politically convenient, and the bid price is based on a mechanism already in the OCSLA. But the back-end penalty requires the winning bidder to pay an additional royalty in an amount sufficient to allow the federal government to subsidize the pump price by bringing it down to the pegged price, and have the federal government make that subsidy.

What would happen? Well, it depends upon what the pegged price is, but at $2 a gallon, I'll bet that no one would bid. The reason no one would bid is that the producers know that drilling on the OCS can't bring down the price of oil by any substantial amount, but they have no incentive to admit that in public. My proposal would make them think about whether they can deliver what politicians would like to promise, and if they can't deliver, then they won't bid. Indeed, the hearings at which we decided the level of the pegged price would be entertaining, because we'd get a good idea of what the true potential pump price reduction would be, based on what the producers claim would elicit their lease bids.

Posted by Craig J. Albert


Paul Scott said...

The more important reason that OFD is destined to fail is that oil is fungible on the world market. Taking your facts as is, even if we went from needing 5 billion to 4.5 billion in "foreign oil", the cost to refiners of that extra 500 million barrels will be at exactly the same price as whatever the world oil price is. Would it help our "oil dependency"? Sure. But that is a national security and trade balance issue, not a cost issue.

The only reasonable reaction to rising oil prices is alternative energy sources. Fortunately, it really is a self-solving problem, since the more expensive oil becomes, the more likely alternate energy use becomes economically viable.

This remains, like so very many other issues, a place where governments would do best to stay out.

I except from this the need for governments at both federal and state levels to levy an appropriate tax to account for the externalities of pollution free-riders. One of the reasons that oil is still viable (and even more so for coal) is that the user of these fuels incurs no cost for the effects of its pollution. This is, effectively, a subsidy for gasoline use which, in turn, makes better fuel sources less viable.

David Crowley said...

This certainly is a clever proposal, but I wonder if it does justice to those who argue for more drilling. The syllogism, as I read it, is: (1) people want $2-gallon gas, (2) more drilling alone cannot achieve $2-gallon gas, (3) once people understand this, they will abandon their demand for more drilling. Would the debate not be fairer to the pro-drilling folks by replacing premise (1) with the statement that people want cheaper gas? True, consumers may not be completely satisfied if they pay more than $2 a gallon, but that does not mean they will reject efforts that reduce the price of gas from its current level to some price closer to $2.

By analogy, there are probably environmentalists who wish to preserve all species in the United States. I’m guessing that the Endangered Species Act, alone, is unable to achieve this zero-loss goal, but that environmentalists still support it over the option to abandon the effort altogether. And while an opponent of the Act might sensibly argue that it should be repealed if the costs (e.g., harm to businesses and development) outweigh the benefits (species preserved), it would be difficult to accept the argument that the Act should be abandoned simply because it do not completely achieve the goals of its supporters. In other words, benefits should be weighed against costs, not against desired benefits.

I’m not a supporter of off-shore drilling. But my concern is not that it won’t lower my gas bill (although I agree that it probably will be largely ineffective), my objection is that it would be better for our environment if we focus on strategies that will decrease our oil consumption. And while it makes sense to engage drilling proponents on their terms by demonstrating that drilling will have minimal effect on pump prices, I think the real win will come when Americans assign a higher cost to activities that adversely impact the environment.

Craig J. Albert said...

Further to David Crowley's argument, the point of the proposal is not to get to $2 gas. Rather, the point is to illuminate the futility of the exercise of trying to bring down prices in any substantial way through offshore drilling. So I would imagine a hearing in which oil producers would testify as to what pegged price would elicit bids, and then we'd gauge public support to see whether the public supports drilling at that price. If we know that no one will bid when the target price is $2, then what about $2.50? $3.50? $3.95? Under my though experiment, if producers claim that $2.50 is the right pegged price, but then we peg it and no bids come in, then we know that the producers weren't revealing truthfully. But as the pegged price goes higher, then we'll need to have a more serious discussion about whether the actual pump price reduction, as revealed by the pegged price bids, is worth the adverse impact of the drilling.

egarber said...

Would it help our "oil dependency"? Sure. But that is a national security and trade balance issue, not a cost issue.

Actually, the way I see it, as long as global prices remain high -- driven by the U.S. consuming 25% of world output -- our national security will always be in danger. The reason is that high prices keep thuggish regimes (those with the largest reserves) awash in oil money, which finds its way into terrorist networks.

Therefore, the *only* way to deal with the national security component is to get off oil, period, regardless of its origin.

I suppose that if we sat on OPEC-proportion reserves, we could knock a dent in global prices (and possibly dilute the strength of regimes and agents who hate us), but it's not even close to that. Three percent of the world's reserves will only add a few drops (comparatively) to global supply.

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