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