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Can increased domestic oil drilling lower prices at the pump? Director of Economic Policy Studies Kevin Hassett examines the economics behind competing congressional proposals to curb high energy prices. Although some would argue that expanding domestic drilling would take years to influence gas prices, it is a well known economic fact that an anticipated future supply change would impact today’s oil prices.
Kevin A. Hassett
High energy prices have everyone who doesn’t own an oil well in the dumps. Consumer sentiment is the lowest it has been in almost 30 years, and a recent analysis of sentiment by Economy.com suggests that high gas prices are the main culprit.
Against this backdrop, it is hardly surprising that politicians are debating ways to reduce energy prices.
To drill or not to drill?
The two sides are as far apart as can be. Republicans have argued that, in addition to aggressively seeking alternatives to oil, we should work to develop new reserves at home. Democrats, for the most part, have argued that oil discoveries can’t affect the current high price, because any newly discovered reserves take so long to deliver.
If exploration can be expected to be successful and significantly increase oil production in the future, then it would cause producers to revise downward their estimates for future prices.
Barack Obama, the presumptive Democratic presidential nominee, summarized this argument concisely recently, when he said: “Offshore drilling would not lower gas prices today, it would not lower gas prices next year and it would not lower gas prices five years from now.”
Who is right? The economics of natural resources clearly favors the Republican view.
The economics of extracting resources is quite simple and intuitive. If you own property that has oil in the ground, then you have to decide how rapidly you wish to deplete your resource. If prices are low today, and you expect them to be much higher in the future, then you will hold off pumping a lot.
Open Spigot Now
If prices are high today and are expected to be much lower tomorrow, then you would rather open up the spigot now when profits will be higher.
If exploration can be expected to be successful and significantly increase oil production in the future, then it would cause producers to revise downward their estimates for future prices. This would increase the attractiveness of extracting more today. As producers respond with higher production, prices today would drop.
The argument that drilling wouldn’t influence today’s price rests on two possible assertions. The first is that exploration will fail. In that case, estimates of future prices would be unaffected by discoveries that won’t happen. The second is that current producers wouldn’t look ahead to lower future prices and increase supply today to maximize profits.
Both assertions are clearly false.
According to the U.S. Department of the Interior, there are about 86 billion barrels of recoverable oil in the nation’s outer continental shelf. Since government agencies tend to be conservative on such matters, this estimate may well be low.
To put that cache of oil in perspective, in 2007, the U.S. produced about 3 billion barrels of oil and consumed more than 7-1/2 billion. The potential undiscovered haul is more than 10 times our annual consumption. It is inconceivable that extraction from such large reserves would have no effect on future prices.
What about prices today? A vast body of academic literature finds that future prices and spot prices are intricately linked in a manner that could only occur if producers are constantly updating their plans based on expected prices.
A recent study by economists Param Silvapulle and Imad Moosa of Monash University in Australia found strong evidence of what is called bidirectional causality. Future prices and spot prices are inextricably linked.
How strong is the case? My American Enterprise Institute colleague, former U.S. House Speaker Newt Gingrich, has been a tireless advocate of a more rational energy policy that allows for more drilling.
In a recent post at his influential blog, Gingrich noted that the top academic energy journal, aptly named, The Energy Journal, recently rejected a study by economists Morris Coats and Gary Pecquet of Nicholls State University in Louisiana that found that higher production in the future would reduce prices today.
The study, Gingrich reported, wasn’t rejected because it lacked academic merit. It was rejected because the finding was so well known. James Smith, the impeccably credentialed editor of The Energy Journal described it this way to the unfortunate authors:
“Basically, your main result (the present impact of an anticipated future supply change) is already known to economists (although perhaps not to the Democratic Policy Committee). It is our policy to publish only original research that adds significantly to the body of received knowledge regarding energy markets and policy.”
A 21st-century energy policy must rationally encourage innovation and conservation, and pay attention to the environmental impact of our choices as well. And if you want oil prices to decline, drill.
Kevin A. Hassett is a senior fellow and the director of economic policy studies at AEI.
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