The recent BP incident in the Gulf of Mexico raises an important policy issue: Should we put a moratorium on new drilling? Should we be drilling now or drilling later? Some might respond with “drill never,” but never is a long time and it is a pretty safe bet that the oil will eventually be extracted. In any event, although the question is pretty straightforward, the issues are not. I cannot provide a definitive answer, but hopefully, I can offer a little clarity.

First, some very simple economics

Let’s first assume that markets are competitive, that we do not expect technical progress, and that there exists oil that can be extracted cheaply, as well as oil that is expensive to extract. Under these conditions, it is straightforward to show that it is best to extract the cheap oil first and the expensive-to-extract oil later. The idea is that it is optimal to minimize the net present value of the extraction costs, and this is accomplished by putting off the high extraction costs until later.

So if we lived in a less complicated world, we would put off deep water drilling and speed up the extraction of oil in low cost places like the Middle East.

Keeping things relatively simple, let’s now assume that technology will get better, making deep water drilling both cheaper and safer in the future. The possibility of cheaper and safer drilling in the future provides an added incentive to delay deep water drilling. Of course, the possibility of technical progress makes this issue more complicated, since by putting off deep water drilling we slow down the technical progress. But still, the possibility of technical progress favors the idea of at least slowing down the deep water drilling.

The economics of the real world

Unfortunately, we live in a more complicated world, which makes the economics of delaying the deep water drilling program much less straightforward. In particular, the international oil markets are not perfectly competitive and there is a relation between oil production and international politics that cannot be ignored.

The first argument to consider is that OPEC, which controls most of the oil that is cheap to extract, restricts supply and artificially inflates oil prices (an assumption, by the way, that not everyone agrees with). If this is the case, then as consumers of oil, we may want to take actions that limit OPEC’s ability to set prices by increasing U.S. production by drilling in deep water.

The second argument is that the U.S. is running an unsustainable balance of payments deficit, and a large portion of that deficit comes from the importation of foreign oil. As T. Boone Pickens told Congress last month, “In January 2010, our trade deficit for the month was $37.3 billion — $27.5 billion of that was money we sent overseas to import oil.” It is certainly the case that at least on the margin, producing more oil domestically, all else equal, will reduce our trade deficit. However, the lower deficit may actually be less sustainable since by consuming our oil today we are more dependent on foreign oil in the future.

The third argument is that increasing production in the low cost Middle East puts more money in the hands of governments that are not always friendly to Americans and reduces what has been referred to as our energy security. This is a complicated issue that I am not really qualified to address, however, it should be noted that there is clearly a time dimension to the political problem as well as the economic problem. If we extract all of our domestic reserves now, we will be more dependent on oil from the Middle East in the future. Perhaps, we should be using their oil now and saving ours for later. This requires, of course, that the costs of continuing to depend on foreign oil do not overwhelm us. Remember Keynes’s admonishment — in the long run, we are all dead!

A proposed exchange agreement

While these are all valid arguments for pursuing high cost drilling programs, we might want to consider other alternatives that provide the benefits from extracting the cheapest (and safest) oil first, while minimizing some of the costs. I will suggest one possibility that may or may not be feasible.
To keep this simple, I will illustrate the idea with a transaction that involves only two parties, the United States and Saudi Arabia.

So here’s the deal: The U.S. agrees to place a 5 year moratorium on all new deep water drilling. In return, the Saudis agree to increase their oil production by an equivalent amount, perhaps to 1 to 2 million barrels per day, which they will sell to the U.S. at a price of, say, $80 barrel. The kicker is that 70% of the dollars spent on this additional oil needs to be spent or invested in the U.S.

If this is done right, the world-wide supply and the price of oil should not be affected; the increase in Saudi oil production directly offsets the decrease in deepwater production. The transaction will, however, increase our trade deficit somewhat, but with the increased Saudi investment in the U.S. this will not create a problem. Moreover, there is an added benefit associated with placing Saudi assets in the U.S. If the Saudis have investments in the U.S., it will decrease the political risk faced by U.S. companies when they invest in Saudi Arabia, since it opens up the opportunity to use the U.S. court system, and to attach U.S. assets, in the event of a default.

What are the disadvantages of this transaction?

The most important is that this could make the U.S. even more exposed to political events within Saudi Arabia and the Persian Gulf, at least in the short-run. But by saving our own oil for later, we may be increasing our long-run energy security.

The other downside is that a halt in deepwater drilling will clearly weaken the domestic oil industry. The recent disaster notwithstanding, the success of this industry to extract oil from increasingly hostile environments has been remarkable. While this proposal would certainly slow down the drilling, the policy should reflect the likelihood that we will eventually drill off the coast of California, as well as in the Gulf, and that it is in all of our interests for the domestic oil companies to continue to innovate so that in the future oil can be extracted more cheaply and more safely.




  • About Sheridan

    Sheridan Titman, Professor of Finance at the McCombs School of BusinessSheridan Titman is a professor of finance at The University of Texas at Austin and a research associate of the National Bureau of Economic Research. He was recently elected Vice President of the American Finance Association and is incoming President in 2012. He is also the Executive Director of the Energy Management and Innovation Center (EMIC) at The University of Texas at Austin.

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  • About this blog

    This blog’s primary focus will be on energy and this will be, more or less, a learning blog. The blog will offer some of my own views, as well as the views of some of the participants at EMIC. I will also raise questions in the hopes of receiving answers, insights and opinions from our participants. Since my own expertise is in finance, much of the initial focus will be on issues that relate to hedging, financing, derivative markets, and the financial evaluation of alternative energy sources. As my knowledge of these issues expand, I would also like to explore issues that relate more broadly to innovation and the role of public financing in this sector.