Sunday, May 2, 2010

Would a “Drain America First” strategy significantly lower gas prices?

In the New York Times today, Jad Mouawad argues that the United States “needs” more offshore drilling in the Gulf of Mexico.

I don’t think the numbers support his claim. Instead, any additional oil would mainly a) lead to increased consumption in other nations, and b) lead to decreased production in other nations, with little net effect on American consumers. This is because oil is a fungible global commodity.

According to his article, Mouawad reports that Gulf of Mexico oil production amounts to 1.7 Million bbl/day. This is just 2% of the 85 million bbl/day produced globally. James Hamilton has estimated that the long run demand elasticity of oil is about -0.2 to -0.3 (although there’s evidence of less elasticity recently). If crude oil accounts for half of the cost of gasoline, then even a 50% increase in Gulf production would lead to only about a 1.5% to 2.5% decrease in U.S. gas prices.

In addition, we must also consider supply elasticity, which further limits the effect of increased drilling on gasoline prices. Bringing more Gulf oil to market would reduce incentives for other nations to bring as much oil to market. Furthermore, it would decrease incentives for investments in alternative energy like wind, solar and nuclear. Thus every additional barrel we drain from our Gulf oil reserves would net less than an additional barrel of oil or its equivalent coming on to the market.

Factoring in both demand and supply effects, it appears that a major increase in Gulf production would have barely a 1% effect on gasoline prices for American consumers. That's less than the average monthly change in prices.

On the other side of the ledger are the risks of more catastrophic oil spills like the BP rig, and the inevitability of negative externalities from increased oil consumption, such as pollution and congestion.

America does not “need” more offshore drilling. On the contrary, an energy strategy focusing on demand and speeding the development of alternatives is likely to be much more effective.

The Official U.S. Energy Information Administration appears to agree:
"Because oil prices are determined on the international market, however, any impact on average wellhead prices [from additional drilling on the Outer Continental Shelf] is expected to be insignificant."


  1. Here are some things to think about Erik. Not all oil is created equal(fungible). West Texas and Saudi Arabia's Ghawar field produce the desirable ‘light’ crude, which is cheaper to refine (also there are limited capacities for refining various grades. Mexico and Venezuala produce heavy crude, and I’m presuming this may reflect the output of undersea drilling in the Gulf of Mexico (but they are going a lot deeper now in the Gulf, with BP’s new well at 35K feet (higher than Everest, about 7 miles).

    The Gulf of Mexico accounts for one-quarter of US consumption, but also produces about one-seventh of US natural gas consumption (the drilling gets both) and is firmly under our military control (you can’t say that for the Persian Gulf, Iraq or Russia despite claims of ‘mission accomplished.’ And received wisdom is that Saudi Arabia is not being honest about the Ghawar field for fear of losing control over prices in their quasi-cartel – they haven’t allowed an audit of the fields since the 1960s (half a century; imagine how the technology has changed) and are said to be vastly overstating their reserves, perhaps by a factor of four.

    Chris Westland

  2. Thanks, Chris.

    I agree that the oil grades are not perfect substitutes, but in the long run, they're very good substitutes.

    Also, if Saudi oil reserves are underestimated and we may lose access to other foreign supplies, then that seems like a good argument to NOT to drain our own reserves too quickly -- let's burn the other folks' oil first and think about ways to encourage conservation and alternatives before we drain the last of our own reserves.