Wednesday, March 28, 2012

Drilling and the Price of Oil

Should United States policy tilt toward more drilling? It's a complicated question that touches on many of today's issues: jobs, foreign relations, environmental protection, and gas prices, to name a few.

A recent Associated Press report claimed that at least one claim made by the "drill, baby, drill" crowd - that increased oil production would lead to cheaper gas - is incorrect. Here are the statistics and analysis that resulted in the report. As reported, the statistical conclusion is unmistakable: there is no correlation between domestic oil production and gas prices.

Some objections, though. First, there's a pretty major flaw in the reasoning behind the report. Oil is a fungible good, which means that its price tends to converge to a stable number worldwide. (This is unlike, for example, natural gas, which has transportation issues that make it more valuable closer to its point of production.) Since gas prices are rooted in the price of oil (plus the cost of refining oil into gasoline, plus taxes, plus profits), they vary with the worldwide price of oil. Domestic production affects a small (and over the period covered, decreasing) percentage of worldwide production, so we wouldn't necessarily expect the effect on prices to be very large.

Second, the law of supply and demand is a bit more complex than a simplistic analysis like this can capture. If the price of a good rises, absent non-market factors such as taxes or regulations (more on this in a moment), this could be because demand has increased, supply has decreased, or both have increased or decreased but in such a way that the clearing price goes up rather than down. All we really know for sure when prices are rising is what did not happen: decreasing demand combined with increasing supply. Since the regression did not look at demand at all, it ignores half of the input to price.

Finally, those non-market factors are important. They do not greatly affect the worldwide price of oil, but local regulations and taxes can affect pump prices greatly. Furthermore, those regulations have changed over the period of time under study. Failing to remove those effects is a problem, and not an easily-solvable one either. (To see why it's not a simple matter, imagine there is a $0.25/gal tax on gasoline. Does this raise the pump price by $0.25? No, because the increased price decreases demand, which lowers the price, which may result in reduced supply, which raises the price, and so on. It would take a detailed and deep analysis to estimate how much effect the tax actually had on prices, and this effect would not be stable from month to month.)

But the important thing about domestic drilling, to me at least, is not the direct result on pump prices. Expanding production of oil certainly won't increase gas prices, so at least we know no harm would be done there. Where we know it would help would be in our balance of trade: since we currently import (net) about 8-9 million barrels of oil per day at a price of over $100/barrel, that's a daily trade deficit of close to $1 billion. Much has been made of the fact that we have become net exporters of gasoline, but that's only because we have excellent refineries. We still import lots of crude and export some of the refining products, for a huge net trade deficit. If we expanded domestic drilling to, say, halve our imports, we could potentially eliminate the deficit, to the economic advantage of the country as a whole.

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