Offshore Oil is Risky Business

Christine O’Donnell’s taking on Biden’s defense of “not drilling”, shows a flaw in the Republican’s armor.  David Anderson, Republican guru (lol), provided a link (albeit in her defense), which goes a long way to prove that their whole argument, drilling to lower gas prices, is nothing more than a bogus arrangement.  I’m afraid that after looking at all of the facts, one can only say that the Republican argument is being made by people who can’t think, for people who won’t think. And had I not been a student of energy over these past few months, even in all my wisdom (lol) I might have thought that dropping prices by drilling offshore, would make sense….

To be honest, it could make sense if the oil drilled today would be in my car tomorrow.  Even by next week, or in maybe two.  The silver bullet which kills dead the other side’s argument, is that if Congressional approval is given, the first oil rolls out in 2019……..

Yes 2019…..

But don’t take my word for it… Together lets find some facts to look at, shall we? Let’s go ahead and make the assumption that drilling reduces our cost of gas, and then let’s look at their proposals with unblemished eyes, and see how they might just work?

Republicans seem to think this is their best argument. David Anderson came to my assistance and sent a link which he said defended Christine’s position.   And so being the curious wonk that I am, I’m reading through it looking for any fact which could be used to show that  oil drilled offshore, would somehow deliver immediate relief. When none were forthcoming, I investigated who is writing this article and for whom was he writing it?  Bloomberg was the publisher, but the American Enterprise Institute was the financial backer… Sitting on that AEI board was the former Chairman of Exxon, Lee Raymond, and its current president Christopher DeMuth, formerly served as co-editor of The Neoconservative Imagination. More about AEI can be found here.

Ok, obviously this is a parallel view of that being spouted from the White House. More than twenty AEI alumni and current visiting scholars and fellows have served either in a Bush administration policy post or on one of the government’s many panels and commissions. Former United States Deputy Secretary of Defense Paul Wolfowitz is a visiting scholar, and Lynne Cheney, wife of Vice President Dick Cheney and former chairman of the National Endowment for the Humanities, is a senior fellow.

Instead of being dissuaded as you might expect from such a partisan compilation of dignitaries, I became excited. For at last my search for the facts behind Bush and McCain’s statement of how offshore drilling would lower prices, was hitting pay dirt. For surely the data necessary to provide proof, could be accessed by this stellar group of scholars, all paid with oil money.,… If there were facts…this group would have them…

So with renewed excitement, I finally began reading Kevin Hassett’s article titiled….Start Drilling Now to Lower Oil, Gasoline Prices

Kevin Hassett bases his argument on this premise:

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.

Yeah, that certainly seems sensible….. but what if prices will be higher tomorrow. i mean they are, after all, higher today than they were last winter….Kevin provides the answer…..

If prices are low today, and you expect them to be much higher in the future, then you will hold off pumping a lot.

Yeow! I wonder why he includes that… With wind, during that controversy, we were told prices would go down this year making wind too costly. They didn’t. Instead they soared to record levels making wind much cheaper in comparison. So let’s see where Kevin is taking this argument…..

Surprisingly the author gives praise to Obama’s conciseness when he correctly stated that: `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.”

If exploration (of continental shelf) 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.

In plain speak what he is saying is that the continental shelf holds so much oil, that it will lower future prices quite heftily. Therefore because of today’s high price, oil companies will pump more immediately out of the fields they currently own…. More oil will drop our prices…..

Ok, some parts of this are a little hazy. For one, we have already slipped past peak oil. There is less and less oil to pump…every day, every minute, every second we have less oil then we did before…

So the real question is whether the continental shelf will replace and offer enough of a surplus, in excess of our current rate, or…. will it just be part of the declining supply as that supply drops off to zero?

The implication is important. For if there is no surplus created, or no future oil glut, then by the author’s own admission, those individual oil companies who were fortunate enough to grab the oil rights to the continental shelf, would sit on them until the price rose even higher before beginning to pump and sell it later at a higher price….. By this conservative author, Kevin Hassett’s own admission, Americans would see no lower prices if after the continental shelf is opened…. no international oil glut occurs…..

The author totally misses that point last stated. Instead he bases his counter-argument on these two premises: One, that no oil will be found, and two, the belief that oil companies won’t open their current sources to sell at today’s higher prices in order to maximize oil companies profits….

The first point is valid. Oil exists offshore… The second requires some investigation, for it goes against common sense.

To illustrate this case,I am going to make the assumption that most of us feel we can live with $3.00 a gallon. I will use yesterday’s $4.00 price to make the comparison….

So let’s get wonkish… If I sell 100 gallons at $4.00, and the gas is costing me $2.50, then $400 dollars minus $250 dollars gives me a profit of $150 dollars for every 100 gallons I sell… Cool… (Just for fun, with every four cars….ka ching…ka ching….I just profited an extra $150 dollars….) So…at $3.00 a gallon, and $2.50 cost, I make $0.50 or $50 dollars profit on every 100 gallons…. Ok, so I need three times as many cars to break even… So how is that going to happen? Are we suddenly going to have three times more cars come out of hiding in order to buy up all this cheap gas that is suddenly available?

We could manufacture them, but if we did, who would buy them? After 7 years of Bush, who do you know that can afford an extra car with what little money they have left after food, fuel, their ARM mortgage, higher insurance deductibles, higher utility bills, plunging 401k’s, 40% drop in their house’s value? Keep in mind, just trading your car in for a new one, won’t do the trick.. You would have to buy another car in addition to the one you already driving, and drive it regularly along with your current car, so that filling stations can make the same money they are making with today’s high prices….. Or for every person now driving a car, two more would have to come off public transportation, buy a car, and fill-up with gas.

Kevin’s argument doesn’t seem to stand up in its real world application…

AEI, when they look at this, will say that my scenario does not take into account the drop that will occur in the cost of fuel. They will argue that cost of fuel will be lower than $2.50…. Ok, that is valid. Let’s look at scenario as well.

To maintain the $1.50 profit margin, at $3.00 a gallon, the cost will need to be at $1.50. So in other words, worldwide…. the price of refined gasoline, will need to come in under $1.50 a gallon…

I just don’t see it happening. To make as much money on $3.00 a gallon of gasoline…..a barrel of oil will need cost $39 dollars….tops….
That means China, India, Europe, and North America will all be able to buy oil for $39 dollars a barrel…..if Kevin’s statement is to hold true.

Now I’m not an oil man……But give me cards and I’m a betting man…. And with this data in hand, I am willing to bet that no oil executive is going to agree to drop his prices down from $4.00 to $3.00 a gallon……If one such executive worked for me…I’d fire him… at even just the pretension of a 25% drop in price.! And to do so, simply on the promise that in 11 years from now, we will have access to 86 billion barrels off Florida’s coasts, in the most fragile and sensitive marine environment existing in North America, doesn’t follow simple mathematics.

So what does Kevin say to defend his position? This.

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.

Again: “It is inconceivable that extraction from such large reserves would have no effect on future prices”.

Like the dread pirate Roberts in the movie Princess Bride…. we have proved otherwise… of course the cost could go down a penny, or five cents, but that would offer us the relief we need now, would it?

But Kevin does not give up. He tells us that:

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. But no sources are cited.

A quick Google search points up only one article defending that notion. It’s author is Kevin Hassett. Still, I’m not persuaded…. As academic proof of his hypothesis, (which we previously debunked by a simple theoretical thought problem) he cites two economists at the world renowned center of academic excellence…..Monash University in Australia. A quick click on the links provides this….. and ….this….. I was sort of expecting a paper or something definitive which would finally show that drilling off-shore would lower oil prices today….. Instead of any study of financial calculations which I was rubbing my hands over in anticipation, all I get is a flat statement, with nothing backing it up, as if Kevin had just proved Guth’s Universal Inflation Theory….without any proof…..And pompously stated it as fact (it’s not)

Future prices and spot prices are inextricably linked.

They are? I don’t think so………For one, you and I together have just proved they weren’t. And two, Kevin has not proved they were….. As you can probably tell, by now, I’m starting to get somewhat disillusioned that perhaps offshore drilling will never lower our gasoline prices……..

In his new found confidence, Kevin loses me into the deep end… Read this and tell me if my interpretation is correct. Here is what I think he says…… “Drilling off-shore will drop prices because Newt Gingrich says so in his blog…..” And here is what he says……”

Newt Gingrich, has been a tireless advocate of a more rational energy policy that allows for more drilling. (The bold is my doing)….

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.

Rejected?…. Are you as confused as I am… Didn’t he just use this fact to contradict his own argument?

Reading on we find that it is not a misprint at least………

The study, Gingrich reported, wasn’t rejected because it lacked academic merit. It was rejected because the facts of the finding were 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.”

Can someone explain just what makes an academic “impeccably credentialed” and how such an “impeccably credentialed” academic can invoke the Democratic Policy Committee in his statement as he turns down the publication of two economists, because their work is too commonly known to be of any news? And just who are these two economists? They are the publishers of this work: The effect of opening up ANWR to drilling on the current price of oil

In that paper’s synopsis, we see the same argument. The key word is the word “significantly”

Since future prices are expected to be lower, future profits are also lower, so the value of oil not produced now, but held for future sales, is lower, making it more profitable to go ahead and produce and sell now instead of waiting for future profits. Using oil now reduces the amount of oil available for the future, which involves the opportunity cost of forgone future profits, which are sometime called the marginal user costs or scarcity rents. In this paper, we use simple two-period models to show that if an amount of newly discovered oil is significant enough to reduce prices in the future, any drop in future prices reduces the future profitability of oil, reducing the marginal user costs of oil now. That reduction in the marginal user costs reduces the current price of oil just as if there were a reduction in the marginal costs of extracting oil now.

Found it: did you catch it? Here it is again.

any drop in future prices reduces the future profitability of oil, reducing the marginal user costs of oil now.

OK, I am beginning to see where it might make sense on a theoretical level; let’s see how it does on a practical one….

Ok, it is like this. Oil sells today for $4.00. We have 100 billion in reserves which we are carrying on our books at our current cost of $2.50 each or at $250 billion. As we use up that reserve, we write off the cost at $2.50 a gallon. Therefore, as before, we net $1.50 per gallon. Now, what these “experts” are saying, is that if we get another 100 billion in reserves added on, and if because of that (remember the word “if”) the cost of providing your gas twelve years from will drop down from $2.50 to $2.00 a gallon, we, the big oil company, being a non profit organization, will immediately use the $2.00 price (on our books), since that is what it will eventually cost us twelve years from now, and can therefore afford to charge you $3.50 a gallon and still make our $1.50 profit…….

That is the reasoning behind this concept of dropping prices by immediately leasing the off-shore drilling to the Big Oil companies. It’s all in their accounting……. They decide to charge themselves less for oil, and they then drop the price…..

OK, so can we apply this novel concept used for offshore drilling to various other parts of our lives…. Ok, lets see…. Ah, here we go……

Those of you who bought a house when prices were rising rapidly. Let us say you bought it for a paltry $200,000……. The price, due to the housing glut has now dropped 40% and will inevitably stay there for a long time…. At a forty percent loss, the most you will be able to sell it for will be $120,000….. But alas, you are making payments and paying interest on the $200,000 amount…..Why can’t you do what the oil companies do and tell the bank you will now start paying them 40% less with each payment….. it would certainly make sense for you to do so…. So why does your bank not agree? All they would have to do is adjust their books, and simply say that your loan was now worth only 60% of what it once was and they would still make the same profit…..

If it works for oil….why can’t it work for banks?

Because it just doesn’t work for banks…. and it won’t work for oil…… Think of it as if it is your money…..If oil is actually selling at $140 dollars a barrel, would you still drop your price downward to a cost of $112 a barrel based on what you think oil will be 12 years from now? I don’t think so.

Remember that word “if” spaced throughout Kevin’s argument? It stated that “if” the price dropped significantly, then this model would occur……”if”…..

All the practical knowledge says it won’t happen. Not even Kevin can prove that it will happen… So, much to my disappointment, at this point in time I have no other alternative but to call the lower-our-price- by-drilling, plain bunk, a sham, and probably just a silly attempt to scare us into letting them grab those environmentally sensitive areas, to keep under their lock and key……..

And I would have surely thought that Kevin and the AEI together, would be able to find some proof to the contrary. ..For based on their philosophy the old maxim holds true…… if they can’t find the connection: then nobody can……