Lynne Kiesling
This Marketplace story from Wednesday does a really good job of explaining the fundamental economics of new oil field discovery. The context for the story is BP’s discovery of a new oil field in the Gulf of Mexico, one of the largest discoveries in the past two decades. Part of the challenge, though, is that the field is 250 miles out from shore, and six miles down from the bottom. Six miles. That’s a very, very long way to drill, right at the upper edge of feasible drilling depths. This FT article provides a good summary of the discovery and the likely consequences, including a good table of other recent discoveries. BP’s stock price has risen substantially as a result of this discovery.
High oil prices induce exploration such as the activity leading to this discovery. Oil field discoveries shift the supply curve out, leading to higher output and lower prices. But the technical challenge of drilling six miles through the ocean floor means that this oil will take quite some time to get to market, perhaps a decade. Plus, as the Marketplace story indicates, although it is a big discovery it is still not that big relative to global consumption levels, so the outward shift will be slow and small relative to global consumption.
For those of you teaching principles/intro this fall, this is a good example to use to illustrate supply shifts.
And then the next stage as well…proving that we can drill 6 miles shifts the technological possibility curve out as well, meaning that the supply shift generated by this find is hugely larger than the oil in this particular find…..
While it certainly is a good example of a supply shift in terms of direction, it is a very tiny one in magnitude. As such, it’s probably not going to lower prices noticeably for two reasons:
1) Drilling six miles is expensive, and will actually require prices to remain high for it to be profitable to drill there. If prices were to fall significantly, this oil would never see the light of day since it just won’t be economical.
2) Quote from the story: “Three-hundred-thousand barrels a day, in the context of a world that right now is consuming, you know, close to 85-million barrels a day.” Indeed. That’s 0.0035% of consumption. Using a very high own-price pseudo-elasticity of 1, this oil supply shift would cause a 0.0035% drop in prices once it’s actually brought to market. Therefore, on a base oil price of $71, this new oil discovery should decrease oil prices by 0.25 cents (a quarter of a penny!) over about ten years (the time it will take before oil can actually start arriving on the market). That is, instead of $71 oil, we’ll have $70.975 oil, and it will take ten years for that price drop to occur.