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The Texas economy: supply responses to changes in the price of oil or gas.

The Texas Economy: Supply Responses to Changes in the Price of Oil or Gas

The Clean Air Act of 1990, no doubt reinforced by the Bush administration's new national energy strategy to be announced early in 1991, signals a fresh approach to energy and environmental policy with major implications for the Texas economy. Placing greater emphasis than in the past on market-based devices, the policy will increase the relative costs of using the more polluting sources of energy, thereby inducing substitution of those that are less polluting. As is already generally appreciated, natural gas, still a major resource in Texas, is the least polluting of the fossil fuels. A relative shift to natural gas, especially if at the expense of coal, could be stimulating to the oil and gas industry and the Texas economy. This is the first in a series of Review articles to address the nature and possible economic effects of the new energy and environmental policy.

A basic question is the likely size of the investment and production response of the Texas oil and gas industry to the market incentives created by the policy. By increasing the demand for less polluting fuels, these incentives will effect increase in the real prices realized by producers, especially gas producers. Consequently, we can learn much from the experience of the period 1973-1986, during which there were wide swings in the relative (or real) prices of oil and gas. In this article we concentrate on oil prices, since during the study period the incentive effects of gas prices were distorted by legislative restrictions on the use of gas, as well as uncertainties concerning the pace of gas price deregulation after 1978.[1] Since market-determined prices of oil and gas tend to rise and fall together (because of their mutual substitutability in some major end uses), we believe that the record of responses to real oil price changes will be sufficiently indicative for our purposes.

The economic theory of the production of any good tells us that a rise in the relative (real) price of that good will induce efforts to increase the output of it. The reason is simply that a rise in the real price of a good -- i.e., a rise in price relative to other prices, including input prices -- increases prospective unit revenues relative to incremental costs and thus holds out the prospect of enhanced profits from increased output. Thus if a market-based environmental policy has the effect of increasing the demand for and real price of natural gas, it will also have the additional effect of increasing the output of gas to accommodate that demand.

The oil (or gas) production cycle is a long one. It involves geological analysis, lease acquisitions, geophysical exploration, exploratory drilling, development drilling in new discoveries, a long period of managed production, and often additional drilling and installation of facilities for secondary and tertiary recovery. A lag of five years or more between a spurt of exploratory drilling and a significant increase in output is common. Space does not allow us to examine the several stages in the response of production effort to real price changes in the period since 1973, but one of the earliest stages, exploratory drilling, is sufficiently indicative for our purposes. The industry always has an "inventory" of geological knowledge and land under lease, so it can react fairly quickly to price stimuli in accelerating exploratory drilling.

Our first chart shows the record of exploratory well completions in Texas and the United States as a whole in relation to the real price of oil from 1970 to 1987. In 1973, the number of completions in Texas was 2,416; and in the nation as a whole, 7,771. Within two years following the first big oil price increase, the figures had risen to 3,291 and 9,459, respectively. Peaks in exploratory well completions of 5,688 and 17,430, respectively, were registered in 1981, a year later than the peak in real price following the second big oil shock. Thus while the real price rose by 458 percent between 1973 and 1980, exploratory well completions rose by 81 percent in Texas and 94 percent in the United States as a whole between 1974 and 1981. By 1987, the completion figures -- 2,190 and 6,474 -- had fallen below their 1973 levels.

While we observe a correlation, as expected, between the real price of oil and exploratory well completions, the response of the latter is less than proportionate during the period in question. The principal reason is that efforts to accelerate drilling and related activities sharply increased the prices of inputs, from drilling rigs to drill pipe and labor, which were in restricted supply initially. Between 1973 and 1981, the real (inflation-adjusted) cost of drilling a 10,000-15,000 foot well, for instance, rose by 133 percent.[2] With a decline in drilling after the real price of oil began to fall, excess capacity in the input sectors drove real well costs down again. This point reminds us that the response of investment and production to a given real price change depends in part on the initial capacity of input industries as well as that of the subject industry.

As for the oil (or gas) output response that follows ultimately from earlier exploratory activities, the second chart shows a marked checking of the downward trend in oil production in Texas and the rest of the lower 48 states about three years after each major increase in real oil prices. Part of this effect resulted from more intensive recovery efforts in already developed reservoirs (with a shorter lag), but most of it resulted from the exploratory drilling boom depicted in the first chart (with a longer lag). Note the resumption of the downward trend in production after 1985, with the price collapse of 1986. It is much easier to cut production rates quickly than to increase them, because it is much easier to idle productive capacity quickly than to create new capacity.

In interpreting the foregoing data, two caveats in addition to the one concerning capacity need to be borne in mind. First, since the production cycle in oil and gas is very long, the size of the stimulus provided by a given real price change depends heavily on how permanent it is considered to be by current and potential producers. A price change that is regarded as temporary will have relatively little effect on exploration and other expensive productive activities. We have no quantitative measure of the long-term expectations in the oil and gas industry associated with the violent price changes in the 1970s, so we cannot be sure that the production responses observed are repeatable in a different historical and policy context. But, as we suggested in an earlier article in this Review, a guaranteed floor price for domestic oil could increase investment in oil and gas capacity at a given real price simply by reducing future price uncertainty.[3]

Second, no major cycle in real price and oil or gas production, such as that of the past two decades, is exactly repeatable because of the unpredictable net effect of two opposing forces over time: steady depletion of the natural resource base, which tends to increase real costs of finding and production; and technological advances, which tend to lower such costs. It is worth noting that, while the former force cannot be avoided as a function of the rate of production, the latter can be strengthened through policy measures relating to research and development and the level and stability of the real oil price. Research and development expenditures, like exploratory drilling, are investments in future productive capacity subject to the same long-term expectations regarding real prices and their stability.

Despite these caveats, we believe that the above evidence on supply-side responses to real oil prices in the past two decades is transferable to the question of how the domestic natural gas industry is likely to be affected by future energy and environmental policy. In future issues of the Review, we shall pursue the question in additional depth and detail.


[1]The Powerplant and Industrial Fuel Use Act of 1978, P.A. 95-620, and Natural Gas Policy Act of 1978, P.L. 95-621. [2]Twentieth Century Petroleum Statistics (Dallas: DeGolyer and McNaughton, 1989), 96. [3]Stephen L. McDonald and Mina Mohammadioun, "The Texas Economy: Economic Impact of a Floor Price for Crude Oil," The Texas Business Review, February 1990.

Stephen L. McDonald Professor of Economics and Senior Fellow Bureau of Business Research Mina Mohammadioun Economist Bureau of Business Research
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Author:McDonald, Stephen L.; Mohammadioun, Mina
Publication:Texas Business Review
Date:Aug 1, 1990
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