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The Texas economy: economic impact of a floor price for crude oil.

The Texas Economy: Economic Impact of a Floor Price for Crude Oil

In a recent policy paper, these authors and other members of a task force suggested that national security could be enhanced significantly by the establishment of a guaranteed minimum domestic price (a "floor" price) for crude oil.(1) Such a floor price, which could be implemented by means of a variable tariff or auctioned import rights, would reduce the uncertainty attending investments in exploration and development of new discoveries and, by raising the average domestic price above the average world price, would stimulate domestic production and motivate both substitution of other domestically produced energy sources and general conservation of energy. All three of these responses would in turn reduce the nation's dependence on insecure foreign sources of oil. We estimated that a floor price of $25 per barrel (in constant dollars of 1989 purchasing power) could stabilize the nation's self-sufficiency in energy at about 85 percent of total energy consumption.

Since the Texas economy still depends to a major degree on the oil and gas and related industries, the question arises: What would be the economic effect in the state of an implemented floor price of $25 per barrel for crude oil, adjusted continuously for inflation? The answer is complex, partly because some major Texas industries that depend on oil or gas for inputs of energy or raw materials would be adversely affected by a higher real price and partly because the substitution and conservation responses to a higher real price would limit the growth of national demand for energy. The limitation would be more severe for oil than for gas, however, since gas is a substitute for oil in some important uses. Moreover, the resource base of gas in Texas is richer than that of oil, so gas exploration and production are likely to be stimulated more than oil exploration and production in response to a higher real price of oil.

Two other factors would play major roles in determining the effects on the state's economy: technological progress in finding and recovery and steady depletion of the resource base, the former tending to lower the real costs of additional oil or gas production and the latter tending to raise them. In the space available here, it is not possible to examine each of these factors separately; the discussion must be confined to the probable net effect on Texas oil production and related economic activities, as suggested by experience with relatively high prices in the 1970s.

Figure 1 shows the relationship of Texas crude oil production to the real (inflation adjusted) price of West Texas Intermediate oil from 1954 through 1987. From 1954 to 1970, Texas had substantial amounts of spare producing capacity; so for this period, both actual production and potential production are shown. The potential production plot alone shows almost unrelieved decline after the mid-1960s. As for the real price of oil in Texas, it declined slowly but steadily from 1954 to 1973, then shot up in two stages in the 1970s in association with the world price, strongly influenced by OPEC. Thereafter the decline was steep, dropping to $16.44 per barrel in 1986. As of December 1989, the real price of oil in Texas was approximately $18 per barrel in 1986 dollars.

With the sharp rise in the real price of oil in the 1970s there was, with a lag of several years, a significant reduction in the rate of decline in Texas production; then, again with a lag, there was an increase in the rate of decline in response to the sharp price reductions after 1980. In fact, the rate of decline slowed from 6.0 percent per year in 1978 to 0.4 percent per year in 1984; then it rose again to 5.8 percent per year by 1987. This behavior reflects the underlying fact that in no year in the 1970s and early 1980s did reserve additions equal production, despite a near tripling of oil well completions. Only in the years 1983-86 did reserve additions exceed production.(2)

While these data suggest that a price of $25 per barrel ($22.50 in 1986 dollars) probably would not succeed in stabilizing production in Texas, they do indicate that it probably could significantly slow the decline that began in the mid-1960s. Merely slowing the decline makes a great deal of difference in the absolute level of output and related economic activity, as the following calculation will show. If the decline rate of 6.0 percent in 1978 had persisted through 1984, production in the latter year would only have reached 718 million barrels. In fact, though, because of the reduction in the decline rate, production in 1984 was 845 million barrels, a difference of 127 million barrels, or 17.6 percent.

As figure 2 shows, the real price of natural gas also rose markedly from 1973 to 1984, with the result that the decline rate fell to zero by the latter year. Since natural gas is a substitute for oil products in a number of important uses (e.g., boiler fuel or feedstock in industry), its price tends to rise in rough proportion to the price of oil; so a floor price for oil would imply a similar floor price for gas. It is likely that the response of gas production to a higher real price would be greater than that suggested by the figure. During the period covered by the chart, gas prices were subject to regulation. Gradual deregulation began in 1978, but there was considerable uncertainty in the industry about its exact pace and about implications for new exploration investments. The remaining resource base for gas in Texas is believed to be much larger than that for oil, partly because gas frequently occurs at depths only recently feasible to drill. So with complete deregulation of gas prices and a floor price of $25 per barrel for oil, there could be a substantial increase in Texas gas capacity and production in the decade ahead.

The impact of oil and gas production on the economy of Texas is by no means confined to the value of that production and associated employment. The impact is expanded through employment and output in oil field equipment manufacturing, oil field services, refining and petrochemicals manufacture, and transportation, to name only the most obvious industries. As we all know well from recent experience, the effect of an oil price and output slump extends to all sectors of the economy, from real estate to retailing, from finance to government.

A recent study by Keith Phillips at the Federal Reserve Bank of Dallas indicates that during the 1972-82 period, the growth of total energy-related employment in Texas was about 4.5 times that of direct employment in "mining," which is almost entirely oil and gas production. In that period, the increase in Texas employment in all industries (except agriculture) was approximately 2.1 million workers. The increase in energy-related industries was .935 million workers, or 45 percent of this total.(3) In a related study, S.P.A. Brown and John Hill found that (on a base of 1985) Texas employment declined 1.66 percent for every $5 decline in the price of oil per barrel.(4) Using the methodology of this study, Phillips calculates that (on a base of 1989) when the economic base is less oriented to oil and gas production, the decline in employment would be 1.21 percent. The suggested floor price for oil is about $5 more than the current price. So its implementation could possibly result in a sustained increase in Texas employment of about 1.2 percent, with a roughly similar increase in gross state product. [Figure 1 to 2 Omitted]


(1)Task Force on oil price stabilization, Stabilizing U.S. Oil Prices: A Report Prepared for Governor William P. Clements, Jr., University of Texas at Austin, August 1989. (2)William L. Fisher, "Changing Perceptions of the U.S. Oil and Gas Resource Base," Keynote Address to IBM Exploration and Production Software Symposium, Houston, Texas, June 1989. (3)Keith R. Phillips, "Energy and the Southwest Economy," The Southwest Economy, Federal Reserve Bank of Dallas, November 1989. (4)S.P.A. Brown and John K. Hill, "Lower Oil Prices and State Employment," Contemporary Policy Issues, July 1988: 60-66.

Stephen McDonald Professor of Economics University of Texas at Austin and Mina Mohammadioun Economist Bureau of Business Research
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Author:McDonald, Stephen; Mohammadioun, Mina
Publication:Texas Business Review
Date:Feb 1, 1990
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