Incentives for Oil Exploration

Last month I posted a list of predictions from the simple economics models of depletable oil stocks. Those predictions were:

INCREASING OIL PRICES create the incentive to invest in transitional technologies.  PRICES OF ALTERNATIVES FALL with investment.  CONSERVATION OF EXISTING STOCKS will ease the transition.

Well, I forgot one.  Higher oil prices create the incentive for existing producer to INVEST IN EXPLORATION. 

With higher oil prices, the oil that used to be too expensive to extract become economically attractive.  Let's use the fruit tree example to illustrate.  At low fruit prices, it might be profitable to stand on the ground and pick the fruit you can reach (low cost).  But, the fruit you can't reach by hand requires more equipment--ladders, mechanical lifts, more labor--to pick (higher cost).  When will producers invest in picking the 'high hanging fruit'?  When the price of fruit rises to the point that it is profitable. 

Same goes for oil. It's relatively cheap to poke a hole in the ground and extract the big pools of oil.  But as stocks deplete it requires more and more investment to extract the deeper, harder to find stocks.  What creates the incentive to extract these tough to extract oil stocks?  Higher prices of course. 

From today's Financial Times...

The Organisation of the Petroleum Exporting Countries, the cartel controlling 75 per cent of the world's oil reserves, on Monday revealed its most important members had drilled 7.5 per cent more wells last year than in 2003 in response to the oil price boom. Opec's annual statistical bulletin also showed that the number of rigs in operation within the 11-member cartel rose 18.8 per cent last year after dropping by almost 6 per cent a year earlier.

Rising prices create incentives for conservation by consumers AND exploration by producers.

UPDATE:  Conumers demanding smaller cars in response to rising gas prices.

Comments

[John Whitehead]

last sentence: incentives for conservation? or exploration?

[Tim Haab]

Huh?

[sampo]

This logic works only to a certain extent.

Once the energy required to extract the oil from the ground exceeds the amount of energy returned, it will no longer be extracted for use as energy. After this point a different set of price points will be in effect based on the other uses of said oil.

There is also the fact that the returns diminish in both directions. Not only does it take more energy/money to FIND the oil, but the oil deposits that are found are going to be smaller and smaller thus returning less and less on each subsequent investment.

[the oil drum (ianqui)]

I should point out that I posted a link to this over at TOD, and it's generated some discussion. Thought you might want to know.

[Silent E]

Tim, have you seen the 2001 Energy and Resource Economics (V.23, N.2) paper by Y.H. Farzin of UC Davis about oil price rises and reserve growth? A mere 1% rise per year in oil prices, sustained over 10 years, should result in a 44% increase in proven reserves, BEFORE considering improvements from any new technological advances in those 10 years.

I'll look for a link...

(aka EvT @ TOD)

[Lilith von Fraumench]

There seemed to be a point missing, but as economics is not my forte, please pardon me if it's a given: If conservation increases, wouldn't lower demand force oil prices downwards? I realize that demand is going up for the forseeable future, especially as China and India ramp up their economies, but wouldn't there be a point where conservation would have a serious impact on prices?

[hendrik]

Tim,

You are absolutely correct. As the reserves, the known reserves, get depleted it is indeed more economical to look at alternative sources of oil. This very reason has brought a regenerated interest into the shale oil in the western U.S. and the oil, tar, sands of Canada. There is money to be made in alternative oil sources and now that oil is back up we should see renewed interest in other methods of petroleum production. Not saying it is a great thing but it is reality.