Incremental Value

I love the New York Times. Just when I think I've exhausted a topic, they provide an irresistible opportunity to explore a new angle of it. When I wrote yesterday's posting on California's love/hate relationship with offshore oil production, I hadn't seen the Times' editorial on the same Senate bill, ironically entitled "Drain America First." The Times cites the "25% of consumption/3% of reserves" ratio that's been going around since the last election, in order to demonstrate the futility of further drilling to reduce America's dependence on imported energy. Fortunately for the rest of us, these figures fall into the category of accurate, but irrelevant. Although I have stated here many times that we don't have enough conventional oil left to become independent of imports at any reasonable level of demand, we certainly have enough to change the dynamics of the international oil market, and that could be very valuable.

Demonstrating this requires expanding our perspective on that 3% figure, and then looking at some economics. First, the reserves. Current US proved reserves total 21 billion barrels out of global reserves of 1.3 trillion barrels; that's less than 2%. But we also need to understand that these figures aren't static. In simple terms, oil gets discovered and moves into "resources", and when it becomes economical to produce, it's reclassified as "reserves." These get added to our previous view of reserves, at the same time we subtract what has actually been produced. We must regard our paltry 2 or 3% of global proved reserves differently, when we realize that we have produced 46 billion barrels over the last 20 years from proved reserves that never exceeded 28 billion.

The USGS has told the Congress that the Gulf of Mexico Outer Continental Shelf (OCS,) the subject of the current legislation, holds an additional 45 billion barrels (mean resource estimate with a 95% confidence of at least 41 billion.) This directly refutes the Times' assertion that the Gulf's remaining oil is insignificant. We can safely assume that these substantial resources could contribute at least an incremental one million barrels per day (MBD) to US oil production. One MBD out of 20 MBD of total oil demand is only 5%. But what if putting an extra 1 MBD into production pushed down the global oil price by $5/barrel? That's not far-fetched, if you look at the amount of global capacity cushion shrinkage that took us from $25/bbl to $40/bbl a couple of years ago, before all the extra political risks were layered on. The price of oil isn't set by the entire 84 MBD we use, but by the last 5-10%.

The oil market is a two-edged sword. When prices go up at the margin, they get applied across all the barrels we buy or produce, but the same is also true when prices fall. The value to the US of an extra 1 MBD of OCS oil would thus be two-fold. At $70/bbl, it's worth $25 billion in and of itself. But a $5 reduction on the 11 MBD we'd still have to import is worth another $20 billion. When you combine these two amounts, it makes the additional volume we could eke out of our OCS waters worth $120/bbl to us. With that kind of market leverage, is this really the optimum time to leave our undiscovered oil in the seabed?

Now, I admit I have glossed over some serious matters of production time-lags, exploration risk, project risk, market timing, and all of the things that any company bidding on new offshore leases in the OCS would have to consider. Nor have I suggested that merely increasing our oil supply constitutes a sufficient response to the current situation, or a real energy policy. I also haven't mentioned conservation or higher efficiency standards. These aren't mutually exclusive propositions, any more than adding to supply precludes keeping retail prices high via higher taxes. All policy choices remain open.

We can choose as a country not to produce this oil, because we fear the possibility of oil spills or are repelled by the sight of production facilities off our shoreline. These are legitimate choices, however inconsistent they are with our economic and strategic interests. But we must not delude ourselves into believing we won't be giving up anything of value in the process. If we don't open up the rest of the OCS, at least in the Gulf of Mexico, it will cost us billions of dollars a year in hard cash for decades to come.