Summary

Overview and Findings

The recent precipitous drop in world oil pricesfrom about $28 per barrel ($28/bbl) in 1985 tobetween $12 and $18/bbl through much of 1986dealt the U.S. oil industry a severe blow. In thefirst year after the price drop, U.S. crude oil pro-duction dropped by nearly 700,000 bbl/day, in-dustry capital spending on exploration and pro-duction dropped from about $33 billion/year toabout $16 billion, drilling activity dropped fromover 70,000 well completions/year to approxi-mately 37,000, and the basic infrastructure of theindustry, including its skilled personnel, shrankconsiderably. There is now a strong consensusthat domestic oil production will continue todrop, to between 6 million and a bit over 7 mil-lion barrels per day (mmbd) by 1990, down fromthe 1985 level of 9 mmbd, if oil prices remainin the $12 to $18/bbl range.

A substantial drop in U.S. oil production is onlyone component of a chain of events . . . resultingfrom lower world oil prices . . . that could createfuture problems for the United States’ economicstability and national security. First, this Nation’sprice-sensitive demand for oil will rise as its oilproduction declines—a combination resulting ina sharp increase in the level of imported oil. Mostindustry projections of the effects of continuedlow oil prices envision imports reaching 50 per-cent of U.S. oil consumption by the early 1990sor before. (Figure 1 shows the National PetroleumCouncil’s import projections for a low and highprice track.) At an oil price of $18/bbl, this willamount to a 50 to 60 billion dollar per year drainon the United States’ balance of payments.

Simultaneously, similar trends in oil supply anddemand will be occurring outside the UnitedStates. Lower oil prices are expected to depressoil production outside of the Organization of Pe-troleum Exporting Countries (OPEC) and the Mid-dle East while increasing the worldwide demand

Figure 1 .—Net U.S. Oil Imports As a Percentage ofOil Consumption, As Projected by the

National Petroleum Council

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1980 1985 1970 1975 1980 1985 1990 1995 2000Year

SOURCE: National Petroleum Council, Factors Affecting U.S. Oil & GasOutlook, February 1987.

for oil (except where higher taxes maintain pricesat previous levels). These changes will increaseOPEC’s share of the world oil market, with muchof the increase going to the Middle Eastern OPECnations. In time, the Middle Eastern OPEC pro-ducers will have returned to the levels of marketshare and production capacity utiIization that inthe past allowed them to affect prices or disruptoil markets. And, thus, they will have regainedan ability to upset U.S. economic stability andnational security.

OTA’s evaluation of a set of factors affectingfuture U.S. oil production lead to the followingconclusions:

1. The available evidence points strongly to acontinuing, and substantial, decline in U.S. oil

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production if oil prices remain in the $12 to$18/bbl range. This evidence includes: a) recentproduction trends and trends in drilling and otheroilfield activity; b) the financial state of the indus-try; c) industry surveys of future oilfield invest-ment; d) the results of oil supply models; and e)a limited amount of economic analysis.

2. Recent rates of drilling activity are much toolow to allow domestic oil production to stabilizeclose to today’s already depressed productionlevels. Even with quite optimistic assumptionsabout the productivity of future drilling, a con-tinuation of 1986 drilling rates would lower year2000 U.S. oil production to about 6 mmbd– athird lower than 1985 production levels.

3. Available estimates of the magnitude of theproduction decline should be viewed as “bestguesses” rather than as precise calculations, evenif the uncertainty associated with future oil pricelevels is disregarded. Most current productionforecasts assume implicitly or explicitly that pre-vious trends and relationships established overthe past few decades will continue into the fu-ture. The severity of the economic dislocationscaused by the recent drop in oil prices, coupledwith major changes in the industry over the pastfew years, imply that this assumption deservesto be reexamined. It is probably prudent to as-sume that the oil industry will adapt in variousways to the new economic environment and, inadapting, will break with many past trends.

4. It is not clear whether a break with pasttrends would lead to production levels higher orlower than an analysis based on historical be-havior would predict. On the optimistic side, theoil industry might be expected to follow an ini-tial period of disrupted operations with move-ment to more efficient management and positivetechnological adaptations. On the pessimisticside, any positive effects on oil production levelsassociated with an adaptive move to higher effi-ciency might be offset by several factors:

● the industry’s higher debt levels caused bythe wave of takeovers and mergers duringthe 1980s, which could depress total explo-ration and development (E&D) investment;

● the improvement in financial terms offeredby several potential overseas producing

countries, which might shift E&D investmentout of the U. S.;the current drop in spending on researchand development, which could slow tech-nological innovation; andthe apparent shift in basic industry E&D in-vestment strategy, downplaying the impor-tance of replacing company reserves andstressing the requirement that E&D invest-ments sat i s fy r igorous prof i tabi l i ty re-quirements.

There is no ready way to estimate the net ef-fect on production of these diverse factors, Also,further uncertainty is added to estimates of fu-ture production levels by the dependence of pro-duction on a number of other factors that are notknown with any precision, such as the magni-tude, geographic distribution, and physical na-ture of remaining oil resources. Finally, uncer-tainty is added by the relatively low priority thatappears to have been given to publicly availableanalysis of the economic attractiveness of newinvestment in drilling and other production-ori-ented ventures (the oil industry conducts extensiveeconomic analysis of new investment prospects,but most of the analyses are proprietary and notavailable to assist in the public policymaking proc-ess). The attractiveness of such investment is thekey indicator of long-term prospects for adequateU.S. reserve replacement and production.

If oil prices do stay low–perhaps averaging be-tween $14 and $16/bbl for the next severalyears—what might be the outcome for domesticoil production? With rapid restructuring of theweaker companies, favorable adjustments in E&Dstrategies, innovation in E&D technology, andfavorable potential for continued reserve growthin older oilfields, domestic production might beable to hold above 7 mmbd through 1990 (theupper end of the range of most industry estimates)and drop less steeply than projected thereafter.For the period beyond the early 1990s, the open-ing of Federal and State lands to exploration andthe successful discovery of large oilfields on theselands could be of special importance. On theother hand, if the industry continues to shift tomore overseas investment and fails to improveefficiency further, technological change slows be-

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cause of reduced R&D spending, and reserve ad-ditions from older fields slow because of reducedgeologic potential and poor economics, produc-tion could sink to the lower end of the consensusrange (about 6 mmbd) in 1990 and conceivablyeven below the expected range in later years.

5. Further economic and technical analysiscould be useful to policy makers concerned withfalling oil production. With or without such anal-ysis, however, substantial uncertainty will remainabout how domestic production will respond todifferent price levels and policy environments,and policy makers must be prepared to make keydecisions without precise knowledge of their out-comes. Some questions that cannot be fully an-swered with further analysis include:

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How will industry investment behavior adaptto the new price environment and to achanging business environment overseas?To what extent will the major industry re-structuring of the 1980s eventually lead tohigher efficiency and increased interest innew domestic E&D ventures? Will newlymerged and restructured companies be ableto eliminate their heavy debt burdens withina few years, and will they then act to boosttheir investment in traditional E&D activities?To what extent will technological change actto offset some of the negative effects on prof-itability of lower oil prices?Will relatively low cost drilling in the UnitedStates’ older oilfields continue to providelarge volumes of new reserves, or did the in-tensive drilling of the past decade essentially“use up” most of these fields’ remaininggrowth potential?If large new blocks of Federal and State landare made available for exploration, especiallyoffshore California and in the Arctic, willsuper giant fields be discovered and de-veloped?How long will it take (or what conditions arenecessary) to restore enough confidence topotential investors in E&D that they will re-spond readily to reasonable profitabilityprospects? To what extent could investmentlevels rebound without a concurrent re-bound in cash flow from the industry’s pastinvestments?

6. There are ways to reduce, though certainlynot eliminate, uncertainty about the magnitudeof a future production decline and the potentialeffect on production of alternative governmentpolicy measures. Of most value would be a com-prehensive analysis of the prospective profitabilityand productivity of new investment in oil explo-ration and development. Although some valuableeconomic analyses are available (e. g., the Na-tional Petroleum Council’s evaluation of E n -hanced Oil Recovery) these are too limited inscope and uncoordinated to qualify for the typeof comprehensive analysis needed for carefulforecasting and policy analysis.

Other potentially useful analyses include:

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A cataloging and analysis of changes in thebusiness environment for oil and gas invest-ment overseas.An evaluation of the dissemination and useof new technologies in oil exploration, de-velopment, and production during the pastdecade, and an examination of new technol-ogies just introduced or on the near horizon.An economic analysis of existing oil produc-tion with high operating costs (especiallystripper production), incorporating collec-tion of physical and economic data at theindividual well level.An examination of the differences in individ-ual companies’ E&D strategies and results,to gain further perspective about the poten-tial for industry wide improvements in E&Defficiency.

Congress is faced with difficult choices, notonly in ‘selecting policies to combat trendstowards lower domestic oil production andhigher imports but also in deciding whether anactive government role is wise. Unfortunately,some of the key issues associated with choosingan appropriate government role are ambiguous.For example, earlier concerns about the effectof higher oil imports on U.S. economic stabilityand national security have been complicated—but not negated–by the significant changes inoil markets and government preparation for mar-ket disruptions since the early 1970s. Thesechanges include the construction of the Strate-gic Petroleum Reserve, the advent of a strong spot

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market for crude oil, the beginning of a futuresmarket, and substantial changes in the role of oilin the U.S. economy.

Another complication is that the majority ofproduction forecasts prior to the 1985-86 oil pricedrop projected domestic oil production to beginfalling rapidly in the 199os; in other words, mostforecasters expected the production decline andsubsequent increase in imports to occur even inthe absence of a large price drop, albeit a dec-ade later. At first glance, these predictions wouldappear to favor a “hands off” policy on oil pro-duction since boosting production today wouldappear to be only delaying the inevitable. Notal I forecasters agree with this “conventional wis-dom,” however; they contend that U.S. produc-tion could have been maintained, had prices nottumbled, with continued intensive field growthand innovation in enhanced oil recovery. Further,“buying” an extra decade of moderate importlevels could be worthwhile if the decade wereused to add flexibility and security to the U.S.energy system, rather than to artificially preservethe status quo, so that the Nation would be bet-ter prepared to deal with higher import levelswhen they occurred.

There is also uncertainty about whether allow-ing U.S. oil production to decline now might yieldhigher future production rates than would be pos-sible if today’s production rates were proppedup and the resource base depleted more inten-sively. Although resource depletion is a valid con-cept, the remaining U.S. petroleum resource baseis less a small resource than it is a low-grade re-source whose recovery is amenable to improvedtechnology. Thus, the pace of technology devel-opment—likely to be more rapid if productionis kept high by tax or other incentives—conceiv-ably may outweigh resource depletion as an in-fluence on future production levels.

If Congress does decide to work to stabilize do-mestic oil production, it can use a number of pol-icy mechanisms. The following options are dis-cussed briefly in the report:

● oil import fees (either to raise wellhead pricesor to establish a price floor);

● tax concessions (including investment taxcredits, depletion allowances, cuts in sever-

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ance and ad valorem taxes, drilling credits,abolishing the Windfall Profits Tax);removing the ban on oil exports from theAlaskan North Slope;bolstering investment in oil exploration anddevelopment R&D; andremoving leasing restrictions on frontier/off-shore areas.

IntroductionThe long price slide that took world oil prices

from about $40/bbl in 1981 to $28/bbl in De-cember, 1985, and then precipitously downwardto the $12 to $15/bbl level throughout much of1986 has created a depression in the U.S. oil in-dustry. Most indicators of the level of oilfieldactivity have been slipping since the “peak” yearof 1981 and dropped sharply in the early monthsof 1986:

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The number of rotary drilling rigs workingin the United States dropped from over 4,000in 1981 to about 1,900 in July 1985 to be-low 700 a year later; they have since re-bounded slightly.Industry employment dropped from a 1982high of 708,000 to 585,000 in 1985 and to422,000 in September 1986, with oilfieldservice employees bearing the brunt of thedrop.Total well completions, which had declinedmoderately from 89,000 in 1981 to 73,000in 1985, dropped below 40,000 in 1986. Fig-ure 2 illustrates the rise and fall of well com-pletions between 1970 and the present.The monthly seismic crew count, that is, thenumber of teams doing seismic surveys foroil and gas exploration and development, fellfrom 681 in 1981 to 378 in 1985 and to 195in 1986.

U.S. oil production has slid from 9.03 millionbarrels per day (mmbd) at the end of 1985 to 8.35mmbd a year later, a decline of over 7 percent.Coupled with increased oil demand, the produc-tion decline has forced U.S. net imports of crude

‘That is, crude oi I plus ‘ I lease condensates, ’ natural gas I iq u idsrecovered in the field. Total domestically prduced petroleum alsoincludes natural gas liquids recovered from gas processing plants,refinery processing gain, and small amounts of alcohol.

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Box A.—Recent Studies by the National Petroleum Council and the Department of Energy

The National Petroleum Council (N PC) and the U.S. Department of Energy (DOE) have recently pub-lished reports on U.S. energy supply: Factors Affecting U.S. Oil & Gas Outlook and Energy Security, re-spectively. Both reports focus particularly on domestic oil production but also evaluate U.S. and worldenergy supply and demand.

The DOE report, the more pessimistic of the two regarding oil production prospects, projects U.S.crude oil production to be 6.9 mmbd in 1990 and 5.2 mmbd in 1995 (compared to about 9 mmbd in1985) if oil prices* rise from about $14/bbl in 1986 to $16/bbl by 1990 and $22/bbl by 1995. The NPCreport projects slightly higher production rates at somewhat lower prices: 7.1 mmbd in 1990 and 5.7 mmbdin 1995 with oil prices at only $12/bbl in 1986 and rising to $14/bbl by 1990 and $17/bbl by 1995. Bothof these projections are well within the mainstream of forecasts released within the past year, and aresubstantially more optimistic than several. For both, net petroleum imports reach the 50 percent level inthe early 1990s.

Both reports also examine a higher oil price case. With prices in the low $20s by 1990 and the high$20s by 1995, DOE projects domestic crude oil production to be 7.8 mmbd in 1990 and 6.6 mmbd in1995; for similar prices, NPC projects production to be 8.0 mmbd in 1990 and 7.0 in 1995. These resultsimply that an import fee that raised oil prices by $5 to $10/bbl could substantially slow the productiondecline.

DOE’S projections are based on a detailed computer model of U.S. energy supply, the Energy Infor-mation Administration’s Intermediate Future Forecasting System. NPC’s projections are based on a surveyof U.S. and world oil supply and demand forecasts from various sources. Both projections are supple-mented by quantitative and qualitative evaluations of oil supply factors. The NPC report plainly acknowl-edges the substantial uncertainty associated with the projections:

Even sophisticated statistical analysis of past events is inadequate for predicting the future if the historical datado not contain an event similar to the current or expected future events . . . Energy forecasters have no recenthistorical events to measure the impact of sharply falling prices of petroleum . . .

Both reports identify the deterioration of industry infrastructure-loss of skilled workers, declining man-ufacturing capacity of critical oilfield equipment, deterioration of the rig fleet, and so forth-as a criticalroadblock to a future drilling recovery. OTA shares these concerns but is somewhat more optimistic aboutthe ability of the industry to increase its rate of additions to oil reserves if incentives improve.

Although both reports evaluate several policy options to increase domestic oil production, only theDOE report presents a quantitative analysis of these options, calculating the net costs and production re-sponse for many of them. The uncertainty associated with these estimates is likely to be extremely high,however (in some cases, e.g. lower minimum bids on Outer Continental Shelf acreage, so high that cost/pro-duction estimates were not made).

*Measured as the cost of crude oil to U.S. refiners.

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oil and petroleum products up by about 14 per-cent over a year before, from 4.9 mmbd, or 30percent of total U.S. petroleum supply, to 5.6mmbd, or 34 percent of supply.

These trends appear to be pushing U.S. oil sup-ply towards a dependence on imports reminis-cent of the situation in the late 1970s, before theproduction stimulating and demand suppressingeffects of the two oil price shocks finally took holdand began weaning the United States from agrowing reliance on foreign oil supplies. In fact,a renewed dependence on foreign supplies is pre-cisely what the oil industry and most energyanalysts are predicting for the United States—absent either a rapid return to previous pricelevels or major Federal intervention in the mar-ketplace. Typically, they are projecting a likelydecrease (from 1985 production levels) in domes-tic oil production of 2 to 3 mmbd by 1990, andsimilar increases in demand, if world oil pricesstay at about $15/bbl. Table 1 presents severalprojections of future U.S. crude oil productionassuming continued low oil prices, as well as pro-jections completed before the price drop for com-parison.

How and Why Would U.S.Production Decline?

Several mechanisms will drive theproduction decline.

Oil

expected

Figure 2.—Oil and Gas Drilling Trends

1970 1972 1974 1976 1978 1980 1982 1984 1986

Year

SOURCE Off Ice of Technology Assessment 1987: based on AmericanPetroleum Institute data

First, production from stripper wells2 and othermarginal wells (wells with high per barrel produc-tion costs) will drop because many of these wellscannot be operated profitably at low oil pricesand will be shut down. These wells cannot re-main out of production for long periods; after ayear (or other period depending on State rules)they have to be “plugged” (sealed with concrete)for safety and environmental reasons, and areunlikely to be reopened thereafter. Other shutdown wells may be lost because of water en-croachment.

Second, fewer new development wells will bedrilled, yielding less new production to offset thenatural decline in production from older wells,

Third, fewer exploratory wells will be drilled,yielding fewer new fields and thus fewer new op-portunities for development drilling,

Fourth, production from enhanced oil recov-ery (EOR) operations, which seek to capture asmuch as possible of the estimated two-thirds oforiginal oil-in-place left behind by conventionaldrilling and waterflooding, will decline becausemost new projects, and many planned project ex-pansions, will be cancel led as no longer eco-nomical.

Fifth, research and development (R&D) will de-cline, exacerbating the overall problem becauseR&D traditionally has been an important driverin pushing the industry into new areas andsources of oil production as older sourcesdecline.

In addition, many analysts warn that the indus-try is losing its ability to recover swiftly in theevent of a return to high prices; the infrastruc-ture necessary for such a recovery is rapidly beingdismantled as drilling rigs are scrapped, cannibal-ized for parts, or even sold abroad; manufactur-ing facilities are retooled; and skilled personnelare laid off, many Ieaving the industry for good.

Although the reasons given for their predictionsmay differ, the analysts have tended to focus theirarguments on three areas in particuIar:

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Table 1 .—Recent Projections of Future U.S. Oil Production

Projected crude oi l product ion(million barrels per day)

Source 1990 1995 2000 Price expectation (dollars/bbl, 1986 dollars)At low prices:DRI . . . . . . . . . . . . . . . . . . 7.8 6.3 5.5 $20 by 1995, $30 by 2000Chevron . . . . . . . . . . . . . . 5.9-6.9 NA NA $10 to $15 thru 1987, $18 to $22 by 2000API . . . . . . . . . . . . . . . . . . 6.2 NA NA Constant $15CWW ... . . . . . ., . . . . . 6.1 NA NA $15Unocal . . . . . . . 6-6.5 NA NA $13.50Amoco . . . . . . . . . . . . . . . 6.7 NA 4.5 “Low price”Fisher . . . . . . . . . . . . . . . . 6.8 NA NA $15Conoco A . . . . . . . . . . . . 7.0 5.5 3.5 <$12 thru 1995, $20 in 2000Conoco B . . . . 7.8 6.9 6.1 <$20 thru early 1990s, $20 in 1995, $26 in 2000GRI D . . . . . . . , . . . . . , . , . . 7 .3 5.4 5.0 $12 in 1986, $14 in 1990, $21 in 2000NPC . . . . . . . . . . . . . . . . . 7.1 5.7 4.5 $12 in 1986, $14 in 1990, $21 in 2000DOE . . . . . . . . . . . . . . . . . 6.9 5.2 NA $14 to $16 thru 1990, $21 in 1995Price outlooks of 1985:Chase . . . . . . . . . . . . . . . . 8.3 7.0 5.7 Drops to low $20’s by 1990, rises 0.9 ‘\. /year thereafterDRI B . . . . . . . . . . . . . . . . . 8.6 NA 6.8 Drops to $21 by 1987, constant to 1994, $32 by 2000EIA . . . . . . . . . . . . . . . . . . 8.1 6.5 NA Dips but is $28 by 1990, $31 by 1995GRI . . . . . . . . . . . . . . . . . . 8.5 8.2 7.8 Dips but is $34 by 1995, >$40 by 2000+xcludeS Natural Gas Llqulds 1985 Product Ion, 9mmbdNA = Not available

SOURCES: DRI Data Resources, Inc , Energy Rewew, Summer 1986.Chevron Economics Department, Chevron Corporation, World Energy Outlook, June 1986API American Petroleum Institute, Two Energy Futures: FJational Choices Today for the 1990s, July 1986 (1990 production actually for 1991)CWW Jack L Copeland, Copeland, Wickersham, Wiley & Co , Inc , Presentation to the Keystone Energy Futures Project: Liquid Fuels POIICY, July 14, 1986.Unocal Fred L Hartley, Unocal Corp j “The High Cost of Low-Priced Oil,” submitted to the US Senate Energy and Natural Resources Committee, March 20, 1986Amoco Economics Department, Amoco Corp., World Energy Outlook, April 30, 1986Fisher Wlillam Fisher, Bureau of Econom!c Geology, Unlverslty of Texas at Austin, Testimony to the Fossil and Synthetic Fuels Subcommittee, Energy andCommerce Committee, March 6.1986Conoco A and Conoco B Coordinating and Planning Department, Conoco, Inc , World Energy Outlook Through 2000, September 1986GRI Gas Research Institute, submission to the National Petroleum Council’s Survey of US. Future Oil and Gas Outlooks.NPC National Petroleum Council, Factors Affecting U.S. 0(/ and Gas Outlook, February 1987.DOE U S Department of Energy Energy Security” A Report to the President of the Un/ted States, DOEL3-0057, March 1987.Chase Chase-Manhattan Bank, Global Petroleum Division, World 01/ and Gas 1985, August, 1985.DRI Data Resources Inc Energy F?ewew Winter 1985.EIA Energy Information Adm!nlstratlon, Annual Energy Outlook 1985, DOE/EIA-0383(85), February 1986GRI Gas Research Institute, Basellne Project/on Data Book 1985 GRI 13asellne Projection of US. Energy Supply and Demand to 2010

Argument One: The established models of U.S.drilling activity and oil production virtuallyunanimously predict low rates of drilling andrapid declines in reserve additions and pro-duction if low prices continue. Current indus-try surveys of expected future drilling levels,reserve additions, and production basicallysupport these predictions.

Available models of U.S. oil supply generallyrely on extrapolation from past trends to projectfuture levels of drilling activity, reserve replace-ment, and production. Under stable conditions,these models can be reliable predictive tools.They are not likely to be as reliable, however,when forced outside the range where past trendsprovide a good analog.

It is virtually certain that the extrapolativemodels of oil production are directionally correctin their prediction of a U.S. oil production de-

cline. Under current conditions, however, pol-icymakers shouId be skeptical of the accuracy ofthese models. The events of the past year, andof the 1980s in general, in several ways are ma-jor departures from past events. The nation hasjust undergone a period during which oil prices,a key determinant of industry exploration and de-velopment activity, have undergone severe dis-location, and in a direction opposite past dis-locations. Moreover, during the 1980s, severalcompanies comprising a large segment of the in-dustry’s reserve replacement capability under-went significant changes in business strategies,were restructured, or merged with other compa-nies. In addition, the period of the early 1970sto the present has been a period of hyperinfla-tion followed by collapse in industry costs; thefuture path of such costs–a key determinant ofthe economic attractiveness of new E&D invest-ment—is unlikely to be stable or predictable.

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While the results of industry surveys of futuredrilling rates, reserve additions, and productionare very important, policy makers are likely to de-mand substantial analytical evidence to back upthe survey results. For one thing, in recent yearsthe industry (along with just about everybodyelse) has not been very successful in predictingwhich way prices and production would turn,and different segments of the industry and differ-ent companies often have been at odds aboutmajor resource and production projections. Sec-ond, the industry participants in these surveyshave been the direct recipients of significant fi-nancial blows and have seen their friends and col-leagues laid off, retired, or even bankrupted. Itseems fair to have concerns about whether theirexpressed views of the future of the U.S. oil in-dustry reflect a cool-headed appraisal or insteadreflect their depression about the immediate re-sults of the industry downturn. Third, the indus-try has a very large financial stake in any policymeasures that could alleviate a production de-cline. Whether or not this stake affects their an-nounced projections of future production, somepolicy makers and segments of the public believethat it may. These concerns suggest that an ana-lytical verification of industry estimates, capableof being reviewed by independent analysts,would be desirable and probably necessary forpublic acceptance.

Argument Two: The large drop in oil prices hasdrastically cut oil industry revenues and placedmany of the industry’s past investments injeopardy. After paying off its obligations, theindustry’s remaining internal cash flow issharply reduced from earlier levels. At thesame time, the industry’s traditional sourcesof outside investment and loan capital, facedwith low prices and uncertainty, have backedaway from the oil market. These capitalsources are particularly important to the in-dependent sector of the industry. Withoutnew sources of investment capital and with-out a restoration of cash flow from prior in-vestments, the industry will not have enoughcapital to invest in the major new explorationand development ventures needed to arrestthe rapid decline in production.

This argument is most important for projectingoilfield activity levels in the short term, perhapsover a 2- or 3-year period. Many of the financialentities generally responsible for U.S. drilling andother production activities have been hurt badlyfrom the large cut in revenues from their past in-vestments; uncertainty about their survival—espe-cially for many of the small independents—willkeep away outside capital, and they have mini-mal internal resources. Similarly, many banks andother sources of investment capital experiencedsevere losses and may be reluctant to reenter theoil market. In the short term, new investment willsuffer because it will take time for the industryto resolve mismatches between financial re-sources, drilling capability, and land positions andreserve ownership. After an industry shakeout,however, drilling and other activity, and reservereplacement, could revive if adequate incentives,measured by the expected profitability of newE&D investment relative to competing invest-ments, were available. Also, a number of com-panies, especially those larger integrated compa-nies and independents that had avoided largedebt loads, still have substantial internal resourcesand/or access to external capital sources. Theargument that inadequate capital resources willprevent the industry from investing in new pro-duction, which attempts to tie the level of newinvestments to the success of old ones, may ex-plain short term investment behavior of the oilindustry (or, at least, some segments of it) butdoes not adequately explain the industry’s long-term investment behavior.

Argument Three: The large drop in oil pricescoupled with fears about future price col-lapses have undermined the expected profit-ability of new investments in exploration anddevelopment. With current price expectationsand conservative investment requirements (toaccount for higher uncertainty), there are toofew economically attractive drilling opportu-nities to spur continuation of the industry’spast level of domestic exploration and devel-opment activity.

This argument ties the level of future invest-ments in reserve replacement and productiondirectly to the economic attractiveness of theseinvestments. In OTA’s view, the attractiveness,

or expected profitability, of future drilling andother production-oriented ventures is the key in-dicator of long-term prospects for adequate U.S.reserve replacement and production.

Current industry analyses supporting conclu-sions about declining U.S. oil production pros-pects generally stress arguments one and two andpay somewhat less attention to argument three.Models and surveys, the bases of argument one,have been widely used. The second argumentabout inadequate capital and reduced cash flowsis analytically very straightforward and has beenadvanced with intensity, especially by spokesper-sons for the independent sector of the industry.In contrast, few in the industry have supportedthe third, “expected profitability” argument withthe careful analysis necessary to establish its credi-bility.3 The substantiation of industry projectionsof declining production that would be providedby a careful analysis of expected profitability mustbe viewed as very important in light of the highsocial costs—many billions of dollars—associatedwith many of the policy measures being consid-ered to arrest the projected decline.

Evaluating the attractiveness of new E&D invest-ment opportunities relative to competing invest-ments is a complex undertaking. It would requirea substantial commitment of resources and in-formation from the industry, and much informa-tion that would be useful in such an evaluationis proprietary. Although many and perhaps mostof the larger oiI companies have undertaken ex-tensive analyses of their own investment pros-pects, these analyses are not likely to be madeavailable to the public. Furthermore, a crediblenational analysis will still have to rely on someform of detailed assumption about that portionof the total remaining oil resource base that isphysically available to the industry for exploita-tion within the time frame of interest. No widelyaccepted resource model currently exists, al-though there are a few computer models of oilsupply (e.g., the Gas Research Institute’s Hydro-carbon Model) that constitute some first attemptsat such a model.

3We do not doubt that many of the i ndustry’s survey responsesabout future 011 production levels are based on companies’ privateevaluations of expected profitability of new E&D investments.

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An Approach to UnderstandingOil Production

Given the concerns about the reliability of cur-rent oil supply models under today’s radicallychanged economic conditions, an appropriatemeans to gauge future oil production is to gainan understanding of both the changes the oil in-dustry has undergone and the forces that willdrive future production. The following discussionexamines:

Economic and resource factors affecting pro-duction:—changes in the economics of dri l l ing

prospects over time;—changes in capital availability and how

these changes affect E&D investmentlevels;

–loss of oil production from stripper wells;—the nature of the oil resource base, and in

particular, the availability of drilling oppor-tunities that might remain profitable in alow price environment; and

—the effects on drilling of the current sur-plus in natural gas supply.

Changes in the oil industry affecting pro-duction:—the potential effects of industry restructur-

ing on industry investment strategy and ca-pabilities,

—the changing business climate for E&D in-vestment overseas and its effect on domes-tic versus overseas spending,

—changes in the efficiency of explorationand development activity and their effectson rates of reserve additions and pro-duction,

—the potential for technological change tooffset some of the drop in profitabilitycaused by low oil prices, and

—the effects of a deteriorating industry in-frastructure on industry’s ability to re-bound to higher drilling levels.

The goal of examining these factors is to deter-mine whether the preponderance of evidencetends to support or undermine the industry’s pes-simistic predictions for future oil production, and

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to better understand how Congress might bestintervene to shore up production if it chose todo SO.

Economic and Resource FactorsAffecting Production

Changes in the Economics ofDrilling Prospects

OTA’s interviews with oil industry plannerspaint a pessimistic picture of remaining domes-tic exploration and development prospects at lowprices. Essentially all of those interviewed con-tend that the “inventory” of economic oil andgas prospects has shrunk enormously at mid-1986 prices of$12 to $15/bbl despite the accom-panying sharp declines in drilling and othercosts. They assert that the only arena capable ofsupporting substantial drilling levels at theseprices is relatively low-risk, low-to-moderate costdevelopment drilling, primarily for oil objectives,with short lead times; they also assert that explo-ration drilling is virtually dead at these prices.

In addition to low risk shallow extension andinfield drilling,4 other prospects still consideredto be viable at oil pricesof$12 to $15/bbl include:

●

●

●

continuation of projects where most front-end capital has been spent (enhanced oil re-covery, offshore development drilling, water-floods5);drilling to satisfy lease and contract require-ments; andsome exploration drilling where productioncould not begin for 7 to 8 years or longer,so the current price environment is not rele-vant (although several major companieshave backed away from this type of drilling).

Most of those interviewed were pessimisticthat an increase to $18 to $20/bbl would spark

4Extension drllllng seeks oil and gas just outside the known bound-aries of discovered fields; infield drilling seeks oil and gas insideof these boundaries by drilling in previously undrilled sections e:drilling at smaller spacing than previous drilling.

Swaterflooding is an oil recovery technique whereby water is in-jected into the reservoir to maintain or restore reservoir pressureand push additional oil towards the producing wells.

a major drilling revival, although all felt that cer-tain additional prospects would become eco-nomic, including:

●

●

●

●

●

●

some deepwater Gulf of Mexico exploratoryprospects;some onshore wildcat prospects;additional enhanced oil recovery, especiallyC02 gas injection projects with readily avail-able sources of CO2, and some projects usingthe injection of polymers;Beaufort Sea exploration and delineationdrill ing;limited offshore California development; andmany waterflood projects.

There are only scattered published economicanalyses that can offer confirmation of these as-sertions. In an attempt to test at least a few of theassertions, OTA examined how the expectedprofitability of small-scale exploration and de-velopment drilling programs i n the United Stateshas changed over time. OTA compared 1986profit expectations with expectations for the samephysical prospects in: 1985, immediately beforethe major price drop; 1981, at the height of thedrilling boom; and 1972–before the first OPECprice shock. Although only a few physical pros-pects were examined, we believe that the resultsare fairly widely applicable to drilling projects ofmodest scale.

In our analysis, we found that the profit expec-tations for the 1986 drilling projects, assumingoil prices would remain in the $14/bbl rangeduring the 1980s, were substantially lower thanexpectations in 1981 and 1985 in every case; forexample, onshore development well drilling proj-ects with expected real rates of return (beforetaxes) of 15 percent in 1986 would have beenexpected to earn 35 to 52 percent in 1985 and23 to 43 percent in 1981. Although drilling costsdropped substantially from 1981 to 1985 and, toa lesser extent, from 1985 to 1986, the oil pricedrop has proved to be the more important fac-tor influencing profitability. This result agreesstrongly with the assertions of the industry that

6Expectecf profitability is calcu Iated by using oil price forecaststypical of the analysis year. Realized or actua/ profitability is calcu-lated by using actual price levels up to the present, and forecastedor assumed price levels thereafter.

11

the price drop has substantially reduced thenumber of profitable domestic E&D opportu-nities.

We also found, in every case, that 1986 ex-pected profitability (based on the assumed $14/bbl future oil price) was much better than ex-pectations in 1972, primariIy because 1972 oilprice expectations were modest. Thus, for thecases examined, today’s economic conditionsfor drilling development wells and explorationwells aimed at small fields would appear to besubstantially superior to conditions in 1972, forwells of the same physical promise. At firstglance, this appears to indicate that the industryhas better economic opportunities today than in1972. Because so many of the better prospectswere drilled in the years between 1972 and 1986,however, today’s remaining physical prospectsmay be considerably poorer than those availablein 1972. On the other hand, this effect of “re-source depletion” is tempered by the additionof new prospects to the resource “inventory” be-cause of improvements in exploration technol-ogies and in geologic understanding. The net ef-fect of these factors is unclear without furtheranalysis, although an industry consensus wouldlikely be that today’s physical drilling prospectsare substantially inferior to those available in1972.

Figure 3 illustrates the change over time in ex-pected profitability for a single exploration pros-pect in the Permian Basin, Texas.

Another important result of OTA’s analysis wasthat the actual profit performance of the drillingprojects was considerably different than the ex-pected performance. For the wells drilled in1972, actual profits were much higher than ini-tially expected; for the 1981 and 1985 wells, ac-tual profits were much lower than expected.7

In fact, there is little difference in realized ratesof return between the 1986 wells and the 1981and 1985 wells. The higher drilling costs incurredin 1981 and, to a lesser extent, in 1985 offset thehigher average oil revenues obtained with thesewells.

7Assumln~ continued $14/bbl oil prices beyond 1986

Figure 3.—How Profit Expectations for the SameProspect Would Have Changed Over Time: An Oil

Exploration Prospect in Texas’ Permian Basin

75

50

25

019

$20 oil

$14 oilprice

1986

Year

The expected drilling program:. 20 wells drilled● 10 producing wells at 8900 ft.● Initial year production = 222,000 bbl.● 10 percent depletion rate

SOURCE:Off Ice of Technology Assessment. 1987, based on CongressionalResearch Service analysis for this study

OTA also examined the effects of assumed $10/bbl and $20/bbl oil prices on 1986 expected prof-itability. At $20/bbl, if drilling costs do not rise,expected profitability for the projects evaluatedwill be in the same range as 1981 and 1985 profitexpectations, implying that a drilling revivalcould occur at this price level. However, thestrength of any revival would be limited by in-creases in drilling costs that would occur as thecurrent “surplus” of drilling services is used up.Also, for a revival to occur, producers must bereasonably assured of continued price stability.Today, many producers say that they are requir-ing proposed drilling projects to pass a ‘‘low-pricehurdle,” that is, they must retain profitability atprices that could occur if surplus productiondrove prices back down again. A hurdleof$10/bbl is frequently mentioned. At $l0/bbI, drillingprospects that would yield 15 percent real ratesof return at $14/bbl become either outrightlosses or yield barely a few percent. Thus, con-servative price/cost accounting in approvingproposed drilling projects may be playing an im-portant role in stifling drilling activity.

Our analyses apply only to oil exploration anddevelopment aimed at small fields and modest-

72

sized development wells, and only to physicalexamples that do not stray far from average con-ditions. In our view, the great importance to na-tional policy makers of having an accurate esti-mate of domestic E&D economics demands awealth of additional analysis. This analysis mustexamine the full range of E&D activity, from thevarious forms of enhanced oil recovery to ex-ploratory drilling in the Arctic and deep offshore,to extension well and infill drilling in older fields,and so forth. Considerable analysis is alreadyavailable, for example the National PetroleumCouncil’s report on enhanced oil recovery, butthe separate analyses must be collected, inten-sively reviewed for accuracy, and reworked tofit into a consistent economic framework. Sub-stantial new analyses will be needed to fill in thegaps.

Problems of Capital Availability

As noted previously, the large reductions incash flow to the oil industry and, to a lesser ex-tent, the withdrawal of outside loan and invest-ment capital are widely viewed as critical factorsin driving down levels of investment in oil explo-ration and development. Total oil and gas well-head revenues were about $70 billion in 1986,about 43 percent below 1985 levels. Althoughreliable data for private financing, a major sourceof funds for independent producers, are not avail-able, many industry analysts are convinced thatavailability of private funds has declined substan-tially because of current conditions in the indus-try. Furthermore, many of the regional bankswhich had financed the efforts of many smalloperators during the late 1970s and early 1980swere placed under severe pressure by the bank-ruptcies of many of their oil service industry bor-rowers and the reduced values of the oil and gasreserves used as collateral for their loans to in-dependent producers. Poor performance in theagriculture and real estate sectors also played amajor detrimental role in the banks’ loan port-folios. Many of these banks have pulled backfrom the oil and gas loan market.

Although capital availability problems are wide-spread, they are not uniform in their intensityacross the industry. The small independent pro-ducers have the worst capital problems, with no

alternative sources of cash flow and profits andgreatly reduced access to the external capitalsources they had relied on; the larger integratedcompanies have been buffered somewhat againstthe effects of reduced production revenues byincreased profits from their downstream (e.g.,refining) operations. Those larger integrated com-panies and independents that previously hadavoided large debt loads generally cannot (anddo not) claim that their E&D spending is capitallimited; they retain substantial internal resourcesand/or access to outside capital. Although mostof these companies have reduced their E&Dbudgets and activity levels, they presumably havedone so because of changed investment pri-orities.

Although the importance of the drop in cashflow and withdrawal of outside capital to theshort-term investment behavior of the industryis not in question, this is not the case with theimportance of these factors to the industry’s long-term behavior. There is disagreement amonganalysts of the industry as to whether the cashflow from previous investments or the profitprospects for new investments will control theindustry’s future level of investment. I n the past,industry investment levels appeared to be closelytied to levels of cash flow. However, classical eco-nomic theory predicts that the volume of new in-vestment should be more closely tied to the char-acteristics of the new investments. Past industryfinancial losses and recently reported shifts in theindustry’s attitude about replacing company re-serves—discussed in the section on industry re-structuring—reinforce the view that the industryis likely to base its future decisions about the mag-nitude of E&D investment primarily on a carefulevaluation of prospective profits.

Over a period of a few years, companies in aweakened financial condition may go out of busi-ness; undeveloped and partially developed prop-erties and equipment will be sold at low prices;companies will merge and be restructured; prob-lem loans will be renegotiated or written off; andnew financial entities will enter the industry ifgood investment opportunities are available. Inthis manner, the industry would be in positionto attract new E&D investment capital if costs are

13

low enough and E&D efficiency high enough tocreate attractive E&D investment opportunities.

Losses in Oil Production From“Stripper” Wells

There is widespread concern that low oil priceswill force many of the nation’s “stripper” oilwells, wells whose production averages 10 bar-rels of oil per day or less (averaged over the lease),to shut down. Once these wells shut down fora year (or other period determined by State rules),they must be “plugged,” i.e. sealed with con-crete; most wiII never be returned to production,and their reserves wiII be lost. This concern ismagnified by the importance of stripper wells toU.S. supply. Over 400,000 stripper wells pro-duced approximately 1.3 mmbd, 14 percent oftotal domestic oil production, in 1985. Thesewells are concentrated in Texas, Oklahoma, Cali-fornia, and Kansas, which together have three-fourths of the Nation’s stripper production.

The probable loss of stripper production atdifferent price levels is highly uncertain becauseof a scarcity of data about stripper well physi-cal characteristics and production costs. Further-more, the data that are available reflect historicbusiness practices and costs. Both stripper welloperators and the businesses that serve themhave been forced to make adjustments in re-sponse to the sharp drop in oil prices. Analysesof stripper well production must account for re-cent declines in the cost of utilities, materials, andservices to operators as welI as changes in oper-ating practices, such as deferring maintenance,that affect both costs and production levels.

Two quantitative studies of lost stripper wellproduction have been conducted. A study spon-sored by the Interstate Oil Compact Commission(IOCC) estimates that, during the first year,176,000 bbl/day of stripper production, 2 percentof total U.S. crude oil production,8 would be lostat $18/bbl oil prices, and 277,000 bbl/day or 3.1percent of U.S. production would be lost at $15/bbl. The Energy Information Administration (EIA)estimates a first-year loss of 85,000 bbl/day, 1 per-

8Based on average 1985 production of 8,9 mmbd.

cent of U.S. production, at $18/bbl oil prices, withan additional 4,300 bbl/day loss in later years asmajor repairs for the still-operating wells becomenecessary; at $15/bbl, first year losses are esti-mated at 148,000 bbl/day, with later year lossesof 77,500 bbl/day for a total loss of 226,000bbl/day or 2.5 percent of U.S. production. ElA’sestimated first year losses are about half of theIOCC’s estimates.

More recently, an IOCC survey of California,Kansas, New Mexico, North Dakota, Oklahoma,Texas, and Wyoming indicates that 110,000 wellsin these States, with 307,000 bbl/day of oil pro-duction, were shut in during 1986, with 12 per-cent of the wells permanently abandoned. Thesevalues do not break out the production lost solelybecause of low oil prices (each year, thousandsof wells are abandoned even at high oil prices),and thus they are not strictly comparable to theprojections above. However, most of the produc-tion loss is likely to be attributable to the pricedrop, and the survey appears to add credibilityto the (higher) IOCC projections.

The Nature of the Resource Base

The nature of the remaining U.S. oil resourcebase will play a vital role in the response of U.S.domestic oil supply to changing oil prices. Thereis, however, substantial disagreement in the oilindustry about the physical nature of the re-maining resources, about where future U.S. re-serves will come from, and at what price.

A central issue in this resource base disagree-ment is the question of whether the major sourceof new reserves will be the discovery of large newoilfields, particularly in the frontier areas anddeep offshore, or whether it will instead be theaggregation of many thousands of modest incre-ments of reserves gained by drilling new wellsin old fields, improving recovery through en-hanced oil recovery techniques, and exploringfor small fields in familiar producing territories.These different views of the remaining resourcesin the United States lead to different preferencesfor policy initiatives (e.g., different degrees of im-portance attached to expanded leasing of newfrontier areas) and to different views of the oilprices necessary for a revival of higher levels ofreserve replenishment. Frontier and deep off-

14

shore oil resources may, in many cases, requireprices in excess of $30/bbl for economic devel-opment, whereas a considerable portion of theresources available from the smaller scale effortsare viewed as available at prices between $15 and$25/bbl.

The recent history of oil reserve additions gen-erally supports the view that the aggregation ofmany small reserve additions, especially from thegrowth of discovered fields through extensionwell drilling and other mechanisms, plays theweightier role in overall U.S. reserve growth. Forexample, about 70 percent of total U.S. reserveadditions during 1979 to 1984 came from drillingin oilfields discovered before this period, and thepercentage of total reserves coming from thissource has increased from earlier decades. How-ever, those who view the frontier areas as the crit-ical source of new reserves believe that the in-tensive drilling of the last decade and a half hasalready squeezed most of the reserve growthavailable from our older fields, and that any re-maining growth requires much higher prices thanbefore because the easy reserve targets were ex-ploited first. Unfortunately for the advocates ofsearching for giant fields, however, the record ofthe past decade of oil exploration has not beenvery promising, with successes in offshore Cali-fornia and the Gulf of Mexico perhaps more thanbalanced by grave disappointments in the Gulfof Alaska, Georges Bank, St. Georges Basin, andelsewhere. Clear signs of this disappointment arethe very large reductions in recent industry andgovernment estimates of frontier resources,

Resolving the potential roles that continuedfield growth and giant new fields may play in thefuture development of the United States’ oil re-sources may not be possible at this time. What-ever the “correct” view of the resource baseturns out to be, however, both the search forgiant fields as well as the intensive pursuit ofsmall-scale reserve additions must be pursuedif the slide in U.S. production is to stand anychance of being halted.

The Effects of the Natural Gas Surplus

The state of markets for natural gas is impor-tant to oil production. Much exploratory drillingsearches for hydrocarbons, not specifically for oil

or gas. Added incentives for finding gas wiII stim-ulate this type of “nondirectional” drilling andlead to more oil resources being found and devel-oped—and inadequate incentives will do the op-posite. Also, because gas is present in nearly alloil wells, the profitability of these wells dependson having a market for the gas at a reasonableprice.

Since the early 1980s, a surge in deliverabilityand declining demand in the electric utility andheavy industry sectors have created a surplus ofnatural gas deliverability. Low oil prices haveadded to the gas surplus by promoting gas-to-oilfuel switching. The gas surplus has, in turn, keptgas prices low and kept some producers fromhaving an assured market for their production.Although the reduced incentive for gas drillinghas tended to help keep drilling costs low, thenet effect on oiI driIling is almost certainIy nega-tive. A tightening of gas markets in the next fewyears, as predicted by many experts, would havea positive effect on drilling in general and wouldlikely lead to increased oil well completions andproduction capacity. However, uncertaintiesabout the volume of additional gas imports thatcould be made available from Canada, the ac-tual level of excess deliverability, the volume ofgas that could be quickly added to the deliver-able base, and future changes in demand for gashave lead to a substantial divergence of opin-ion about the timing of any end to the currentnatural gas surplus.

Changes in the Oil IndustryAffecting Production

The Effects of Industry Restructuring

During the 1980s, the oil industry underwentimportant changes that seem likely to affect theindustry’s exploration and development strate-gies and financial capabilities. These changeshave included a series of mergers, both volun-tary and “hostile,” as well as internal restructur-ing measures such as asset redeployment, stock-enhancement through stock buy backs, spinoff ofnew companies, asset sales, elimination and con-solidation of functions, and other measures.While many of these changes are widely viewedas destructive of the industry’s willingness and

capability to replace its reserves, some of thesame changes are defended either as strength-ening industry’s reserve replacement capabilitiesor simply as being necessary to allow the partici-pating companies to survive.

During earlier debate over the effects ofmergers and acquisitions in the oil industry, manyof the representatives of acquiring companies,their investment bankers, and their defendersstrongly denied that exploration efforts would bereduced. Despite these assurances, mergers andacquisitions have been widely viewed as destruc-tive of the industry’s reserve replacement capa-bility. Between 1979 and 1985, over $75 billionwas spent on oil industry acquisitions in excessof $1 billion each, adding substantially to longterm debt and presumably lowering the capitalavailable for E&D spending. According to OTA’sreview of a group of companies, merged com-panies have spent substantially more of theiravailable cash flow on debt repayment and lesson oil and gas exploration than other companies.The merged companies typically cut combinedcapital spending significantly in 1984 to 1985,while other large companies in the group weremore often maintaining or increasing their invest-ments. In addition, a number of companies haveadded substantial debt in the process of fightingoff attempted hostile mergers, or simply in pre-paring defenses against potential takeovers. De-spite potential long-term benefits of mergerssuch as improved management and improve-ments in the “fit” of assets and financial andmanagement capabilities, the available evidencestrongly suggests that the short-term effect ofmergers and attempted mergers on the oil in-dustry’s investment in exploration and develop-ment has been negative on balance. Initial suc-cesses of some merged companies at reducingdebt loads may, however, signal that this bal-ance could change.

A significant apparent change in industry be-havior, more a cause of the restructuring than asymptom of it, is a shift in emphasis among manyintegrated companies away from maintaining asecure domestic source of reserves to supplytheir refining and marketing operations, andaway from the former high priority they gaveto recycling much of their production revenues

back into exploration and development. Com-panies are now said to be evaluating E&D invest-ment as a separate profit center, requiring eachinvestment to meet stringent financial criteria.These behavioral shifts are said to be the resultof both the financial losses incurred by many ofthese companies in their past E&D investments,and the easy availability of crude oil associatedwith the expanded role of the spot market. If thiswidely perceived behavioral change is real andpermanent, a return to previous levels of profitpotential in production investments may notcause a return to previous levels of drilling andreserve replacement. This has negative implica-tions for the likelihood of a “rebound” in pro-duction following a price increase.

The Changing Business Climate Overseas

Industry experts consulted by OTA claim thatone cause of the current low level of domesticinvestment in E&D is that the U.S. oil industry hasdecided to shift its domestic/overseas balance ofE&D investments in favor of overseas investment.

In earlier years, many U.S. companies focusedon domestic E&D despite the relative “maturity”of the United States’ oil resources and the bettergeologic prospects overseas. They did this partlybecause of the greater stability and security avail-able within the United States, but also becausemany oil-bearing countries offered relativelydemanding terms for development of their oil re-sources.

Although problems of stability and security re-main, many countries have eased their terms foroil development. They have removed formercaps on the prices paid to foreign developers,eased currency restrictions, lowered taxes androyalty rates, and otherwise improved the po-tential profitability of private oil and gas devel-opment. At the same time, industry spokesmenhave claimed the United States has enacted taxand regulatory changes that worsen the businessclimate for domestic oil and gas investment.

Evaluating the relative business climate for pe-troleum investments of the United States versuscompeting foreign nations is complicated, andOTA is not aware of a comprehensive attemptat such an evaluation. Nevertheless, the attempts

16

by many nations to ease investment restrictionsand improve potential profitability in develop-ing their oil resources clearly have increased theattractiveness of overseas investment vis-a-visUnited States investment. In evaluating the ef-fects of this increase, however, policy makersshould keep in mind that most analysts believethat any increased oil supply outside of the Mid-dle East will tend to enhance market competi-tiveness and stability whether it occurs insideor outside of the United States—and that, dol-lar for dollar, overseas exploration investmentswill tend to purchase considerably more oil re-serves than will U.S. investments.

Changes in the Efficiency of Explorationand Development Activity

An accurate projection of the reserves foundand production capability created by the shar-ply reduced levels of drilling and other oilfieldactivity caused by low oil prices requires an ac-curate estimate of the “efficiency” of this activ-ity, as measured by the footage and wells drilledper rig, the reserves found per well, the wildcat

Isuccess rate, and so forth. These measures haveproved to be sensitive to oil prices and oilfieldactivity levels. For example, rig efficiency (foot-

I age and wells drilled per rig per year), reserves

1 added per well or per foot drilled, and manyother measures of efficiency declined from themiddle 1970s to the early 1980s as oil prices roseand oilfield activity accelerated. Part of this de-cline was due to the use of inexperienced per-sonnel and marginal equipment, made possibleby the inability of the supply of services to keepup with the demand. Another element of declinewas the spread of drilling activity to more mar-ginal prospects with lower reserves and some-times under more difficult physical conditions.This was partly a result of the improved eco-nomics of these prospects and partly an effect ofresource depletion as the best prospects wereused up.

The decline in oil prices that began in 1981forced the industry to become more efficient. Forexample, drilling became more efficient as thenumber of inexperienced drilling crews declined,inefficient rigs were dropped from service, foot-age and turnkey contracts replaced contracts that

paid drillers by the day (day rate contracts offeredlittle incentive for efficiency), and drilling tech-nology improved. These factors were importantcauses of the sharp increase in rig efficiencymeasured between 1981 and 1985. The indus-try drilled 89,000 wells in 1981 with nearly 4,000rotary rigs active; 84,000 wells in 1982 with 3,100rigs active; and 85,000 in 1984 with 2,400 rigs.

Unfortunately, however, the precise dimen-sions of the actual increase in efficiency are ob-scured by other factors that also affect measuredrig efficiency. These factors include:

●

●

●

the proportion of total drilling devoted to ex-ploration, because exploratory drilling ismore time-consuming than developmentdrill ing;possible changes in the number of rigs thatare not included in the datag9; andshifts in the geographic distribution of drill-ing, because drilling in some areas, such asthe Gulf Coast, is more rapid than in others,e.g., the Midcontinent and Rocky MountainOverthrust Belt, because of different rockconditions and other physical factors.

Similarly, as the industry cuts budgets anddrilling rates and retreats from marginal areaswith high costs and low payoffs, measures suchas reserves added per well or per dollar investedshould improve. Consequently, reserve addi-tions should not drop quite as precipitously asdrilling or drilling budgets have. This effect willbe tempered, however, by a likely shift in drillingpatterns away from deep, high risk exploratorydrilling (see the earlier discussion on the Eco-nomics of Drilling Prospects), and also towardshallower and lower risk (but potentially loweryielding) targets. Also, drilling patterns are af-fected by company lease positions and contrac-tual obligations.

Figure 4 shows the regional variation in oil re-serves added per well, illustrating the potentialeffect of shifting the geographic distribution ofdrilling.

Shifts in drilling during the early part of 1986seemed to follow the expected pattern of retreat-ing from regions with low average returns. If only

‘Commonly used rig counts include only so-called rotary drilllngrigs, rigs that drill by rotating a drill bit and its attached drilling pipe.

Region

18

the regional shifts in drilling are considered, thereserves added per average U.S. well in 1986could be 37 percent higher than the 1981 to 1984United States average.10

Although this estimate could be interpreted asoptimistic for U.S. oil supply, in fact it is sober-ing. Even if these reserve/well values are correct—and they are almost certainly too high—theystill imply a substantial drop in U.S. oil produc-tion if recent drilling levels continue. For exam-ple, estimating Alaskan and stripper well produc-tion separately, if mid-1986 drilling levelscontinue for the next decade and a half andachieve the regionally adjusted (and optimistic)values of reserves added per well, year 2000United States production will still be 29 percentbelow 1985 levels, or about 6.4 mmbd. Thus,the United States cannot hope to slow the cur-rent decline in domestic oil production unlessit increases substantially its level of drillingactivity.

A reliable projection of future production ratesrequires an accurate estimate of how the indus-try will adapt its investment behavior to the newI

I price environment. Since this adaptation should, take a few years, current drilling patterns shouldI

not be viewed as permanent. At this time, a pro-jection of likely adaptive behavior, and its likely

Ieffect on reserves/well values and other measuresof E&D efficiency, will clearly be speculative.

Insight on the potential for adapting to lowprices might be gained by analyzing the differ-ences among individual oil companies’ histori-cal investment patterns, management styles, andinvestment outcomes. Some companies, such asShell Oil, have had consistently low finding costsover the past decade or more. If the more suc-cessful companies have simply occupied low cost“niches” in domestic E&D, their success may notoffer much room for hope that the rest of the in-dustry could, with appropriate changes in invest-ment behavior, successfully match their cost per-formance. On the other hand, if their success isowed primarily to behavior that could be copiedby the rest of the industry, the long-range out-look for production might look considerablybetter.

101986 drilling based on July 1986 projections.

The Effects of Technological Change

The continuing evolution of oilfield technology,particularly as it may facilitate the exploitation ofexisting resources at lower cost, clearly is an im-portant factor in the ability of the industry to keepreserve replacement and production close tohistoric levels in the face of low oil prices. In gen-eral, however, the majority of the operators andanalysts we talked with were skeptical of the po-tential for both new technology and improve-ments in existing technology to allow access tosignificant volumes of oil that currently are un-economical at prices below $20/bbl. In supportof this view, statistics of important measures ofexploration and development efficiency-such asreserves added per well drilled and explorationsuccess rates—have either held steady or deteri-orated over the past decade despite the introduc-tion of such technologies as three dimensionalseismic analysis, seismic interpretation with per-sonal computers, advanced reservoir modeling,and an array of others. If technology develop-ment has made a difference during the past dec-ade, especially in the onshore lower 48 States,it appears to have been primarily one of coun-terbalancing the negative effects of continuingresource depletion.

Nevertheless, there is a significant minority inthe industry who have a far more positive viewof the potential of improved oilfield technology.They can point to a number of new technologiesjust being deployed, or on the immediate hori-zon, that have promise for lowering industry costsenough to either allow development of additionalresources at current low prices, or at least to al-low added resource recovery at prices signifi-cantly lower than previously thought possible,often in the lower $20/bbl range. These technol-ogies include:

●

●

●

important improvements in the resolutioncapability and cost of seismic imagery;new developments in chemical enhanced re-covery that lower the price threshold from

$25 to $30/bbl to about $20/bbl; andimprovements in horizontal drilling that of-fer the potential of expanding a field’s recov-erable reserves by allowing operators to ex-ploit thinner pay zones.

19

Even if industry optimists are correct, the po-tential of new technology will not be realizedwithout a significant R&D effort on the part of theindustry. Although precise figures are not avail-able, industry observers agree that industry R&Dexpenditures are down by at least 30 or 40 per-cent over the past 3 years. Although some cut-backs clearly are appropriate (e.g., for effortsaimed at accessing very high-cost resources in dif-ficult environments that are not now technicallyrecoverable) the overall size of the cutbacks anda general shift away from long term research tar-gets are of substantial concern.

Effects of a DeterioratingIndustry Infrastructure

The large drop in industry activity levels accom-panying the price drop has meant a shrinking ofthe industry’s “in frastructure,” that is, the inven-tory of rigs and other equipment used in explo-ration and development activity, the manufactur-ing capacity to produce the equipment, and thepeople to man the equipment and plan and su-pervise its use. The industry has expressed theconcern that, in the event of an oil price rise orother incentive for a “rebound” in activity levels,the lack of infrastructure would mean severe de-lays, inefficiency, and cost inflation as too muchdemand for oilfield goods and services chases toolittle supply–a repeat of the hyperinflation inthese goods and services that marked the mid-dle to late 1970s and early 1980s.

Any rapid improvement in E&D investmentprospects, fueling increased demand for oilfieldgoods and services, will create delays and in-flationary pressure, but increasing effective oil-field activity should be less difficult and infla-tionary than it was in the 1970s. One reason forthis conclusion is that the level of activity of theearlier drilling “boom” was much higher thanwas justified by the results, primarily becausedrilling rigs were operated inefficiently, inade-quate equipment was used, and many wells weredrilled with minimal prospects for success. Thus,it is not necessary to return to 1981 levels of ac-tive rigs or employment to achieve 1981 levelsof reserve additions and added production ca-pacity. Another reason is that most oilfield equip-

ment is relatively sturdy and will not deteriorateexcessively if moderate precautions are taken i nstorage. Finally, in recent years there has beenan oversupply of trained workers and profession-als in the industry, and there is little reason tobelieve that most of these have been irrevoca-bly lost to other fields. A 2,500 rig fleet, operat-ing efficiently, probably can achieve the sameresults as a 4,000 rig fleet did in 1981. For nowand for at least another few years, there shouldbe adequate equipment and personnel to assem-ble and operate such a fleet relatively quickly—perhaps within 6 months to a year. However,this conclusion presupposes that a rebound inoilfield activity levels will be accompanied byinvestor and industry confidence that the re-bound will not be short-lived, so that contrac-tors will be willing to invest in refurbishing rigs,laid off workers will be willing to return, etc.This is not necessarily a foregone conclusiongiven the “lesson” administered by the recentprice drop. Also, the capability for a reboundwill decline over time.

Policy makers should recognize that OTA’sguarded optimism about the ability of industryinfrastructure to support a rebound in activity isnot shared either by the National PetroleumCouncil or the Department of Energy. Their re-spective reports, Factors Affecting U.S. Oil andGas Outlook and Energy Security, both identifythe destruction of the industry’s infrastructure asa key roadblock to a drilling recovery.

Resisting a Decline in U.S. OilProduction: Should Government

Play an Active Role?

For reasons encompassing both national secu-rity and U.S. economic competitiveness, manyenergy analysts and significant segments of theoil industry (especially the independent produc-ers) are arguing that the Federal Governmentshould intervene to halt or ameliorate the ex-pected decline in U.S. oil production.

The policy preferences of Federal policy makersare likely to depend on how they would answerthe following two questions:

1. Will declining domestic oil production seri-ously damage U.S. economic and nationalsecurity interests? and

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2. Can Federal intervention succeed at stabiliz-ing domestic crude oil production withoutincurring unacceptably high costs (in termsof direct consumer spending, Federal bud-get impacts, or market distortions)?

Properly addressing both of these questions re-quires a comprehensive examination of U.S. andworld energy supply and demand, not merely anexamination of domestic oil production. For ex-ample, the shift in oil trade away from long termcontracts to the spot market has served to makethe world oil market more unified. With thepresent market structure, new discoveries andproduction capabilities anywhere in the world–and especially outside of the Middle EasternOPEC nations–contribute to market stability andthus to U.S. economic and national security in-terests, Similarly, the ability of energy consumers

I to switch to other fuels, improve their efficiencyof energy use, or even shift the basic structure

i of their economies will affect their reliance onI

oil. Consequently, an evaluation of United Statest crude oil production can provide only a piece

of a larger puzzle, albeit an important piece. Inthe following discussion, we address the abovequestions in the limited fashion allowed by thebounds of our analysis.

Will Declining Domestic Oil ProductionSeriously Damage U.S. Economic andNational Security Interests?

If imports provide the least expensive sourceof oil, should we care if U.S. domestic oil pro-duction decreases and import dependence rises?Are the potential damages from rising import de-pendence large enough to justify the costs to theU.S. economy of subsidizing domestic oil produc-tion or taking other measures to restrain importlevels? This question forms the core of a seriouspolicy dispute. Unfortunately for policy makers,there are a number of substantive opposing argu-ments as well as significant uncertainties aboutthis issue.

Advocates of oil import fees and other meas-ures designed to forestall added U.S. dependenceon oil imports believe that both economic andnational security interests justify the costs of suchmeasures. They note that the drop in oil indus-try investment has hurt significant sectors of thenational economy as well as the economies of

oil-producing States such as Texas, Oklahoma,and Louisiana, and that expanded imports hurtthe U.S. trade balance. Perhaps most importantfrom an economic standpoint, they believe thatexpected increases in oil demand and decreasesin non-OPEC oil production capacity will soonreturn market control to OPEC and thus restorethe potential for future price shocks and accom-panying economic disruption. As for nationalsecurity, the industry points to the strategic im-portance of oil to the United States, both for it-self and even more for its allies, and the likelihoodthat increased import dependence will translateinto an increased vulnerability to future oil dis-ruptions.

These arguments must be balanced against thepotential negative impacts an import fee or thelike would have on the U.S. economy, as wellas arguments that the national security implica-tions of rising oil imports have been temperedsubstantially by economic and physical changesthat have occurred since the earlier price shocks.

The negative economic effects of an import feeare viewed as including an increase in the rateof inflation, a decline in gross national productresulting from reduced discretionary income, anda decline in trade competitiveness among theUnited States’ energy-intensive industries (e.g.,chemical products). Balancing negative and posi-tive impacts requires extensive, sophisticated eco-nomic analysis, with the best analyses yieldingresults that will still be highly sensitive to argu-able input assumptions.

Changes in oil markets and the U.S. economicstructure that have occurred since the early1970s, combined with certain insurance meas-ures such as the Strategic Petroleum Reserve,have likely made the United States less vulner-able than previously to future oil price shocks andsupply disruptions. For example, the growth ofa large spot market in crude oil has made em-bargoes extremely difficult to enforce and shouldact to curb the “inventory panic” that in the pastserved to escalate prices rapidly at the first signsof a shortage. Other positive changes include:

● the U.S. decontrol of oil prices, which allowsa more rapid market adjustment to changesin oil supply and prices;

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●

●

●

the increase in diversification of producingcountries, which adds stability to worldsupply;the increase in oil stocks held by Japan, WestGermany, and other U.S. allies; andthe growth of natural gas supplies through-out the world, which allows for substantialfuel-switching capability in industrial andelectric utility markets.

Although these improvements in the U.S. stra-tegic situation do not imply that growing oil im-port levels represent no threat, they do imply thatcomparisons with earlier years must be viewedcautiously.

To keep these arguments in perspective, it isimportant to understand where U.S. oil produc-tion was heading before prices dropped soprecipitously. Even before the sharp 1986 de-clines in world oil prices, most energy analystswere predicting a future of declining domesticoil production and increasing imports. For ex-ample, one so-called “consensus view” of futureU.S. production under previous price expecta-tions (prices in the mid to low $20s/bbl for a fewyears and a gradual increase thereafter) had U.S.production declining from about 8.9 mmbd in1985 to below 7 mmbd by 1995 and below 6mmbd by 2000. Therefore, the recent price dropmight be said to have advanced by 5 or 10 yearsa process of declining U.S. production that mostindustry analysts believe would have occurredanyway because of the maturity, and thus de-clining prospects, of the U.S. resource base.

Not all analysts would agree with this view. Aminority of oil analysts believe that U.S. produc-tion could have been maintained at stable levelsfor another few decades had oil prices held upand had the industry expanded its efforts to at-tain increased recovery from its older fields. Thismore positive view is based on an optimisticassessment of the remaining oil resources that canbe recovered by more intensive drilling as wellas by enhanced recovery. If correct, this view im-plies that the “cost” of the price drop to theUnited States, in terms of lost domestic produc-tion capacity, could be considerably greater thanimplied by the more pessimistic pre-price dropproduction forecasts.

Policies To Bolster U.S. Oil Production

Advocates of government action to slow thedecline in U.S. oil production have suggested avariety of potential solutions, Most involve sub-stantial present or future costs; all of these areopposed by powerful constituencies.

OTA has not undertaken the kind of compre-hensive evaluation that policy makers must havebefore deciding on a specific course of action.Although the results of OTA’s study offer a num-ber of insights about the effectiveness of specificpolicies, we were not able to measure the actualeffects on oil production of the policies nor theirnet social costs.

1. Oil Import Fees.–Oil import fees may bestructured either as a constant dolIar addition tothe prevailing price of imports or as a sliding feedesigned to raise import prices to a predeter-mined value (e.g. $25/bbl). An interesting alter-native is a price floor, deliberately set belowprices prevailing at the time of enaction, designedto guard against future price drops and thus toease the downside risk of new production in-vestments.

To the extent that an import fee raises domes-tic oil prices higher than prices that would haveoccurred without it,11 it will raise industry reve-nues and improve the prospective profitability ofnew production investments. This in turn will en-sure that oil investment and production will alsobe higher than without the fee, at least for a con-siderable period. For example, OTA’s economicanalyses show that for the small scale develop-ment and exploratory drilling prospects exam-ined, increasing oil prices from $1s to $20/bblraised expected rates of return to the levels ex-pected in 1981,12 when oilfield activity was ata peak. Such an increase in expected profitabil-ity would be bound to stimulate new oil in-vestment. However, policy makers must be con-

1 I Over the long term, an import fee might help to hold down

world oil prices by reducing the demand for Imports and thus re-ducing OPEC market dominance. It is therefore quite conceivablethat the net domestic oil price could eventually be lower than itwould have been in the absence of the fee.

1 zASSUnllng drll[lng costs would not rise. This assumption will be

reasonable only if any increase in drilling activity stimulated by theprice rise was not so large as to use up much of the current sur-plus of drilling capacity.

cerned about the cost to consumers of higher oilprices, both directly and as a result of higher man-ufacturing costs, and the effects of such highercosts on the U.S. balance of trade. In addition,because of uncertainties about the resource base,the effects of structural changes in the industry,and other factors affecting production, policy-makers cannot predict with a high degree ofconfidence how much additional productionwill be “purchased” with an import fee. Thereis little agreement in the industry as to what oilprice would be necessary to stabilize produc-tion—or whether it is even possible to do so.

Based on OTA’s conversations with industryplanners, the sharply perceived threat of futureplunges in oil prices plays an important role inindustry reluctance to invest, especially for longerterm projects. If this is so, the institution of aprovisional tax designed to establish a price floorbelow current price levels–possibly at $15/bbl—could also boost investment at no immediatecost to consumers. OTA’s economic analyses re-veal some of the potential of such a price floor.For small-scale development and exploratorydrilling, using a $10/bbl “hurdle price” to guardagainst future price risk transforms an attrac-tive prospect at $15/bbl—with a projected real(before tax) rate of return of over 15 percent—into an outright loser. Thus, for investors whofeared future price drops, a price floor couldprovide the assurance necessary to proceed withdrilling.

The perceived attractiveness of a price floor de-pends in large measure on the policy maker’s ex-pectations for future oil prices. If he expects pricesto stay above $15/bbl at most times, with occa-sional brief declines below this price, a $15 pricefloor looks particularly attractive because it re-duces risk at a low cost. On the other hand, ifhe envisions prices plunging below the floor pricefor extended periods, the consumer cost and bal-ance of trade questions may become paramount.

2. Tax Concessions.—OTA examined the ef-fects of several tax changes on the expected prof-itabiIity of small-scale driIling. These changes in-cluded reinstituting investment tax credits (of 20percent), allowing a 27.5-percent depletion al-lowance for all producers, cutting severance andad valorem taxes in half and to zero, and institut-

ing a 20-percent drilling credit. For the small-scale drilling examined, lower State taxes andadditional tax credits for Federal income taxesimproved the prospective profitability of newinvestments, with a 20-percent drilling creditand a higher depletion allowance having thegreatest effect. However, none of these meas-ures achieved nearly as much of an increase inprofitability as a $6/bbl increase in oil prices.13

For example, for the development wells exam-ined, cutting severance taxes in half addedabout 2 percentage points to the real after taxrate of return, whereas adding $6/bbl to the oilprice increased the return by between 12 and17 percentage points.

Industry spokespersons have claimed that thenew tax code will hurt the industry’s investmentcapability. An examination of this claim is beyondthe scope of this study. However, OTA did ex-amine the effect of the new code on the profitexpectations for a series of small scale explora-tion programs. Contrary to OTA’s expectations,the calculated after tax return on investmentfrom a number of small exploratory drilling pro-grams was slightly higher under the new taxcode than under the old. For these cases, thebenefits of the lower tax rates in the new codeoutweighed the loss of the investment tax credit.Were company profits low or nonexistent, how-ever, the lower tax rates would have little valueand the loss of the investment credit would havebeen the primary factor. The alternative minimumtax in the new code, not accounted for here, mayalso affect the balance of the old and new codes.

The industry has been united in its advocacyof repeal of the Windfall Profits Tax (WPT), whichwas originally enacted to prevent domestic pro-ducers from obtaining a financial windfall fromthe decontrol of domestic oil prices. Although thetax is not collected at today’s lower oil prices,it represents both an administrative burden to theindustry and a disincentive to E&D investment,especially for projects with delayed productionstarts and for investors who expect oil prices torise significantly during the production lifetime

13The reader is reminded that a fair comparison of alternative POl-icy measures requires an estimate of costs as well as results. Ideally,policies should be judged based on a measure of (productiongained) /(cost).

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of the project. The magnitude of the investmentincentive represented by WPT repeal depends onthe price expectations of the oil companies; giventhe wide range of announced price forecasts andthe current turmoil in the market, estimates ofthe oil production potentially added by repealwiII be especialIy uncertain,

3. Removing the Ban on Oil Exports From theUnited States.– Federal law currently prohibitsthe export of Alaskan North Slope crude oil fromthe United States. The effect is primarily to forcethe shipment of Alaskan crude oil via high-costdomestic tankers to a saturated west coast mar-ket or all the way to gulf coast or east coast mar-kets. Were Alaskan oil to be shipped via lowestcost tankers to Pacific markets, the reduced ship-ping costs would yield a significantly higher netback price to the producer; additionally, reducedpressure on west coast markets would likely raiseproducer prices there as well. The Minerals Man-agement Service has estimated the prospectiveincrease in Alaskan wellhead prices resultingfrom an end to the export ban to be $2 to $3/bbl; others have estimated the increase to be ashigh as $4 or $5/bbl. Even at the lower end ofthe range, the price differential represents a sig-nificant percentage of current well head prices,because these are kept well below world oil pricelevels by the Trans-Alaskan pipeline fee (about$6/bbl) and other shipping and tax costs.

4. Bolstering Investment in R&D.—Improvingthe technology of exploration, development, andproduction is an important means by which theoiI industry can minimize the negative effects onoil production associated with continuing lowprices. As noted earlier, however, the industryhas been cutting back on R&D in line with its de-creasing oil and gas revenues. In particular, theoilfield service sector has played a major role inprevious industry R&D, yet has absorbed thebrunt of financial damage associated with theprice drop.

Research and technology development thatcould help the industry stem the production slideat low prices include:

. improved understanding of the potential foradding new reserves in older fields from con-ventional drilling;

improvement in enhanced oil recovery tech-nologies, and better understanding of howto apply them to a wide variety of geologicsituations;improvement in the resolution and cost ofseismic analyses, to allow the wider use ofpre-drilling geologic analysis, to reduce dryhole risk, and to allow better placement fordevelopment wells; andfurther development of offshore productiontechnologies that negate or moderate the re-quirement for giant production platforms.

The first three research areas might be includedin a more general program aimed at improvingthe state-of-the-art in petroleum geosciences (i.e.,improving our understanding of where the oil isin a reservoir, how it moves, and how it can berecovered).

Policies to bolster R&D appear especially attrac-tive because they are an order-of-magnitude lessexpensive than direct economic incentives forincreased production. However, policy makersmust recognize that most industry planners be-lieve that technological change can play only amodest role in stopping a production slide in theface of continuing low prices. Also, designing apolicy measure that will provide an efficient in-centive to promote effective R&D is not likely tobe easy, with particular problems being indus-try fears about losing proprietary advantages, thepotential for government direction to be out oftouch with industry requirements, and the diffi-culty of restricting the benefits of incentive pro-grams to the primary R&D objectives.

Suggested policies for bolstering R&D include:

government sponsorship of industry/univer-sity cooperative projects,allowing intra-industry cooperative projectsby granting anti-trust exemptions,direct government assistance in the form ofgrants and contract awards,government-directed research projects, andtax incentives.

5. Removing Leasing Restrictions on Frontier/Offshore Areas.–Industry groups have longurged the Federal Government to open up a va-riety of publicly owned properties to oil explora-

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tion and development as a means of bolsteringdomestic oil reserves and production capacity.This recommendation has become more urgentin light of the recent oil price drop and its pro-jected negative impact on domestic production.Two of the primary target areas are the Califor-nia offshore basins and the Arctic National Wild-life Refuge (ANWR); both have potential recov-erable oil resources of a few billion barrels. Bothof these areas have been held from leasing be-cause of environmental objections. For Califor-nia, the primary objections involve the potentialeffects of spills on vulnerable ecosystems andhigh-value recreational areas and the air qualityproblems associated with production, transpor-tation, and other ancillary facilities associatedwith development. For ANWR, the primary ob-jection is the potential danger to the PorcupineCaribou herd and to other important species, andthe loss of the area’s wilderness character.

Arguments about opening these areas to oil ex-ploration and development center about threetypes of questions:

1. Are the estimates of environmental impactsaccurate?

2.

3.

Will development of the areas really makea difference in the United States’ long-termstrategic position vis-a-vis energy supply?Which are more important, the environ-mental values that would be preserved byforegoing development or the energy sup-plies that would be made available? IS it pos-sible to have development while protectingmost of the environmental values.

These questions have been extensively airedin the media and in reports and congressional tes-timony, and there is little OTA can add at thistime. One point worth making, however, is thatvolumes of oil obtained from these areas shouldbe compared to rates of domestic oil production,and not to total U.S. energy consumption, as issometimes done to illustrate the supposed insig-nificance of the resource. By the time areas suchas ANWR could be developed—not much before2000–oil will be even less interchangeable withalternative fuels than it is now, assuming the shareof oil used for transportation fuel or chemicalfeedstocks continues to grow.