The Effect of Oil Prices on Oil Drilling in the U.S.
by Mike Kimel
The Effect of Oil Prices on Oil Drilling in the U.S.
Oil markets have changed dramatically in the past couple of decades or so. Except for a few years following the second Oil Embargo – prices got as high as $60 (in 2005 $) a barrel in 1981 – real prices have tended to be below $25 a barrel through about 1999. Conversely, 2003 prices have been higher than that – in some years quite a bit higher. Now, there are all sorts of explanations for this big change we’ve observed over the past few years, ranging from Peak Oil to the war in Iraq to the rise of the BRICs to market manipulation, but that’s the point of this post…
Instead, I want to look at the relationship between the price of oil and the number of oil rigs, and how that relationship has changed over the last couple of decades or so. Oil rigs, of course, are the machines that dig oil wells; once a well is completed and has begun production, the rigs are removed and either go into storage or move on to drilling another well. Data on the number of oil rigs in operation in the United States used in this post comes from Baker Hughes. Regular readers know I normally do not use data from private sources, but Baker Hughes data are as close to “official” as possible, as the figures you’ll find the Dep’t of Energy’s website on rigs originate with Baker Hughes. Rig count data comes out weekly and begins in mid-1987. I’ve taken annual averages beginning in 1988. Price data are annual averages from Table 5.18 of the 2010 Annual Energy Review put out by the Department of Energy. That data runs through 2009.
Now, a few details. Some time toward the end of the last millennium and the first few years of this one, there was a revolution in the drilling of oil (and natural gas). Two new technologies, hydraulic fracturing and horizontal and/or directional drilling, changed everything. Hydraulic fracturing is the fine art of pumping sand and water mixed with small amounts of some fairly toxic chemicals at high pressure to break apart some types of rock formations (usually shale) in which oil (or gas) is trapped. And the other thing available now are rigs that don’t just drill straight down, but instead can drill sideways once they reach the desired depth.
There is no fine line we can point to and say: this is the point when these two technologies became widespread. Instead, based in part on the numbers, I’m just going to say that until about 1998, those technologies were rarely used in the US, but after 2002 they were in widespread use. So… let me put up two graphs. The first one shows the relationship between the rig count and the price of oil from 1988 to 1998, and the second shows the same relationship between 2002 and 2009.
(A few comments to the statistically oriented… yes, I know that a single equation regression is nothing more than a correlation, but this was for illustrative purposes. And before you mention autocorrelation, take a look at the graph again and think of exactly what would change if I did correct for it.)
So what does all this mean? A few comments:
1. The relationship between prices and rig count exists because as world prices rise, U.S. producers have an incentive to drill more.
2. In the first period, for every dollar increase in the price of a barrel of oil, on average 25 rigs were added in the U.S. In the second period, for every dollar increase in the price of a barrel of oil, on average only 3.5 rigs were added.
3. Part of the difference noted in 2. is just due to the fact that rigs are so much more efficient today than they were a decade and a half ago.
4. Another part of the difference noted in 2. is that there are only so many resources available to install new rigs in the U.S.
5. Yet another explanation for the difference in 2. may be price volatility; given price fluctuate so much these days, prices today aren’t as indicative of prices in six months or a year as they used to be.
6. Drilling for oil is a capital-intensive and risky operation. The relationship observed in comment 2. might be even greater were it not for the low interest rates prevalent in the second period.
7. The fit is much better (i.e., the relationship between price and rigs is much tighter, as there are fewer points far off the line) in the second period.
8. Do 2. and 7. indicate that perhaps oil drillers are becoming “more professional”?
9. Should this serve as a bit of an automatic stabilizer on price volatility? In other words, do the volatile oil prices reduce volatility in oil output, which in turn might reduce price volatility?
10. One other thought, only semi-related, and I’m not sure how it fits. In the oil market, you can get a lot of price volatility with even a small change in output. If world output falls by, say 1%, there are a lot of users without that many good substitutes (at present) willing to bid up the price on the marginal unit.
And one last thought…. does any of this say anything, one way or the other, about the notion of Peak Oil?
A few notes. First, full disclosure – I am not authorized to speak on its behalf, nor do I necessarily see the big picture, but I believe the company I work for would benefit from increased regulation of hydraullic fraccing. Second, the idea of looking for a relationship between prices and the means of production of a similar commodity came from Craig Truesdell. I’ve found Craig’s insight seems to provide useful intuition in a lot of markets.
Cross-posted at the Presimetrics blog.
Well, now that UBL is dead prices should drop some. If not we’ll just send the Donald over to do some head banging negotiating.
you cover a lot of territory here, mike, hard for me to wrap my thoughts around it…
there’s been a lot of recent discussion in the blogosphere around the elasticities projections in the new IMF world economic outlook; stuart staniford has been following up on it, and links to most others who have weighed in:
stuart is a good source, has been writing for the oil drum for years; recently looking at saudi rig counts, but i’m sure he covers ours too…
IMF outlook, Chapter 3. Oil Scarcity, Growth, and Global Imbalances http://www.imf.org/external/pubs/ft/weo/2011/01/pdf/c3.pdf
jim hamilton is another good source, recently posted on the Brent-WTI spread and has been covering that since the diversion…ie, willison sweet in north dakota sells for $96 while louisana sweet goes for $127…(lack of transport infrastructure)
anecdotally, my brother is the head of exploration for a major domestic driller & they wont explore for oil or put a new drilling bit in the ground unless they can contract to sell that oil above $80, so his entire team of petrogeologists sat on their hands for a whole year when oil slid below $70 in ’09….all the easy oil has been found, & it’s increasing becoming a question of expected energy return on energy invested…
I know this idea is opposed by mainstream economics, but the 1970’s price controls and windfall profits tax actually made investment in drilling more attractive than it would have without these measures.
Oil production is an unusual economic sector in that virtually all of the cost of recovering oil is fixed cost and virtually none of the cost is variable cost. So once you have drilled a well and look at the cost of drilling versus the oil recovered you come up with a cost per barrel and that will be essentially unchanged regardless of what happens to the market price of oil. So if you have an operating well where the cost is about $5.00/bbl and the price of oil is $6.00 your profits are $1.00. If the price of oil goes to $10 your profits are now $5.00.
Given this structure when the price of oil increases the incentives for oil companies to expand drilling is muted because they are making such high windfall profits from existing wells.
The price controls of the 1970s and the windfall profits tax took this structure into account and limited the profits oil companies could realize from existing wells when market prices rose. Without the price controls and/or windfall profits taxes when oil prices rise oil companies see their profits soar without having to do anything. They can just sit there fat, dumb and happy and see their profits and stock prices soar.
But what the price controls and windfall profits tax did was take the windfall profits away from the oil companies. But under both sets of conditions the oil companies were free to make all the profits they could from new wells. So if they could drill a new well with a cost structure of $8.00 /bbl and the price of oil was $10.00 they could get $2.00 / bbl profits while the regulations or taxes kept the profits on existing well from increasing as oil rices rose. Consequently to increase profits the oil companies had to increase drilling.
Now without price controls or windfall profits tax when oil prices rise the oil companies make large profits on their existing well. So they do not need to expand new drilling to increase profits as they had to under the 1970s regulations and taxes. They wiil still expand drilling, but not to the extent they did in the 1970s when essentially the only way they could expand profits was to drill new wells.
In the first period, for every dollar increase in the price of a barrel of oil, on average 25 rigs were added in the U.S. In the second period, for every dollar increase in the price of a barrel of oil, on average only 3.5 rigs were added.
You need to redo those figures. Should be number of rigs per percentage change in hte price of oil.
$1 on $15 oil is very different from $1 on $60 oil. Four times different in fact: 4x 3.5 is 14….explaining half your gap right there.
This graph also puts to rest the idea that we can drill our way to lower oil prices. Oil companies exist to benefit their shareholders, not for the public good. Any CEO who suggested that his company should continue to explore and increase output in the face of falling prices would be fired – and rightly so, from the business standpoint.
It was a technological revolution that caused the collapse of the price of oil and gas. Seismic technology improved dramatically in the eighties and we were able to see the last pools of oil that we had missed before.
We found them, get over it.
Thank you for highlighting the effect of Oil Prices on Oil Drilling. Its a rare information and i only found here. Thank you once again of the information.