Modeling Shocks in the Upstream Sector of the Oil and Gas Industry

Mr Gerhard Toews, University of Oxford

More than 80 years ago Hoteling (1931) provided the economic profession with a way to think about the optimal extraction path of an exhaustible natural resource. Despite the well devel- oped theoretical literature there is barely any empirical evidence supporting the assumptions made and the predictions suggested in the literature. One of the most common assumptions made in theoretical models are constant extraction costs or costs being a function of the level of extraction and the stock of the remaining resource. Our results suggest that costs in exploration and development are additionally significantly determined by the imperfectly elastic supply of inputs necessary in the process of oil and gas extraction. Moreover, barely anything is known about the dynamics of the response to an oil price shock in the oil and gas extracting sector. How quickly do companies react to a shock? How quickly do prices respond in the input markets. And, finally, how quickly does the supply of inputs adjusts? We employ three different data sets to answer how oil price shocks affect activity and extrac- tion costs in the oil and gas sector. On the disaggregated level we use a unique micro level data set on activity and extraction costs from Wood Mackenzie covering the whole world. In particular, we use the total number of wells drilled in the last 20 years and the unit costs of drilling a well as reported by the 25 major private and state-owned companies in the oil and gas sector. In the first step our identification strategy is based on the assumption that oil price shocks are predetermined to the drilling of individual wells. The predicted number of wells drilled from the first step is then used in a second step to estimate the slope of the supply curve. On the aggregated level we use regional data covering the whole world from IHS CERA and US specific data from the Bureau of Labor Statistics. Alternative strategies are employed in a structural VAR framework to identify the effect of oil price shocks on activity and extraction costs.

Overall, our results suggest that a 10% increase in the real oil price increases activity in the oil and gas sector by 5%. The effect on activity appears to be instantaneous and permanent. The effect on extraction costs is typically delayed and is also transitory in nature. In par- ticular, the results suggest that a 10% increase in the oil price increases costs in exploration and development by 2-4% up to one year after the oil price shock. This effect starts decreas- ing after one year but does not disappear completely. These results suggest that costs in exploration and development are significantly determined by the imperfectly elastic supply of inputs and that oil companies have to share their profits.

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