The 3 biggest benefits of producing more oil

May 3, 2012, 9:08 PM UTC

FORTUNE — The outrage over a top EPA official’s statement that he aimed to “crucify” oil producers perceived as violating the agency’s rules has revived a debate crucial to America’s future.

President Obama argues that a campaign to substantially raise domestic crude oil production would provide miniscule benefits in lower prices and enhanced growth. With gasoline at over $4 a gallon in some places, and turmoil in the Middle East igniting fears that a big squeeze could strike at any time, it’s important to examine whether the economic argument for a major expansion in drilling is really as weak as the administration claims.

In fact, tapping the potential gusher within reach would enrich our future in three ways. First, despite the President’s declarations to the contrary, the extra output could be large enough to lower world prices by several dollars a barrel, chiefly through exploiting the enormous promise of shale oil. Second, adding to capacity would provide a sort of catastrophic insurance policy by cushioning shocks in supply that are especially damaging in the kind of tight, vulnerable market we’re experiencing today. And third, raising production means lowering our oil imports, and hence greatly improving our balance of trade. By pure GDP math, shrinking “net imports” would lift America’s growth trajectory.

How we got here

To appreciate the advantages of prizing the oil patch, it’s crucial to understand how global oil prices are established. In normal times, the world price equals the cost of the last, most expensive barrel that consumers are willing to buy. Times are anything but normal. Right now, that barrel is probably being produced from Canadian tar sands at between $70 and $80. So why is the prevailing price around $105? The reason is that worldwide excess production capacity is extremely tight.

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“I estimate that extra capacity is only around half-a-million barrels a day,” says David Kreutzer, an economist at the Heritage Foundation. “That’s about the same level we saw when prices spiked in 2008.”

Tight capacity means that almost all wells are pumping full tilt. To bring on more oil, producers that could react quickly may choose not to. A country like Saudi Arabia would need to spend lots of money uncapping old wells, and upgrading old fields, investments it’s now unwilling to make, in part from fears these high prices are temporary.

That leaves oil-hungry consumers to bid for the fixed number of barrels entering the market each day. In effect, someone commuting by car in London outbids a Chicago driver for scarce gasoline, and the Chicago driver saves by taking the train. That bidding is now driving the price far above the cost for the producer drilling the world’s most expensive oil, creating what’s called in economics a “scarcity premium.” And it’s why Exxon Mobil (XOM) and other oil giants are generating such huge profits.

How did the market reach this bind? From 2003 to 2008, demand for oil rose sharply, driven primarily by rapid industrialization in China and India. “The oil rich nations matched the rise in demand by producing more until around 2006,” says Lutz Kilian, professor of economics at the University of Michigan. “Then, production went flat, and even when demand started increasing again after the recovery began, production didn’t keep up.”

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Among the reasons were the shrinkage in production in the Gulf of Mexico following the British Petroleum (BP) disaster, and the hostility of big players such as Russia, Venezuela and Mexico towards private oil companies, leaving those nations to rely on inefficient domestic producers. “It became difficult for big oil companies to find places to invest where they didn’t have to fear they’d be expropriated,” says Kilian.

The U.S. is loaded with oil reserves that can be produced far below both the current world price of $105 as well as what would be the world price in a normal market, between $70 and $80. Any extra oil the U.S. produces, then, must lower the world price. The question, as we’ll see, is by how much. If the U.S. pumps lots of new supplies at $35 to $40, the cost of shale oil, total world demand could be satisfied without the priciest oil sands production at $80. All the new oil might even make the “most expensive barrel to clear the market” crude that scooped from the Gulf of Mexico at $55.

Or, if demand keeps rising, the extra U.S. production could help total world output keep pace. That could hold prices at, say, the $70 or $80 level, whereas they might rise far higher in the absence of a surge in U.S. supplies.

More oil, lower prices

So how much new oil must the U.S. must produce to substantially lower the world price? A lot. By Kreutzer’s reckoning, an additional 1% increase in world output lowers the global price by between 2% and 3%. Today, the U.S. makes produces 6 million barrels a day of crude. So what would happen if the U.S. were able to produce an additional 2 million barrels a day? That’s 2.3% of world supply, so that prices –– all other things being equal –– would fall between 4.6% and 6.9%. We’re talking about a decline of between $4.70 to $7.10 a barrel, based on today’s prices.

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But is an increase on that scale conceivable? Today, shale oil flowing from such booming fields as Bakken in North Dakota, Eagle Ford in Texas and Marcellus in Pennsylvania are pumping around 400,000 barrels per day. According to a study by energy consulting firm Purvin & Gertz, that number could rise to 1.3 million barrels by 2020. Reaching the 2 million mark would require a shift in regulatory policy in favor of far more drilling.

For example, the administration has rescinded drilling permits for the Chukchi Sea in Alaska and left the Atlantic and Pacific coasts off-limits to production under the Outer Continental Shelf Oil and Gas Leasing Program. Those two areas boast reserves equivalent to almost 40 billion barrels. Getting an extra 1 million or more barrels a day from domestic sources is indeed feasible: Since 2007, crude production has already jumped about 1 million barrels per day, or 20%. History tells us that high prices eventually create new production, and new discoveries, on a scale that confounds practically all the forecasts.

Right now, the looming danger is that prices will soar far above today’s already elevated levels. A perilous scenario is poised to play out, either soon or in future versions. Since capacity is extremely tight, any sudden surge in buying will enormously inflate prices. It doesn’t have to be a sudden shutdown in supply, triggered by a war in the Middle East.

“On the contrary,” says Kreutzer, “the big danger is that customers will that fear oil supplies will be cut off, so they start storing big volumes of oil to protect themselves. All that buying causes an explosion in prices well before any big event happens.”

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In that case, even a relatively small jump in demand could cause a sharp spike in prices––once again, because capacity is so tight. But the reverse is also true: A relatively small amount of new capacity could provide a crucial shock absorber. The solution is to encourage the producers to sink more wells and open new fields, and the best candidate is the U.S. “Even the addition of 500,000 barrels of extra capacity in 2008 would have prevented the price from spiking nearly so much,” says Kreutzer.

Hence, measures that help raise output in the U.S. are a crucial safeguard against the threat we’re facing today, a volatile mix of a market stretched to the limit, and the daily reports of turmoil in the most oil-rich regions on the planet. The rhetoric is dizzying, but the economics are clear: More drilling makes sense for America.

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