Is America Over A Barrel?

What Prudhoe Bay tells us about oil prices

BP's unexpected shutdown of its oil production facilities in Alaska's Prudhoe Bay cuts U.S. domestic production by 400,000 barrels per day. That amounts to about 8 percent of domestic production and about 2.6 percent of daily consumption. The oil fields on the North Slope of Alaska produce a total of about 900,000 barrels of oil per day. Skittish world oil markets reacted by running up the price of oil by $2 to almost $78 per barrel (which is still a far cry from the $100 price achieved after the 1979 Iranian revolution).

The BP shutdown comes at a particularly nervous time for oil traders. Iraqi production has never returned to pre-war levels and is threatened by a potential civil war. According to some reports, Nigerian production has been reduced by almost 700,000 barrels per day by attacks from separatist groups in the Niger delta. Iran threatens to withhold its daily exports of 2.5 million barrels of oil if the United Nations imposes sanctions on it in an effort to halt its nuclear program. The state-owned oil companies in Russia, Venezuela and Mexico are under-investing in their production facilities. Meanwhile, global demand for oil continues to grow, if at a somewhat slacker pace than a year ago. Interestingly, Saudi Arabia announced yesterday that it would boost its production to make up for the shortfall from Prudhoe Bay.

Since there is essentially no excess global oil production capacity, prices rise rapidly in response to any disruption or possible disruption. For example, oil prices rose last week when tropical storm Chris looked like it might spin up into hurricane and shut down oil production in the Gulf of Mexico. As late as 2002, the world enjoyed a production cushion of 6 million barrels per day. Today, excess capacity has fallen to less than 1 million barrels per day. What happened? In the 1990s oil sold for around $10 per barrel, so cash-strapped oil companies effectively ceased to develop current fields or explore for new fields. They are now playing catch-up to try to meet burgeoning demand.

U.S. domestic oil production peaked in the 1970s and wealthier and more environmentally conscious Americans increasingly adopted a not-in-my-backyard attitude toward various plans to boost domestic production. Consequently, the Arctic National Wildlife Refuge (ANWR), sections of the Gulf of Mexico and both the East and West Coasts have been closed for about three decades to oil exploration and production. Estimates of oil reserves in ANWR vary, but a 2004 report by the Energy Information Administration (EIA) offered a mean estimate of 10.4 billion barrels and predicted the field could eventually produce around 1 million barrels per day. Oil production from the North Slope of Alaska peaked at 2 million barrels per day in 1988 and will continue to decline unless ANWR is opened to production.

Last week, the Senate voted to allow the Interior Department to lift a 25-year moratorium on oil and gas drilling on 8.3 million acres in the eastern Gulf of Mexico. This area is about 100 miles from the nearest land and 125 to 310 miles from Florida's beaches. Ironically, while American oil companies are forbidden to drill close to Florida, Cuba has given China's state-owned oil company permission to explore for oil within 50 miles of Florida's coast on Cuba's side of the Florida Strait. In 2005, the U.S. Geological Survey estimated the North Cuba Basin may contain 4.6 billion barrels of oil.

Again, estimates vary, but one EIA report projects that deepwater Gulf oil production could rise from 1 million to 2.2 million barrels per day by 2016. The House of Representatives is considering legislation that would open up oil and gas drilling in areas more than 100 miles from U.S. shores and permit individual states to authorize drilling within 50 miles of their shores. The good environmental news is that the amount of oil spilled in the United States has steeply declined over the past three decades.

Opening up currently closed domestic reserves is not a silver bullet for high oil prices. However, any boost of production here combined with increased production in other areas of the world could eventually ease prices. One econometric model by the consulting group DRI-WEFA suggests that excess production capacity exceeding 5 percent of world demand would result in oil prices falling to around $35 per barrel. The latest report from the International Energy Agency foresees oil prices falling to $35 per barrel by 2010 and rising to around $40 by 2030. The IEA projects that even if future oil production is constrained by underinvestment the price in 2030 should be around $52 per barrel. Higher oil prices naturally inspire thoughts that the world may have finally reached the peak of oil production. However, most analysts do not think so.

To conclude: Oil markets and prices will settle down as soon as: peace comes to Iraq; Iran's ayatollahs halt uranium enrichment; the demands of Nigerian separatists are satisfied; and Venezuela's Hugo Chavez and Russia's Vladimir Putin boost investment in production. In other words, it may be a while.