Investment and returns in exploration and the impact on oil and natural gas supply

Abstract

An econometric model is developed to explain the investment in exploratory activity and the resulting accumulation of proved reserves of oil and natural gas in the continental United States. The model explicitly takes into account therole of geological uncertainty as well as the effect of depletion in the context of a finite resource base. The model for reserve additions describes the process of generating new discoveries of oil and natural gas in two stages. The first stage describes investment in exploration under conditions of geological uncertainty and a continuing process of depletion of the hydrocarbon resource base. Exploratory companies are assumed to choose a level of investment that maximizes the firm's value after balancing expected returns against the risks involved in exploration and the corresponding costs. Combined with a characterization of costs of exploration and development, this analysis leads to an expression for the total amount of exploratory drilling in each production district in terms of estimates of anticipated returns and anticipated risk. In the second stage, the model predicts the parameters of the size distribution of alternative drilling prospects, and updates them from period to period to reflect the continuing process of depletion of prospects as well as new information on geological and economic variables. The amount of drilling activity can then be translated into actual discoveries of oil and natural gas through the estimates of success fractions and sizes of discovery (conditional on a success), which depend on these parameters. Structuring the model in this way enables us to take account of possible shifts in the relative proportions of extensive and intensive drilling as a result of changes in economic variables. Additions to proved reserves can also occur as a result of extensions and revisions of existing fields and pools. Extensions and revisions are modelled as functions of previous discoveries, exploratory wells drilled, existing levels of accumulated reserves and production, and an index of geological depletion. An important aspect of the model is that it gives explicit consideration to the process of long term geological depletion as well as the role of risk in determining the amount of exploratory activity. It also accounts for the fact that on the level of new discoveries oil and natural gas are in fact joint products, and must be treated symmetrically. Finally, the model allows for shifts in the relative proportions of intensive and extensive drilling in response to changes in economic incentives. The model is estimated and simulated to verify its pre- dictive validity over a historic period. It is then used to examine the influence of alternative regulatory policies on the oil and natural gas reserves and production. Combined with an existing model of demand for oil and natural gas (the MacAvoy-Pindyck Model), this provides a basis for estimating future shortages and increases in economic incentives needed to ameliorate them.