Drilling & Rational Expectations

by Ali-Asad

Energy has popped up as an important issue in the US presidential campaign. John McCain and his campaign consider energy as one of their strongest domestic issues because the public at large wants the government to do something about the record high gas prices. Hence, McCain’s continued insistence on increasing offshore drilling. But Obama, along with most Democrats, has always regarded offshore drilling as a fraudulent policy. The argument goes that new offshore drilling will not produce a drop of oil for at least seven years according to the US Energy department. Additionally, drilling for more oil will not solve the long term problem of depleting fossil fuel reserves. On the surface, both arguments make sense. Increasing oil supply seven years from now will not impact the price of gas at the pump tomorrow. Also, fossil fuels will run out eventually, and drilling for more oil while damaging the environment does not seem like a good long-term tradeoff. But these arguments have surprisingly convincing and logical counters.

Firstly, the possibility of new oil drilling could impact the price oil and gas at the pump even if it takes several years to see that oil. How? The theory of rational expectations comes from the premise that people behave intelligently, and so people (especially oil traders) will deduce that the supply of oil will increase in the future. Separately, demand for oil will fall because of higher oil prices, which will result in investment in alternative energies and reduced oil consumption (already Americans are driving fewer miles and an analytic company predicts 500 million fewer miles will be driven in the next year). This reduced projected demand combined with higher forecast supply creates a mental image of lower prices in the future. And so, with these future projections, oil traders will sell more oil contracts than they will buy, hence reducing the price of oil today.

One could argue that the decline in oil prices over the last month is a direct result of the increased support of more oil drilling. Last month, President Bush ended the federal moratorium on oil drilling and put Congress under pressure to act. Now, Congress seems to be converging towards a bipartisan compromise that would allow for some drilling. These events have occurred over the last month while oil prices have been coming down. While causation is almost impossible to prove, the probability of higher oil supply definitely entered the thinking of market analysts and traders. People are smart. When they see supply going up in the future, they know prices will come down. So, they adjust and bring prices down now. Prices always reflect current levels of supply and future expectations.

Secondly, fossil fuels are not just yesterday’s energy source, they are today’s energy source as well. The longer fossil fuels last, the more time we have to develop alternatives. We could just stand by and wait for an alternative to become economically viable and energy efficient or we could try to lengthen the transition period from fossil fuel to wind/solar/geothermal/biofuel etc. This transition would give scientists and government more time to develop the technologies and infrastructure needed to supply the world economy.

Therefore, on balance, the argument for drilling holds more weight than the argument against drilling. Drilling will not serve as a silver bullet. If the mere possibility of drilling as helped bring down gas prices, imagine what actual drilling will cause.

And that’s jus’ the tip.

Any thoughts? Comment Below.