Intermediate Microeconomics and Its Application 12th Edition by Walter Nicholson,Christopher Snyder

Exercise 10

Boom and Bust in the Oil Patch
The production of crude oil by both large and small firms provides a number of illustrations of the principles of shortrun supply behavior by price-taking firms. Because prices for crude oil are set in international markets, these firms clearly are price takers, responding to the price incentives they face. Drillers face sharply increasing marginal costs as they drill to greater depths or in less accessible areas. Hence, we should expect oil well activity to follow our model of how pricetaking firms respond to price changes.
Some Historical Data
Table 1 shows U.S. oil well-drilling activity over the past 4 decades. Here, drilling activity is measured in thousands of feet drilled to measure firms' willingness to drill more wells deeper. The table also shows the average price of crude oil in the various years, adjusted for changing prices of drilling equipment. The tripling of real oil prices between 1970 and 1980 led to a doubling of drilling. In many cases, these additional wells were drilled in high-cost locations (for example, in deep water in the Gulf of Mexico or on the Arctic Slope in Alaska). Clearly, the late 1970s and early 1980s were boom times for oil drillers. As predicted, they responded to price signals being provided through the market.
Price Decline and Supply Behavior
Recessions in 1981 and 1990, combined with vast new supplies of crude oil (from the North Sea and Mexico, for example), put considerable pressure on oil prices. By 1990, real crude oil prices had declined by about 40 percent from their levels of the early 1980s. U.S. drillers were quick to respond to these changing circumstances. As Table 1 shows, less than half the number of feet were drilled in 1990 as in 1980. Many smaller firms ceased production of crude oil entirely during this period because the very low prices did not even cover their variable costs of production such as labor costs and costs of electricity to run their wells.
Price Recovery and the Fracking Revolution
Drilling continued to decline during the 1990s as prices for crude oil stagnated. But, starting after 2000, prices began a major move upward and this increased drilling dramatically. By 2008 (the latest year data are available), real prices had risen dramatically and the number of feet drilled had expanded by more than 250 percent from its low point.
Our model of supply behavior is a relatively static one- it does not allow for technical improvements in production. In later chapters we will seek to remedy this shortcoming. For now, however, we should remark on a major innovation in drilling technology that occurred during the 2000s. With the introduction of hydraulic fracturing ("fracking") and horizontal drilling, oil deposits that could not previously be used profitably became accessible. This revolution in technology in part explains the huge increase in drilling by 2008. More recent data would show an even greater increase. Clearly the high oil prices of the 2000s not only caused firms to drill more, but also led to significant innovations in drilling technology.
Drilling for oil is politically controversial in the United States and much of the rest of the world. Such controversy stems both from the environmental hazards associated with drilling itself and from concerns about climate change that may be induced by using the oil produced. The advent of fracking has exacerbated these disputes with several U.S. states and many European countries banning the practice. Are such outright restrictions the best way to address environmental issues that surround the drilling for oil?