Economics

How ‘Green’ Policies Accelerate Oil Production

Recent news out of the United Arab Emirates (UAE) suggests the country is planning to ramp up oil production. The state-owned oil company, Abu Dhabi National Oil Co, is now planning to increase its production capacity to 5 million barrels of oil a day by 2025.

As Bloomberg reports, this timeline is five years sooner than the government’s previous goal.

So why the increase in production? It’s a safe bet that the push for “green” policies are at least partly to blame.

Drill Baby, Drill?

How do green policies lead to increased oil production? Consider the decision faced by oil companies.

An oil company must make the decision about how many barrels of oil to produce a day. By using more resources, a company can increase daily production and drain its oil reserve faster.

The upside of this is obvious. More production means more oil sales, which could mean more revenue today. When a company receives more money today, they can put that money into investments which grow in value.

This means, everything else equal, businesses will prefer a dollar in sales today more than a dollar tomorrow because a dollar today can earn interest.

This raises the question: why not drain reserves completely as fast as possible and earn interest on selling all the oil? Why keep any oil in the ground at all?

There’s two major reasons why companies decide to leave oil in the ground each day.

First, as businesses extract more oil, the cost per barrel extracted is going to go up. This is because when businesses buy machines and pay laborers, they choose those which are the most cost effective.

If two machines are equally good at extracting oil, a business will always buy the cheaper one. If one worker is 100% more productive than another worker, but is willing to work for only 50% higher wages, the business will hire the more efficient worker.

Since businesses always hire the most cost effective factors of production first, this implies that when they choose to hire more machines or workers, they’re picking from a pool which is less cost effective than the previously hired factors. Over some point there may be gains from expanding production, but eventually all businesses will hit the point of diminishing returns when hiring factors of production.

In summary, when production increases, the cost of production per additional unit produced will necessarily increase (past some point). This cost increase must be weighed against the benefit of receiving dollars today.

Second, oil buyers are already purchasing their desired number of barrels at prevailing prices. If gas is $80 per barrel, and a company chooses to buy 300 barrels a day at that price, that implies the 301st barrel is not worth $80 to them. If it were worth $80, they would have purchased it.

This implies that if oil production companies want to sell more barrels than they’re currently selling, they’re going to have to sell for lower prices. Perhaps a price of $79 will convince the buyer to purchase barrel 301.

In other words, as the price of a good falls, the quantity of that good demanded will increase. Economists call this the first law of demand.

If companies produced too much gas, they’d drive prices to rock bottom and the company could no longer make as much revenue.

Companies must balance these factors. A barrel of oil sold for $80 in five years is worth less than a barrel sold for the same price today because of the interest you could earn by selling it today. But, on the other hand, ramping up production today means higher costs of drilling and lower prices, which will ultimately mean less profit.

If the return from interest is greater than the higher drilling cost and lower revenue from the fallen sale price, the oil company should drill and sell today. If not, the company should leave it and sell it in the future.

Gas vs. Green

This is where green policy presents a major problem. Consider how the choice facing companies changes when governments like those in California begin to signal they will make it illegal or extremely expensive for their citizens to buy gas in the future.

Now, the future demand for your oil is going to be lower, which means the future price of your oil has fallen relative to the current price.

When this happens, the cost of leaving oil in the ground increases dramatically. When you choose not to drill, you not only forgo interest from selling today, you also forgo selling at the presumably higher present price.

So, as more policies are passed committing polities to anti-oil futures, oil companies will increase the speed at which they produce oil.

More oil today means more pollution today. Not only that, pollution becomes more temporally dense—more pollution happens in a shorter timespan. Instead of companies slowly releasing reserves to balance the costs and benefits of current and future production, they now rush to produce as much as they can before government policies demolish the value of their assets.

This effect of green policies leading to more pollution today was observed by economist Hans-Werner Sinn in his brilliant book, The Green Paradox.

The book, published a decade ago, predicted exactly what we’re witnessing out of the UAE. The results are both unfortunate and predictable. Despite the goals of green apologists, future commitments to lower fossil fuel use may actually worsen climate change.

The Art of Economics

Economist Henry Hazlitt once observed:

“The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.”

While green policies seeking to curb future fossil fuel consumption may seem like they’ll improve the environment, a solid understanding of economics gives us the tools to see the opposite is likely true.

Market forces already constrain how much oil companies are willing to produce a day. Increasing costs and lower willingness-to-pay among customers cause oil companies to limit their activities.

Unfortunately, government policies often work against market forces. In this case that means more resources will be used to accelerate the production of oil to avoid disruptions caused by future policies.

For politicians, it appears economics is a lost art.

The post How 'Green' Policies Accelerate Oil Production was first published by the Foundation for Economic Education, and is republished here with permission. Please support their efforts.

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