Bureau of u ·ness Research College and Graduate School of Business, University of Texas at Austin August 1990 The Texas Economy: Supply Responses to Changes in the Price of Oil or Gas The Clean Air Act of 1990, no doubt rein­forced by the Bush administration's new nation­al energy strategy to be announced early in 1991, signals a fresh approach to energy and environmental policy with major implications for the Texas economy. Placing greater empha­sis than in the past on market-based devices, the policy will increase the relative costs of using the more polluting sources of energy, thereby inducing substitution of those that are less pol­luting. As is already generally appreciated, natural gas, still a major resource in Texas, is the least polluting of the fossil fuels. A relative shift to natural gas, especially if at the expense of coal, could be stimulating to the oil and gas industry and the Texas economy. This is the first in a series of Review articles to address the nature and possible economic effects of the new energy and environmental policy. A basic question is the likely size of the in­vestment and production response of the Texas oil and gas industry to the market incentives created by the policy. By increasing the demand for less polluting fuels, these incentives will ef­fect increases in the real prices realized by pro­ducers, especially gas producers. Consequently, we can learn much from the experience of the period 1973-1986, during which there were wide swings in the relative (or real) prices of oil and gas. In this article we concentrate on oil prices, since during the study period the incentive effects of gas prices were distorted by legislative restric­tions on the use of gas, as well as uncertainties concerning the pace of gas price deregulation after 1978. 1 Since market-determined prices of oil and gas tend to rise and fall together (because of their mutual substitutability in some major end uses), we believe that the record of responses to real oil price changes will be sufficiently indica­tive for our purposes. The economic theory of the production of any good tells us that a rise in the relative (real) price of that good will induce efforts to increase the output of it. The reason is simply that a rise in the real price of a good-i.e., a rise in price relative to other prices, including input prices­increases prospective unit revenues relative to incremental costs and thus holds out the prospect of enhanced profits from increased output. Thus if a market-based environmental policy has the effect of increasing the demand for and real price of natural gas, it will also have the addi­tional effect of increasing the output of gas to accommodate that demand. The oil (or gas) production cycle is a long one. It involves geological analysis, lease ac­quisitions, geophysical exploration, exploratory drilling, development drilling in new discover­ies, a long period of managed production, and often additional drilling and installation of faci­lities for secondary and tertiary recovery. A lag of five years or more between a spurt of ex­ploratory drilling and a significant increase in output is common. Space does not allow us to examine the several stages in the response of production effort to real price changes in the period since 1973, but one of the earliest stages, exploratory drilling, is sufficiently in­dicative for our purposes. The industry always has an "inventory" of geological knowledge and land under lease, so it can react fairly quickly to price stimuli in accelerating explora­tory drilling. Our first chart shows the record of explorato­ry well completions in Texas and the United States as a whole in relation to the real price of Ii 1111111 ! ! : Iii i ! ! i I!!:·! i ! 1111!I~i:1111111111i111i11ii11 ! iii Iii l 1111 i ;;Jr7 oil from 1970 to 1987. In 1973, the number of completions in Texas was 2,416; and in the na­tion as a whole, 7,771. Within two years follow­ing the first big oil price increase, the figures had risen to 3,291 and 9,459, respectively. Peaks in exploratory well completions of 5,688 and 17,430, respectively, were registered in 1981, a year later than the peak in real price following the second big oil shock. Thus while the real price rose by 458 percent between 1973 and 1980, exploratory well completions rose by 81 percent in Texas and 94 percent in the United States as a whole between 1974 and 1981. By 1987, the completion figures-2,190 and 6,474­ had fallen below their 1973 levels. While we observe a correlation, as expected, between the real price of oil and exploratory well completions, the response of the latter is less than proportionate during the period in question. The principal reason is that efforts to accelerate drilling and related activities sharply increased the prices of inputs, from drilling rigs to drill pipe and labor, which were in restricted supply initially. Between 1973 and 1981, the real (inflation-adjusted) cost of drilling a 10,000­15,000 foot well, for instance, rose by 133 per­cent. 2 With a decline in drilling after the real price of oil began to fall, excess capacity in the input sectors drove real well costs down again. This point reminds us that the response of in­vestment and production to a given real price U.S. and Texas Exploratory Well Completions and the Real Price of Crude Oil, 1970-1987 Number of wells (Ratio scale) 1966 dollars 100,000 100 10,000 10 Source: West Texas Intermediate crude oil price and explora­tory well completion levels, 1988 Energy Statistics Sourcebook and the Texas Railroad Commission. change depends in part on the initial capacity of input industries as well as that of the subject industry. As for the oil (or gas) output response that follows ultimately from earlier exploratory ac­tivities, the second chart shows a marked check­ing of the downward trend in oil production in Texas and the rest of the lower 48 states about three years after each major increase in real oil prices. Part of this effect resulted from more in­tensive recovery efforts in already developed reser­voirs (with a shorter lag), but most of it resulted from the exploratory drilling boom depicted in the first chart (with a longer lag). Note the resump­tion of the downward trend in production after 1985, with the price collapse of 1986. It is much easier to cut production rates quickly than to increase them, because it is much easier to idle productive capacity quickly than to create new capacity. In interpreting the foregoing data, two caveats in addition to the one concerning capacity need to be borne in mind. First, since the production cycle in oil and gas is very long, the size of the stimulus provided by a given real price change depends heavily on how permanent it is consi­dered to be by current and potential producers. A price change that is regarded as temporary will have relatively little effect on exploration and other expensive productive activities. We have no quantitative measure of the long-term expectations in the oil and gas industry associ- U.S. and Texas Crude Oil Production and the Real Price of Crude Oil, 1970-1988 Millions of barrels 1966 dollars 3,800 100 111111111 ! : : ! l I!!! I!!!~: 111!111!I!i!1111111111!!11i111111: f: ii 1111111 iillr Employment and Unemployment Rate by Metropolitan Area Total nonagricultural employment (thousands) Total employment (thousands) Unemployment rate Area May 1990 May 1989 Percentage change May 1990 May 1989 Percentage change May 1990 Abilene 49.2 48.8 0.8 48.9 49 .3 -0.8 6.1 Amarillo 77.8 77.5 0.4 92.1 92 .9 -0.9 5.3 Austin 369.8 364.0 1.6 410.4 412.4 -0.5 4.8 Beaumont -Port Arthur 139.1 135.I 3.0 151.3 148.8 1.7 7.7 Brazoria 64.8 62.9 3.0 81.6 80 .3 1.6 5.6 Brownsville-Harlingen 75.9 73 .3 3.6 95 .7 91.9 4. 1 11.2 Bryan-College Station 53.0 52.4 1.2 59.2 59.4 -0.3 3.7 Corpus Christi 129.1 127.l 1.6 147.2 146.9 0.2 6.4 Dallas 1,359.5 1,345 .9 1.0 1,357.7 1,371.8 -1.0 5.2 El Paso 207.4 201.4 3.0 225.6 223.7 0.9 10.7 Fort Worth-Arlington 575.4 562.0 2.4 686.0 685 .0 0.2 5.7 Galveston-Texas City 75.4 75 .7 -0.4 101.9 104. I -2.l 7.1 Houston 1,541.6 1,495.1 3.1 1,595.l 1,571.1 1.5 5.3 Killeen-Temple 75.2 73. l 2.9 92 .6 90.0 2.9 6.7 Laredo 44.2 41.4 6.8 47.6 45 .3 5.1 10.0 Longview-Marshall 68.7 66.9 2.7 74.3 73 .1 1.6 6.9 Lubbock 97.l 94.9 2.3 109.0 108.9 0. 1 4.6 McAllen-Edinburg-Mission 100.5 97 .3 3.3 135.5 134.0 I. I 16.9 Midland 44.7 44.7 0.0 46.2 46.8 -1.3 5.5 Odessa 42.6 42 .6 0.0 47.3 48 .3 -2 . 1 6.2 San Angelo 36.l 37 .1 -2 .7 41.5 43.4 -4.4 6.1 San Antonio 519.l 517.8 0.3 567.6 577.8 -1.8 7.0 Sherman-Denison 37.1 36.9 0.5 44.3 44.8 -I. I 5.3 Texarkana 47.1 46.1 2.2 53.7 53 .9 0.4 6.3 Tyler 62.2 61.8 0.7 70.0 70.5 -0.7 6.2 Victoria 28.5 27.5 3.6 34.7 33.4 3.9 4.9 Waco 82.3 80.6 2.1 88.6 88.2 0.5 5.9 Wichita Falls 50.4 50.8 -0.8 52.4 53 .8 -2.6 6.6 Total Texas 6,919.6 6,808.7 1.6 7,886.8 7,887.1 0.0 6.2 Total United States 111.031.0 108,745.0 2.1 118,277.0 117,039.0 1.1 5.1 Note: Data are not seasonally adjusted. Figures for 1989 have undergone a major revision; previously published 1989 figures should no longer be used. Revised figures are available upon request. All 1990 figures are subject to revision, with the exception of Texas and U. S. total employment. Sources: Texas Employment Commission and U.S. Department of Labor, Bureau of Labor Statistics. 1.35 1.30 1.25 1.20 1. 1 5 1. 1 0 1.05 1.00 0.95 Nonagricultural Employment in Five Largest Texas Metropolitan Areas (January 1984=1 .00) 1.35 1. 30 1.25 1.20 1.1 5 1. 1 0 1.05 1.00 0.95 Total Employment in Five Largest Texas Metropolitan Areas (January 1984=1.00) wwwww­ wwwww w r ~u ls 1 0 s WWW W WWW WW WWW 1 ... 1 l51 WWW WWW -=---w= w LIBP~ lb BUREAU OF BUSINESS RESEARCH 4 CP l!~ t"'ermit No. 1630 P.O. Box 7459 Austin, Texas 78713-7459 Address correction requested. Editor: Lois Glenn Shrout Texas Business Review is published six times a year (February, April, June, August, October, and December) by the Bureau of Business Research, Graduate School of Business, University of Texas at Austin. Texas Business Review is distributed free upon request. The Bureau of Business Research serves as a primary source for data and information on Texas and on the dynamics of change. The Bureau's research program concentrates on the deter­minants of regional growth and development. The information services division answers in­quiries by telephone and mail, responds to walk-in visitors, and offers computerized data from the 1980 census of the population and on manufacturing firms in Texas. The publications division produces periodicals, directories, books, and monographs on a variety of topics that shape the development of the Texas economy. Announcements On June 23, the Bureau hosted a field hear­ing for the U.S. House of Representatives Committee on Banking, Finance and Urban Affairs. The hearing focused on the current condition of the Texas economy, supply of and demand for credit in the state, and the disposi­tion of properties held or formerly held by financial institutions. Representative Henry B. Gonzalez, chairman of the House Banking Committee, conducted the hearing; Representa­tives J.J. (Jake) Pickle of Austin and Steve Bartlett of Dallas also participated. Per capita income data by county and metropolitan area for 1988 have been released by the U.S. Department of Commerce, Bureau of Economic Analysis. Metropolitan area figures were printed in the June issue of Texas Economic Indicators; county figures appeared in the July issue. To order those issues, call (512) 471-1616.