Regional Update (July-September 1998)

Index The State of the States Views From the Region Southeastern Manufacturing Survey Southeastern Economic Indicators

Cover Story - What Is Fueling Atlanta's Housing Growth?

Homebuilder John Wieland Assesses Housing Industry Developments

Gulf of Mexico Oil Companies Gush Over New Drilling Technology

Gulf of Mexico Oil Companies Gush Over New Drilling Technology

I f you know the story of the Beverly Hillbillies, you'll recall that one day Uncle Jed, the patriarch of the Clampett family, "was shootin' at some food, and up through the ground came a bubblin' crude." The rest is... well, television history.

While Uncle Jed was lucky and struck it rich, oil or natural gas exploration is not quite as simple, random or inexpensive as using a double-barrel shotgun and some rock salt. In fact, the process can be complex and quite expensive, but at times it can pay off big, just as it did for the Clampetts.

While there are potential rewards, there are also high risks, one being the fluctuation in the price of oil. In the past, the oil industry has been susceptible to economic shocks in the form of a sharp rise or drop in the price of oil, which is generally based on supply availability.

Recently, however, new technologies — three-dimensional imaging and directional (or "horizontal") drilling — have lowered oil extraction costs and made feasible the reopening of wells and fields whose economic usefulness had ended under the old technology. The result has been a surge in certain parts of the energy sector, one that may be lasting because it is not being pushed by a spike in price but rather by a drop in production.

This new technology has been particularly beneficial to companies searching for oil and natural gas in the Gulf of Mexico's complex geological formations, where it has been more expensive to extract these natural resources than in other oil-rich areas like the Middle East.

A recent article in the Atlanta Fed's Economic Review by Thomas J. Cunningham, vice president of the Bank's regional research section, and economic analyst Whitney Mancuso examines these new technologies and their effect on Louisiana, the Gulf Coast state benefiting the most.

The History of Oil in the Gulf

For over 60 years, oil companies, some small independents and some large mutinationals, have drilled for oil and natural gas offshore in the Gulf of Mexico. At times, companies have been quite successful at extracting these natural resources and, based on the going rate for the commodities at a given time, have been profitable. This success was particularly apparent in the early 1970s when the Organization of Petroleum Exporting Countries (OPEC) began a wide-scale oil embargo. After this event, domestic price controls that put a cap on the per barrel price of domestically produced oil sold in the United States were lifted and drilling activity in the gulf picked up.

Then, in the late 1970s, worldwide oil prices rose significantly again as the oil-rich nation of Iran, at the time involved in political turmoil, cut back its production. Further production cutbacks in the Middle East resulted from Iraq's invasion of Iran in the early 1980s. As a result, OPEC instituted another embargo, prompting prices to rise and domestic oil production to increase, particularly in the Gulf of Mexico.

Oil prices were expected to remain high for some time, but in 1985 prices plunged when Saudi Arabia lifted its supply restrictions, pouring cheap oil into the world market. In the Gulf of Mexico, oil companies decided that they could no longer afford the high costs related to finding and extracting the commodity. The effects on the region were dramatic: companies returned hundreds of the offshore drilling leases awarded by the United States and the State of Louisiana in the 1960s and 1970s, drilling was cut back and employment in the sector dramatically declined.

In 1988 oil prices began to recover, but major oil companies were not as interested in the deep water of the gulf. Independent (and largely local) operators, however, remained interested and went heavily into debt purchasing large tracts of offshore extraction rights from major companies.

To survive, independents had to cut drilling costs significantly, and they did so by erecting low-cost offshore platforms and by economically refurbishing old platforms. Despite efforts at cost-cutting and switching from drilling for oil to drilling for natural gas, 1992 and 1993 were painful years for gulf operators as oil prices fell below $18 per barrel.

Finally, however, in 1994 the emergence of new technologies in tandem with rising oil and natural gas prices culminated in both lower drilling costs and higher profits for gas operators. Two new technologies drastically reduced extraction costs in the region.

Chart 1

Source: Price of Louisiana oil from Louisiana Department of Natural Resources; mining employment statistics from the U.S. Bureau of Labor Statistics
New Technologies

One of the new technologies that has affected offhsore drilling is three-dimensional seismic imaging. This technology provides geophysicists with more detailed interpretations of seismic data for greater precision in locating oil and gas deposits in deep geologic formations. With more detailed data, scientists can model and identify those formations likely to contain extractable hydrocarbon deposits, reducing uncertainty — and thus costs — in the exploration process.

The second technology, directional drilling, allows for precise extraction along a long and complex path. This new process is unlike the more conventional process that drills more or less vertically beneath the earth's surface. With directional drilling, steering the drill in virtually any direction is possible, allowing exploration of much larger areas from one offshore rig.

On an operational level, however, the new technologies are not without drawbacks. Because both technologies are relatively sophisticated, specialized workers command high pay. Moreover, during the last drilling slowdown in the Gulf of Mexico, many experienced workers left the industry. These developments placed a great premium on specific industry skills. Additionally, the new drilling technology offers the greatest comparative advantage in deep-water exploration, and drilling off the continental shelf requires large investments and long planning lags.

Boost to Louisiana

Nonetheless, the application of these offshore drilling innovations in the gulf has resulted in something of a miniboom to Louisiana.

With the new technology, the energy extraction industry in the state has expanded rapidly. This growth has occurred despite considerable volatility in the price of a barrel of crude oil — a mild price run-up in 1995 and 1996 and, more recently, a run back down with little net price movement from the beginning of the gains in drilling in 1995 (see Chart 1).

The state was a prime beneficiary of the last surge in energy extraction activity sparked by the high oil prices of the 1970s and early 1980s. During this time, the energy industry directly provided a large portion of the state's overall tax revenue as well as considerable personal and business income to the workers and firms employed in or associated with the industry.

Will the current positive energy shock from technological innovation have implications for the state similar to an increase in the price of oil or natural gas? To date, Louisiana's energy sector and state tax revenues have clearly benefited, the authors note.

A glimpse at Louisiana's oil and gas revenues shows the recent good times (see Chart 2). These revenues are made up of royalties (paid by oil companies to the state for oil extraction), leases (paid by companies to the state for offshore drilling within three miles of the mainland) and severance taxes (levied by the state to companies that consume its natural resources). Importantly for Louisiana, recent revenues generated by the oil industry have remained relatively steady — and in fact grew in 1994-95 — while oil prices fell. The very recent fall in prices has reduced onshore drilling in the state but has had limited impact on offshore drilling to date.

Chart 2

Source: Louisiana Department of Natural Resources unpublished data
Even though the petroleum industry has once again become interested in drilling prospects in the waters off Louisiana's coast, oil and gas production remain far below that of the late 1970s, and relatively low oil prices have prevented the state from realizing a windfall in tax receipts. But clearly, the efficiencies of the new technologies have positioned the state and Gulf Coast to better compete in oil and gas extraction during the recent period of lower oil prices.

Will the Good Times Last?

With the new technologies permitting greater production at prevailing energy prices, Louisiana has experienced an employment surge in the high-wage energy extraction industry and related industries. This surge may not be as fragile as the ones experienced during the OPEC embargoes, when considerable international collusion was required to keep prices up.

On the production side, these new technologies are making it easier to identify potential energy deposits, rendering it more feasible to extract oil from existing formations and also enhancing overall efficiency, thus driving down the average production costs. These factors hint that Louisiana may continue to enjoy the good times brought about by the new extraction technologies.