xt741n7xmv6x https://exploreuk.uky.edu/dips/xt741n7xmv6x/data/mets.xml   Agricultural Experiment Station, Department of Agricultural Economics, University of Kentucky 1977 journals kaes_research_rprts_28 English University of Kentucky Contact the Special Collections Research Center for information regarding rights and use of this collection. Kentucky Agricultural Experiment Station Research Report 28 : February 1977 text Research Report 28 : February 1977 1977 2014 true xt741n7xmv6x section xt741n7xmv6x THE SUPPLY OF
Angelos Pagoulatos, Emilio Pagoulatos and David L. Debertin
RESEARCH REPORT 28: February 1977
University of Kentucky :: College of Agriculture
Agricultural Experiment Station :: Department of Agricultural Economics `

{ -

The Supply of New Discoveries of Crude Oil, Production of Reserves and
Determination of Total Refinery Output in the United States ......... 5
A Theoretical Framework ............................... 6
Crude Oil Reserves ............................... 6
Total Refinery Output ............................. 8
Production out of Reserves ........................... 8
Imports, Natural Gas Liquids and Processing Gain ............. . . 9 I
Structure and Estimates of the Model ......................... 10
Statistical Results and their Interpretation ................... 14
New Additions to Reserves ........................... 14
Determining of total Refinery Liquids ..................... 15
Conclusion ....................................... 16
References ....................................... 18

‘ ` u
{ -

Angelos Pagoulatos, Emilio Pagoulatos, David L. Debertin*
An examination of the responsiveness to economic incentives of the U.S. petroleum
industry is vital if the nation’s oil supply is to be maintained or possibly increased.
Government policy toward the petroleum industry might include price ceilings, import
quotas, depletion allowances and other tax breaks, restrictions on gasoline comsumption,
and antitrust suits. Little is known with respect to how each of these government policies
ultimately affect the prices and availability of oil and oil products to the consumer.
ln this paper an econometric model designed to represent the economic relationships
governing the petroleum industry is presented. The identification of crucial variables that ·
regulate the flow of petroleum to refineries can provide some insight as to the impacts of
alternative petroleum policies on the generation of reserves. Production out of reserves
determines the flow of petroleum to the refineries. An examination of the responsiveness to
I economic incentives of petroleum exploration is vital if the nation’s proven reserves are to
be increased.
Imports of cmde petroleum will be explicitely taken into consideration. All liquids
that go into the process used to produce refined petroleum products will be modeled.
Equations representing the supply of new discoveries to increase proven reserves and the
production out of reserves are specified. Since crude petroleum is a nonrenewable asset
special attention is paid to the issue of exhaustibility.
A number of econometric studies of the domestic petroleum supply have appeared
recently. Fisher’s [7] was the first to estimate supply equations for the U.S. petroleum
industry. The influence of Fisher’s model is evident in subsequent empirical studies.
Erickson, Millsaps and Spann [6] , specified a model of crude oil reserves stocks. Khazzoom
[ll] dealt with the oil discovery problem. Epple’s study [5] dealt with petroleum
discoveries and the decisions of the oil exploring firms. Adams and Griffin [1] concentrated
only on the petroleum refining industry. They estimated the supply of refined products
with a linear programming model. The Federal Energy Administration’s Project
Independence Report is being revised to forecast oil and natural gas supply and energy
demand. Haussman discussed potential biases identified with the FEA’s model [9] . l\~lcAvoy
and Pindyck are the first to have attempted a intergrated model of all aspects of the natural
gas industry. They dealt with regulatory policies for the natural gas shortage [I3] .
A model explaining exploration, reserves determination, production out of reserves
and total liquids to be refined will be developed and estimated.
*The authors are respectively: Assistant Professor of Agricultural Economics at the University of Kentucky;
Assistant Professor of Economics and Research Associate of the Center for Intemationsl Studies at the University of
Missouri - St. Louis; and Associate Professor of Agricultural Economics at the University of Kentucky.

 - — _ Q 6
C V   A j A Theoretical Framework
Q l   Crude Oil Reserves
i . »   i Reserves available in any time period influence petroleum industry’s decisions with
l A i l l respect to the quantity of extracted oil to be refined in petroleum products.
; l   The sector of the petroleum industry most difficult to capture is the supply of new
l T proven reserves. Actual additions to reserves through new discoveries occur by a
i T i T complicated process involving a large number of technological factors. Structural equations
r — l - can be formulated to link economic and technological variables that are important in cmde
. ‘ V y oil additions.
; ’ A r r In geophysical exploration, as the major structures (oil pools) are discovered and
i i i tested, the search must increasingly turn to more subtle structural features (in terms of
= l i O difficulty of drilling, thickness of the productive stratum and permeability of the
' `   formation). Oil deposits occurring in such features are likely to produce less oil than those
. previously found in more favorable structures.
g i . Assuming that an adequate incentive exists to encourage an intensified exploration
‘ i l effort, there is a physical limit to the amount of exploration that can be accomplished
V 3 within a given period of time. The limit is determined largely by the number of drilling rigs
; available and the rate at which the drilling can be done. Progress has been made in increasing
y drilling speed and lowering drilling costs. Further improvements can speed the rate of
exploration and development of sites as well as to make economic some of the sites that
l . previously did not warrant such development.
, 2 Fisher’s [7] study of wildcat drilling and discovery has shown that for economic as
A, ` well as geologic reasons, small prospects considered by operators tend to be relatively
V T   . certain and the big prospects relatively risky. This is so because large prospects, by offering
larger returns on investment, attract operators at higher levels of risk than do small
r prospects.
. i Economic incentives influence the amount of exploration that occurs and determine
· exploration characteristics. An increase in economic incentives leads to more wildcat
drilling. This wildcat drilling takes place on prospects poorer than those which would be
drilled at a lower incentive level. Fisher suggests that the underlying size distribution of
prospects is highly skewed, for risk tends to be reduced by information-gathering activity
before drilling is seriously considered. Further, operators may prefer to drill smaller, less
risky prospects as prices increase. Fisher explains that there tends to accumulate a set of l
undrilled prospects about which some information is known. This set consists principally of
relatively small, relatively certain prospects. Hence, an increase in price induces a decrease in
average size of the prospect which is drilled.
_· This partially offsets the increase in risk which would otherwise occur. The effect is
short—run and is restricted to price increases. Furthermore, although higher oil prices would
y T be expected to result in more drilling activity, over time the size of discovery decreases
owing to the depletion of a finite stock of the resource. However, the discovery of large
prospects is also tied to the amount of research effort geared toward the identification of
` large oil pools. This process involves substantial costs which are sustained over several years.
As the amounts invested in identification and exploration processes continue over time, on
the average, larger pools of oil are likely to be discovered. Such is the case of oil found in
the Outer Continential Shelf.
` Measures such as average size of discovery or the success ratio (the ratio of
L F productive to total wildcats) are functions not only of the distribution of petroleum
prospects found in nature but also of the risk attitudes of operators in the industry. For

example, the success ratio cannot be taken as a measure of the probability of discovery. An
increase in the success ratio tends to be associated with a decreased probability of discovery
in the following year.
The search for oil and gas is carried out jointly. For a given probability of finding
either oil or gas, the higher the ratio of past gas discoveries to past oil discoveries, the higher
will be the probability of finding oil. The discovery of large gas fields may act as an
li incentive for the drilling of large structures.
The major component of new reserve additions is the drilling of new wells. Some are
vv successful crude oil wells, some are successful natural gas wells, and some are unsuccessful I
a (dry holes). The drilling of wells depends largely on economic incentives. ln our model,
is drilling is assumed to be dependent on average drilling costs, the price of crude oil at the
ye wellhead, the success of discovery in the previous period (i.e. the proportion of productive
to total number of wells drilled), and the average discovery size of natural gas in the
d previous time period.
if The rate of exhaustion of potentially productive oil-bearing land is not solely
tc determined by the oil-prospecting firm. The oil prospecting firm buys or rents inputs
ae (exploratory wells and oil-bearing land) and produces outputs in the form of information
about the locate of crude oil deposits. Therefore, it is the owner of the mineral rights to
»n land who determines the rate at which exhaustion occurs. This is done through the decision
yd ` to permit exploration to proceed or to withhold the land from exploration.1 An increase in
gs the unit-rent on oil- bearing land of a given quality will lead to an increase in the a.mount of
ig land supplied. This is because the land is bid away from other uses and because landowners
Of who were withholding land from exploration in the expectation of an increase in rents will
at be induced to make their land available.
The average size of discovery of crude oil is a function of the average discovery size
as of crude oil of the previous time period. Average discovery size in the previous period
ly depicts the depletion effect for large prospects. ln addition, the average size of discovery of
ng crude is dependent on the size of discovery of natural gas in the previous time period, the
all success ratio of the previous time period, a distributed lag of costs sustained for
identification and exploration, and the price of crude oil at the wellhead. Equations
ne determining the success ratio and the average size of discovery of natural gas are specified in
zat ~ &CCOrdance with the foregoing relations (including secondary and tertiary recovery).
be Extension of crude oil reserves depends on both economic incentives and amounts
of of crude previously discovered through exploratory drilling. Economic incentives account
ity for the use of either new technologies or making present tertiary recovery methods
ess economic. Furthermore, if discoveries at any point in time are small, an incentive exists for
of the recovery of oil from already existing reservoirs by recovery from greater depths.
of The revisions of established reserve levels do not seem to respond to any specific
in economic or technological variable. In our model, revisions are assumed to be proportional
to prior discoveries and reserve levels.2
t is For any time period t, total proven reserves of crude oil in the U.S. are given by the
uld identity:
ses .
I`g€ Rt = Rt-_1+ DCt + EC] + RCt · St
i of
ars. _———__-___-———_
OU 1See Epplc [5, pp. 66-69].
i in ’
2Thc disaggregation of revisions and extensions follows the example of the work of McAvoy and Pindyck [13]
Oi. for natural gas.
For l

 Q ` s
i ·   ( { where extensions (ECt), revisions (RCt) and new discoveries (DCt) are combined to form
I   ( additions to reserves. The amounts of crude oil extracted (St) are the only major subtraction
g i from reserves.
’ ( = _ i Total Refnery Output
` ( { Crude oil and lease condensate are the primary inputs for the refining process which
i . i . yield the refined petroleum products. The aggregate supply of refined products (DlSTRt) is
e i t calculated by the following identity for any time period t:
A A V l DISTRt = St + Mt + NGt + GAt
_ _ The amount of crude oil and lease condensate (St), imports (Mt), the amount of natural gas
i _ liquids added for the refining process (NGt), and the processing gain (GAt) realized in the
i refineries sums to the total amount of refined products.3
` ( Production out of Reserves
~ The supply of production is simply the marginal cost (in the short-run) of
. developing existing reserves so that a particular level of annual flow can be achieved.
Marginal production costs will depend on reserve levels relative to production, and as the
T i reserve to production ratio becomes small marginal costs would be expected to rise
» sharply.4
Yi In oil production, a reserve-production ratio of about 8:1 is required. Hence, an
E increase in eight units of recoverable reserves is needed to maintain a one-unit increase in
( i production. However, present technology recovers only about 40 percent of total reserves.
About 20 units of oil would, therefore, need to be discovered to increase production by one
i. » unit.
If economic means were to become available for recovering oil that is currently
identified but not recoverable, proved reserves would immediately be increased. This would
come about through new technology or price increases, sufficient to make present tertiary
recovery methods economic.5
Although price would be expected to be positively related to production out of
reserves, if reserve production ratios are lower than 8:1, current prices may have little
impact on extraction decisions.
Since crude oil is an exhaustible nonrenewable stock resource, oil industry decisions
regarding extraction rates refer to the entire planning horizon which coincides with the
e ( depletion of the resource.
The equilibrium path that the price of nonrenewable resources should follow to the
point of exhaustion has been derived by both Hotelling and Solow. The equilibrium price
changes over time so that market price (net of extraction costs) is increasing exponentially
i i at a rate corresponding to the interest rate. As a result, extractors will be indifferent
Bltems left out of the identity, such as exports of crude petroleum, change in stocks, ets., constitute less than
one percent of the total amount of crude or refined products.
, 4This argument was first made by McAv0y and Plndyck [13] regarding natural gas production. The same
E underlying assumptions seem to be holding in the ease of crude oil production.
5See Adelman [2, 3] and McAv0y and Pindyck [13] .

 9 .
between extracting and holding [12, 15, 18].
Z Firms in the petroleum industry are composed of joint stock companies. The assets
of these firms can be easily exchanged. Furthermore, the industry has a ready access to the
loan market.
As long as expected profits from the refining and marketing operations are higher
than the rate of return from alternative investments crude oil will come to the refineries.° A
positive difference between profit rate and interest rate over future periods would bring
h forth an increase in supply out of- reserves. This is because of the possibility of investing I
is present profits so to yield an additional return. The larger the difference between expected
profits and expected interest rate in the present and near future periods, the larger the
forthcoming supply of crude oil. Capital intensity characterizes the petroleum industry.
Hence, production expenditures in fixed assets would then be expected to be highly
correlated with supply of production out of reserves in every time period.
is · Epple [5] refutes the common belief that the price of an exhaustible resource will
lc rise at the rate of interest. While this is true when the initial resource endowment is fixed '
and marginal production costs are zero, this is not generally the case. If technical progress in
extraction is sufficiently rapid, it is possible that the resource price may remain constant or
even decline for a time. One would expect that a price increase would call forth an increased
supply of the resource unless the increase in price caused expectations of future price
increases. For a given price a decrease over time in the quantity of the resource produced is
gf expected because of the effect of cumulative extractions in increasing the costs of
d production. Technical progress could offset this effect. ‘
Sc Imports, Natural Gas Liquids and Processing Gain
in Imports of cnide petroleum can be assumed to respond to domestic economic
m influences as well as the price of imported crude oil [4] . The price of imports can be taken
is' as given since it is fixed by the Organization of the Oil Producing and Exporting Countries.
nc Imports can be thought of as a demand for foreign crude oil. It is hypothesized that current
lv imports are a function of imported crude oil in the previous time period, the price ’of
la imports, the domestic supply of crude and the utilization of domestic refining capacity
I _ (which acts as a capacity constraint).
rl As the amount of crude oil that is refined increases and the utilized capacity
Of approaches the total refining capacity, imports may not increase so rapidly.
[lc The refinery processes not only uses crude oil and lease condensate but also natural
gas liquids. The amount of natural gas liquids added to the liquids to be refined has been
steadily increasing. Both economic and technological factors have been responsible for this.
  The quantity of natural gas liquids depends on the price of crude relative to the price of
natural gas liquids and a linear time trend.
he The processing gain is the final component needed to determine the total amount of
. liquids from the refinery process. This is the summation of the quantities of all refined .
[Ti products produced (DISTRt). The processing gain represents the expansion of fuels owing
mit to some of the refining processes such as reforming and cracking. The equation for the
' processing gain contains the amount of natural gas liquids added for refining, the amounts
h of crude oil and lease condensate run through stills, and a linear time trend.
6The steady flow of the supply of crude petroleum can be viewed as is minimum amount of output which will be
`amc produced each year because the industry is confronted with a down sloping demand curve for the product which is
increasing over time. Large decreases in the level of output will allow substitutes to take over the market.

 I ‘ I IO
i ’ i ‘ I I Structure and Estimation of the Model
Q j I , The organization of the model is described in simplified form in Figure 1. The model
i » I consists of I I stochastic equations and 3 identities. Both linear and log linear versions of the
i ‘ model were estimated using time series data for the period 1959-72. Two-stage least squares
l i L · estimation was used since several of the endogenous variables are simultaneously
; i 5 determined. Ordinary least squares estimates were also obtained for comparison. The
E f logarithmic specification was preferred because of the higher coefficients of determination
i ‘ i associated with the estimated equations and lower overall standard errors. Data source and
3 transformations and the symbols used are summarized below.
- I t = subscript denoting year.
I TED = number of new exploratory wells drilled. These are the total productive and dry
' I _ holes drilled each year, and they are published in the "Annual Statistical Review"
I by the American Petroleum Institute.
; l SUC = success ratio (ratio of productive to total new wells drilled).
ADSZ = average size of new oil discoveries is the ratio of new discoveries to total
productive and dry holes.
SZNG = average size of new natural gas discoveries is the ratio of new discoveries to total
` productive and dry holes, and they are published in the "Annual Statistical
y " Review" by the American Petroleum Institute.
DC = new oil discoveries measured in 42-gallon barrels. The figures are found in
"Petroleum Facts and Figures" of the American Petroleum Institute.
e I EC = extensions of oil reserves measured in 42-gallon barrels.·The figures are found in
"Petroleum Facts and Figures" of the American Petroleum Institute.
TR = total reserves at the beginning of the year. The figures are in 42-gallon barrels and
I are published in "Petroleum Facts and Figures" of the American Petroleum
DEP= average depth of new exploratory wells. The figures are in feet, and they are
found in the "Annual Statistical Review" of the American Petroleum Institute.
EX= expenditures for exploration and drilling. The figures are computed from tlie
"Annual Statistical Review" of the American Petroleum Institute.
‘ ACW = average cost per exploratory well drilled. The figures are in dollars, and they are
published in the "Annual Statistical Review" of the American Petroleum
I R= crude petroleum reserves are the proved reserves at the end of the year. The
1 figures are in 42-gallon barrels and are published in "Petroleum Facts and
, Figures" of the American Petroleum Institute.

` PNG = price of natural gas liquids at the well head (dollars per barrel). The figures are
reported in the "Minerals Yearbook" of the Bureau of Mines.
I P = price of crude oil at the well head (dollars per barrel). The figures are reported in _
»del the "Mineral Yearbook" of the Bureau of Mines and they were deflated within
the the wholesale price index.
isly S= production of crude oil (in thousands of 42—gallon barrels, from the "Annual
l`he Statistical Review" of the American Petroleum Institute). I
and PRO = profit rate on equity of the petroleum industry. The figures are the rate of return
on book net assets and is reported in the "Monthly Letter" of the First National
City Bank, New York.
INT = interest rate. The figures represent the price of commercial paper 4 to 6 months
lry reported by the Board of Governors in the "Federal Reserve Bulletin." (
K = production expenditures in fixed assets of the petroleum industry. These figures
are published in "Financial Analysis of a Group of Petroleum Companies" by the
Energy Economics Division of the Chase Manhattan Bank, New York, and they
were indexed with 1960 as the base year.
M = imports of crude petroleum. The figures are reported in the "Yearbook of
International Trade Statistics" by the United Nations. The Standard International
>tal Trade Classification number is 331.01, and the figures are converted to thousands
ical of 42-gallon barrels from metric tons.
PM = average import price. The figures are computed as a per unit price from the value
in (f.o.b.) and quantity figures reported in the "Yearbook of International Trade
Statistics" of the United Nations.
lin REF = refining capacity utilization (as percent of total). Total capacity for refining is
reported in thousands of 42-gallon barrels, and it is found in the "Annual
Statistical Review" of the American Petroleum Institute.
rum NG= natural gas liquids added, in thousands of 42-gallon barrels, from the "Annual
Statistical Review" of the American Petroleum Institute.
are GA= processing gain in thousands of 42-gallon barrels from the "Annual Statistical
. Review" of the American Petroleum Institute.
the PBL = price of bituminous and lignite. The figures are computed as a per unit price from
value and quantity (short·ton) figures reported in the "Minerals Yearbook" of the V
Bureau of Mines.
zum T = linear time trend.
DISTR = sum of domestically supplied refined product (net of imports, exports and change
The in petroleum stocks). The figures are in 42—gallon barrels and are reported in the
and "Minerals Yearbook" of the Bureau of Mines.

 2 12
A   l P/PNG = price of crude relative to the price of natural gas at the wellhcad.
  A 1 RC = revisions. The figures are in 42-gallon barrels and are published in "Petroleum
f Facts and Figures" of the American Petroleum Institute.
. ) The resulting estimates a.re*:
T New exploratory wells
i · (1) 1nTEDt = 3.09 - 1.21 1n ACWt - 1.20 1nSUCt_1+ 0.359 1nl’t +
. (7.29) (0.24) (1.16) (1.17)
l ( 1.39 1nSZNGt_1
. i (0.99)
V · Average discovery size of oil
(2) 1nADSZt = -95.02 - 0.162 1nADSZt_1 +1.30 1n[1.1(0.42E.Xt_1+
(48.15) (0.08) (2.10)
0.32EXt_2 + 0.26EXt_3)] + 15.01 1nSUCt,1 + 1.27 1nSZNGt_1 -
( ( (6.07) (0.19)
1.52 in?.
V (4.67)
Success ratio
(3) 1nSUCt = 2.34 - 0.298 1nSUCt_1 - 0.013 1nADSZt_1 - 0.018 1nSZNGt_1 +
(1.12) (0.27) (0.004) (0.008)
0.547 1nDEPt
I Average discovery size 0 f gas
(4) 1nSZNGt - 42.43 - 0.185 1nSZNGt_1 + 0.040 1nADSZt_1 + 9.05 1nSUCt_1 +
1 (54.09) (0.16) (0.11) (10.93)
0.365 1nPNGt
(1.71) —
L *Values in parenthesis are standard errors.

Extensions of reserves
(5) 1nECt = 2.88 - 0.761 1nECt_1+ 1.99 1nTEDt_1 - 0.009 11110Ct +
(1.70) (0.23) (0.31) (0.03)
»m 0.498 lnlgt
Revisions of reserves _
(6) 1nRCl = 7.18 + 0.4621nARTt_1
(2.48) (0.16)
Production out of reserves
(7) 1nS - 9.42 + 0.235 1nl[1.05 [0.255(PROt — 1NTt) + 0.205 (PROP1) + 1
(1.09) (0.06)
0.18 (PROt_2 -1NTt_2)+ 0.18 (PROP; - 1NTt_3) · 0.18
(PROL4 - 1NTt-4)] 1] + 0.259 1n1’t + 0.158 1n'1Rt + 0.6741nKI
(0.28) (0.06) (0.08)
Imports of crude oil
(8) 1nMt = -14.73 +1.121r1Mt_1+ 0.905 1n8t - 0.0691nPMt — 2.95 1nREFt
(5.71) (0.29) (0.66) (0.40) (0.43)
Addition of natural gas liquids
(9) 1nNGt = 12.49 + 0.004 1n(1;t/PNGI) + 0.156 1nT2
(1.32) (0.05) (0.02)
Processing Gain
(10) 1nGAt = - 67.55 -10.521111QGt +14.11 1118. +1.47 111"I2
(59.40) (8.01) (9.51) (0.76)
Price of crude oil
+ (11) 1nPt = 8.04 + 0.029 111PBLt - 0.099 1111Rt + 0.209 1nPNGt - 0.488 1nSt_1 - A
(3.02) (0.13) (0.16) (0.09) (0.15)
0.460 1I1Pt_]_
(12) DCt = AD8Zt X TI3Dt

 i 14
{ · at . (13) TRt=Rt_1+DCt+ECt+RCt
2   1 (14) St + Mt + NGt + GA]; = DlSTRt
[ l [ `I Statistical Results and their Interpretation
[ l ll Coefficients for most parameters estimated via 2SLS were substantially larger than
Q . ` the respective standard errors, and signs agreed with hypothesized results throughout the
‘ 1 model.
_ New Additions to Reserves
i · [ The elasticity of exploratory drilling with respect to the price of crude is about +
[ 0.35 [equation   . The elasticity of the average size of discovery with respect to the crude
, 1 price is about -1.52 [equation   . The elasticity of the extensions of proven reserves with
. respect to price of crude is about + 0.49 [equation   .
` [ Although prices do not have coefficients substantially larger than the standard
. errors, signs support theoretical arguments. There is little evidence to suggest that price
[ incentives stimulate exploratory drilling activity but cause a deterioration of discovery size.]
Furthermore, price incentives induce more extensions of proven reserves by making
[ economic new technology for recovering additional oil from already drilled oil wells.
s The number of exploratory wells drilled (TED) at time t is negatively related to the
P [ · average drilling cost per well (ACW) and the success ratio of the previous time period
1   i (SUCt_1). The negative coefficient of the success ratio implies that, when relatively small
and certain prospects tend to accumulate during a year, the success ratio is higher than usual
during that year and the accumulated incentory of such prospects is being depleted at a
_ faster than usual rate. The following year there are fewer prospects to be drilled at a
i profitable rate. Consequently, the number of prospects drilled would be expected to
decrease in time t + l. Fisher [7] argues that the effect of inventory depletion is to reduce
the number of small prospects that would otherwise be drilled so that the average discovery
size increases. Finally, a rise in SUCt_]_ is accompanied by a fall in SUCt. The effect of
SUCt_1 in equation 3 is negative, because of the inventory depletion effect, and positive in
equation 4 because of the "incentive-toward-larger-prospects effect."8 The success ratio
(SUC) furthermore is positively related with depth in that the deeper the exploratory wells
are dug the larger the expected success ratio tends to be.
The average discovery size of crude oil (ADSZ) is positively related to the amount of
money spent for exploration over past periods. lt usually takes a substantial exploratory
V effort before new large reserves can be discovered.9
7'I`his same conclusion was first reached by Fisher [7] and subsequently by Erickson and Spann [6] in their
work on natural gas and oil supply. Epple [5] concludes "...the analysis was motivated by the suspicion that earlier
~ estimates resulting in the assertion of a highly elastic supply curve for crude oil were based on an incomplete model of
supply. The analysis of Chapter 3 demonstrated that this was in fact, is the case, and the results indicated that the assertion
of a highly elastic supply curve was warranted." p. 104.
` 8'This point comes more clearly across in this study, because of the district-distinguishing effects, involved in
_ Fisher‘s study [7] .
_ 9Such is the case of offshore prospects in the recent past.

The clear implication of the above·mentioned facts is that the sensitivity of new oil
discoveries to economic incentives is substantially less than that for wildcat drilling. This is
primarily caused by the discovery size deterioration which comes about when small
prospects are made attractive by a price increase. The average size of natural gas discoveries
(SZNG) becomes important in crude oil exploration because the two products are jointly
produced. Prior discoveries of natural gas (SZNGt_1) indicate possibility of finding crude
oil} ° Large natural gas discoveries suggest large structures of undiscovered crude oil. This
makes the elasticities in equations (1) and (2) positive. Since large prospects and certainty i
tend to be inversely related, SZNGt_1 must be positively related to the success ratio in
equation   But because of inventory depletion the average size of natural gas discoveries
decreases over time. Equation (4) suggests that SZNG has an elasticity with respect to
SZNGt_1 of -0.18. Furthermore the price of natural gas has a positive effect on the average
discovery size of natural gas, which is consistent with the McAvory and Pindyck findings
[13] .
Extensions of crude oil reserves (EC) depend on previous extensions (ECt_1) and
total exploratory wells drilled (TEDt_1). The short-run depletion effect of extensions in
i equation (5) is given by the elasticity -0.76 with respect to ECt_l. Total exploratory drilling
I (TEDt_1) has a positive effect on extensions. Finally, small discoveries of new oil will induce
_ the pumping of oil _out of old wells from greater depths, as indicated by the elasticity of
Y -0.008 of variable DC in equation  
The revision of crude oil reserves (RC) (equation (6),) responds to the change of
g previous year’s reserves. The elasticity of 0.46 implies that one barrel increase in the stock of
_ reserves generates about 0.46 barrels of increase in the crude oil reserves revisions one year
i later.
1 . . . . . .
1 ' Increased crude oil prices do not necessarily act as   incentive to exploration and
Ll discoveries of new oil reserves. Rather, prices interact with variables such as (a) investments on
a identifying reservoirs (b) exhaustion effects stemming from the average discovery size, (c) the
a success ratio and (d) extensions that affect the willingness of the industry to intensify the
O exploration effort. Discovery diminishes size when small, but certain prospects become
C attractive as prices increase. Hence, it is difficult to determine the net impacts of