U.S. Economy
Oil and Natural Gas Prices Rise, Drilling Activity Falls

Since the first of the year, oil prices have surged more than 35 percent, but drilling for oil has declined by 3 percent. Over the same period, natural gas prices also have risen by nearly 30 percent, while drilling for natural gas has dropped nearly 15 percent. Stephen P. A. Brown and Priscilla Caputo examine reasons for the puzzling decline in drilling.

The reasons for the puzzling decline in drilling appear to be somewhat different for oil than natural gas. An overhang in the capacity to produce oil is restraining oil drilling, while a continued adjustment to previous declines in natural gas prices is driving down natural gas drilling.

Chart 1

As shown in Chart 1, drilling for crude oil generally moves with oil prices. A closer relationship is more evident prior to 1998. As OPEC pushed prices upward by restricting production in 1999, however, the relationship weakened. The overhang of excess capacity in OPEC created the possibility that oil prices might fall. The result was a muted and delayed response in oil drilling. Oil drilling did not pick up until growing demand pushed OPEC closer to full capacity.

The story is similar today. Political uncertainty and OPEC production restraint have pushed world oil prices upward, although excess capacity is nearly 10 percent of world oil consumption at 6 million barrels per day. The overhang of capacity creates the possibility of a sharp oil price decline and adds considerable risk to future oil prices, which discourages exploration and development activities.

Chart 2

Drilling for natural gas also moves with natural gas prices, but with a delay. As Chart 2 shows, however, natural gas drilling still appears to be adjusting to the sharp decline in natural gas prices that occurred in 2001. Natural gas drilling was greatly stimulated by the strong rise in natural gas prices that occurred in 1999 and 2000, and the natural gas rig count remains relatively high despite recent gains in natural gas prices. In addition, relatively high inventory levels of natural gas in storage raise the possibility of slippage in natural gas prices.

Chart 3

As the economy strengthens, however, drilling for oil and natural gas is likely to pick up. The demand for both oil and gas moves with the business cycle—but more strongly so (Chart 3). U.S. oil consumption varies by 60 percent more than GDP over the business cycle. U.S. natural gas consumption varies by 40 percent more than GDP. As the growing economic activity boosts energy demand, reduces inventories, pushes OPEC closer to full capacity and possibly boosts oil and natural gas prices, drilling for oil and natural gas should rebound.

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