Taxation & the Optimization of Oil Exploration & Production: The UK Continental Shelf

In a recent paper H. Pesaran (1990) has developed an econometric model for the analysis of the exploration and extraction policies of “price taking” suppliers of oil and has applied it to the UK Continental Shelf (UKCS) . The model takes explicit account of the process of oil discovery and of the intertemporal nature of the exploration and production decisions. Estimation of the model over the period 1978( 1)-1986(4) produces an important trade-off between statistical fit and the plausibility of the estimates. The use of rational expectations delivers statistically significant results with estimates of the structural parameters that have the theoretically expected signs, but average marginal extraction costs over the sample take an implausibly high value of over $100 and the “shadow price” of oil in the ground is not
always positive. Sensitivity analysis reveals that one important reason for the implausibly high average estimate of the marginal extraction cost is the low estimate obtained for the intertemporal discount rate: the most plausible estimates for the marginal extraction costs are obtained by setting the discount rate to infinity, i.e. by assuming that the future is irrelevant to the exploration and production decisions of the firm. The aim of this paper is to evaluate the sensitivity of this result to the inclusion of taxation in an intertemporal model of exploration and production of North Sea oil.

By: C. A Favero