TAXATION AND THE OPTIMIZATION OF OIL EXPLORATION AND PRODUCTION: THE UK CONTINENTAL SHELF *

Abstract

IN a recent paper 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, ie. 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. The necessary condition to omit taxation from an economic and econometric model is that the tax system is neutral. A system can be considered neutral if it does not affect the decision of economic agents. A non-neutral tax system has to be explicitly modelled because, by definition, it affects firms' decisions with respect to exploration, development and production activities. When a non-neutral tax system is omitted, its instability might cause the break-down of the econometric model every time the tax system is modified.' The first section of the paper is devoted to a description of the North Sea oil tax-system over the period 1978-86 in order to assess its neutrality and stability. In the second section tax-dependent supply and exploration equations are * I have greatly benefited from detailed comments by Hashem Pesaran. The paper has been greatly improved by the comments of two referees and the editor, Peter Sinclair. I have also benefited from discussion with Robert Mabro and Cristina Caffarra of the Oxford Institute for Energy Studies. The data-set and the econometric package Micro-Fit have been kindly provided by Hashem Pesaran. This paper is part of a research project sponsored by the Oxford Institute for Energy Studies. Partial financial support from the Newton Trust of Trinity College is gratefully acknowledged. ' Instability certainly causes break down of a backward looking econometric model in which taxation is omitted and the true structure is forward looking (Lucas (1976)), but it does not affect the stability of the coefficients in a forward looking model, when the changes in the tax-system are not predictable by the optimizing agents.