AN ECONOMETRIC MODEL OF OIL EXPLORATION AND

DEVELOPMENT IN THE UK CONTINENTAL SHELF

GEORGE KUBANTSEV
ECONOMICS 4551

INTRODUCTION
The brisk economic growth and high oil prices have raised the importance of
energy supply. Successful exploration activity is a crucial factor for future oil and gas
production. In recent years, the exploration activity in UK Continental Shelf (UKCS)
region decreased substantially, which can be shown by the declining number of
exploration and appraisal (E&A) wells started up in each year. The production of oil is
also falling (Digest of UK Energy Statistics, 2013). There are a number of factors that
influence this plummeting, including an increase in taxation on North Sea production
made without warning in 2011 (Mearns, 2013). This unsteady situation in the UK
Offshore oil region definitely has influence on the oil supply projections in the UKCS.
It becomes interesting to try to estimate the influence of economic and geological
factors on the supply of oil in the region.
Modeling of oil exploration and extraction is a complex task and involves
important economic, geological, and political considerations. The modeling task is
further complicated by the fact that it is hard, if not impossible, to predict the discovery
of new oilfields and to the lesser extent oil prices (Hashem, 1990). Therefore, only
careful and thorough consideration of all possible input and output decisions made by
the region authorities can lead to a model that will be capable of prediction the
petroleum supply for a certain time period. However, it is nevertheless interesting to
estimate the influence of different geological and economic factors on the petroleum
output and the infrastructure development of an oil and gas producing region. The
requirements for the model specification are not so overarching in this case. Therefore it
is possible to determine the effects that certain conditions have on the oil and gas output
in the region.

The exploration and development of oil in the North Sea began in the middle of
the 1960s, however the level of exploratory activity started to increase rapidly only by
the mid-1970s when two major oilfields at Forties and Brent were discovered and the
oil prices surged in 1973. The level of exploration activity since then has undergone
important cyclical variations and one of the aims of this paper is to see whether these
variations can be explained adequately (Hashem, 1990).
The idea of finding the factors that influence the development of the industry in
the oil region is not new, various econometric models were suggested. Models with
different combinations of geological and economic variables to explain the oil and gas
exploration and output have been in use for more than 40 years. The pioneering study in
this field was done by Fisher (1964), who was estimating equations for the drilling rate,
success rate and the discovery rate using such variables as oil prices, seismic crews and
proxy variables for drilling costs. The subsequent studies by Erickson and Spann
(1971), and MacAvoy and Pindyck (1975), who added more explanatory variables and
used improved data.
Pindyck (1975) considers the problem of the simultaneous determination of the
optimal rates of exploratory activity and production in the context of a continuous -time
model under certainty. He shows that the optimal rates of extraction and exploratory
effort critically depend on the initial level of reserves.
However, all these studies lacked a theoretical and geological basis. The models
of Eckbo et al. (1978), and Kaufman et al. (1991) were based on sound geologicstatistical data. However, they did not account for economic factors and failed to
response to changes in oil prices.
Some integrated approach models emerged in 1990s for the exploration and
production of oil and gas in UKCS shelf, when it became possible to use a sufficient
number of years of production in the study. However, their explanations of exploration
were quite simple. Moreover they failed to establish robust estimates in support of intertemporal maximization. The assumption of inter-temporal behavior was relaxed in later
studies by Iledare and Pulsipher (1999), Farzin (2001).

Kaufmann (1991), and Pesaran and Samiei (1995) used econometric techniques
to specify and estimate an integrated model of petroleum supply, with specific
application to the Lower 48 States in the USA. In their studies they used the model
offered initially by Hubbert in 1956 that the oil production in the lower 48 US states
follow a bell-shaped curve, reaching its peak in 1970s. Despite its success in
prediction of oil production at that time, his lifecycle model has been widely criticized
in the subsequent years. One of the flaws of the model is that it doesnt include explicit
economic variables. The other problem is in the presence of advancements in
technology (Hubbert, 1956).
Kaufmann (1991) adopted a two-stage approach to integrate the economic and
geological variables. In the first stage he used Hubbert's bell-shaped curve, which in
theory should represent the rate of petroleum production as an inverse proxy for longrun average costs of production. In the second stage, he regressed economic variables
on the error term obtained from the estimation of the symmetric bell-shaped curve in
the first stage.
One of key problems is that the variables that capture technological progress tend
to move monotonically over time and, therefore, correlate with indicators of maturation
and depletion. The inclusion of the time trend, like in the studies by Forbes and
Zampelli (2002), may be, however, a weak but at least manageable instrument to assess
the impact of technology over time.
Kemp and Kasim (2006) estimated a system of equations for the UKCS using the
notion that oil companies adapt their exploration strategies according to changes in
economic conditions, thus the oil price variables should not be included in the equation
for the discovery process. The petroleum supply process is considered as a series of
input/output decisions which are connected both contemporaneously and with a time
lag. The same approach will be taken in this paper.

WORKING HYPOTHESIS
The idea that oil production in a region follows a bell-shaped curve, was
originally offered by Hubbert in 1956. He predicted that oil production in the lower 48
US states would reach a peak in 1970, and he was correct (Hubbert, 1956).
Despite the criticism surrounding this approach, the idea that the shape of the
output curve depends on the reserves in the region is reasonable and naively can be
observed on the Figure 1, using the data for production and proven reserves (divided by
10 for illustrative purpose).
Figure 1 shows that starting from the peak in 1988-1989, the output trend
resembles, with a certain lag, the reserves trend.
Figure 1. Oil production and reserves over time*
160
140
120
100
80
60
40
20

19
75
19
78
19
81
19
84
19
87
19
90
19
93
19
96
19
99
20
02
20
05
20
08
20
11

* constructed by author

Output
Reserves/10

However, the underlying assumption of the recent studies on the supply of

petroleum was that not only the information about the geological reserves but also the
economic information has a crucial influence on the exploration and production activity
of the oil and gas region (Kemp, 2003).
For example, the rapid drop in the numbers of proven reserves can be explained
by the decline in the exploration activity in the region, which has lead to much smaller
number of exploration and appraisal wells start-ups. It is possible that the recent decline
in the number of exploration wells and the oil production can jointly be explained not
only by the shrinking amounts of reserves left but by the economic factors of
production. Still, there is always a possibility of external factors, which can not be
easily observed such as political factors and the decisions of the management of the oil
and gas operators in the region that can influence the petroleum production.
Further, the information gathered from the exploration and appraisal activity used
to make a decision about the number of development wells drilling, which in turn helps
to determine both the levels of production and remaining reserves (Kemp, 2003).
Therefore, the feedback structure of the petroleum supply process is determined
by the number of interdependent processes that can be described both as an effect and a
cause in different situations.
The UKCS region is characterized by the production of oil and gas from the same
basins and wells. Therefore, it maybe be effective to consider not only vertical
relationships (exploitation of only one resource type) but also horizontal (the joint
exploitation of oil and gas in the region). Several studies suggested that this approach is
more powerful. However, due to the lack of time to gather all the necessary
information, this study utilizes only vertical dependence approach, which can be less
effective.
Thus, the structural equations of the model consist of the variables and
relationships that are important in the process of the exploration and extraction of oil in
the UKCS region. The main principles of the model are consistent with the basic
postulates of economic theory relating to the natural resources supply and related to the
outcomes of the study by Moroney and Berg (1999), which stated that the partial

adjustment model that combines reserves, the real price of oil and lagged production
yields the better results that models that uses reserves or real price of oil alone.
This model is empiristic in nature, therefore it is not necessary to rely on
restrictive assumptions like the presence of the perfect competition or the extraction
principles postulated by Hotelling (1931) and Hubbert (1956). The systems approach
allows not ignoring the indirect influences of the variables. However, there is always
the possibility of omitting the important variables that are harder to find, primarily
geological in nature, like the average water depth of the wells. This fact can have
negative influence on the results obtained.

THE MODEL
The model presented in the paper consists of six equations and one identity. It
contains 30 variables, seven of which are endogenous. The structural equations describe
the fundamental relationships in the oil exploration, development, production, costs and
reserves based on plausible economic propositions and the findings of the earlier studies
(Kemp, 2003).
The approach is to estimate the outlined processes by the available economic and
geologic explanatory variables. The identity in the model is used to define the number
of reserves of oil remaining as a difference between the proven reserves and the
cumulative production of the oil during the observed period of time, from 1975 to 2013.
All monetary variables are expressed in real terms, the price of oil is in real US
dollars, all other variables are in real pounds (the base year is 2012). The relevant data
on oil wells, exploration and production were obtained from UK Government statistics
website (Oil and gas: UK Oil Portal, 2013), PWC Report (2012), British Geological
Survey Report (2005), Petroleum Exploration Society of Great Britain Report (2013).

MODEL DESCRIPTION
The system of simultaneous equation model is specified as follows:
1) OPROS = f1 (CUMOEA(t-1) OPROS(t-1))
2) OEACOST = f2 (OEA OEACOST(t-1))
3) OINV = f3 (time WATDO PROVENO OPRICE ODED OINV(t-1))
4) OUTO = f4 (ODED OUTG OPRICE CUMOUTO d_OPEXO OUTO(t-1))
5) OTR = f5 (OPRICE OTR(t-1))
6) PROVENO = f6 (OINV OPROS time PROVENO(t-1))
where d denotes change in a variable; (t-1) first difference of a variable
ENDOGENOUS VARIABLES:
OPROS = Oil exploration success rate in year t (percentage)
OEACOST = Oil exploration and appraisal cost in year t ($, real2012)
OINV = Oil investment ($, real2012)
OUTO = Oil output in year t (mln tones)
OTR = Oil gross total revenues in year t ($, real2012)
PROVENO = Initial proven reserves of oil in year t (mln tones)

EXOGENOUS VARIABLES:
TIME = Time trend
WATDO = Average water depth of oil development wells starred in year t (feet)
OPRICE = Price of crude oil at time t ($ per barrel real 2012)
ODED = Oil development wells start-ups in year t (no. of wells)
CUMOUTO = Cumulative oil output at the beginning of year t (mln tons)

ESTIMATION RESULTS
The model was estimated using the 3SLS technique in the Gretl and Stata
econometric packages (Greene, 2002). The 3SLS approach was chosen because the
errors of the equations in the model are likely to be correlated. The detailed results are
presented in Appendix 1 and briefly discussed here. All important for the model
purposes estimated coefficients have the anticipated signs, however some coefficients
have big standard errors that do not allow to reject null hypotheses. The adjusted Rsquared for all models except one ranges from 0.64 to 0.97. The equation for the
exploration success rate, though very important for the overall significance of the
model, which restricts the possibility of excluding this variable from the model, has
very poor explanatory power. One of the obvious reasons for this can be that the
observations for the dependent variable were obtained from the unchecked source with
significant error. If there is a possibility to get more reliable information for this
variable, the results should be better.

EXPECTED RELATIONSHIPS
1) The exploration Success Rates Function describes the oil exploration success
rate functions. They are postulated as being functions of their respective cumulative
levels of E and A efforts and remaining reserves. It is expected that oil and gas finding
rates would be negatively related to their respective cumulative E and A efforts while
being positively related to their remaining reserves.
In the model estimated the explorations success rates are positively related to
both, cumulative E&A activity and proven reserves. It can be explained by the fact that,
E&A activity declined during the recent years, so did the success rates.
2) E&A Costs Functions: The levels of oil related E and A costs are postulated to
be influenced positively by the respective levels of E and A activities and the immediate
past period costs. The same situation is in the estimated model.

3) Development Investment Functions: The current Levels of oil development

investments are postulated as being determined positively by reserves, prices, current
average size of finds, and current number of new development wells start-ups, and
negatively by the average depth of development wells, and technology. As a technology
change proxy time trend was chosen, however, it appeared not effective.
Investment depends on all of the variables in the list as predicted except of the
development wells start-ups. Figure 2 shows the negative interdependence of these
variables.
Figure 2. Oil investment and the number of development wells start-ups over
time*

* constructed by author

4) Production Function: Oil and gas production are postulated to be positively

related to the current levels of their development wells start-ups and negatively to
operating costs and cumulative production, given the depletion of reserves. The peculiar
explanatory variables in the oil production equation are the current levels of real oil

prices and gas production. Oil price is postulated to positively influence oil production,
but no a priori assumption is made about the direction of influence of gas production on
oil production (and vice versa).
The gas production has positive influence on the oil production. It can be
explained by the cross-effects of these values.
5) Gross Revenues Functions: Oil and gas gross revenues are postulated to be
positively determined by their respective product prices.
6) Initial Proven Reserves Functions: Current levels of initial oil and gas proven
reserves are postulated as being determined positively by current field development
investment, technology and exploration finding rates.

ESTIMATION RESULTS
The initial idea of the model is to assist in the forecasting of the future values of
the dependent variables, using the estimated coefficients. However, due to the fact that
some values of the variables were obtained with error, it is necessary to gather more
information prior to the using of the model. Since nearly all of the important
coefficients have expected signs, the model can be used for preliminary prediction of
the future values of the dependent variables. The ones of particular interest should be
oil investment and production functions. The Stata 13 package can perform forecasting
and compare the results with the real values on the graph for the results, obtained by the
3SLS regression.
The sign of gas output in oil output equation is positive and significant, which
suggest about complementarity between oil and gas in the region. However, other
studies suggest that the opposite relation is sometimes negative, i.e. oil output has
negative influence on gas output in UKCS region. This suggests that the nature of
cross-effects is dynamic and exhibits signs of complementarity and substitutability in
different periods of time. Given the significance of the estimated coefficient in the
model, it is possible to conclude the existence of the strong cross-effects in oil and gas

production in UKCS. The latter can be attempted to be proven in the subsequent study,
which should include equations for gas exploration and production.
The complementarity is a norm for associated gas fields, where the share of dry
gas is smaller than 50%. Since the beginning of 21st century, the number of wells with
such structure is increasing, whereas in 1975 dry gas accounted for 100% of production,
which suggest about the aforementioned idea about the depletion of existing basins,
while no new significant discoveries are present.
The Hausman test was performed to test if the results of the 3SLS and 2SLS
regression differ significantly. The test rejected the hypothesis of the significant
difference between the estimates. This may be a problem of the data gathered, because
the correlation of the errors of the equations is very likely and the 2SLS approach is not
a good estimating procedure in this case. The results of a test are in the Appendix.
CONCLUSIONS

A main proposition of this paper is that the integrationist approach of combining

both economic and geological data yields better results than the separate regressions.
The model was estimated for oil variables only, due to the lack of time and relevant
information, with some errors in gathered data, which had a negative impact on the
results obtained. It is clear that if gas variables be used, the outcomes should be much
more reliable. It can be seen from the statistically significant coefficient of gas output in
the oil output equation.
Nevertheless, the interim results, obtained in this study can be used for making
preliminary forecasts for oil exploration and production activity. Further actions to
improve the estimates include gathering and inputting data for gas exploration and
output in the model and obtaining more relevant data for the existing variables.

REFERENCES
Eckbo P., Jacoby H "Oil Forecasting: A Disaggregated Process Approach." The
Bell Journal of Economics, 1978.
Erickson F., Spann R. "Supply Response in a Regulated Industry: The Case of
Natural Gas. " Bell Journal of Economics and Management Science, 1971.
Farzin Y. The Impact of Oil Prices on Additions to US Proven Reserves.
Resource and Energy Economics, 2001.
Fisher F. Supply and Costs in the U.S. Petroleum Industry: Two Econometric
Studies The John Hopkins Press, Baltimore, Maryland., 1964.
Forbes K., Zampelli E. "Technology and the Exploratory Success Rate in the
U.S. Onshore". Quarterly Journal of Economics and Finance, 2002.
Fretwell N. UK Analysis - Where the Exploration Task Force is going, Total
Exploration & Production UK, 2013.
Greene, W. Econometric analysis (5th ed.). Prentice Hall, 2002
Hubbert M. Nuclear Energy and the Fossil Fuels, Presented before the Spring
Meeting of the Southern District, 1956.
Iledare O., Pulsipher A. Sources of Change in Petroleum Drilling Productivity in
Onshore Lousiana in the US, 1977-1994, Energy economics, Amsterdam, 1999.
Kaufmann R. "Oil Production in the Lower 48 States: Reconciling Curve Fitting
and Econometric Models." Resource and Energy Economics, 1991.
Kemp A., Kasim S. An Econometric Model of Oil and Gas Exploration
Development and Production in the UK Continental Shelf: A Systems Approach, The
Energy Journal, Vol. 24, No. 2, 2003.
McAvoy P., Pindyck R Price Controls and the Natural Gas Shortage
Washington DC: American Enterprise Institute, 1975.
Mearns E. UK North Sea Oil Production Decline, Energy Matters, 2013
Pesaran M., Samiei H. "Forecasting Ultimate Resource Recovery. International
Journal of Forecasting, 1995.

Stoker S., Gray J. The importance of stratigraphic plays in the undiscovered

resources of the UKCS, British Geological Survey, 2005.
Department of Energy & Climate Change Digest of United Kingdom energy
statistics , 2013.
Department of Energy & Climate Change, Oil and gas: UK Oil Portal, 2013.
PriceWaterHouseCoopers Report The Total Tax Contribution of the UK Oil &
Gas industry, 2012.

APPENDIX 1
Table 1 Estimated simultaneous equations model
EQUATION

COEFFICIENT

S.E.

P>|Z|

[95% Conf. Interval ]

.0015488
.0636463
25.97529

.0009386
.163415
5.445692

1.65
0.39
4.77

0.099
0.697
0.000

-.0002909
-.2566412
15.30193

.0033885
.3839338
36.64865

6.871844
.5624954
.4412913

1.315644
.0794699
117.8186

5.22
7.08
0.00

0.000
0.000
0.997

4.29323
.4067372
-230.479

9.450459
.7182536
231.3616

38.44059
4.048134
1.599071
10.22448
3.861539
.1452554
1522.639

0.17
-0.91
1.12
0.69
-0.51
4.66
1.10

-68.72264
-11.63752
-1.349506
-12.93803
-9.530447
.3928649
-1304.159

81.96172
4.230875
4.918737
27.14118
5.606507
.9622554
4664.475

1) Expl orati on
success
rate
CUMOEA (t-1)
OPROS(t-1)
CONST

2) E&A
Costs
OEA
OEA COST(t-1)
CONST
3) Oil
Investment
TIM E
WATDO
PROVENO
OPRICE
ODED
OINV(t-1)
CONST

6.619544
-3.703321
1.784616
7.101573
-1.96197
.6775601
1680.158

0.863
0.360
0.264
0.487
0.611
0.000
0.270

4) Oil
Production
ODED
OUTG
OPRICE
CUMOUTO
OPEXO(t-1)
OUTO(t-1)
CONS

.0730107
.4927394
.0960946
-.0333527
.0137697
.5241316
-5.633291

.0314939
.136051
.072487
.0055816
.0025491
.0616947
7.218499

2.32
3.62
1.33
-5.98
5.40
8.50
-0.78

0.020
0.000
0.185
0.000
0.000
0.000
0.435

.0112837
.2260844
-.0459774
-.0442924
.0087736
.4032122
-19.78129

.1347377
.7593944
.2381666
-.0224129
.0187657
.6450511
8.514706

100.5353
.6053951
4175.22

36.57808
.0783899
1858.422

2.75
7.72
2.25

0.006
0.000
0.025

28.84361
.4517539
532.7793

172.2271
.7590364
7817.661

.0168607
1.694172
.075304
.9064256
-118.8741

.0048311
2.105245
1.274898
.0444112
81.2135

3.49
0.80
0.06
20.41
-1.46

0.000
0.421
0.953
0.000
0.143

.0073919
-2.432032
-2.423449
.8193813
-278.0496

5) Oil total
revenues
OPRICE
OTR(t -1)
CONST
6) Oil proven
reserves
OINV
OPROS
TIM E
PROVENO(t-1)
CONST

.0263296
5.820377
2.574057
.9934699
40.30148

APPENDIX 2
A Hausman test of the difference between 2SLS and 3SLS was performed.
The Null Hypothesis is: difference in coefficients not systematic.
Estimated results for 2SLS and 3SLS regressions are present in the Table 2.1.

Table 2.1. Hausman test of the difference between 2SLS and 3SLS

COEFFICIENTS
2SLS

3SLS

Difference

S.E.

CUMOEA(t-1)

0.00137

0.00154

-0.000176

0.00029

OPROS(t-1)

0.0450

0.0636

-0.1861

0.06992

Chi2(2) = 0.49
Prob> Chi2 = 0.78
The test suggests about the small difference in the coefficients. If 2SLS was giving
biased estimates that 3SLS corrects they would be different. Possible explanation
is the problem with the data used. It was gathered with errors.