Question

As a consultant specializing in economics, you have been hired by the small island nation of Petrolo. Although Petrolo’s landmass is small (about the size of Florida), it enjoys enormous oil reserves that rank number five in the world for high grade petroleum. To date Petrolo has not found it necessary to drill into its substantial but at a higher production cost of offshore reserves that are within the 18 mile territorial limit. Petrolo has prospered by pumping enough onshore oil to allow its government to provide handsome social benefits and low taxes to its population while maintaining full employment. Although its only industry is crude oil supply, the country enjoys one of the highest standards of living in the world. Unfortunately, the industrial economies of the world have slowed tremendously in petroleum consumption; world demand for oil is now at a 25 year low; oil prices are at about 30% of what they were a year ago. Today a barrel of oil is selling for $40 while Petrolo’s current average cost of pumping oil is $50 per barrel. As the special consultant to the President, you have been asked to evaluate the economic impact of four options and make a specific recommendation for what the country should do. The options are: Option 1: Stop pumping until the market price reaches at least the extraction cost of $50 a barrel. Option 2: Keep pumping to provide some cash flow. Option 3: Sell offshore licenses to private international companies, which would pay a royalty of $15 per barrel with all extraction costs borne by the licensees. Option 4: Prepare a bond to finance entry into the leisure market with high-end hotels, casinos and entertainment venues. Although this would restrict drilling operations to southern half of the island, the northern end of Petrolo could become a magnificent tourism venue for the world’s wealthy. Tax-free operations for the first ten years of operations for major hotel/casino operations would entice investment. Assignment Prepare a 4 - 6 page paper that uses 2 or more sources, adheres to APA standards and addresses the following: For each of the four options, identify three (3) potential economic impacts considering both possible benefits and downsides and implications for Petrolo’s government and citizens. Based on your analysis and research, make one or more specific recommendations to address the issue.

Answer 1

Option 1: Stop pumping until the market price reaches at least the extraction cost of $50/barrel. The possible benefits are that the oil will not be sold at a loss to the market players and oil inventory will reduce as oil storage is also turning costly with more supply and less demand. The downside will be that the oil producing companies will face severe economic distress as their production facilities will be completely shut, this will increase debt levels and maintenance costs of the equipment and facilities. Citizens would be unemployed as majority of them will be working for the oil industry, and government revenue will also reduce.

Option 2: Keep pumping to provide some cashflow, this will lead to viability of the business and proper maintenance of the facilities. Downsides will be that oil will be sold at a loss and this will incrementally harm the business and employment opportunities. Petrolo's government revenue collection will reduce and citizens will be paid at a lower rate then they were previously, but there would be less unemployment.

Option 3: This could be implemented, but there have to be takers, at this current juncture there would be no takers with limited availability for oil storage worldwide, instead it would prove them expensive to conduct such exercise. What it could do is just do exploration at this current juncture so that they frame what the production costs will be and how much oil is currently available in the offshore area. This could help increase the future cashflows of the government when oil demand starts to pick up. It could also increase investment opportunities and more players would vie for the spot and seek to invest, this could increase the revenue collection of the government. It could also increase employment opportunities.

Option 4: Possible benefits will be higher revenue for the government as this could prove as a major impetus to the local industry. Plus the reliance on just the oil industry which is in distress currently would reduce as there would be another industry which will drive up the GDP of the country. It could increase employment opportunites and help the government further increase the per capita GDP of the population.

Thus the country should opt for option 4 as its reliance on the oil industry will reduce and new industries will emerge which have the potential to drive future GDP growth of the country. One could also recommend that it give licenses to the offshore sites so that low production costs alternatives could be found and focus on services and trade industry to drive growth, or invest the reserves which the government and its population currently has on some foreign ventures where they will be able to earn a higher return on investment. I would also recommend inviting investment opportunities for manufacturing facilities and pharmaceutical companies as hospitality industry has been severely dented due to Covid 19.

Source: Bloomberg, Economist and Guardian.