The option value of not drilling for oil

By Felix Salmon
April 20, 2011
paper out today, explaining that the US is using a crazy system to determine whether to allow offshore oil drilling.

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NYU Law School’s Institute for Policy Integrity has an important paper out today, explaining that the US is using a crazy system to determine whether to allow offshore oil drilling.

Under something known as the Revised Program Outer Continental Shelf Oil and Gas Leasing Program 2007-2012, the Bureau of Ocean Energy Management, Regulation and Enforcement does a very basic cost-benefit calculation when deciding whether or not to allow drilling in a certain spot: it looks at the costs, and then at the benefits, and then if the benefits outweigh the costs, it gives the go-ahead.

What this calculation misses is the significant option value of doing nothing. The oil is, after all, not going anywhere — and if you don’t drill for oil right now, there’s a good chance that the costs of drilling for oil in the future, both economic and environmental, will be lower than the costs of drilling for oil in the present:

Once the decision to drill has been made, it cannot easily be unmade. But that does not mean the only choices are either to drill now or never: waiting to decide is also an option. Because safer drilling techniques and more effective cleanup technologies continue to be developed, the costs associated with drilling should decline over time—perhaps in fits and starts, but following a generally downward trend. Meanwhile, future market prices for the extracted oil are uncertain, jumping one day and falling the next. Given this uncertainly, it only makes sense for the American public to wait to cash in the value of their finite oil reserves until the price is right: when the oil can be sold high, but environmental costs are low.

Unfortunately, the government’s analysis has consistently failed to take into account the option value associated with waiting to drill, even though the methodology to do so has existed for decades. Because of this analytical failure, the government risks the possibility of selling the American public short to the tune of hundreds of billions of dollars.

It’s entirely possible to run a cost-benefit analysis on the value of not drilling for oil — or, more precisely, of waiting until the value of drilling is higher than it is now. If you don’t calculate the benefit of not doing something, then you’re much more likely to do it. And as a result, there’s probably a lot more offshore drilling going on right now than makes rational economic sense:

Calculations that fail to take into account option value are overly simplistic to the point of being misleading. As Dixit and Pindyck stated in their early textbook on the subject, failing to account for option value “is not just wrong; it is often very wrong.” An economic analysis that ignores the option value of waiting overvalues the net benefits of immediate exploitation and will systematically lead to inefficient overexploitation.

The paper makes the case that the current state of affairs is not only economically irrational, but is also both illegal and dangerous:

More complete economic models may have helped prevent the BP Gulf Coast Oil Spill. The value of waiting is greater for relatively more risky drilling activities, like the deep sea operations at the center of the BP spill. Such techniques are relatively newer, and inexperience increases the uncertainty about the extent of risks, the robustness of safety technologies, and the ability of cleanup and containment efforts to reduce harm. If the agency had used an adequate model of costs and benefits when evaluating this kind of deep sea operation, the benefits of waiting for better technologies might have exceeded the short-term costs of delay, leading to smarter use of our offshore resources and fewer risks imposed on the public.

The science of drilling for oil is improving very rapidly — and as a result, a moratorium on offshore drilling might actually cost nothing, once the benefits of improved future drilling techniques are taken into account. Wonks like energy secretary Steven Chu can understand this easily enough. But will they do anything about it?

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