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.

" data-share-img="" data-share="twitter,facebook,linkedin,reddit,google" data-share-count="true">

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?

More From Felix Salmon
Post Felix
The Piketty pessimist
The most expensive lottery ticket in the world
The problems of HFT, Joe Stiglitz edition
Private equity math, Nuveen edition
Five explanations for Greece’s bond yield
Comments
13 comments so far

I agree with almost all of this (who wouldn’t, of course). But innovation doesn’t happen in a vacuum. And unless you drill deeply, and have to solve those problems, it’s very difficult to get funding (or the on-the-ground smarts) to anticipate the potential hazards.

Posted by CharlesR | Report as abusive

And as we reach peak oil, the value of the option increases. On the other hand, a technological breakthrough in solar, wind or wave energy reduces its value.

Posted by RZ0 | Report as abusive

It is likely to be at least a couple of decades before we have viable options to replace a liquid or gas fuel that allows for very portable transportation.

It has been pretty clear since the fall of the Soviet Union and the rise of capitalist China that we will be competing for hydrocarbon resources. It has made no sense to me that we would willingly deplete our own reserves when oil is still relatively cheap and put ourselves in a position where we would then need to buy a lot more expensive oil from other countries in the future.

We need to use the next couple of decades to develop sustainable alternate fuels for many of the purposes that oil and gas are currently used for. Having a long, broad top to US peak oil would be preferable to a much sharper spike that could have negative consequences a couple of decades from now.

Posted by ErnieD | Report as abusive

Apropos of Hotelling, Journal of Political Economy in 1931,
THE ECONOMICS OF EXHAUSTIBLE RESOURCES

“1. The Peculiar Problems of Mineral Wealth. Contemplation of the world’s disappearing supplies of minerals, forests, and other exhaustible assets has led to demands for regulation of their exploitation. The feeling that these products are now too cheap for the good of future generations, ….

cheapness they are being produced and consumed wastefully”

(you can read it in Bulletin of Mathematical Biology Vol. 53, No. 1/2, pp. 281-312, 1991)

Posted by FixedCarbon | Report as abusive

The mistake in thinking of this as an option value problem is that it doesn’t ask “whose option?” Theoretically it should be the US citizenry. But of course the oil companies on whom we depend for extractive technology are in a different position. None of them have the option to delay extraction – or rather, if one of them decides to delay, another will extract now in its place and receive the profits. Its an agency problem… And the oil companies have effectively bought and paid for a compliant congress and administration – and the populace goes along because most of us are way too dense to understand anything beyond “OMG! Gas prices have gone up!”

Posted by FosterBoondog | Report as abusive

Felix, you are missing a key point here: if we stop most oil drilling in anticipation of future rapid progress in drilling technology, this progress won’t happen. The technology progresses only when we drill. It won’t just happen in a university.
You can argue that drilling will still likely to happen abroad and thus technology will progress regardless of our decision, but then we will have to import, not export these technologies, which is hardly inconsequential.

Posted by ipla | Report as abusive

Less drilling in the short term would have both pros and cons.

On the pro side it would preserve a finite resource further into the future.

On the con side it would increase both imports and prices and decrease goverment revs (the goverment gets royalties and corporate taxes from drilling.)

All and all I’ll say drill baby drill.

Posted by y2kurtus | Report as abusive

Charlesr, ipla: the gulf of Mexico is not the only deep water drilling field in the world. All of the major private oil firms are multinational. Innovation will occur whether it is in our backyard or somewhere else.

I say let’s allow Petrobras to pioneer deep water drilling technology and the setbacks (read: high cost and accidents) that come with it off the coast of Brazil.

Posted by kmandu37 | Report as abusive

Rushing into leasing high grade acreage without understanding the option value of oil is sheer folly. Whether the landowner is the US Government with deep water acreage or a private landowner in the Eagle Ford, knowing and understanding what is below the ground can earn you fantastic riches. I have witnessed with utter dismay at how landowners have unwisely squandered their once in a lifetime great fortune here in the prolific Eagle Ford by rushing to sign any oil and gas lease presented to them, even really, really bad leases with terrible terms.
Technology is improving at a very rapid pace. Better recovery factors and higher prices will ultimately pay patient landowners rich dividends. Those who wait will be richly rewarded.

Posted by libertadormg | Report as abusive

Nonsense. What a limited opinion, on a complicated subject. I find it irresponsible to disregard 100 years of data just to make a cse for not drilling. Prices to produce will go up, regardless of technology gains, the regulators will demand it. Alternatives? lol, the magic silver bullet that we all think exsists. Depending on business to innovate our way our of this problem and then using government to punish those who do, the irony of democratic capitalism. I think the US should be worried much more about the pace of education and our competitivness with developing states then how and when we should use resources that are easily and cheaply attainable, with public approval. As long as this government and green lobby keeps us captivated with something as meaningless as off shore drilling, how can we complain about the failure of a sucessfull democratic system.

Posted by savannah05 | Report as abusive

Replacing the blow-out preventer on the maintenance schedule, would have prevented the Gulf spill. It had nothing to do with “manipulation” of anything. Do you walk barefoot, no clothes and use absolutely NOTHING processed with some petroleum product? No you don’t. So, your opinion, along with all the other idiotic one’s, are mute. As usual.

Posted by Yourkidding8 | Report as abusive

The absurdity of this article beggars belief.

Error No. 1 – Oil reserves aren’t finite, not at all. Proven reserves are limited only in the methods utilized in determining their size. In other words, more imaginative means of discovering and assessing reserves usually reveals larger-than-expected reserves, and usually in places where, again, they weren’t expected.

Error No. 2 – Following the reasoning that energy resources should be left in the ground, or under water as the case may be, then ALL oil drilling should be stopped, NOW. Hey, it’ll be worth more in the future, right? Meanwhile, let’s start a fire using wood and striking stones together. That’ll support an industrial economy, just like all those silly windmills.

Posted by Elektrobahn | Report as abusive

I see your point about looking at future value versus present value. I also understand that most of these models don’t work.

For instance, what is the value to our nation if we reduce our dependence on foreign oil by “x” percent? What is the cost to our country of allowing our costs for energy to be higher than they otherwise might be during a time in which China, India, Brazil and others are rising superpowers?

Does it not appear that this future value tool is simply a way to justify doing nothing at all for ulterior motives?

Posted by charliethompto | Report as abusive
Post Your Comment

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/