Felix Salmon

Back in June 2007, I looked at an intriguing idea coming out of Ecuador, whose massive Ishpingo-Tiputini-Tambococha oil fields lie underneath the most important area of biodiversity on planet Earth: Yasuni National Park. (Time’s Bryan Walsh has been there. It’s worth reading his report to get a feel for just what’s at stake here; suffice to say that it’s a place which makes even grammar sticklers want to use the term “most unique”.)

Ecuador’s president, Rafael Correa, had a bright idea: instead of drilling for oil in the park, he would ask the global community to pay him billions of dollars not to drill in the park. $3.5 billion, to be precise, to be paid at the rate of $350 million a year for ten years.

On the face of it, the proposal has a certain amount of logic to it. The world has quite a lot of oil; it has only one Yasuni. And while Ecuador would get some desperately-needed cash from drilling for oil, the world would lose an area of paramount importance.

The problem is that we’re talking about Ecuador, here. What was there to stop Ecuador cashing the checks and then drilling for oil anyway? It’s a sovereign country, after all, and one which has reneged on many promises (a/k/a bonds) in the past. As Kevin Koenig puts it:

The proposal has been riddled with problems from the outset, many of them of President Correa’s own making. The proposal’s political and financial guarantees were slow in coming, which is problematic given Ecuador had seven presidents and two constitutions between 1996 and 2006, and defaulted on its Brady Bonds in 2008. Donor confidence was further eroded by several changes in the financial mechanism of the proposal, and frequent turnover of members of the negotiating team and foreign ministers who were the face of the initiative internationally. These factors, coupled with a series of Correa public outbursts and contrarian environmental policies, undermined the proposal’s credibility.

Nevertheless, the Ecuador Yasuni ITT Trust Fund was set up, under the auspices of the United Nations Development Group, and now, more than four and a half years after the original ask, Ecuador has proudly announced that it has managed to raise $116 million, which is enough of a down-payment that it won’t start drilling for the time being.

Obviously, the $116 million which has been raised by the end of 2011 is a far cry from the $1.4 billion that Correa originally hoped to have raised by this point. And if you look at the source of that $116 million, it’s even less impressive. $51 million came from Silvio Berlusconi, who deducted it from the money that Ecuador owes Italy — as though Ecuador was ever going to pay that money in any event. And another $40 million came from Correa himself, who donated the monster libel damages he extracted from opposition newspaper El Universo, in a suit that Amnesty International said “will have a chilling effect on freedom of expression in the country”. Which leaves just dribs and drabs from elsewhere: $100,000 from Turkey, $500,000 from Australia, that sort of thing. There’s no way that those sort of sums can ever hope to come close to replacing potential ITT oil revenues.

At the same time, Correa’s decision to declare victory and hold off on drilling for the time being is entirely rational. For one thing, there’s a lot of domestic popular opposition to the idea of drilling for oil in one of Ecuador’s two great national treasures of biodiversity. (The other, of course, is the Galapagos Islands.) It’s not that the population doesn’t want the money, but more that they’re very proud of the Ecuadorean Amazon, and very skeptical that if drilling does begin, that the proceeds would go to them rather than into the pockets of oil companies and kleptocrats.

On top of that, there’s a very real option value of not drilling for oil. It’s not like the oil is going anywhere, after all: no one else is in a position to drink Ecuador’s milkshake. Ecuador is retaining the option to drill — and that’s a valuable thing, which it loses the minute it actually starts drilling.

And the value of the option is only increased by the precedent set by the existing trust fund. Ecuador has done something important, here: it’s demonstrated that not drilling for oil is something valuable, and something which at least some of the rest of the world is willing to pay for. From here on in, it can continue not drilling for oil every year, getting rents for doing so all the way. Sometimes those rents will go up, and sometimes they will go down. But the more stable and trustworthy Ecuador’s governance, the more seriously its proposals will be taken. And, of course, if drilling starts in Yasuni, then all those future rents get thrown away forever.

Finally, there’s the fact that the reluctance of the international community to trust Ecuador in its oil-related dealings is mirrored by a similar reluctance on the part of international oil companies to enter into long-term contracts with the country. If you were ExxonMobil or Shell or BP, you would have a lot of very good reasons not to sign a contract to drill in Yasuni: you would be paying a lot of money up front, for a share of future oil revenues which could at any point be expropriated by a future government. And of course you would incur even more wrath from all environmentally-minded people around the world. You might not have heard of Yasuni now, but if Chevron started drilling there, I can promise you that you’d know all about it.

As a result, the ITT reserves would have to be drilled for by Petroecuador — certainly Hugo Chavez isn’t going to want Venezuela’s PDVSA to get involved. And Petroecuador is already giving all the money it can to the Ecuadorean government: it couldn’t find any more money just by starting to drill in Yasuni. In order for real money to start flowing, Ecuador would have to wait many years, for the wells to get drilled, the pipelines built (in the face of what would surely be massive opposition), and physical oil actually sold. Much easier to just collect millions right now, hope for much more in the future, and bask in the happy glow of knowing you’re doing the right thing by your national patrimony and for the natural wealth of the planet.

Oilfields, eventually, run out of oil. But untapped oilfields never do. Ecuador’s onto a good thing, here: it would be foolish to throw it away. Which explains why Correa isn’t drilling, despite the fact that he’s only received a tiny fraction of what he asked for.

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?

Did the markets really think the top kill was going to work? Evidently so — BP shares fell 15% today, to $36.52. But before we declare this the end of BP, let’s put this in perspective: the shares traded as low as $34.06 in March 2009. And over the last three years, BP is down 46%, compared to 30% for the S&P 500 (and Exxon Mobil) and 93% for Citigroup.

The most likely fate for BP at this point isn’t death but rather takeover. There’s been a lot of speculation along those lines, and with BP’s leadership looking even weaker than its stock price, the rest of Big Oil is surely salivating at the prospect of picking BP up without much difficulty.

What’s more, BP could easily be broken up, like ABN Amro, and divvied up according to its various geographical units. Here’s what the analysts at Norwegian financial group DnB NOR are thinking:

If several companies were to bid on BP – on a combined basis – Exxon, Royal Dutch Shell, Total and Statoil would fit well together. Then more companies could split the risk of the final massive oil spill bill.

My guess is that this kind of a disappearance into the footnotes of oil history is now the base-case scenario, and the main thing supporting the BP share price. The Deepwater Horizon catastrophe might well spell the end of BP as an independent company, and it’s unspeakably tragic for hundreds of thousands of families in the Gulf. But it might just represent the opportunity that ambitious oil executives in other companies have long dreamed of — and I doubt that BP shareholders, scared as they are of billions of dollars in possible costs and fines, would put up much of a fight.