Offshore drilling: why it makes economic sense to wait

Activists surround Shell Oil rig in Seattle’s Elliot Bay to protest Arctic drilling plans. Daniella Beccaria/Flickr, CC BY-SA

From chants of “Drill, Baby, Drill” to outrage over the BP oil spill, offshore drilling has been highly controversial in recent years. Some view it as a vastly underused revenue source, while others see it as a grave environmental threat. In parts of the Gulf of Mexico, drilling continues on a regular basis. In most other regions it is the subject of fierce political debate.

The Obama administration recently reversed its plan to allow drilling off of the mid-Atlantic coast, which it proposed in 2010, suspended after the Deepwater Horizon spill, then floated again in 2015. Critics have attacked the Atlantic decision, arguing that the government is turning its back on much-needed revenue and resources.

But this line of thinking rests on a flawed economic rationale that ignores our ability to revisit decisions in the future. This “now-or-never” fallacy has driven U.S. offshore leasing policy for years. Convincing the Department of the Interior to finally adopt an economically rational approach that values delaying risky decisions required a lengthy advocacy campaign and a federal lawsuit. Offshore leasing decisions can be incredibly complex, and should be informed by balanced economic analysis.

The economic value of patience

The basic economic principle at stake is known as option value. It recognizes that it can be smart to wait before making irreversible decisions with uncertain outcomes.

When we preserve the option to act at a later time, we can benefit from new information and technological innovation. Financial analysts and economists have recognized this concept for decades. U.S. economists Robert C. Merton and Myron S. Scholes won a Nobel Prize in 1997 for developing sophisticated tools to place a price tag on this value.

Economists have applied the idea of option value to such diverse actions such as forest management and spraying pesticides. In the offshore leasing context, option value puts a price on the benefits of waiting for potential improvements in drilling and spill remediation practices and new information about fossil fuel availability and environmental risks.

Leases for offshore oil and gas development are awarded under five-year plans issued by the Interior Department. Shortly after President Obama took office in 2009, the Interior Department began updating its offshore leasing plan for 2007-2012. Consistent with prior practice, the agency did not properly consider the value of waiting in its analysis of the costs and benefits of opening new areas for oil drilling.

The Institute for Policy Integrity, a nonpartisan think tank at New York University that analyzes law, economics and regulatory policy to improve government decision-making, filed public comments on the decision. (I was the institute’s director at this time.) We argued that Interior’s approach “systematically overstates the value of immediate resource extraction” and could “cost the American public hundreds of billions of dollars” by ignore the potential for future extraction when prices might be higher and the risk of costly environmental damages might be lower.

Oil rigs on the coast of Scotland idled in 2015 due to low oil prices. Michael Elleray/Flickr, CC BY

When the agency refused to modify its strategy, we filed a formal petition to the Interior Department asking the agency to account for option value in all leasing plans and relevant economic analyses. Interior denied the petition but claimed that it was studying whether option value might be included in future leasing decisions.

From our perspective, Interior’s approach was doubly flawed. First, it ignored a substantial economics literature on the importance of option value. Second, it violated a statutory requirement to consider “economic, social, and environmental vlaues” when planning offshore leasing. As I argued in a subsequent law review article, failing to account for option value thus led not only to bad decision making, but also exposed the agency to litigation risk.

Other advocates supported this view. In 2012 the Center for Sustainable Economy (CSE), an environmental advocacy group that focuses on natural resource use, challenged the 2012-2017 leasing plan in court, claiming that Interior’s flawed and incomplete economic analysis violated the Outer Continental Shelf Lands Act by failing to account for option value. The Institute for Policy Integrity helped represent CSE, and I argued the case in my new role as a law professor at the University of Virginia. The three-judge panel included Chief Judge Merrick Garland, now a nominee to the Supreme Court.

The decision in that case, Center for Sustainable Economy v. Jewell, issued in March 2015, rejected the now-or-never fallacy, although it did not strike down Interior’s leasing plan. Writing for herself and Judge Garland, Judge Nina Pillard found that the costs of delay could be offset as technology improves, “drilling becomes cheaper, safer, and less environmentally damaging,” and “more becomes known about the damaging effects” of drilling. At the very least, the panel ruled, Interior should perform a qualitative assessment of those benefits. (This point allowed Interior to move forward based on updated qualitative analysis in its final plan. The third judge on the panel, Judge David Sentelle, dissented on unrelated grounds.)

As this case wound through the courts, Interior was already developing its 2017–2022 leasing plan. In the draft version, released in January 2015, the agency announced that it would offer drilling leases covering more than 100 million acres off the Atlantic coast between Georgia and Virginia – the first oil and gas exploration in this area in decades. This proposal triggered a new wave of controversy. Some state leaders embraced offshore leasing, which they saw as a major new revenue source, but coastal communities and environmental groups voiced outrage over the risks.

While the new Atlantic leases drew most of the attention, the draft leasing plan also included some welcome changes. With the CSE v. Jewell litigation hanging over its head, Interior moved to incorporate a much more nuanced and detailed analysis of option value. For the first time, the agency seriously rejected the now-or-never fallacy. Even as it was exploring new leasing areas, Interior began to provide an extensive discussion of the environmental and social benefits of delay.

Interior’s announcement last month that it would not authorize drilling in the Atlantic is the final act of this protracted drama. After conducting an even more detailed assessment of option value, Interior abandoned its plans to open the Atlantic for drilling in the final 2017–2022 plan. It also committed to performing even more analysis of option value during the lease sale process for all offshore areas.

This last move is especially important because, although Atlantic drilling has been put on ice (for now), Interior has not completely abandoned proposals for leasing in risky areas, including the Arctic. The revised 2017-2022 plan includes both the Beaufort and Chukchi Seas off the coast of Alaska. Those leases are not terribly attractive today: several large oil companies have canceled plans to drill in the region in response to technical challenges and low oil prices.

But if oil prices rebound, we can expect industry interest to follow. In that case, given the massive uncertainties associated with drilling in these treacherous and environmentally sensitive waters, placing the proper economic value on patience will be vital. Interior has taken some important steps to incorporate option value in its thinking, but the real test may lie in the future.