The Option Value Of Not Drilling

NASA photo of Gulf oil slick, May 9

One of the quirks of capitalist economies is that depleting a finite stock of resources counts as adding to rather than subtracting from your nation's stock of wealth. This can lead to naive calculations that drastically overstate the merits of engaging in natural resource extraction—a dirty, dangerous businesses—at home, rather than paying someone else to do it. Another way of looking at it, suggested by a new paper (PDF) from the NYU Law School Center for Policy Integrity, is that not engaging in offshore drilling for oil and gas has a substantial option value. Right now, as Felix Salmon explains, "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."

But perhaps this would be better:

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.

This wouldn't be such a big deal if oil and gas companies were fully liable for the harms caused by drilling mishaps. But as we've learned, they're not. Liabilities are strictly capped at a preposterously low rate. And on this front as on every other the very same conservative politicians who oppose stringent ex ante prudential safety regulation also oppose stringent ex post legal liability.