The Vine

Why Offshore Drilling Can Wait

By

Michael A. Livermore is the executive director of the Institute for Policy Integrity at New York University School of Law. He is the author, along with Richard L. Revesz, of Retaking Rationality: How Cost-Benefit Analysis Can Better Protect the Environment and Our Health.

Last summer, when oil prices shot past $140 per barrel, offshore oil drilling became the biggest topic in politics for a short while. In the months leading up to the election, congressional Democrats went ahead and let the offshore-drilling moratoria expirekicking the issue up to the administration. At the moment, President Obama and his Interior Secretary Ken Salazar are under no obligation to open up new areas to oil companies. They just have to come with a plan to auction drilling rights, and they have broad discretion to decide where and when to allow drilling.

In the final week before President Bush left office, his Interior Department put out a controversial Draft Proposed Program describing a five-year plan for oil and gas leases. Salazar is now revising that plan, with the department receiving public input from industry, consumers, and environmentalists. On Monday, Interior held the first of four open hearings to get the public’s opinion on the plan. (See the video here.) Comments at the Atlantic City meeting were about what you'd expect: Oil companies were touting the new jobs that would be created by new drilling, while environmentalists recounted the hazards of global warming.

But there's another approach to offshore drilling, suggested on Monday by the Institute for Policy Integrity, that, if taken, could potentially avoid wasting hundreds of billions of dollars on these leases. Basically, the Minerals Management Service (MMS) should hold off on selling the leases until the price is right.

In the current plan for selling offshore-drilling rights, MMS has failed to value the option of waiting to auction drilling leases. MMS uses a "net present value" formula which works fine for now-or-never type decisions, but can't tell us anything about when we should act. But economists have recognized for decades that when decisions are irreversible and conditions are uncertain, another model is needed. Building on an understanding of financial optionslike the ones executives receive in compensation packagesthey have developed new models to place a value on the option to wait.

The result of using the inappropriate net-present-value formula is a bias in favor of drilling too much, too soon. If decisions are based on the current report, which ignores up to $600 billion in option value, the result would be a huge loss in wealth for the American public. To avoid this, MMS should update their economic models to include "option values." By failing to account for the potential benefit of waiting to lease drilling rights, the MMS plan essentially values all of the drilling options held by the American public at zero. It’s like exercising an executive option at too low a stock pricewe're clumsily hitting the "sell" button before our assets mature, costing ourselves billions.

(Photo credit: mrchriscornwell)

--Michael A. Livermore

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