Drill, drill, drill?: the economics of drilling

by on September 4, 2008 at 11:31 pm in Economics | Permalink

Matthew Kotchen and Nicholas Burger have done a real study of the economics of drilling in ANWR (ungated, published version here).  Ben Muse reports some of their results:

What are the benefits?  Kotchen and Burger estimated that the oil had a
value of $374 billion (writing in July 2007, they assumed a long-term
price of $53/barrel), but that it would cost $123 billion to extract
and market.  The net return of $254 billion is divided consists of
industry rents of $90 billion, Alaska tax revenues of $37 billion, and
Federal tax revenues of $124 billion.

Under the authors’ understanding of incidence, consumers wouldn’t benefit much at all because oil prices would not fall noticeably.  Still, drilling makes economic sense if the loss of environmental amenities is valued at less than $1,141 a person (per American, not per Alaskan) and that was with a price of oil roughly half of today’s price. 

At today’s price of oil, a rough estimate of the benefit — not counting environmental costs — is over $600 billion.  So the whole issue seems much more important than I had thought just one hour ago.  Some approximation of taxes and transfers and auctions are available, so these gains can be redistributed to some extent if you wish.

That’s a lot of wealth.

Tom Kelly September 4, 2008 at 11:49 pm

Another big benefit is pushing the oil producers farther down the learning curve on drilling, producing, and transporting in very challenging, environmentally sensitive areas- where more and more big oil deposits are likely to be found.

odograph September 4, 2008 at 11:50 pm

And of course if the number is low, we face downsides from coming up empty.

That is not really a Peak Oil argument. It is a Domestic Oil argument.

Patrick September 5, 2008 at 12:31 am

Is that a Wire reference as your title?
http://www.youtube.com/watch?v=r6eAOmz-Aag

happyjuggler0 September 5, 2008 at 12:52 am

What could a $123 billion investment in alternative energy sources bring us?

An economic loss? And that is not counting opportunity cost.

Jason Armstrong September 5, 2008 at 1:17 am

odograph: The numbers released to the public are always on the low end of possible values. 9 times out of 10, the ultimate output is far greater. The estimates are from the USGS, the same guys who said that the Bakken shale had only 100-125 million barrels of oil in it. After 125 million+ barrels were pumped out of it, with no end in sight, they revised their figures to 1 billion plus barrels in the Bakken. Don’t be fooled. There is a lot of oil in Alaska. A heck of a lot.

Anonymous September 5, 2008 at 1:51 am

GA:

Profits are always convex in prices. Therefore the benefit increases at least linearly with respect to the price of oil.

dearieme September 5, 2008 at 6:28 am

“the loss of environmental amenities is valued at less than $1,141 .. per American”: since almost no Americans will ever go anywhere near the place, an approximate value of zero might be fitting.

Bob Murphy September 5, 2008 at 7:31 am

Steve Sailer said,

I could never get excited about drilling in ANWAR when oil futures were at $40, but if they are over $100, why not? Let’s just make sure the federal treasury (i.e., us taxpayers) gets most of the increase in value instead of the oil companies or the state of Alaska, who were both willing to do it when oil was worth $40.

Steve, if you’re still checking this, would you mind elaborating? Is there a market failure argument embedded in the above (perhaps because of environmental reasons)? I.e. if people who live hundreds/thousands (I’m guessing) miles away from you want to engage in voluntary transactions, do you often not get excited about them, and, I take it, think it’s fine to prevent them from doing what they want to do? Or is there something specific to this operation?

Valuethinker September 5, 2008 at 8:26 am

The Net Present Value of drilling in Alaska is the Net Present Value of drilling now MINUS the NPV of drilling in the future.

So if the price of oil rises faster than the real discount rate, then you are justified delaying drilling.

If you think oil prices are going to be higher in the future, you are justified in buying (cheap to produce) Saudie Arabian oil, rather than expensive to produce Alaskan Oil. If you think oil will be scarcer in the future, you do not want to pump it now.

You should also (in both cases) subtract out the cost of environmental damage.

Since environmental damage is in perpetuity, for $600bn of positive cash flows from selling oil, a cost to the neviornment (and to society) of $6-8bn pa (at a real discout rate of c. 1.3% ie the real rate on US government bonds right now) would make the NPV (sum of positives and negatives) less than or equal to zero.

Put it another way, does giving $1000 (or $2000) to every American citizen now, justify damaging the ANWR for all of the future? That’s only a once-off contribution you can have, in a country with GDP per capita over $40k.

spencer September 5, 2008 at 8:56 am

I do not know anyone who has been claiming that at current, or even reasonable prices that drilling in ANWR would not be profitable.

Can you show me a quote of some politician saying it would not be profitable?

As far as the impact on supply and/or price this study say roughly the same thing the EIA study said that virtually everyone quotes.

Aren’t you doing the same thing politicians do of claiming someone said something they did not say and then disagreeing with the incorrect quote?

Jim September 5, 2008 at 8:59 am

How could drilling cause permanent environmental damage? You drive in the equipment, drill a well, attach a pipe, and leave. ANWR is 19 million acres, and the wells would only go in a 1.5 million acre part of it.

Cities and farms permanently displace wildlife habitat. Oil wells do not.

liberalarts September 5, 2008 at 9:22 am

The $374B number is a wrong one, only the net 254 B matters, which is less than $1000 a person. And, since I am not an Alaskan, the $37B that they would jack us for has no benefits to me. So, that gives us $214B for 300 million of us, or closer to $700 each. Still not bad, but not $1,100. Am I missing something?

bruce Humbert September 5, 2008 at 9:54 am

I would love for some one to explain to me what exactly is “environmental damage”. I am having a really hard time grasping what that means. I would argue that “developing” ANWR could be either positive or negative [or $0] in terms of long term impact. Tossed around loosely the term seems to imply that we do damage by living – existing. My suggestion to those of you that believe this owe it to the rest of us to “leave” [in an environmentally sound way of course].

eccdogg September 5, 2008 at 10:10 am

Do those who point out that Oil is likely to rise faster than the risk free rate also believe that Oil is in a “Bubble” driven by speculators and Oil companies not pumping enough?

This seem to be inconsistency.

You don’t need to drill now to get the value now. Just auction the rights today and let the owners do the rate of return and risk calculations. They may drill now or not.

John Dewey September 5, 2008 at 10:29 am

Valuethinker: “So if the price of oil rises faster than the real discount rate, then you are justified delaying drilling.”

Real simple, isn’t it? But exactly how does one “know” how fast the price of oil is going to rise? Oil prices have risen and fallen many times in my lifetime of 57 years. Very intelligent “experts” have staked their reputations on predictions about oil prices – and were wrong at least as many times as they were right.

Remember that the decision to drill will not be made by a single person who is the landowner. It will be made in the U.S. Congress.

valuethinker: “You should also (in both cases) subtract out the cost of environmental damage.”

Again, that sounds pretty simple. But how will we ever get agreement on the short term and long term environmental costs – and benefits – of drilling in a remote location? And how will we get agreement on the environmental costs of the alternatives which are pursued because we did not drill in this remote location?

odograph September 5, 2008 at 10:45 am

Stepping away from bubbles … if you believe global wealth will increase faster than oil production, then you believe price will increase over time(*).

* – the only escape clause is to invoke undiscovered technologies (magic)

eccdogg September 5, 2008 at 11:02 am

Odograph doesn’t that logic lead us the conclusion that we should never drill?

1) Global Wealth is always likely to grow faster than oil production
2) Thus Oil prices will always increase over time
3) So there will never be a point in time that it is a good idea to drill because oil prices will always be forecast to increase.
4) So we should never drill and thus never get the value out of the ground.
5) So we never realize the value of an asset that we own.

My take is that the foward curve clears at a point where producers are indiferent about producing today or 10 years from now at the margin.

Regardless we don’t need to take any of that into account if we are going to Auction off rights to ANWR. The companies that buy the rights will do that calculation and pay you more if they think oil prices will rise.

The only case you could make for not selling at that price is that the buyers of the rights and the forward market undervalue the future price of oil relative to your forecast. In that case you might believe that the market is undervalued (inverse bubble) and by waiting potential buyers opinions will converge to your own. However my guess is that the Exxon’s of the world have a better handle on what the future price of oil might look like than you or I or Senators McCain or Obama and the prices in a competive auction will end up being pretty fair given the available knowledge today.

Isaac September 5, 2008 at 11:07 am

By the costs continuing indefinitely, I of course mean the unmeasured environmental costs and not the financial costs of drilling.

Jeff Goldman September 5, 2008 at 11:11 am

This is a very interesting and intelligent blog post for sure.

But it doesn’t change my views, actually it lends them credibility: I would gladly pay $1,141 right now if it meant that there will never be any drilling in ANWAR. And if you say that I should pay more than that since minors can’t be expected to pay, I would be willing to pay for three people ($3,423).

I don’t understand how we can say that there is any type of crisis when the American people collectively engage in such enormous waste of our natural resources. Even after the recent shift to smaller vehicles, people continue to buy and operate vehicles that are way overpowered for their needs. An East German built Trabant was able to carry 4 people at 60 miles per hour using a 22 horsepower engine. While we may wish to have more comfort, safety, and speed than the Trabant had, it shows that for everyday driving we may need at most around 60 horsepowers. As an example, a 280 horsepower Nissan Altima has performance capabilities that are absolutely impossible to utilize on public roads, even if you drive in a lawless manner. It is truly depressing that so many people are willing to destroy the last few expansive wild areas we still have in the United States just so that the operating costs of a vehicle with capabilities that they will never be able to utilize will be marginally lower.

jorod September 5, 2008 at 12:37 pm

The idea is that $350 billion would be spent in the good old USA on American workers and goods and services. Not on foreign oil companies and workers. I assume that’s per year. The idea that we have to send $700 billion per year to subsidize foreign oil workers because of some polar bears or reindeer is totally nuts. By most estimates, it will take about 30 to 40 years to develop significant alternative energy sources. Until then, drill, drill, drill. And to hell with the polar bears..!!

Valuethinker September 5, 2008 at 1:06 pm

jorod

What happens if, shock horror, these American workers and companies buy foreign goods? You know, like Japanese cars or SUVs that burn Saudi (or Canadian) oil? Or maybe their wives shop in WalMart and buy goods made in Asia?

Conversely what if these ‘foreign’ oil companies hire Schlumberger (or Haliburton) to do their well logging and construction in those foreign lands?

You’ve raised the old problem with all attacks on free trade: making your own economy less efficient might be a nice revenge for you, but it won’t raise your standard of living.

Note that your $700bn of year of oil imports (actually at $100/bl it’s over 1 trillion now), would change by, at most, 10% by tapping ANWR.

And once ANWR is gone, it’s gone. If the price of oil in the future is significantly higher, or the US has trouble getting hold of foreign supplies- -tough. Like our North Sea, production will fall quickly once the field hits maturity.

Caribou are quite special, and ANWR was picked in part because it is the centre of their breeding grounds. But the threat to birds (which are crucial further south because they eat insects which prey on people and crops) is arguably greater.

It seems a lot of damage to do for elusive gains– since (see below) it can’t change the US dependence on foreign oil meaningfully. It’s just about robbing the future to feed the present’s hunger for oil.

The polar bears are probably doomed by global warming in any case– the Arctic is increasingly ice free, and the bears drown, swimming from ice floe to ice floe.

Sam Penrose

Drilling in the Arctic is now a forgone conclusion, given that ice free year round is within shooting distance. ANWR won’t make a blind bit of difference either way (although the gas will displace some coal-fired generation, so a net positive) in the greater scheme of things.

The general point, that we can’t drill our way out of the global warming problem, is absolutely true.

But what the proponents of ANWR drilling have not done is answered the question ‘why’? When it will be meaningless for oil prices, meaningless for US energy independence (5% of CURRENT consumption, never mind future rates of consumption– 1m b/d on 21m b/d) and economically inefficient.

Economically inefficient because it is inefficient to produce high marginal cost oil (like Alaska) if other countries are willing to sell the US low marginal cost oil.

joshua corning September 5, 2008 at 1:15 pm

if you believe global wealth will increase faster than oil production, then you believe price will increase over time(*).

You are now an advocate for drilling for oil now rather then later.

odograph September 5, 2008 at 1:54 pm

“I have no idea why you would refer to undiscovered technologies as “Magic”. Petroleum wasn’t magic when it replaced whale oil and coal as an energy source. Neither were magic when they replaced wood. Nothing magic about the power distributed from hydroelectric dams.”

When oil replaced whale (etc.) it was a known known, not an unknown unknown.

(Joshua, WTH? Why would higher price later force me to drill now?)

odograph September 5, 2008 at 2:10 pm

I’ll give you this, there is the school of thought that you can tap everything, because the natural progress from primary recovery, to secondary recovery, to tertiary .. means that there isn’t a hard and fast “empty.”

Still I, as a fiscal conservative, would keep an “account” in reserve.

piglet September 5, 2008 at 3:37 pm

“At today’s price of oil, a rough estimate of the benefit — not counting environmental costs — is over $600 billion… That’s a lot of wealth.”

Oh please. What is your time horizon? 10 years? 20 years? 50 years? Spread out over time and over the whole US population, the potential benefit is by no means “a lot of wealth”. And you haven’t even tried to quantify the external cost that would have to be subtracted from the benefit. If you can’t do any better than that, you have chosen the wrong job.

salfino September 5, 2008 at 4:42 pm

http://www.livescience.com/environment/080219-kurzweil-solar.html

Solar and wind power currently supply about 1 percent of the world’s energy needs, Kurzweil said, but advances in technology are about to expand with the introduction of nano-engineered materials for solar panels, making them far more efficient, lighter and easier to install. Google has invested substantially in companies pioneering these approaches.

Regardless of any one technology, members of the panel are “confident that we are not that far away from a tipping point where energy from solar will be [economically] competitive with fossil fuels,” Kurzweil said, adding that it could happen within five years.

The reason why solar energy technologies will advance exponentially, Kurzweil said, is because it is an “information technology” (one for which we can measure the information content), and thereby subject to the Law of Accelerating Returns.

“We also see an exponential progression in the use of solar energy,” he said. “It is doubling now every two years. Doubling every two years means multiplying by 1,000 in 20 years. At that rate we’ll meet 100 percent of our energy needs in 20 years.”

Other technologies that will help are solar concentrators made of parabolic mirrors that focus very large areas of sunlight onto a small collector or a small efficient steam turbine. The energy can be stored using nano-engineered fuel cells, Kurzweil said.

“You could, for example, create hydrogen or hydrogen-based fuels from the energy produced by solar panels and then use that to create fuel for fuel cells, he said. There are already nano-engineered fuel cells, microscopic in size, that can be scaled up to store huge quantities of energy, he said.

odograph September 5, 2008 at 4:50 pm

Right salfino, those things have promise. Mr. Kurzweil freely promises.

It’s like saying “lets spend our savings because my stockbroker promises that Funky Solar will break through next year!”

jorod September 5, 2008 at 5:02 pm

Valuethinker: So we buy imports, What are the other countires going to do with American dollars?

So, some people might buy imported goods. It won’t do anything to measurably reduce oil dependence…. Great, let’s do nothing and let people collect unemployment insurance and we’ll have a socialist paradise!

But maybe some people will take that money and invest it companies that export goods. And then we will make even more money. Yipppeeee!!!! Why don’t I just buy a pineapple and talk to it…?

Matt September 5, 2008 at 10:40 pm

I actually do energy analysis professionally (I personally specialize in natural gas as opposed to oil, but no matter). Several points (more aimed at the commenters than Tyler):

1) As a general economics rule, if a project is “in the money”, you go ahead and do it. The opportunity cost argument for an alternative investment doesn’t hold water- if both potential investments are profitable, you do both. If firm-level scale economics prevent one firm from doing both, then the equilibrium outcome is two firms separately pursuing the projects. In either case the capital investments for both projects end up taking place. If you’re arguing that the capital resources are inadequate for both projects, then what you’re really arguing is that there has been a massive market failure with regards to valuing the resources required to develop the projects. Arguments premised on massive market failure are usually faulty. If the capital resources were truly constrained, then in an efficient market they would be valued such that one project was profitable and the other was not. Arguing for alternative energy projects as a better use of public funds is irrelevant since the entirety of the investment capital for ANWR would be privately raised under any development plan I’ve ever heard of.

2) Project economics for large-scale oil development can be very tricky (I haven’t read the paper yet, so I’m not necessarily saying they did it improperly, just pointing out some landmines). First of all, because of long development times(5-10 years), high upfront costs relative to operating costs, and the lifespan of a project once in operation (35+ years, probably longer in ANWR’s case), NPV is extremely sensitive to the choice of discount rate. Secondly, even though the lifespan of a project is pretty long, because of compound discounting project economics are also very sensitive to the oil price in the first years of production. You can be spot-on with your average price assumption and still have a project that turns out poorly. Thirdly, for the same reasons of discounting, project economics are also very sensitive to development time. Delays in construction don’t have to be all that long to significantly deteriorate project economics. (If you’ve ever wondered why oil companies tend to be conservative in their development plans, these reasons are why)

3) The assumption of “no effect on price” is probably accurate, but not for the reasons most probably think. Short-term (“short run” in oil means 2-3 years) oil prices tend to be very volatile (hence their exclusion from most measures of inflation), because both supply and demand are largely inelastic to price. Because of that, changing supply by relatively small amounts can have a major impact on price. The amount of production from ANWR would certainly be sufficient to lower price were oil a competitive market. However, oil is not a competitive market; it is an oligopoly market. Not only that, it’s an oligopoly market with (as mentioned above) inelastic demand where the oligopolists (OPEC) are the low-cost producers. In practice, the degree of control OPEC has over the price of oil is analogous to a central bank’s control over inflation- absolute in the long-term, tricky to measure and operating with a lag in the near-term.

4) Anyone who talks about futures markets, particularly long-dated futures, should be aware that they are NOT pure prediction markets. They are more properly thought of as price-risk markets, which places them halfway between a prediction market and an insurance market (with speculators as the insurers, and physical participants as the insurees who in one way or another pay a premium to the speculators for assuming risk). That’s still a major simplification. The point is that a long-dated futures price should not be considered an unbiased predictor of actual future prices. How futures markets “clear” is a topic of dissertation-level complexity (and I say this as someone who has dealt both with grad-level economics and futures markets up close).

Scott de B. September 6, 2008 at 3:49 pm

You don’t need to drill now to get the value now. Just auction the rights today and let the owners do the rate of return and risk calculations. They may drill now or not.

The argument being made for drilling is ‘we need to drill, and we need to start tomorrow.’ Now you are admitting that the oil companies might not even want to start drilling tomorrow (as is the case with other locations where they currently have rights).

Either we need to start drilling tomorrow (in which case the oil companies should be legally obligated to, even at a loss), or we don’t, in which case the whole argument is moot.

Dude September 6, 2008 at 5:40 pm

Has anyone bothered to point out that the reason Alaskans are in favor of drilling in ANWR is that they, personally and directly, stand to profit from it? If Alaska is to get (at least) $37 billion from drilling in ANWR, that will work out to (at least) $54000 per person (for Sarah Palin’s family, that’s over a quarter of a million dollars). And what’s more, they know this. So, asking Alaskans if they support more drilling in Alaska is like asking New Yorkers if they’d be willing to support pushing New Jersey into the sea if it would net 50 grand for them and everyone in their families.

The real question we should ask ourselves is, why is it that Alaskans are only 75% in favor? You’d get more people in favor of much more destructive policies in return for a $50k check anywhere else.

Neil B September 6, 2008 at 8:53 pm

I saw in comments claims that environmental degradation in a place hardly anyone visits/sees etc. has negligible valuation for comparison of cost/benefit. Well, doesn’t that go against the idea that the consumer, the economic person, gets to decide how much to value it instead of some thinker who tells them how much it “ought” to be worth to them? Lots of people (me included) just want pristine environments to “exist”, I don’t want to be told what conditions make it reasonable for me to so value it.

But OTOH, let’s ask both those who are opposed to drilling, and those who are for it, to actually put up about what the effects might be, not just have it assumed one way or the other. So many of the “drill here, drill now” folks act like we should assume the environmental effects are negligible or can be easily controlled. I don’t want them getting away with that anymore than I want environmentalists to get away with assuming it would cause such and such harm.

tyrannogenius

Damien B September 6, 2008 at 9:46 pm

Somebody wrote that we shouldn’t count the $37 billions captured by Alaskans, but everybody seems to agree that the environmental costs are shared by all americans. I think that’s right. But let’s go further: the environmental value of ANWR may have a price for the whole humanity. I’m French, and I want my share. It’s not indifferent to me that caribous may lose their breeding ground. If the place doesn’t belong only to Alaskans, why would it belong only to Americans ?

So you should actually divide the potential profit by 6 billions. That makes fifty bucks. Not worth it (for me, at least). Keep our nature intact.

Anonymous September 7, 2008 at 12:11 pm

I find it hard to be impressed by a “windfall” of $200 billion. That’s about half of the amount of wealth destroyed by the mortgage industry alone in about two years. It’s an absolutely tiny amount of money.

Let’s put it in more realistic terms, since cash can be extracted from this oil only gradually. $1200 or so is the value of annuity that pays about $80 per year. That $80 is the relevant number. Americans on average make $40K per year, and we’re supposed to be impressed by $80 a year. Please.

By the way, can someone explain how the tax revenues from a $90 billion profit by oil companies can possibly be $164 billion? Our corporate tax rate is not 65%. Maybe the authors meant oil industry rents of $164 billion and tax revenues of $90 billion (that’s a tax rate of about 35%, much more realistic).

John Dewey September 7, 2008 at 3:51 pm

Matt: “As a general economics rule, if a project is “in the money”, you go ahead and do it.”

Matt, that’s true for the energy company, right? But is it necessarily true for a nation? If the rulers of an oil-exporting nation wish to maintain power as long as possible, wouldn’t it make sense for them to only gradually develop their nation’s petroleum reserves? If native Americans wish to make their petroleum windfall last as long as possible, might they be in favor of a gradual development? In the case of ANWR, I can see the point of some that this natural resource might best be reserved for future needs. I don’t agree with that point, but I can understand it. Basically, some might discount the value of any current revenue beyond the level required for a comfortable lifestyle. They might not discount as much the value of leaving natural resources to benefit future generations.

Charles Hill September 12, 2008 at 1:19 pm

John McCain to support drilling in ANWR, biggest news from Palin/Gipson interview.

http://strategicthought-charles77.blogspot.com/2008/09/john-mccain-to-support-drilling-in-anwr.html

Sword of the New World Vis January 2, 2009 at 3:12 am

Welcome to our company which sells all kinds of Sword of the New World Vis.

Comments on this entry are closed.

Previous post:

Next post: