He comments:
...Kotchen and Burger seem to ignore that the oil-drilling problem is a textbook application of dynamic programming. In particular, Dixit and Pindyck (1994, ch. 12) highlight the analogy between an undeveloped oil reserve and a call option on a dividend-paying stock. They conclude, referencing Paddock, Siegel and Smith's (1988) original study, that "the use of standard NPV methods would lead to substantial undervaluation of the reserve as well as premature development."
The rest is under the fold...
Since the option is perpetual, a closed-form solution is easy to
obtain if one makes standard assumptions: production from a developed
reserve is represented by exponential decline, the price of oil is a
geometric Brownian motion, asset markets span, etc.Following the authors cited above, assume:
– a payout yield of 4% from a developed field;
– a risk-free real interest rate of 1.25%;
– a volatility of 0.2
Then the option value of waiting is such that we should only drill when
the present value of the developed reserve is at least 1.6195 times the
cost of developing it.Suppose that the price of oil follows a martingale, so the current
price of $105 per barrel is also the expected future price at any time.
Suppose the ANWR reserve comprises 7.06bn barrels and that once the
oilfield is developed it will pump out 5% of the reserve every year at
a constant marginal cost of $5 per barrelThen at the 1.25% discount rate the developed reserve is worth
$564.8bn (which is reasonably close to Tyler’s $600bn estimate).
However, if we start drilling now the reserve will be developed in 10
years (EIA 2004, 2008), so we must calculate the present value of this
sum. The correct discount rate here is the payout rate of 4% (Dixit and
Pindyck 1994, p. 403), so the NPV of drilling now is $378.6bn.
Therefore, the option value due to volatile oil prices implies that we
should drill now only if the cost of drilling, including its
environmental impact, is below $233.78bn.Since the cost estimate above ($5 for getting a barrel of oil to
market from an existing well in Alaska) only accounts for an NPV of
$18.93bn, Kotchen and Burger’s figures leave me with a $103.87bn cost
of developing the reserve. Then we should drill now if the
environmental cost is less then $130bn, or the willingness to accept
compensation to allow drilling less than $590 per voter.Admittedly all my figures are very rough estimates, but I believe
this is the correct order of magnitude. The reserve is indeed worth
about $600bn, but that is not very important, because the choice is not
between drilling now or foregoing drilling forever, but between
drilling now or waiting and seeing.Furthermore I have ignored the possibility of cost-reducing
technical progress. I don’t see why drilling should become costlier or
more environmentally damaging; but it probably could become more
efficient on either account. That would increase the option value of
waiting.Obviously, we should rush to drill now if we expected oil prices to
decline sharply in the future, because then the reserve would be
rapidly depreciating while it is left in the ground. But that does not
seem to be the argument of the bozos on either side of the aisle.
It’s also worth noting:
1. Critics of drilling usually want to shut down the option forever and the political window cannot be expected to remain open forever.
2. There is a general global warming case against developing the resource. Note that supply restrictions can be far more effective than a Pigou tax. A Pigou tax doesn’t guarantee the stuff won’t be pumped anyway, albeit at lower profit.
3. The Pigouvian case against developing ANWR makes sense only if we are taking other systematic actions to raise the price of fossil fuels and restrict fossil fuel use. Otherwise we may just be leaving a $600 billion dollar bill on the proverbial sidewalk. This may be a classic case of twin-peaked preferences.
4. Depending how the money is spent, and on the general equilibrium properties of the system, it still may make sense to have a) a Pigou tax on fossil fuels, and b) ANWR development. For one thing, it does matter who captures the profits from fossil fuel development. You could imagine an even stiffer tax on imported fossil fuels (relative to what would be optimal without ANWR), combined with ANWR development. You can spin out lots of tricky problems here.
I was thinking something similar about the Large Hadron Collider. Why didn’t we just wait ten more years to build it? Surely it would have been half the price and twice as useful. Do physicists just get bored waiting?
In this week’s Nature podcast, Cory Doctorow talks about that with an LHC person. The answer they give is that it’s just not acceptable to the grant-givers to put the money in the bank and have the scientists sit on their hands.
“Critics of drilling usually want to shut down the option forever and the political window cannot be expected to remain open forever.”
That being said, if oil becomes truly scarce worldwide, the window will reopen. Isn’t ANWR best used as a rainy day fund, allowing the USA to make a steadier transition to the new energy economy in the future?
The central question for this argument is, will the world transition to new energy sources before we hit peak oil, or afterwards? Surely that time will come, especially with 3rd world demand rising so fast, and we might not be ready for it. Even if the US is entirely on renewable fuels at that time, will India be?
I would rather have insurance against an oil-starved future than to give today’s America $600 billion to spend. If you wanted to invest the entire profits in clean energy tech, that’s another story.
I don’t know why valuethinker and I did not represent sufficient appeal to authority.
I like it, but how is this analysis affected if we change the question from “should we drill?” to “should we rent/allow companies to drill on it for a sufficient fee?” Because that’s really the question isn’t it? At least, I’m assuming the U.S. government would not be the one forming and running the drilling company (correct me if I’m wrong). Rather, we would lease the land or allow drilling rights (or something) for a fee/tax/bribe/combination/whatever.
In that case the only question is what is the fee and is it sufficient? But USG would, of course, control the fee. We don’t even have to decide “whether to allow” drilling. We could just hold a perpetual auction for drilling rights and wait till someone comes along (or not) with a bid higher than the floor implied by the above calculation + assumptions about how much we value the caribou (etc). If not, drilling won’t occur; if so, they will drill, but for a fee that will be compensating us for the ‘social cost’ by construction.
I suspect drilling opponents/environmental protectors would not like this solution because the dollar-values-per-family that would pop out of the equation (such as above, & in previous post) would threaten to bring to the forefront of the conversation just how overly highly they are valuing, e.g., “pristine land” on behalf of the rest of us.
Giacomo’s comments are very insightful. Real options is clearly the right framework to apply in this case.
However, in addition to the volatility of the price of oil, it might also make sense to include volatility in climate change. As Marty Weitzman points out, there is a small, but significant chance that we will face a true climate catastrophe due to oil burning (via climate change). We don’t know exactly what will happen, but severe warming is a realistic possibility according to the consensus of climate experts.
In that case, would it make sense to wait until that uncertainty is resolved, or at least better understood, before taking actions that increase the chance of catastrophe?
Since the price of oil is expected to rise over time, waiting is not necessarily very costly in terms of forgone wealth (it’s like money in the bank, earnig interest), but waiting does allow us to preserve the option of keeping the CO2 out of the atmosphere.
I don’t know how the numbers would turn out, but given the stakes, climate uncertainty might be a material factor in the decision if you apply real options theory.
Perhaps someone could do the real options analysis in reverse: how much volatility in climate change would be needed to make it optimal to drill now vs. wait?
Furthermore I have ignored the possibility of cost-reducing technical progress. I don’t see why drilling should become costlier or more environmentally damaging; but it probably could become more efficient on either account. That would increase the option value of waiting
If the surrounding supporting infrastructure decays then the cost of extracting the oil will increase. And it costs a lot to maintain infrastructure. Oil production has declined in Alaska in the last 20 years to about 40% of its peak.
http://tonto.eia.doe.gov/dnav/pet/hist/mcrfpak2a.htm
If there is not a sufficient flow to the Alaska pipeline it will shut down and you would have to rebuild it.
Disagree on the large hadron collider criticism. Of course, I disagreed on the supercollider too. Basic science research is the most important thing. It’s not merely to fund intellectual excitement. It may lead to further discoveries that get us out of the energy problem. If you take the history of science from Galileo to here, we have no idea what’s coming next. It appears that we extend cognitively into the universe, and it is economizing and productive — just to begin with, in the sense that Ernst Mach praised memory, language and science as economizing of mental effort. We should explore the subatomic realm right away, all the way. Why are we succumbing to biases that suppose nothing useful will be found here?
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