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Hail Giacomo Ponzetto!
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 barrel
Then 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.
Posted by Tyler Cowen on September 5, 2008 at 05:03 PM in Economics | Permalink
Comments
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.
Posted by: Lee at Sep 5, 2008 5:29:51 PM
I expect that in the long run (greater than 10 years) the price of petroleum will decline as technology makes substitutes available. (Nature can store, retrieve and use energy much more efficiently than we can today. This leads me to believe that someday humans will figure out how to make cheap solar power and cheap efficient batteries.) That is the way that I am betting on the stock market.
If the rights to drill were sold for greater than the environmental costs the owners would make the appropriate calculation concerning the future price of petroleum. Thus we would only need to settle on the environmental costs.
The Pigouvian case against developing ANWR is undermined by the fact that the petroleum output could replace use of tar sands and perhaps even coal to liquid which are more polluting per unit of fuel.
Posted by: floccina at Sep 5, 2008 5:37:27 PM
"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.
Posted by: Mike Yeomans at Sep 5, 2008 6:30:44 PM
1. Critics of drilling usually want to shut down the option forever and the political window cannot be expected to remain open forever.
To be precise, I think most critics of drilling want to shut down the option politically until the price of renewables is reduced to the point that it shuts itself down economically. In the long run, the price of oil goes up and the price of solar goes down. If critics of drilling can hold out until the intersection, forever is achieved.
Posted by: sidereal at Sep 5, 2008 6:54:34 PM
I don't know why valuethinker and I did not represent sufficient appeal to authority.
Posted by: odograph at Sep 5, 2008 7:16:01 PM
"1.6195": five sig figs. That must be a rather specialised area of econmics.
Posted by: dearieme at Sep 5, 2008 7:16:12 PM
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.
Posted by: Sonic Charmer at Sep 6, 2008 1:17:00 AM
floccina
Oil is a homogeneous market so there's no way of telling whether Alaskan oil would replace synthetic oil.
By lowering the price of oil (if it were to do that,and the effect of adding 0.75% to current world supply, for 30 years would be trivial on prices) it might actually increase oil consumption.
In any case, against the environmental issue of the Alberta Tar Sands (say 200bn barrels extractible) the ANWR reserve (10 to 20 bn barrels, but those are way out there optimistic numbers) is essentially irrelevant.
Lee
by delaying the LHC, we reduce the present value of the future benefits the research will create. Since the transistor, and hence the internet, let alone the atomic bomb and the nuclear powerplant, (did I mention radiotherapy for cancer?), sprung out of sub atomic particle research I think we can agree the upside could be very large.
There's also a declining option value problem. The physics infrastructure of people and research will decay if it is not used. The sort of physics LHC does, attracts the brightest minds in the world and they are only fresh for a certain time. Turn that off, and you can't necessarily rebuild it.
Sonic Charmer
- we don't know how much oil is under ANWR. Lots of indications are there is not much. It's a camel's nose in the tent strategy to get access to offshore, and to build the Alaska gas pipeline.
Any floor price we set would be subject to political manipulation. The US is bad at extracting back the economic rent from the auction of its mineral rights.
My view on ANWR is 'what is our rush'?
- it won't change the world price for oil
- it constitutes 2-3 years of US consumption at the maximum and that's on optimistic estimates
- if there is such a thing as 'peak oil' then it will be much more valuable to extract at $200 or $300/bl
- its' original purpose was to serve as a US Navy strategic reserve in time of desperation for the US-- a final national security barrier. That still strikes me as a pretty good strategy
- I am a believer in the 'Cambridge school thesis' because I believe it models quite well what has happened in the UK with the North Sea (and 'the Dutch Disease' before it). Oil discoveries lead to overvalued exchange rates, and economic rent seeking. As a result, the economy has less traded goods employment (manufacturing) than it would otherwise have, and a greater gap between rich and poor (the rent seeking class).
This models very well what happened in Britain in the 1980s, and Holland in the 70s, and Indonesia (and Saudi Arabia, and Nigeria) now.
Because we found the North Sea, the UK has not sought alternatives to oil and gas and we are less efficient users of same. We have no equivalent of the French nuclear programme (we are trying to get Electricite De France in, to restart ours). To be fair, we tax gasoline very heavily, but by European comparisons, we are inefficient users of energy. All of this happened because we had big domestic energy sources.
This time has run out. We are about to be almost completely dependent on foreign sources of energy (oil and gas and coal) for our transport and our electric power.
And then on top of this with ANWR you have the permanent damage to a unique area of extreme environmental sensitivity.
Why make this choice? Why not wait a couple of decades and see how the world shapes?
Posted by: Valuethinker at Sep 6, 2008 9:26:54 AM
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?
Posted by: a student of economics at Sep 6, 2008 11:37:20 AM
Problems do not get easier to solve by not solving them, and drilling in the Arctic is so different to drilling anywhere else that I find it hard to understand how anyone can claim that the cost of drilling will get cheaper if we simply do nothing.
In addition, I wonder about the opportunity cost of not drilling. There is all that economic activity that will not be expended, the people who will not be employed, and so forth, and wonder if the main motivation of those opposing are to deny economic opportunities to certain people.
Oh, yeah, and I think there are solid arguments that AGW is a crock.
Posted by: Richard Sharpe at Sep 6, 2008 12:02:44 PM
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.
Posted by: sort_of_knowledgeable at Sep 6, 2008 12:12:53 PM
valuethinker,
- we don't know how much oil is under ANWR. Lots of indications are there is not much.
This just begs the question of what 'not much' means. But let's say you're right; then companies won't want to put up the overhead required to go get it. Issue solved.
If ANWR is opened to drilling, and companies do come, well one can only conclude that perhaps they think there's more oil there than you do.
Any floor price we set would be subject to political manipulation.
Yes it would. Both ways.
The US is bad at extracting back the economic rent from the auction of its mineral rights.
Interesting, will read up. thx
My view on ANWR is 'what is our rush'?
Again, with my proposal "we" wouldn't be "rushing". We would just allow for the possibility of oil extraction by others. It's up to them to come, or not.
- it won't change the world price for oil
This is dubiously definitive. Everything "changes" the world price of oil. Perhaps what you mean to say is that it won't change it materially. Well I don't know. What's wrong with trying and seeing?
- it constitutes 2-3 years of US consumption at the maximum and that's on optimistic estimates
This is the sort of nonsense calculation that I wonder why people do. Nobody is proposing that the US extract oil from ANWR and get it from nowhere else.
- if there is such a thing as 'peak oil' then it will be much more valuable to extract at $200 or $300/bl
But we have to discount that back and we have no idea when we'd be extracting at that level, so whether this argument works as don't-drill-now depends on assumptions that you have no basis for. If I understand, the calculation above already employed a lognormal growth model so it is already factoring in the effect of increasing oil prices.
- its' original purpose was to serve as a US Navy strategic reserve in time of desperation for the US-- a final national security barrier.
This just seems to be plain untrue. It's a wildlife refuge by original intent. ANWR
Anyway, even if this were the purpose, the point is there's a possible PV argument for using the reserve now - in other words that it's more valuable to use it now than to 'save it for a time of desperation'.
- I am a believer in the 'Cambridge school thesis' because I believe it models quite well what has happened in the UK with the North Sea (and 'the Dutch Disease' before it). Oil discoveries lead to overvalued exchange rates, and economic rent seeking. As a result, the economy has less traded goods employment (manufacturing) than it would otherwise have, and a greater gap between rich and poor (the rent seeking class).
A bridge already crossed in the US, no? :-)
And then on top of this with ANWR you have the permanent damage to a unique area of extreme environmental sensitivity.
What 'permanent damage' are you referring to, precisely? And what are the ramifications of the 'extreme environmental sensitivity' - what would happen if oil were retrieved from under that ground, exactly?
Why make this choice? Why not wait a couple of decades and see how the world shapes?
Because that means leaving wealth on the table for no good reason and after all, our country is not infinitely wealthy. At least, that's the argument.
Anyway, like I said, I don't think we should have to "make the choice". I think all we need to do is set the price.
Posted by: Sonic Charmer at Sep 6, 2008 4:17:06 PM
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?
Posted by: lee A. Arnold at Sep 6, 2008 5:54:05 PM
Effectively, undeveloped US oil resources are part of the Strategic Petroleum Reserve - or they would be if we took things far enough that the oil was easily available. I see no reason not to increase the size of that reserve.
Obama's notion of tapping the existing SPR just because prices have risen (although now falling) makes no sense - there is no supply crisis (an embargo or worse.) The increased demand that has driven the price increase isn't going anywhere but higher.
We should also treat unpumped oil as an asset, and invest the proceeds, rather than treating the monetization of that asset as income and simply spending it.
Posted by: Larry at Sep 7, 2008 8:28:26 AM
