The right option for offshore leasing

The U.S. government could learn important lessons on offshore leasing from financial markets and oil companies.

A recent report commissioned by a conservative think tank calls for a vast expansion of offshore drilling near the East Coast, claiming that the benefits outweigh the environmental costs. But the magnitude of these costs is not yet well understood, and rushing into irreversible offshore leasing decisions could prove disastrous for the environment and the economy.

{mosads}Deep-water drilling entails huge uncertainties, as BP can attest. No oil or gas has ever been produced from the U.S. Atlantic continental shelf, so there is no safety record for offshore development in this area. Early exploratory drilling yielded no results, and in 1983, lawmakers enacted moratoria on offshore leasing in the region.  

The Atlantic offshore leasing area is diverse, stretching from the edge of New Jersey to Florida, with a huge range of depths and undersea topographies. Some tracts are just offshore from highly populated areas, magnifying the risks. Drilling could take place mere miles from coastal cities and tourist destinations like Newport, Charleston, and the Florida coast. Further, the technology involved in offshore drilling is evolving rapidly, causing uncertainty about environmental impacts, including habitat disruption, water pollution, and air and climate impacts. Many safety questions remain unanswered, and risks are high—imagine the economic costs of shutting down the Jersey Shore for a summer.

The report’s flawed conclusion about environmental costs stems from a common mistake. It assumes that leasing decisions boil down to an immediate “yes” or “no” from the government. As both financial markets and oil companies have demonstrated for decades, there’s also value in considering a third choice: “maybe later.”

Financial markets and companies have long accounted for “option value”—the value associated with delaying a decision in order to discover more information about an uncertain outcome. Stock options are ubiquitous in global markets. The oil industry routinely accounts for the value of delaying to gather information, recognizing that time will help clarify uncertain oil price trends, costs associated with new production technologies, and spill remediation methods. Indeed, companies frequently purchase offshore leases and wait years to begin drilling. 

The value of delay can be significant for decisions on natural resource exploitation—these decisions are often irreversible, and they can entail catastrophic risks with costs that are not yet fully known. Methods to quantify option value for natural resources are well established among economists.

To make the federal leasing system fair—and to catch up to the private sector—option value should be factored into all government leases for resource extraction. The U.S. Court of Appeals for the D.C. Circuit will soon rule on Center for Sustainable Economy v. Jewell, which focused on this issue for the Department of Interior’s current leasing plan for the Gulf of Mexico and the Alaskan coast (full disclosure—Livermore argued the case on behalf of the Center). The Department of the Interior—representing the American public—holds perpetual options to develop or lease offshore tracts, and the agency must decide when and where exercising those options will be most opportune. Selling public leases too quickly and too cheaply costs taxpayers billions of dollars, and effectively gives away for free the option value of these leases to drilling or mining companies.

Framing leasing decisions as now-or-never choices made within a single five-year period will systematically lead to inefficient overexploitation of natural resources. By taking into account the option value of delaying a decision, the government can match the oil industry’s own game and strike the proper balance between efficient levels of offshore development and environmental stewardship.

Hein is the policy director at the Institute for Policy Integrity. Livermore is the founding executive director of the Institute for Policy Integrity, and an associate professor of law at the University of Virginia.