CASE STUDY:  Petro Economics

The dramatic fluctuations in crude oil prices over the past two years have sparked renewed  interest in U.S. oil exploration and development. Some politicians and commentators argue  that an increase in exploration could have a marked impact on oil prices. Others say the  price impact would be small. 

The policy debate currently focuses on allowing drilling in a small part of Alaska's Arctic  National Wildlife Refuge (ANWR). Drilling has been banned in ANWR due to various  environmental concerns.

The ANWR is a national wildlife refuge in north-eastern Alaska, United States. It consists of  19,286,722 acres (78,050.59 km2 ) in the Alaska North Slope region. The coastal plain in the  ANWR (often referred to as the "1002" area) is jointly owned by the federal government, the  State of Alaska and Native American corporations (Energy Information Administration (EIA),  2008a). This region is thought to contain a relatively large amount of oil that would be  relatively cheap to develop. Environmentalists and others have opposed drilling in this area  because it is a pristine (but inhabited) area that they believe is ecologically unique. In  particular, they are concerned that a spill or pipeline leak would endanger a key wildlife  habitat.

History

The Trans-Alaska pipeline system got virtually completed in 1977. The Alaska National  Interest Lands Conservation Act, signed by President Jimmy Carter in December 1980,  created more than 104,000,000 acres (420,000 km2 ) of national parks and wilderness areas  from federal holdings in that state and also allowed drilling in ANWR but not without prior  approval from Congress. Section 1002 of the act allowed the evaluation of potential  petroleum reserves in the 1002 area from surface geological studies and seismic exploration  surveys. However, no exploratory drilling was allowed.

In November 1986, a draft report by the United States Fish and Wildlife  Service recommended that oil and gas development be allowed in all of the “1002 Area” of ANWR. The report argued that the oil and gas potentials of the coastal plain were needed  for the country's economy and national security. Conservatives, however, expressed  concerns that oil operations would harm the ecological systems that support wildlife.

No major developments took place within the next decade. In 1996 the Republican-majority  House and Senate voted in favour of allowing drilling in ANWR, but this legislation  was vetoed and turned down by President Bill Clinton.

In 2000, President George W. Bush pushed to perform exploratory drilling for crude  oil and natural gas in and around the refuge after the USGS estimation of reserves in 1997.  The House of Representatives voted in mid-2000 to allow drilling. In April 2002 the Senate rejected it.

On June 18, 2008 President George W. Bush forced Congress to reverse the ban on offshore  drilling in the ANWR in addition to approving the extraction of oil from shale on federal  lands. President Bush cited the growing energy crisis as a major factor for reversing the  presidential executive order issued by President George H. W. Bush in 1990, which banned  coastal oil exploration and oil and gas leasing on most of the outer continental shelf.

Estimated Oil Reserves

Technically recoverable oil within the ANWR 1002 area (excluding State and Native areas),  as estimated but the United States Geological Survey in 1998, lies between 4.3 and 11.8  billion barrel of oil (BBO) (95% and 5% certainties respectively), with a mean value of 7.7  BBO.

As estimated by USGS, this quantity of technically recoverable oil is not distributed  uniformly. The un-deformed area is estimated to contain between 3.4 and 10.2 BBO (95%  and 5% certainties respectively), with a mean of 6.4 BBO. The deformed is estimated to  contain between 0 and 3.2 BBO (95% and 5% certainties respectively), with a mean of 1.2  BBO. The oil is expected to occur in a number of accumulations rather than a single large  accumulation.

Commercial viability of a discovery depends on factors like oil price, accumulation size, recovery technology, and proximity to existing infrastructure (pipelines, markets etc.).

Economic analysis of oil reserves of the “1002 area” includes the costs of finding, developing, producing, and transporting oil to market (lower 48 West Coast) based on a 12 percent after-tax return on investment, all calculated in constant 1996 dollars. Estimates of economically recoverable oil, expressed by probability curves, shows a directly proportionate relation between quantity of oil and its price. It was found that at a market price of $24/barrel, there is a 95% probability of at least 2.0 BB of economically recoverable oil and a 5% probability of at least 9.4 BB with a mean or expected value of 5.2 BB. At prices less than $13/barrel, no commercial oil is estimated, but at a price of $30/barrel, between 3 and 10.4 BB are estimated.

It is interesting to note that the best estimate of 7.7 BBO in ANWR is very close to domestic consumption in 2005 in the U.S. But still the recovery of the first barrel of crude oil would take many years. In 2025, it is forecasted that 0.9 million barrels of oil per day (MBD) would be recovered and the domestic production is forecasted to be 4.6 MBD (EIA 2004). Thus, at its high, ANWR is forecasted to account for 20% of domestic production. Finally, total supply in 2025, including imports, is forecasted to be 28.3 MBD, so ANWR at its peak is predicted to account for approximately 3.2 percent of domestic oil consumption.

Benefits of Drilling

According to Hahn and Passell (2010), net benefits are estimated for a price scenario of $50/barrel. It is estimated that at $50/barrel, 7 billion barrels are economically recoverable. The benefits include the revenue generated, price-reduction benefit and the reduced-disruption-cost benefit.

The per barrel price-reduction benefit is generated by reduced world demand for imported oil. It is calculated as the reduction in the import bill divided by the decline in the number of barrels of oil imported by the U.S. Leiby (2007) estimated it to be $10/barrel. The reduced-disruption-cost associated with reducing oil imports is estimated to be $5/barrel.

These values are applied to the net decrease in total U.S. imports, which is equal to the increase in U.S. oil production less the increase in U.S. oil consumption caused by the lower price.

7 categories of costs are considered. These are:

1.         Direct costs that producers incur in extracting the oil and bringing it to the market. Estimated average direct costs: $19/barrel.

2.         Cost of not being able to use the affected resource for other purposes if drilling occurred or „Use Value‟. Kotchen and Burger (2007) estimate it to be 0/barrel.

3.         Cost of valuing a resource but never intending to use it or „Non-use Value‟. It is estimated roughly to be $11 billion (Carson et al. 2003).

4.         Global air pollution or greenhouse gas damage. It is assigned a value 0 as share of ANWR drillings to the global air pollution is negligible.

5.         Local air pollution. It is estimated to be $22 billion (Parry 2005).

6.         Traffic congestion. It is estimated to be $18 billion (Parry 2005).

7.         Traffic accidents. It is estimated to be $23 billion (Parry 2005).

Thus, Total Benefit= $455 billion.

Total Costs= $203 billion.

Net Benefit= $252 billion.

Under the current tax policy, this would generate social benefits as industry rents of $90 billion, state of Alaska tax revenues of $36 billion, and federal tax revenues of $125 billion.

Challenges to Drilling

Drilling in ANWR would lead to several environmental concerns. Potential adverse effects on the environment would result from two principal sources: transportation as part of seismic analyses, and infrastructure for extracting and transporting oil. The US Fish and Wildlife Service (2001) reports that drilling in ANWR will have “major effects” on Porcupine caribou herd and musk oxen as well as “moderate effects” on wolves, polar bears, seabirds and coastal fish. Aside from direct effects on animal populations, oil spills are a serious concern.

Finally, another environmental concern that is usually debated is that ANWR oil will promote  air-pollution and greenhouse-gas emissions. The argument is that oil consumption will  increase, causing increased emissions with adverse effects on environmental quality, human  health, and climate change.

To allow drilling in ANWR, the most common technique is contingent valuation, which asks people willingness to pay (WTP) or willingness to accept (WTA) for a proposed policy or change in environmental quality. While it is natural to think about economic value in terms of WTP, the conceptually correct measure for the question of drilling in ANWR is WTA.

In order to calculate the minimum amount that the individuals will be willing to accept to  allow drilling, i.e. breakeven WTA, the relevant population of the US aged 18 or older in  2005 is considered, which the US Census estimates as 220,377,406 people. Dividing our best  estimate of the oil benefits as calculated above, $252 billion, by this population yields an  average WTA of $1,141/person. These estimates represent a one-time payment. We can,  however, pay this WTA annually for 30 years, which is the duration over which ANWR oil is expected to flow. This would yield a present value WTA of $38 per year.

With the best estimate we can make the following statement: If the average WTA for a  onetime payment to permit drilling and development in ANWR is $1,141 (or $38 per year for  30 years), then the social costs will exactly equal the estimated benefits. If the true WTA  falls short of this estimate, then economic efficiency recommends drilling. Alternatively, if  the true WTA exceeds the estimate, then economic efficiency does not recommend drilling.  The question, then, is whether the estimate falls within the reasonable expectation of what  US citizens would be willing to accept in order to allow drilling in ANWR.