Patience is an Economic Virtue: Real Options, Natural Resources, and Offshore Oil

Abstract

The financial concept of real options has important consequences in areas of environmental and natural resources law where irreversible decisions are made in the face of uncertainty. This article argues that consideration of real options is necessary to maximize economic return from non-renewable natural resource extraction, using offshore oil drilling as a case study. Because decisions over drilling are often framed as a now-or-never choice, the option to wait (or “real option” value) is improperly treated in administrative processes that determine whether, when, and how offshore oil resources will be tapped. The value associated with the option to delay can be large, especially when there is a high degree of uncertainty about price, extraction costs, and/or the social costs imposed by drilling. The value of the information generated during a period of delay can outweigh the value of immediate extraction. Failure to consider option value leads to over-early exploitation of non-renewable resources, and socially undesirable environmental damage. In the case of offshore drilling, the governing statute requires the Department of the Interior, the administrative agency charged with overseeing the leasing of offshore lands, to consider the economic consequences of its choices, a charge it has implemented through detailed cost-benefit analysis of its planning decisions and through a sophisticated bidding system for lease auctions. But because both the cost-benefit analysis and the bidding system fail to account for real option value, they are fundamentally incomplete, leaving leasing decisions open to litigation risks and failing to maximize the net benefits generated by this public resource.

Keywords: real options, OCS, offshore oil, natural resources

JEL Classification: K00, K20, K23, K32