Policy commentary

Drilling for Oil in the Arctic: Considering Economic and Social Costs and Benefits

Jun 2, 2011 | Alan J. Krupnick

Alaska MapShell Oil Company has submitted to federal regulators plans to drill four exploratory oil wells in the Beaufort Sea and Chukchi Sea off Alaska. News reports indicate that Shell intends to apply for permits to drill additional wells. Because this represents a possibly major expansion of offshore activity in Alaska, it is an appropriate time to ask whether providing these drilling permits is in the public interest. The environmental damage and the harm to the local economy caused by the recent Deepwater Horizon spill in the Gulf of Mexico illustrate the environmental and economic risks of offshore oil drilling. High oil prices, however, have caused the price of gasoline to rise above $4 per gallon, and much of the public is demanding policies that would reduce gasoline prices. At the same time, drilling proponents argue for the energy security benefits of increasing domestic oil production.

How should these competing interests be weighted in determining whether to allow drilling in the Arctic? This commentary provides an economic framework, and although it does not provide a quantitative cost–benefit analysis, it does explain how economic theory applies to this difficult question. There are at least five key issues—the first three represent the private economic value of the oil to producers and consumers and the last two represent the social costs and benefits. Not all of these issues seem to be equally important, but very little is known about the full scope of the costs and benefits of offshore drilling in Alaska.

1. Value to Consumers of Reducing Gasoline Prices

Current high gasoline prices are not a reason to drill for oil. In the best circumstances, it will take 10 years to go from offshore exploratory wells to producing and selling oil produced from those wells. Prices may react before this time, as expectations of future supply increases could depress prices in advance. But this effect is likely to be small because prices are determined on the world oil market and the increase in supply would be small compared to the overall scale of the market. Note that the societal benefit of lower prices and higher consumption is lessened because higher consumption causes more pollution and traffic congestion.

2. Value of the Oil to Producers and Alaska

The fact that oil prices may not change does not mean that the oil would not have economic value. Presumably, because Shell wants to drill, it expects that the value from selling the oil will outweigh the costs. If prices do not change much, oil consumers would not benefit from this production, but stockholders and employees of Shell would. In addition, there will be economic benefits for Alaska, as the increased jobs and incomes from new drilling activity and tax revenues ripple through the local economy.

3. Option Value of the Alaska Pipeline

The Trans-Alaska pipeline is operating at about one-third capacity because of declining production out of Prudhoe Bay—at a rate of about five to six percent per year. This trend will make it physically impossible to continue running the pipeline because the oil will freeze. Even before that occurs, however, it will be uneconomic to run the pipeline. More importantly for society, the contract for running the pipeline between the government and the pipeline owners requires that the pipeline be dismantled if it is shut down. Consequently, shutting down the pipeline would eliminate the value of the pipeline assets. However, the establishment of production wells in the Beaufort Sea or on the North Slope would increase oil use of the pipeline and therefore make it economically feasible to run the pipeline in the future. There is therefore an option value associated with continued use of the pipeline. Most of the option value is internalized by the owners of the pipeline and the companies developing the oil fields, although there are also energy security benefits that need to be taken into account.

4. Energy Security Benefits

Economists in general are skeptical of big energy security benefits. The best argument for the link between oil production and energy security is probably that importing oil limits U.S. foreign policy options. Beaufort Sea reserves hold perhaps oil enough for one year of U.S. consumption. Adding the Chukchi Sea, which is farther from the North Slope, possibly would add another two years. But a more appropriate perspective is that the production from a well typically spans 20 to 30 years. This would imply an average production of about 320 million barrels per year from the Beaufort Sea, or five percent of annual U.S. consumption. The effect on the trade balance would be smaller than this, however, because one barrel of domestic production typically displaces less than a barrel of imported oil.

5. Environmental Risk

For drilling in the Beaufort Sea, the environmental risk—that is, the risk of a spill occurring and reducing environmental quality—can be higher or lower than the risks of deepwater drilling in the Gulf. The risks depend on the probability of a spill, the amount of oil that is spilled, and the effect of the oil on surrounding ecosystems. The probability of a spill can be lower (and the size of a spill, smaller) when wells are in shallower water (15 to 300 feet) and the oil is under less pressure. Risks can be higher because the ice and cold would make it challenging to contain a spill. Several aspects of the Beaufort Sea and Gulf are similar, including storm conditions (average wind speeds and gusts during storms), and the oil-eating bacteria that appear to have reduced the damage from the Deepwater Horizon spill are likewise present in Alaska.

The damages caused by a given reduction in environmental quality, however, may be different in Alaska than the Gulf. The Deepwater Horizon spill caused considerable damage to the local fishing and tourism industries, as well as other industries. Yet other regions may benefit, for example, from an increase in tourism that leaves the Gulf. By comparison, there is far less economic activity in these Arctic regions under consideration, although there are native populations that rely on local natural resources for subsistence and that would be harmed by a spill (and by drilling activity as well). Damages also include the effects on public health and use and nonuse value of the resource. Public health and use effects may be smaller because there are so few people living in the Arctic.

But as is the case with many other wild places, even those who may never directly experience Arctic ecosystem can place a significant value on it, just as someone who never expects to see tigers in the wild contributes money toward the protection of their habitats. What economists term “non-use” damages to sensitive Arctic ecosystems and landscapes could very well end up being significantly larger than the direct damages experienced by residents.

The oil companies are convinced that they have the technology to prevent a spill, and that even if one occurs they have the technology to plug the leak and collect the oil. Shell recently released its response and prevention plans for exploratory drilling, which indeed go beyond the legal requirements. Yet the public has no real idea of the risks because, as in the Gulf, there are no strict legal requirements for fully assessing the risks, an approach that companies drilling in Norwegian waters, for instance, must follow.

In summary, the effect on gasoline prices and the energy security benefits of offshore oil in Alaska are probably small. The question of whether it is socially desirable to allow drilling therefore amounts to weighing the private benefits—including the value of the oil to producers and the option value of the pipeline—against the public benefits of reducing environmental risk and improving energy security.

Further Reading

Krupnick, Alan J., Sarah Campbell, Mark A. Cohen, and Ian W.H. Parry. 2011. Understanding the Costs and Benefits of Deepwater Oil Drilling Regulation. Discussion paper 10-62. Washington, DC: Resources for the Future.

National Commission on the BP Deepwater Horizon Oil Spill and Offshore Drilling. 2011.The Challenges of Oil Spill Response in the Arctic. Staff Working Paper No. 5.