Environmentalists can hardly contain themselves with news that Royal Dutch Shell abandoned oil exploration in the Alaskan Arctic for “the foreseeable future.” For example, Greenpeace USA claimed that “this is, in no small part, thanks to public pressure from people around the world who have taken action to keep Arctic oil in the ground.”
Well, not really. To be sure, the oil companies are under tremendous pressure to keep carbon “in the ground.” But that is not what triggered Shell’s decision. Shell has also experienced several costly mishaps in the Arctic, and recent federal permit requirements made drilling more expensive for the company in the Chukchi Sea. Those events undoubtedly contributed to Shell’s decision.
But the root cause is quite simple: profitability. In the summer of 2014 oil prices were north of $100 per barrel. A bit more than one year later they hovered around $40 per barrel, and there are no signs of a significant uptick in the near future. Working in the Arctic is extremely expensive, so Shell decided to cuts its losses when one exploratory well did not pan out.
This is an example of economic truncation, a foundational principle in the economics of petroleum exploration. An oil company carries an inventory of undrilled prospects. It rank orders and then develops those prospects in order of decreasing profitability. If oil prices are high, then some of the higher cost prospects are developed. If oil prices are low, the prospects list is “truncated” to go after the richest targets.
The accompanying graph illustrates the truncation principle. The horizontal axis is class size, i.e. the size of new oil fields discovered (1 is small, 20 is big). The vertical axis shows the number of fields discovered in each size class. In the Permian Basin, the average size of new discovery increases as drilling depth–and hence cost–increases. Greater depth requires a bigger field to justify the investment. The Gulf of Mexico is a very high cost environment compared to Permian Basin, and thus requires a very large average field size to justify development.
If and when higher oil prices return, expect renewed interest in the Arctic by the major oil companies. Protection of the Arctic could be achieved with an expansion of Federal regulation such as that afforded to Bristol Bay in Alaska. A longer lasting solution is to fundamentally change the economics of oil and gas exploration. This is two-headed political monster. First, remove the massive government subsidies that the oil and has industry receives, which will raise the cost of exploration. Second, internalize the equally as massive external environmental and human health costs by taxing oil and gas. That will reduce the demand for oil and gas, and encourage low carbon substitutes and energy efficiency.