‘Idle Drilling Leases’: Fact or Fallacy?

We’re fascinated by the power of informational networks, and by the vast increase in their scale and efficiency that modern communications technology has enabled. A good example is a political talking point that seemed to spread like wildfire after President Bush’s recent speeches imploring Congress to open the Intercontinental Shelf to coastal drilling. We’ve been unable to identify the source(s) of this argument, but it goes something like this:

 All told (onshore and offshore), 68 million acres are leased and sitting idle. Over 10,000 permits are currently ’stockpiled’ by industry. But still they want more.

Apparently, this sounds like a damning claim to many pundits and politicians, but it’s terribly ignorant of the underlying economic and financial realities. A business will not leave an asset idle if its employment (or its development, in this case) is expected to be economically profitable. In the case of drilling leases, energy companies are purchasing what the finance community terms "real options", or assets with an uncertain future value. And the critical point to understand is that while all options cost something, most options expire worthless (it’s also important to understand that the exploration and development of a drilling lease is both time and capital intensive).

Here’s a thought exercise, using market-traded financial options as an analogue. If you want to buy (or sell) an option on, say, the S&P500, the options exchanges will match you to a seller (or buyer). In that way, options contracts are created and destroyed according to the requirements of the market. But imagine that there’s only a single governing body with the authority to issue S&P options, and that it has declared an indefinite moratorium on issuing new options contracts. Let’s assume for simplicity that all options that were in the money have been cashed out by their holders, and that there exists a large number of outstanding options that are out of the money. Naturally, there would be an outcry from market participants to issue new contracts. Would it make any sense at all for the governing body to say that it will issue new contracts only after all out of the money options have been exercised? Of course not.

It makes even less sense in the case of drilling leases when you consider that: (1) leases provide ongoing revenue to the federal government, and (2) that an expanded pool of diverse leases, like a diverse basket of real options, can only improve the probability that domestic oil and gas production will increase, and put downward pressure on the prices of those commodities.

Insofar as the anti-drilling lease argument is based on the risk of environmental and other damages, it’s on reasonable ground, as fossil fuel production and consumption clearly have external costs. However, the ‘idle lease’ argument is an utter fallacy, and one that arouses some suspicion, as it seems designed to maintain the relative scarcity of existing drilling leases. It would be interesting to see how the ongoing revenues from existing leases are divvied up by the public sector. Perhaps there are some vested interests who would be harmed by a more plentiful supply of leases?

Getting back to the power of networks, some good counter points have been provided to the "68 million acres, 10,000 leases" mantra, including an op-ed from the American Petroleum Institute, "The Idle Oil Field Fallacy", and "Facts about Non-Producing Leases" on an energy industry website.