Community Perspective

Why tax credits for a fading oil industry?

Many believe oil exploration is like throwing darts at a map. The reality is a journey affected by two forces: First, greater information increases your probability of finding new oil. Second, depletion, where once a field like Prudhoe Bay is found it cannot be found again and thus there is one less major oil field left to be found, reduces your probability of finding new oil. More information makes it easier and cheaper to find oil. More depletion pushes against that information effect and makes it harder and more expensive to find oil.

The information effect and the depletion effect work in tandem opposing each other, but early on the information effect dominates and causes early discoveries and production to go up. Later, it is the opposite, where the depletion effect dominates and discoveries and production go down.

Consider also option values. To drill a single well is not actually about finding oil to extract; it is more about finding information that will compel you to drill more wells. If you believe that the first well will give enough information that you expect you will drill a second well, then the value of the option, the first well, is high. If on the other hand you believe that there is a high likelihood that the information from the first well will inhibit you from drilling a second well, then the option value is low. It is the subsidy of this option by Alaska that is economically inefficient and wasteful even for the new citizens’ initiative.

To visualize the process, consider how a jet has both thrust moving it forward and atmospheric friction, also called drag, pushing the jet backward, although where the net effect is still a forward movement. Most jets are high in the sky in thin atmosphere to reduce the drag, but drag still exits. Then, if you want to fly even faster, like Mach 1 (the speed of sound) or Mach 3 (three times the speed of sound), you not only need more fuel to increase the thrust in order to move faster, but the atmospheric drag increases exponentially. So, doubling or tripling your speed may require five or 10 times more fuel to overcome the increased drag, even with an aerodynamic fuselage.

This is why the Supersonic Transport (SST) was so expensive to run. When it flew at Mach 1 or higher, it used an awful lot of fuel, which had to be paid for. The time efficiency value per dollar of expense, then, even for a busy business person and considering that you still had to contend with jet lag, was not worth it. You spent so much fuel just to save a few hours, that it was as if your time was worth thousands of dollars per hour. The real value of the SST was to say you had ridden on it, not so much your time savings.

The cost-effective way to look for oil, then, is to judiciously consider existing information and to use slow revealing seismic or other studies to estimate an optimal exploration plan. Subsidizing such exploration plans to make them quicker reduces the ability to use existing information and slowly build new information. It is similar to the SST’s wasted expense for a small time gain.

As the Alaska Oil and Gas Association says, “it costs the state nothing to offer the credit until the investment is made,” which sounds like getting something for nothing when it is more like playing a game of “heads I win, tails you lose.” You can argue Alaska will gain a fair share of the wins, if and when they happen, but normally the expected probability of success for the well being drilled should be high enough to compensate for losses. This makes oil exploration more careful and less haphazard. Yes, maybe some jobs are created but at a tremendous expense to Alaska. Corporate welfare is not the same as being “open for business.”

Nevertheless, you can blame the oil companies, the politicians or even the humble economists about misinforming the public about the tax credits, but probably the real reason Alaska has undergone to give away so much money to the oil companies is because we don’t want to face the reality of a slowly dying industry and the difficult transition to new industries. Gone is the heyday of Alaska’s oil industry as we move into a lower level of oil production with less free money and into alternative, less-lucrative industries.

Doug Reynolds is a professor of petroleum and energy economics at the University of Alaska. He can be contacted at DBReynolds@Alaska.edu.

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