The BP Oil Spill and Problems with Taking the Long View on Energy Policy

June 19, 2010

It is not difficult to be sympathetic to skeptics of climate change models based on pollution levels because of a larger skepticism of modeling in general. [1] But it is unarguable that our species has polluted the earth. The impact of this pollution and its long-term effects are debatable. What is also unarguable is that we will continue to pollute because we really need energy and we may well be running out. [2] We are in the midst of the energy crisis but how we address it necessitates a consideration of a time horizon spanning out several decades-a longer time horizon than we may be properly able to consider.

The BP oil spill in the Gulf of Mexico has drawn the public’s attention to our dependence on oil. BP’s very viability is at issue depending upon the extent of the damages and of course the inevitable flood of lawsuits. What is knowable is that while the environment may never recover and livelihoods forever lost, an army of lawyers will amass fortunes as the only people to be better off because of the catastrophe.

BP would have known that the risk of a catastrophic accident existed as a result of deepwater drilling and the likelihood of containing a massive oil spill resulting from any accident would be extremely small. The fact remains that the incidents of catastrophe in deep water drilling are not that many. BP’s oil spill is an extremely rare catastrophic event but in the final analysis, the risk of its occurrence was not quantifiable.

Our financial models do not account for catastrophic events. They assign likelihood to the possibility of certain events occurring. Financial models assume a normal distribution (a bell curve) of asset returns or risk. That most market events occur in a normal distribution is the single key assumption made by many financial models, including the capital asset pricing model (CAPM), the Black-Scholes option pricing model (BSM) and VaR. Using a normal distribution, events that diverge from the mean or center of the bell curve, by five or more standard deviations, known as a five-sigma event, are very rare and ten-sigma events are nearly impossible. However, the 1987 market crash represents a change of 22 standard deviations. The odds of such a 22 standard deviation event occurring are so low as to deemed impossible. An event that is 5 standard deviations from the mean is said to occur once every 76,000 years, an event that is 9.5 standard deviations is said to occur once every 1018 years…well over a quadrillion years, which is also older than the universe.

In the financial markets, events considered nearly impossible by financial models assuming normal distributions of events, not only are possible, they are occurring frequently. There have been multiple fluctuations greater than 5 standard deviations in our most recent past. In other words, events which are each only supposed to occur according to a normal distribution once every 76,000 years have happened together multiple times in the past 10 years.

Events that according to a Gaussian Bell Curve are supposed to occur only once every 76,000 years are occurring several times in a decade. Such events, like our current credit crisis, the market crashes of 1987 and 2000, Long-Term Capital Management, the collapse of Bear Stearns, the Savings and Loan Crisis, the crash of 1929, the collapse of Northern Rock, the Russian Debt crisis, the 1997 Asian financial crisis, the 1990 Japanese asset bubble crisis, the 1973 oil crisis and 1978 energy crisis, etc. do not even remotely fit into a normal distribution.

Unfortunately, the economists that dictate government policy and make recommendations to presidents and prime ministers alike, teach at universities and educate business school graduates, along with leaders and policy makers all largely believe in the sanctity of economic theory. Despite the fact that models based on the theory that actors are rational and will relentlessly and efficiently optimize their interest is at once a gross simplification, idealization and approximation. Modeling must necessarily simplify and in a sense, falsify reality is by making assumptions about human beings, which are not true. For example, modeling tends to assume that humans, whether in a marketplace or in a poker game are rational and that they act at all times in accordance with their best interests. This is not borne out by reality. Any cursory historical account of human behavior belies that humans act according to their own interests. Human beings are emotional actors as much as they are rational actors. [3]

The point being that Wall Street’s modeling of price distributions as normal is erroneous, not that modeling in general is wrong. Yet we have no other predictive models, other than those that assume a normal distribution of events from which to predict or plan for catastrophic events and our existing models simply cannot.

BP did not plan for the oil spill any more than Wall Street’s risk models accounted for the credit crisis. One could argue, why should it have? How rational would it have been for BP to spend a significant portion of its resources trying to prevent a catastrophe whose odds of occurring were admittedly extremely small but still unquantifiable? If it did think there was more than unquantifiable risk, it would as a rational actor wanting to remain an ongoing public company, have done everything it could have to prevent it-it is much more likely that it did not.

If there is any culpability for the BP oil spill, it must be shared by the Federal Government’s office of Minerals Management Service, which is supposed to regulate offshore drilling. The activities of BP in the Gulf of Mexico that were outsourced to Deepwater Horizons were both known and approved of by the Minerals Management Service.

If BP met all existing regulations, then to what extent are the regulators and the regulations at fault? [4] What is the payoff for any company, regulatory commission or politician to take a long view of events that are really very unlikely to occur but if they do, the consequences are catastrophic. Recent catastrophic events like the earthquake in Haiti, the Indian Ocean Tsunami or the World Trade Center bombings are not only virtually impossible to plan for, they are not predictable using any econometric or risk model. In the simplest terms, the CEO of an oil company is responsible for maximizing the value of the company’s shares and seeing that profits grow quarterly. The job of an elected official from the governor of Louisiana to the head of the regulatory agency is to ensure that the American people have access to relatively cheap oil. What elected official wants to take the political heat of putting a halt to all oil drilling based on the unquantifiable risk of a catastrophic event-which has not occurred? How long would such an elected official remain in public office? And we are not even considering all the
entrenched special interests along process of bringing oil to the market and their political leverage.

Our political system, like our financial culture, rewards participants who take a very short view. Politicians almost always simplify reality and issues into easily disseminated sound bites to appeal to the short-term interests of the mass electorate. CEOs of publicly traded companies seem to have to adopt a time horizon of a quarter a time. Where does a longer time horizon ever come into play? News media outlets compete for rating by sensationalizing human interest stories and dumbing down reality into black and white issues. Where in all this is the mechanism to discuss the ten or twenty year interests of this country-the long view? Who will carry such a dour message in the first instance?

It has been suggested that the United States is facing a period of peak oil or will soon. Peak oil is the point in time when the maximum rate of global petroleum extraction is reached, after which the rate of production enters terminal decline. In other words, it is possible some say, that we are running out of oil.

If this is true, then we can and must foresee a time when even were we to switch to natural gas or coal, we could have peak natural gas or peak coal. We need to seriously consider alternative energy. We cannot run out of sunlight or wind-we can assume of normal distribution of both.

There are two main problems with alternative energy sources. Both wind-farms and solar energy farms rely on intermittent energy sources. While it is impossible to think we will run out of sunlight, it is possible we can have many cloudy days and days with not enough wind.

The second problem with alternate energy sources is that it appears (admitting to being ignorant of any specifics) that it is conceptually difficult to scale up the production facilities for wind and solar in order to meet our existing energy demands. For example, we would need hundreds if not thousands of miles of land to house wind farms and possibly solar cells. We then have to build them and make them operational. If we suddenly had to rely on either source to power the nation, we would have a very real albeit logistical problem. It is not as if we can go to a coal factory and power on the production of coal.

We could consider nuclear power but then again, the memory of Three Mile Island and Chernobyl remains and seems to prevent this from being a politically viable issue.

A possible solution may be to incentivize the private sector and emerging energy technology companies to come up with more efficient sources of alternate energy by some blend of subsidization and the legislative phasing out of oil consumption over time. We have to mindful however that legislation that imposes taxes on energy consumption are not regressive and disproportionately affective to the people that rely on cheap oil to drive to work and support their families.

Another possible solution may be to evaluate the extraction and use of oil found in tar sands and shale. Presently, all our oil is pumped out of the ground and requires minimal processing to be converted to usable petroleum. However, several accounts verify the existence of sufficient oil resources consisting largely of tar sands and oil shales that require greater processing to extract liquid petroleum but would provide enough oil (perhaps 14,000 billion barrels) to last us for the next five hundred years based on year 2000 consumption rates. [5]

Perhaps the biggest problem with not having taken the long view heretofore in addressing our energy crisis is that we are now out of resources. We are so much in debt and have overspent by so very much as a nation that we do not have the resources to spend on implementing a solution, were we to agree on any.

[1] This is not to say that modeling and using assumptions taught by the social sciences are not useful and that they do not have a purpose and a function in everyday life and business. But simply living through yet another financial crisis does leave a person skeptical of the predictive capacity of financial risk models, not to mention economists in general. In the weather field, we are forced to assume that the equations used in weather predictive models are correct (not a small assumption) and that all of the enormous data entered is correct (a much larger assumption). If there are any tiny errors in the data inputted into a weather model, as in the butterfly effect, the output could be widely divergent and incorrect.

[2] Some environmentalists claim that declining oil production is inevitable, based on the Hubbert model of energy production. Hubbert based his estimate on a mathematical model that assumes the production of a resource follows a bell-shaped curve - one that rises rapidly to a peak and declines just as quickly. In the case of petroleum, the model requires an accurate estimate of the size of the total amount of oil available-this is apparently a best guess and possibly wrong. M. K. Hubbert, "Techniques of Prediction as Applied to the Production of Oil and Gas," in S. I. Gass, ed., Oil and Gas Supply Modeling, National Bureau of Standards Special Publication 631, 1982, pages 16-141 But for the sake of argument, we will assume that it is correct because at a minimum, oil is similar to every other source of energy in that it is not sustainable and the supply is nonrenewable at least in any meaningful time frame.

[3] This is not to say that emotion and rationality are distinct. The creation of a dichotomy between rationality and emotion is itself a simplification of the mind. What we consider rational is linked to, and arises out of, our emotional selves. The writer refers to emotions as distinct from rationality, but this is in a sense a creative artifice to illustrate a point.

[4] The legislator cannot strictly speaking be sued for making less than optimum regulations because principals of governmental immunity prevent lawmakers from being haled into court and held accountable for bad laws. Just think though that were this not the case, an unintended but wildly positive result would be the dramatic curtailing of the rampant use of billions of dollars in earmarks and quid pro quo through campaign contributions.

[5] Porter, "Are We Running Out of Oil?" American Petroleum Institute Discussion Paper - No. 081, 1995.