U.S. crude oil production has reached almost 9 million barrels per day, driven by enormous production increases in the Permian, Eagle Ford, and Bakken formations. This is one of the biggest oil booms in history and it is fueling economic growth and providing tremendous benefits to the U.S. economy.
At the same time, however, this growth raises important questions about environmental risks. Setting aside climate concerns, the challenge for policymakers is how to encourage the continued development of these valuable resources while ensuring environmentally safe drilling and production. This is no easy task, but as Judson Boomhower shows in a new Energy Institute at Haas working paper (available here), making producers more accountable for environmental damages can help balance these different objectives.
As the paper explains, there is a moral hazard problem that can lead oil and gas producers to take too many risks. Bankruptcy protection insulates small companies from worst-case outcomes by limiting their liability to their current assets. In addition, some types of environmental damage, like groundwater contamination, may take years to be detected. At that point, small producers may no longer exist or have the resources to finance cleanups or compensation.
So how do producers respond to these incentives? In “Drilling Like There’s No Tomorrow” Boomhower uses a formal economic model to show that in markets like this we should expect to see a large number of small and medium-sized firms. By staying small, producers can limit their liability. The business plan is pretty simple. You produce as much oil and gas as you can and then, if a serious environmental accident occurs, you go bankrupt. (This New York Times article from a few days ago includes a couple of vivid examples.) Sounds kind of cynical, but this is exactly what you would expect given the way bankruptcy protection works.
Boomhower then shows how much this incentive problem matters in Texas onshore oil and gas production. The market is surprisingly unconcentrated. There is a group of larger firms that produces a substantial share of total output. But there are also thousands of small and medium-sized producers. These are companies few of us have ever heard of, most of which have relatively few assets that can be used to pay for environmental damages. In fact, many are unable to pay even the relatively modest expenses associated with “plugging” a well after production has been completed, to say nothing of the much higher costs of surface- and groundwater pollution events.
Texas introduced legislation in 1991 and 2001 aimed at reducing the bankruptcy problem. Essentially, these policies required producers to post bonds. Most producers complied by buying a “surety bond” from an insurer. In exchange for annual premiums, the insurer agrees to pay for environmental liabilities left over if the producer goes bankrupt. Bonding requirements are commonplace in the oil and gas industry (but there is little direct evidence on their effectiveness). From no bonding before 1991, Texas now has some of the stricter bonding requirements in the U.S.
What happened? High-risk producers found that they faced very high bond premiums, just like unsafe drivers face high auto insurance premiums. This meant that many higher-risk producers were no longer profitable. Hundreds of producers exited the market immediately. Both in 1991 and again in 2001, you see in the figure below a significant spike in exit that corresponds exactly to when the new requirements were being rolled out across firms.
Although this is a large number of producers, the exiting firms tended to be small and unproductive. In addition, 88% of the oil and gas leases owned by these exiting firms were transferred to larger firms that had better safety incentives. Consequently, total oil and gas production in the market was essentially unaffected by the new requirements.
The exiting firms represented only a small share of the market, but they were responsible for a disproportionate share of total environmental damages. Boomhower documents significant improvement in several environmental outcomes. After the bonding requirements are imposed, you see fewer violations of water protection rules, fewer blowouts, and fewer unplugged wells.
Boomhower’s paper shows that well-designed regulations can protect the environment without slowing economic growth. This is important, particularly given the enormous recent increase in U.S. oil and natural gas production. Several states are considering new environmental regulations, but there is a glaring lack of evidence on whether and how regulation creates the right safety incentives for producers. This research is directly on point for those discussions. Moreover, this is one of the first economic studies, in any market, to convincingly show how bankruptcy protection can distort industry structure.
Lucas Davis is the Jeffrey A. Jacobs Distinguished Professor in Business and Technology at the Haas School of Business at the University of California, Berkeley. He is Faculty Director of the Energy Institute at Haas, a coeditor at the American Economic Journal: Economic Policy, and a Faculty Research Fellow at the National Bureau of Economic Research. He received a BA from Amherst College and a PhD in Economics from the University of Wisconsin. Prior to joining Haas in 2009, he was an assistant professor of Economics at the University of Michigan. His research focuses on energy and environmental markets, and in particular, on electricity and natural gas regulation, pricing in competitive and non-competitive markets, and the economic and business impacts of environmental policy.