Internalizing Production Externalities: A Structural Estimation of Real Options in the Upstream Oil and Gas Industry

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Muehlenbachs, Lucija
Nerlove, Marc
Rust, John
There are hundreds of thousands of crude oil and natural gas wells across North America that are currently not producing oil or gas. Many of these wells have not been permanently decommissioned to meet environmental standards for permanent closure, but are in an inactive state that enables them to be more easily reactivated. Some of these wells have been in this inactive state for more than sixty years which begs the question of whether they will ever contribute to our energy supply, or whether they are being left inactive because the environmental remediation costs are prohibitively high. I estimate a structural model of optimal well operations over time and under uncertainty to determine what conditions or policies might push any of the inactive wells out of the hysteresis in which they reside. The model is further used to forecast production from existing wells and recoverable reserves from existing pools. The estimation uses data on production decisions from 84 thousand conventional oil and gas wells and estimates of the remaining reserves of 47 thousand pools. As the producer's decision depends on their subjective belief for how prices and recoverable reserves change over time, I also estimate the probability of changes in prices and recovery technology. I model increases and decreases in the estimated recoverable reserves to depend on price, and predict that natural gas reserves are more responsive to changes in price than conventional oil reserves. Under high prices there is potential for large increases in gas reserves, however this is not the case for oil reserves when the oil price is high. And likewise, under low prices, gas reserves decrease more than oil reserves. The dynamic programming model predicts that with only a drastic, arguably implausible, increase in prices and recovery rates will there be a significant increase in the number of inactive wells that are reactivated. If ideal conditions are not enough to induce well reactivation then this implies that typically wells are left inactive not because of the option to reactivate, but rather because the cost of environmental cleanup is too high. Should there be externalities from idling the wells (such as continued contamination of groundwater) that are not accounted for in the decision, then this behavior may not be socially optimal. The model predicts that a Pigouvian tax on inactive wells would have the added benefit of inciting the reactivation of oil and gas wells, however in the case of oil, a tax would incite more wells to be decommissioned than reactivated.