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Removing the Oil Spill Liability Cap Could Be Dangerous

by Michael Levi
August 2, 2010

The spill bill is in deep trouble in the Senate. Democrats want to eliminate the existing libability cap for offshore oil accidents. The Wall Street Journal summarized the Republican position yesterday:

“The main effect, if it passed, would be to push the small- and mid-sized producers that account for most domestic drilling out of the Gulf, regardless of their safety records.”

Jon Chait gave the basic Democratic response at The New Republic:

“The pure free market position is that oil companies should be able to drill wherever they want as long as they’re responsible for their own externalities, like cleaning up the cost of oil they spill. The Journal’s position is that this is no fair — not every oil company can afford to clean up the cost of their oil spills! So the government has to subsidize offshore drilling by promising to cover the cost of any cleanup beyond a given size. The justification for this corporate subsidy is that even oil firms with great safety records won’t be able to afford the insurance. But why not?….  And if insurance companies won’t cover that risk at a price small oil firms can afford, that means the risk is too high.”

Chait goes on to add: “That is, if you think the market works. The Journal sees this as a market failure requiring government intervention.”

I share in his enjoyment at watching the Journal editorial page twist itself into hypocritical knots. But alas, on this count, I think that they’re probably right.

There are three potential market failures here. First, while there are public risks associated with offshore drilling, there are also public benefits. When a company extracts oil from the Gulf of Mexico, the government collects part of the rent in the form of royalties, which benefits the American people as a whole. Leaving that oil in the ground is leaving money on the table. That doesn’t mean that all oil that’s out there should be extracted – but it does mean that the market won’t recognize its entire value by itself.

Second, U.S. production displaces production elsewhere in the world. The United States produced 1.6 million barrels per day (mb/d) from the offshore Gulf of Mexico last year. Let’s say that removing the liability cap knocked out 0.5 mb/d (more on that in a moment), and that OPEC countries responded by increasing their own production by 0.5 mb/d, holding the price of oil (and hence demand) constant. At $80/bbl, The United States would send an extra $40 million abroad each day for oil, for a total of $14.6 billion each year. At the same time, OPEC countries would gain $14.6 billion in annual revenues. Removing the oil spill liability cap is worth something in terms of reduced oil spill risk. I doubt that it is worth paying a $14.6 billion annual premium to OPEC. Basic market dynamics do not price this problem in.

All of which leads to the critical question: Would removing the liability cap really knock out a big chunk of production? I think there’s good reason to believe that it would. Supermajors will probably fail to pick up a good chunk of the leases that smaller players control if those independents are put out of business; the business is just too different. Those independents won’t survive if they can’t get insurance. (Or at least those with somewhat diverse portfolios, which they won’t be willing to risk, won’t survive.) Chait makes the standard argument to the contrary – insurance companies should be able to price the risk of a spill and sell insurance accordingly. But that’s not quite how insurance companies work. Say I have a one-in-a-thousand risk each year of incurring $40 billion in oil spill damages. I should be willing to pay a bit more than $40 million each year to insure that risk, and an insurance company should be willing to sell me that insurance for that price. But the insurance company has another consideration: it needs to have the money around to pay out in case I have an accident. $40 billion is a lot of money. Even if I’m insuring a few dozen companies, I’ll only take in a few percent of that (at most) each year. There are decent odds that I’ll decide that it’s not worth risking my insurance business to pick up these small premiums. The small and medium sized oil companies will be out of luck.

So what’s government to do? It can step in as the insurer. Here’s what I suspect the government needs to do. First, figure out what sort of premiums would make sense for an insurer that is only worried about the probability of having to pay out, not about risks to its own solvency. Next, sell companies that insurance (or at least the part of insurance that isn’t available in the private market) itself at that price. In practice, this would probably look like a fee on oil producers, combined with some sort of liability cap. Some companies will be knocked out — and they should be. Also, there’s no doubt that the government won’t get the price or the cap quite right. (And industry lobbyists will help it screw up even more.) But the laissez faire alternative may be to implicity set the price of insurance for most independents at somewhere around infinity, while ignoring public benefits from offshore production. That doesn’t seem right either.

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