The Gulf Oil Leak and Optimal Safety Precautions-Becker

Economists over the years have had a schizophrenic attitude toward low probability but highly costly events. One school of thought argues that most people give less attention to such events than is merited, and that this explains why many households do not to take out flood, earthquake, and other insurance on very small risks (although there may be other explanations of this fact). Some psychologists and economics claim the opposite, that people give too much attention to low probability events, as in much of modern behavioral economics.

Whether BP paid enough attention to the chances of and damages from a serious leak on its Deepwater Horizon rig in the Gulf of Mexico is at the heart of any evaluation of whether BP was negligent in its safety approaches to this well. The chief executive of BP, Tony Hayward, claimed that an accident of the magnitude of this one had “a one in a million” chance. It is ironic that when Hayward became chief executive, he vowed to focus “like a laser” on safety and reliable operations.

Suppose that his estimate is correct, in the sense that the probability of an accident of this magnitude in any year was one in a million. If the accident ends up causing a $100 billion worth of damages to fish, beaches, loss of lives, and in other ways, the discounted value (at a 5% interest rate) of this expected cost over time would then be approximately 20 times $100 billion divided by one million, or $2 million. A risk neutral BP would rationally not want to spend more than that amount to prevent such a leak from happening. Perhaps the damages from this oil spill will turn out to be as much as $200 billion, although this seems highly unlikely, especially since the value of BP’s shares have declined by about $90 billion since the April 20^th disaster. Even if the damages were more than twice as large as the decline in share value, the expected damages would only be about $4 million, a modest expected risk for any large business.

Of course, to justify their poor preparation to combat such a large leak of oil, Hayward may have greatly understated its probability. As Posner emphasizes, it is very difficult to estimate with any precision what is the actual probability of highly infrequent events, and such a leak would fall within this class. So if the annual probability were really more like 1/10,000 rather than 1/1,000,000, the expected discounted cost would be about $200 million, a more considerable sum. These examples show that only when the annual probability of such a disaster was reasonably large would it have paid for BP to spend a lot to prevent such a leak from happening.

Given the litigation that resulted from the 1989 Exxon Valdez oil spill off Alaska, and from other oil leaks, BP should have expected that it would be held liable in court for the damages caused by leaks from its deep water drilling. However, it could hardly have expected to be liable for new types of claims, such as the one proposed by the Obama administration that BP should be responsible for the wages lost by workers who are laid off as a result of the six month moratorium proclaimed by the president on all drilling off the American coast. It is ironic that Obama had on March 31^st, just a few weeks before the Deepwater Horizon oil spill in April, proposed an extension of offshore drilling. Nevertheless, if the Deepwater leak alerted us to greater risks of offshore drilling than had been realized, BP should not be punished for (inadvertently) providing this useful information.

The president may be right in asking for a moratorium to spend a few months reviewing the safety precautions on all drilling off the US coastline. However, it would be unfortunate if this disaster led to permanently much greater restrictions by the US on offshore drilling for oil since that is at present the most promising source of additional US production of oil. The likelihood, and cost, of future spills has to be weighed against the gains to US national security and energy independence from having greater access to domestically produced oil. Since I believe these gains are substantial, I expect offshore oil production to continue to have an important place in US (and other countries) production of oil since offshore oil is the last frontier in the search for new deposits of oil.

Comments

[Brian Davis, Austin, TX]

Deepwater offshore E&P makes fundamentally a lot more sense than hoarding up on gold, doesn't it, Mr. John Paulson and Mr. George Soros?

[mba india]

Interesting article. You make some good points. Thank you again.

[Bill]

Does your calculation assume a $200 billion damage per YEAR in perpetuity?

[Bill]

oooops - I should have specified $100 billion per YEAR in perpetuity.

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[Scott]

Great article about the probabilities of such a disaster.

It's disconcerting how this is yet another "million to one" accident according to BP, given their horrendous safety record.

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Hope that similar things do not happen.

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I hate the disaster ,I hope there is no disaster,thank you for your information.

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Recently a number of similar incidents, it should be an alarm awakens.

[Jesse the Best Motor Oil Review Guy]

Infrequent high risk events are difficult to place a probability on but this reminds me of the comments from Richard Feynman on the NASA Challenger disaster review... he said it was going to happen again and NASA provided their analysis that it was highly improbable... well it happened again. In the case of this oil spill it would be prudent to be properly prepared for another.

Probabilities of 1/10,000 to 1/20,000 are reasonable and the 1/1,000,000 figure is just your typical corporate CEO rhetoric.

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At least it is capped now.

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Lets just hope that all of this oil spill mess that really affect our marine and aquatic wildlife will be totally cleaned up.

[Pandora Bracelet]

it is very difficult to estimate with any precision what is the actual probability of highly infrequent events, and such a leak would fall within this class. So if the annual probability were really more like 1/10,000 rather than 1/1,000,000, the expected discounted cost would be about $200 million, a more considerable sum.

[OSHEM Solutions]

The BP Oil spill shows that safety is not an add on, its just good business. Put aside the repair costs, the clean up costs, the compensation that will be paid. You can even forget the loss of production. How much damage has been done to be BP brand out of this incident. They have received negative publicity day after day, week after week, right across the world.

Risk Management, Emergency Preparedness and Safety Compliance are not nice-to-haves, they are crucial components to ensuring an organisation's sustainability.

Peter Gaul
OSHEM Solutions

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Probabilities of 1/10,000 to 1/20,000 are reasonable and the 1/1,000,000 figure is just your typical corporate CEO rhetoric.

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