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The Cost of Risk in the Oil Market

How Risk Premiums Are Paid

SOURCE: AP/Ed Andrieski

Crew members with Anadarko Petroleum Corporation work on a drilling platform on a farm near Mead, CO. If policymakers in Congress and the Obama administration manage to reduce our country’s dependence on oil, the cost of oil's risk premium to consumers could be spent on other things.

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The inexorably spreading oil disaster on the Gulf Coast highlights once again the risks associated with drilling, pumping, transporting, and refining petroleum. The costs of this particularly catastrophic oil gusher won’t be known for years, but they will certainly be large, including the clean up, and the lost current and future business for fisheries and tourism (and the wide range of manufacturing and services sectors that depend on these two industries) along the Gulf Coast. Then there’s the money spent on cleaning up this Texas-sized mess that could have been used more productively for other purposes.

BP plc, the U.K.-based global oil giant and primary owner of the broken oil well, says that consumers, taxpayers, and voters should not worry about the cost of the current disaster since it will take care of the costs. BP almost boastfully notes that it is “self-insured” for just such an event. Problem is, “self-insured” is just a euphemism for costs that ultimately are borne by consumers and businesses for the inevitable risks of oil production. BP says it has the money on hand for its self-insurance, but that cash, of course, consists of accumulated past profits. Future profits in all likelihood will also go toward covering the costs associated with the risks of oil drilling.

Many of these costs are unique to oil production. They include (but are not limited to) risks from technology, natural disasters, and geopolitical turmoil. The technological problems, such as broken drills, exploding wells, leaking pipelines, and sinking tankers, are now on the forefront of people’s minds. But a few years ago, weather dominated the discussion as hurricanes destroyed oil platforms and threatened refineries in the Gulf region.

Before that, it was geopolitical turmoil. Major sources of oil are often found in geopolitically volatile areas and risk premiums reflect uncertainty about the reliability of supply. Case in point: Violence in Nigeria, Africa’s largest oil producer and a major source of petroleum for the rest of the world, can lead to a spike in prices as a result of cuts in output. War or terrorist attacks in the Middle East, or the on-and-off Sunni or Shia insurgencies in Iraq, can have the same effect.

Many of these risks do not apply to renewable energy since a breakdown of a windmill or solar panel does not cause anywhere near the environmental damage that an oil disaster does. Nor are there threats from insurgent rebels to blow up wind farms in the Mojave Desert. Natural disasters can threaten renewable energy production, of course, but renewable energy production facilities by their very nature do not cause much pollution if damaged.

The oil industry is well aware of the risks it takes, which is why oil companies factor in a risk premium for the cost of engaging in the exploration, extraction, transportation, and refining of petroleum. The risk premium is every much a cost of doing business as is the cost of drilling, the pay of geologists, and all the rest. Those costs go into the price base and so does the risk premium. All of these additional costs to cover these risks are ultimately paid for by consumers and businesses at the pump, in their heating bills, or in the petroleum-based products (think plastics) they purchase everyday.

The money that U.S. consumers and businesses may spend in a given year to cover the risks associated with oil production quickly adds up. A reasonable estimate suggests that these costs will amount to about $11.4 billion to $18.7 billion in 2010—numbers that our analysis below will detail. This is money that covers the “self-insurance” of the oil industry for the contingencies of disruptions. It is just part of doing business with oil.

If policymakers in Congress and the Obama administration manage to reduce our country’s dependence on oil, then the cost of this risk premium to consumers could be spent on other things. Our analysis below shows that such a shift could, for instance, power almost 500 thousand homes through solar energy, or establish well over 100 new wind farms in just one year, or increase by over 20 times the amount allocated under last year’s American Recovery and Reinvestment Act toward green job training so we can retrofit hundreds of thousands of commercial buildings and residential homes to make them more energy efficient—driving down the cost of energy all the more.

None of this can happen on the scale we need to happen unless the risk-premium costs associated with oil come down so that we can invest more wisely in renewable energy. And as we’ll demonstrate, there is a lot of money to be found by reducing this risk premium paid by our society. But first, let’s define what this risk premium is and how it is calculated.

Oil can carry a substantial risk premium

Fossil fuels, specifically oil, carry greater price risk than other commodities. This risk is reflected in oil price fluctuations but also in the swings of the stock prices of oil companies, whose primary source of profit is oil. Those who need to buy and sell oil will look for some measure of protection from the unpredictability of oil prices since it makes investment decisions much more difficult.

There are several ways that businesses can protect themselves from the risk that comes from the uncertainty of future oil prices. Oil futures, for instance, are ways for companies to hedge against these fluctuations and potential risk by allowing buyers to contractually purchase oil at a designated price at some point in the future. Risk premiums are priced into these contracts and reflect how much risk is associated with buying that contract. The more risky a futures contract is, the higher the premium is for that contract, and the higher the potential profit. [1]

The specific mechanisms through which companies buy this insurance against unpredictable and undesirable oil price fluctuations is not relevant for our purposes here. We are only interested in an approximation of the cost of this insurance to get a sense of how much consumers and businesses spend in the aggregate on it. The fact that there are markets for oil, for stocks of oil companies, and for oil futures and other oil-based financial derivatives provides researchers with ways to estimate the risk premium in the oil market. The complexity of oil production makes these estimates somewhat imprecise but nonetheless useful.

Finance professor Sheridan Titman at the University of Texas at Austin—an expert on energy markets—is the first to acknowledge this imprecision. “Unfortunately, there is no way to really know what the appropriate risk premium on oil [is],” he explained in a recent paper. “For example, some people think that there is no risk premium on oil, and others think it is as high as 5 percent.” [2] Professor Titman uses risk premiums in the range of 3 percent to 5 percent of current oil prices.

Ibbotson Associates, a consulting firm with expertise in financial market valuations and a subsidiary of the Morningstar Inc. investment research company, estimates that the risk premium on stocks of oil companies amounted to 4.4 percent in 2009. [3] This risk premium should be highly correlated with the risk premium in the oil market since oil companies generate the vast majority of their profits from the petroleum market. And financial services company A.G. Edwards, Inc. reportedly estimated a risk premium of $13 that was included in the $40 per barrel price during the Iraqi insurgency in the spring of 2004, although others put the risk premium between $4 and $8 per barrel. [4] The disruptions associated with the occupation in Iraq consequently put the risk premium at a minimum of 11 percent and possibly as high as 48 percent.

More immediately, the price of a barrel of oil first jumped to over $86 dollars a barrel from about $82 per barrel before the current oil disaster hit the Gulf Coast—a jump of close to 5 percent. [5] Thus, a range of 3 percent to 5 percent of oil prices seems a reasonable ballpark approximation for the risk premium associated with the variety of risks that are associated with oil production.

The cost of risk premiums can add up

We are interested in calculating how much total money U.S. consumers and businesses will spend in 2010 on insurance to protect from the risk of unexpected oil price fluctuations. We assume this risk premium will be included in an average price of about $80 per barrel for 2010. Oil prices have fluctuated between a low of $71 per barrel to a high of $87 per barrel so far in 2010. [6] Most experts do not expect the large oil price fluctuations that have characterized previous years since the global economy is still struggling to come out of its worst recession since the Great Depression and demand for oil will grow more slowly than it did in the years before the U.S. housing and global financial crises.

And finally, we assume that total daily U.S. crude oil input amounts to 14 million barrels of crude oil for a total of 350 days. [7] The average daily crude oil input into refineries ranged from a low of 13.6 million barrels to a high of 15.2 million barrels. An average of 14 million barrels thus likely understates the average daily input for 2010.

Now, let’s add all of these factors together and see what the aggregate cost of insurance against the risk of oil price fluctuations adds up to. A 5-percent risk premium that is included in an $80 per barrel price is equal to $3.81, and a 3-percent risk premium amounts to $2.33 per barrel. Multiplied by 14 million barrels, the daily aggregate risk premium thus ranges from $32.6 million to $53.3 million. The totals for the year range between $11.4 billion and $18.7 billion. [8]

What we can buy for the money?

Tens of billions of dollars put in context can highlight just what this amount of money could be used for instead of self-insurance by oil companies against the risk of massive oil spills. We could, for example, build a lot of windmills. A 50-megawatt wind farm has a capital cost of $65 million and can produce 150 million kilowatts of energy a year. [9] The entire risk premium on oil is thus equivalent to between 175 and 288 similar wind farms for a total production capacity of between 26.3 billion kWh and 43.2 billion kWh of renewable energy annually. This could power between 2.4 million and 4.1 million homes a year. [10]

We could also generate billions of kWhs of solar energy a year by diverting the cost of the oil industry’s risk premium to renewable energy investments. An investment of between $11.4 billion and $18.7 billion a year would generate 18.5 kWh and 30.4 kWh of electricity per year. This is enough to power between 1.8 million and 2.9 million homes a year. [11]

We could also significantly expand investments in green technologies. Last year’s American Recovery and Reinvestment Act included such investments, among them $500 million for green job training, $2 billion for renewal energies research, $6.2 billion for the Weatherization Program, or $11 billion for investments in a smart grid. These programs could be significantly expanded if consumers and businesses no longer had to pay the full risk premium charged by oil companies.

These are just a few examples of what tens of billions of dollars could buy us in a single year. The fact is there are a myriad of ways we could use such money to lessen our dependence on oil.

Conclusion

Oil is a risky business. Recent events drive home just how costly it can be. In addition to the environmental hazard that oil poses, as seen through disasters such as the Deepwater Horizon tragedy now unfolding along the Gulf Coast and the Exxon Valdez disaster in Alaska 20 years ago, many of the risks associated with oil production are borne by the consumer. The risk premium we estimate Americans pay to the oil companies for their energy—$11.4 billion to $18.7 billion in 2010 alone—could be better spent on decreasing our reliance on oil and move us in the direction of a cleaner, and less risky, energy economy.

Christian E. Weller is Associate Professor, Department of Public Policy and Public Affairs, University of Massachusetts Boston, anda Senior Fellow at the Center for American Progress. Luke Reidenbach is a Research Assistant at the Center. For more on this topic see the Economy and Energy and Environment pages of our website.

Endnotes

[1] Gary Gordon and K. Rouwenhorst, “Facts and Fantasies about Commodity Futures” (Fairfield: IA: Capital Management Partners June 13, 2004), available athttp://www.capmgt.com/com_futures.html.

[2] Titman, Sheridan, “Thoughts on Future Oil Prices, Energy Insights: Energy Policy and Discussion from a Financial Economist’s Perspective,” Energy Insights, May 05, available at http://blogs.mccombs.utexas.edu/titman/2010/05/05/thoughts-on-future-oil-prices/.

[3] Ibbotson Associates, “2009 Ibbotson Risk Premia over Time Report” (Chicago, IL: Morningstar, Inc.).

[4] J.W. Schoen, “Oil prices include growing ‘risk premium’ – fears of attack, supply disruptions add to crude costs,” msnbc.com, May 12, 2004, available at http://www.msnbc.msn.com/id/4962032/c.

[5] U.S. Department of Energy, Energy Information Administration, “Petroleum – Prices” (Washington, DC: EIA, 2010), available at http://www.eia.doe.gov/oil_gas/petroleum/info_glance/petroleum.html (last accessed May 6, 2010).

[6] Ibid.

[7] This allows for some down times.

[8] For the purposes of calculating risk premium we use input data throughout this analysis. Total petroleum consumption may vary on account of drawing down stock piles, additives, or consumption of propane.

[9] American Wind and Energy Association, “The Economics of Wind Energy”(Washington: DC, 2005), available at http://www.awea.org/pubs/factsheets/EconomicsOfWind-Feb2005.pdf.

[10] Daniel Weiss and Alexandra Kougentakis, “Waitin’ On a Sunny (and Windy) Day,” Center for American Progress, April 1, 2008, available at http://www.americanprogress.org/issues/2008/04/clean_energy.html.

[11] Ibid.

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