Legal Commentary

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.