Strategic Decision-Making with Information and Extraction Externalities: A Structural Model of the Multi-Stage Investment Timing Game in Offshore Petroleum Production

When individual petroleum-producing firms make their exploration and development investment timing decisions, positive information externalities and negative extraction externalities may lead them to interact strategically with their neighbors. If they do occur, strategic interactions in petroleum production would lead to a loss in both firm profit and government royalty revenue. The possibility of strategic interactions thus poses a concern to policy-makers and affects the optimal government policy. This paper examines whether these inefficient strategic interactions take place on U.S. federal lands in the Gulf of Mexico. In particular, it analyzes whether a firm’s production decisions and profits depend on the decisions of firms owning neighboring tracts of land. The empirical approach is to estimate a structural econometric model of the firms’ multi-stage investment timing game. According to the results, when the tract sizes are large, firms do not impose externalities on each other on net when choosing to explore or develop, and, as a consequence, strategic considerations are second-order. This is the case with most of the tracts in the federal leasing program. However, in the few cases where the tract size is small, externalities do matter, and they cause firms to interact strategically with their neighbors. For small tracts, the effect of having a neighboring tract explored reduces real profits by about 26 million dollars, while having a neighboring tract developed raises real profits by about 3.5 million dollars. On the small tracts, the externalities cost about 17 million real dollars per tract developed.