Hindsight Regulation of Hydrocarbon Exploration: Lessons from Israel's Gas Bonanzas
Malkiel, Yakov, Energy Law Journal
Synopsis: Behavioral scientific research reveals that retrospective evaluations of probability tend to be skewed by "hindsight bias." This insight is applied, in this article, to the regulatory regimes that govern oil and gas exploration. These regimes rely on ex ante assessments of the prospects of exploration to determine what oil and gas developers' rewards should be. If exploration is ultimately successful, it will tend to appear, in hindsight, more promising than it had been in fact-and pressure will arise to adjust developers' rewards retroactively. The article argues that this scenario is worrisome, and explores this concern both in the abstract and as applied to a recent case study from Israel. It also examines several approaches toward addressing this concern, including, most promisingly, the United States' model of private oil and gas rights.
Crude oil and natural gas, or just "oil" and "gas," play pivotal roles in the world's energy production. In 2010, they accounted, together, for 69% of energy use worldwide.1 Oil and gas developers, who are usually large corporations, drill on- and off-shore wells to extract oil and gas from underground reservoirs. A given reservoir usually provides both oil and gas. Reservoirs lie at varying depths, ranging from hundreds of feet to tens of thousands of feet below ground (or sea).2
Efforts to discover commercially viable reservoirs of oil and gas are known as hydrocarbon exploration. Exploration consists primarily of seismic surveys and exploratory drilling.3 Exploration projects are expensive, and their rewards are highly uncertain. Any given project will only be profitable if it unearths a substantial source of oil and gas, and if the costs of extraction from this source are not prohibitive. But "more often than not, a commercial discovery will not occur, in which case it will not be possible to recover the exploration costs."4
An elaborate body of law governs various aspects of oil and gas exploration and development.5 This article is limited to one facet of oil and gas law: the collection of rules that determines the developer's share of the profits that will accrue if exploration is successful. These rules-which are generated by legislation, by contracts, and sometimes by administrative guidelines-address three primary questions: Who owns the oil and gas before they are extracted? How will the profits from development be distributed between the pre-extraction owner and the developer? And how will these profits be taxed? I will use the shorthand "exploration regulation" to denote this set of rules taken as a whole.
The aim of this article is to explore a particular concern about exploration regulation. This concern derives from behavioral science, an increasingly prevalent basis for legal policy analysis.6 The worry is, in brief, as follows: Once an event has come to pass, we tend to overestimate its initial likelihood. This tendency, which is known as "hindsight bias," is likely to make discoveries of oil and gas seem more probable than they were, in fact, at the outset. This may cause exploration-regulation regimes to appear excessively developerfriendly. In turn, this perception may lead to the enactment of retroactive adjustments to exploration regulation.7
The core argument of this article is that such "re-regulation" of exploration is indeed worrisome, both in the sense that it is likely and in the sense that it is undesirable. This argument is developed in Part IV, first in the abstract and then as applied to a real-world case study. The bare bones of the case study are these: In 2009, large stores of gas were found offthe shores of Israel. These finds led to rigorous public scrutiny of Israel's regime of exploration regulation, and ultimately to re-regulation of the successful exploration projects. I will suggest that hindsight bias may have played a role in this story. The Israeli case highlights just how crucial regulatory decisions regarding exploration can be, since for geopolitical reasons, homegrown energy sources are extremely important to Israel. …