To Get The Most Out Of Our Fossil Fuel Resources, Rely On Auctions
Thom Covert via Forbes
While U.S. oil and gas companies have relentlessly improved the efficiency of the wells they drill, an inefficient market for mineral leases--which transact in informal and decentralized negotiations, not centralized auctions--prevents them from getting the best bang for their buck, writes EPIC's Thom Covert.
For the last decade and a half, U.S. oil and gas companies have relentlessly improved the efficiency of the wells they drill. They've applied hydraulic fracturing technologies in newly-discovered shale formations, are continuously learning how to use these technologies better, and many of the biggest producers invest hundreds of millions of dollars into research and development every year. However, firms with the best technology can only get value out of it if they have mineral resources to deploy it on. Unfortunately, the market for mineral leases, contracts between land owners and oil and gas companies, is surprisingly inefficient. Why? The vast majority of mineral leases transact in informal and decentralized negotiations, instead of centralized auctions.
Most undeveloped mineral resources in the United States lie underneath privately-owned land. To develop an area, oil and gas companies must first figure out who owns mineral rights, and then bargain over the terms of mineral lease contracts with thousands of individual landowners. With such dispersed land ownership, and no central body organizing these negotiations, the situation truly resembles the "wild west," with dozens of oil and gas companies racing to sign landowners by any means possible. Some of the biggest oil and gas companies in the world, like Exxon and Chevron, compete against much smaller companies, some of which may be much less productive. In this environment, it's quite possible, perhaps even likely, that the best users of a given parcel are not successful in signing a lease on it. Thus, even though the market for mineral leases is certainly "free," in the freedom sense, its lack of organization may hinder its efficient development.
Decades of economic theory suggest an alternative approach to matching oil and gas companies to mineral leases: auctions. By design, an auction awards a mineral lease to the company whose valuation for it (i.e., its ability to produce from it) is highest. Because auction participants compete against each other, they also may steer more economic benefits to landowners than informal negotiations do. However, while there is no administrative data on how mineral leases transact (auction vs. informal negotiation), survey evidence suggests that auctions are rare in private mineral lease transactions. In contrast, leases for minerals in public lands nearly always transact in transparent, centralized auctions. State and federal government organizations publicly announce which parcels are available for lease, solicit bids from all interested companies, and award leases to the high bidders.
My colleague Richard Sweeney and I decided to see if auctions actually perform better than negotiations in real-world data, comparing thousands of auctioned and negotiated leases that were signed in Texas between 2005 and 2016. Our analysis found that not only do landowners gain millions of dollars more when leases are negotiated through auctions, but these auctioned leases actually produce more. That means the oil and gas industry is missing out on substantial revenues when they lease by negotiation instead of by auction.
To get these results, we focus on an interesting but nevertheless sizeable class of land in Texas where the State technically owns a large share of mineral rights, even when that land has private surface owners. Thanks to legislative decisions made a century ago, in Texas' Relinquishment Act of 1919, a historical "coin toss" determined whether or not individual parcels of land sold by the State, to support its Permanent School Fund (PSF), included a share in the minerals underneath. PSF landowners who got an effective mineral interest in their land have the right today to "negotiate" mineral leases on this land, on behalf of the State, while the State uses auctions on the other PSF parcels. This results in a "checkerboard" pattern of auctioned and negotiated leases sitting side-by-side, throughout the State. This unusual situation allows us to compare otherwise equivalent negotiated leases and auctioned leases, something that would be impossible to do in other mineral leasing settings.
Our analysis shows that auctions result in substantially more efficient mineral leases. Auctioned leases are 22% more likely to be drilled and produce 44% more output than negotiated leases. Because our comparisons are between leases overlying nearly identical land, transacting at basically the same time, we know these differences in investment and output aren't telling us that auctioned land is inherently "better" than negotiated land. Instead, these differences must reflect differences in the productivity of the firms who win in auctions relative to negotiations. We suspect that these results are not driven by persistently "good" firms winning in auctions while persistently "bad" firms win negotiations, because the productivity gains to using auctions even exist between leases signed by the same firm. Instead, the data suggest that auctions facilitate better "matches" between a given piece of land and the firms who wish to develop it.
Auctions also deliver sizable economic benefits to private landowners, in the form of up-front payments that are 67% higher than those from similar negotiated leases. This difference is worth more than $200,000 for the average landowner, and, surprisingly, is not offset by lower royalty rates. Over the course of a decade, it adds up to hundreds of millions of dollars more in upfront payments that these landowners could have collectively earned if they had used auctions. Though this difference is sizable on its own, we suspect that auctions could make an even bigger difference for landowners in other parts of the United States. Because the minerals in the land we study technically belong to the State, government officials in Texas pay close attention to these informal negotiations and sometimes advise landowners to ask for better terms. We found that 19% of these negotiated leases are somehow improved before being approved, with typical improvements in bonuses and royalty payments of 50% and 17%, respectively. In contrast, landowners outside Texas don't have this additional protection, so our findings likely underestimate the potential value auctions could have throughout the country.
With trillions of dollars of privately-owned oil and gas reserves at stake, it pays to get this system right. Our research shows that both oil and gas companies and the landowners they contract with would benefit from using auctions to lease mineral rights instead of using informal and decentralized negotiations. Luckily, private landowners can use auctions today, without any changes in policy. The same internet-based mineral-lease auction platforms, like EnergyNet.com, that government organizations use, are available to private landowners at a relatively low cost.
View on Forbes…
, Fossil Fuels
Under current policies, fossil fuels will play an important role in the energy system for the foreseeable future. EPIC research is exploring the costs and benefits of these fuels as...
, Ensuring Americans Receive Fair Value for U.S. Oil and Gas Resources
Ensuring Americans Receive Fair Value for U.S. Oil and Gas Resources
Federal mineral leasing could deliver higher returns for taxpayers and better protect the environment if policymakers increased royalty rates and minimum bids, eliminated deductions, shortened primary terms, and strengthen bonding...
More on this U.S. Energy & Climate Roadmap: Chapter Brief
Insight / Research Highlight•Apr 01, 2019
Relinquishing Riches: Auctions vs Informal Negotiations in Texas Oil and Gas Leasing
Thom Covert, Richard Sweeney
For Landowners Sitting on Oil or Gas Reserves, Auctions Can Pay Large Dividends
Insight / Podcast•Apr 27, 2022
Has Carbon Pricing's Moment Arrived?