To strike it rich, auctioning off drilling rights pays more than private deals

It’s everyone’s dream that one day, someone will come knocking on your door to tell you that you’re sitting on a gold mine. Due to remarkable improvements in hydraulic fracturing technology for shale resources, hundreds of thousands of U.S. households have had this experience over the last decade and a half.

"Landmen," sent by oil and gas companies, approach these newly asset-rich households, offering large up-front payments and the promise of future production royalties, in exchange for exclusive rights to drill on their land. While landowners know that the terms they are offered are clearly better than nothing, they might not know how much better they could do if they were to bargain for better terms or "shop" the deal to other oil and gas companies. In practice, many accept the first offer they receive.

Decades of economic theory research suggest that landowners could do better, by replacing their informal "negotiations" with auctions. How much better? A new study finds that landowners are missing out on earning hundreds of millions of dollars in up-front and ongoing payments when they negotiate leases on their own, rather than using auctions, like state and federal governments do for leases on public lands. What’s more, negotiated leases end up being substantially less productive than auctioned leases.

"While governments own mineral rights in most of the world, private landowners own them here in the United States," explains co-author Thomas Covert, an assistant professor at the University of Chicago Booth School of Business. He’s also an affiliated researcher at the Energy Policy Institute at the University of Chicago who studies investment behavior in energy markets. "Unfortunately, landowners often don’t have enough information to reach a fair bargain, or to choose the best leasing partner. We’ve found that by trying to negotiate mineral leases on their own, landowners are missing out on revenues-and, surprisingly, so is the industry."

Covert and his co-author Richard Sweeney, an assistant professor at Boston College, are the first to measure the gains from using auctions instead of informal negotiations in mineral leasing. Their study compared thousands of auctioned and negotiated leases that were signed in Texas between 2005 and 2016. Thanks to a natural experiment stemming from a brief period of Texan independence in the 19th century, some of these leases were awarded via auction, while others were informally negotiated. Since the sales mechanism was determined a century before the fracking boom, the difference in outcomes between auctioned and negotiated leases has a causal interpretation.

Using a rich dataset containing all contractual terms, payments and production, they discovered that when auctions are used, landowners receive upfront payments that are 67 percent higher than those from negotiated transactions-a difference of more than $200,000 for the average negotiated lease. Auctioned leases also do a better job at matching landowners to the most efficient firms, making auctioned leases more productive than negotiated leases. These auctioned lands yield 44 percent more oil and gas for the industry-and more royalties to the landowner.

"With U.S. oil and gas reserves worth more than $4 trillion, and private landowners responsible for managing the vast majority of those resources, it’s important that we understand how best to produce from them, and how to ensure landowners capture their fair share," Sweeney says. "Formal, centralized auctions are a transparent way for landowners to earn more and for industry to produce more."

--Article originally appeared on the EPIC website.

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