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Ryan Kellogg

Assymetric Information, Royalty Distortions, and Drilling Deadlines: Explaining Oil and Gas Lease Contracts

During the last decade, hydraulic fracturing and horizontal drilling have driven a considerable expansion in U.S. oil and natural gas exploration and production. The rights to extract this oil and gas are often controlled by private landowners who write lease contracts with firms to drill for and produce the oil and gas. This research project is aimed at understanding the economic rationale for commonly-used contract terms and the impacts of these terms on the productive efficiency of this large and rapidly changing industry. This research is co-authored with two former Michigan Economics PhD students: Evan Herrnstadt (now a post-doc at Harvard) and Eric Lewis (now with the anti-trust division at the Department of Justice).

Our research focuses on a ubiquitous feature of oil and gas leases known as the “primary term”. The primary term is the period of time—typically three to five years—granted to the firm to exercise its option to drill a well on the lease. If the firm does not drill and produce oil or gas by the end of the primary term, it loses the lease, and the mineral rights owner is then free to sign a new contract with another firm. If, however, the firm does commence production, the lease enters a “secondary term”, which lasts until the firm ceases production. In exchange for being granted the lease, the firm pays the landowner an up-front cash “bonus” when the lease is signed, along with a royalty on all oil and gas that is extracted.

We have gathered detailed data on lease terms, drilling, and natural gas production from the Haynesville Shale in Louisiana. Our preliminary analysis of the data provides strong evidence that primary terms substantially impact drilling activity: a large share of all wells were drilled just before the firm’s lease expired. The next step of our research is to understand why so many wells are influenced by the primary term and generate counterfactual predictions of how drilling would have evolved under different contractual structures, such as the absence of the primary term or the royalty. Crucially, because the primary term will cause firms to drill wells sooner than they would like, whereas the royalty causes firms to drill wells later than they would like (since the royalty is essentially a tax on drilling), it is not clear ex ante whether wells are being drilled inefficiently early or late due to these common contract terms. To address this question, we are currently building a model of firms' negotiations with landowners and firms' drilling decisions.