Streetwise Professor

August 30, 2008

Property Rights Economics 101

Filed under: Economics,Energy,Russia — The Professor @ 9:52 am

An article on the McClatchy wire states that the Russian oil industry is facing a dire future due to “the practice of reaping quick profits and ignoring long-term interests.” This is no big surprise to those who understand the effects of insecure property rights on the incentives to (a) invest in specific assets, and (b) take as much as you can grab today because it may not be yours tomorrow. There are few assets more specific than an oil well. If you invest wisely today to maximize the present value of the well’s future output, that does you no good if you’re not around to claim those future flows (because, for instance, you’re rotting in a jail in Chita.) So, to hell with the future–maximize what you can produce today, even though that impairs the well’s long run value.

This is somewhat ironic because in the early days of the oil boom, the property rights regime in the US favored accelerated depletion of wells due to its failure to address the common pool problem, whereas Tsarist Russia encouraged a longer view. This was reflected, in part, by the far larger number of wells drilled in the US to produce a given amount of oil. In the US, competing producers (including wildcatters) drilled wells to get the oil from a given pool before somebody else did. This wasteful competition was attenuated in Russia.

Short-termism is clearly an important–and arguably the dominant–source of friction between BP and its Russian partners in BP-TNK. The Russians want to maximize current cash flows, BP wants to take a longer view. This short-termism is also likely an important cause of the relatively low rate of fixed investment in Russia. And this short-termism is a direct result of the insecurity of property in Russia. The constant threats of state expropriation and corporate raiding a la Russe will continue to impede Russian economic growth.

The contrast with China is of some interest. Formal property rights are absent in China too, but China’s rulers act more like “stationary bandits” (in Mancur Olson’s felicitous phrase) with an “encompassing” interest in the long run health of the nation’s economy. They apparently figure they have a high probability of being around for awhile, and therefore temper their short term exactions in order to enhance their future take. Thus, property rights are informally protected and relatively secure (by comparison to the Chinese past and Russia, but not to the US.)

Russia’s rulers, by contrast, act like Olson’s “roving bandits.” Apparently insecure in their future prospects, they lean towards taking today and letting the future take care of itself. The Putinists probably have a longer view than the pirates of the 90s, but they clearly have shorter time horizons than their Chinese counterparts. In an environment where competing clans vie for control, this is probably a rational view. My clan may control asset X today, but who is to say that the competing clan may not seize it tomorrow? So rather than enhance X’s future potential, grab as much as I can from it today.

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5 Comments »

  1. Could someone please expand on the common pool problem? I don’t understand how this explains why arrangements in the States initially favoured rapid depletion of oil reserves depsite the country being more market orientated.

    Comment by not an economist — September 1, 2008 @ 6:25 pm

  2. The common pool problem in the US oil industry arose in the early 20th century when different operators (some corporations, some sole proprietorships, some partnerships) had interests in the same large oil and gas fields whose physical dimensions overlapped the plots of land that each operator had leased.

    The problem was especially significant when there were a large number of leaseholders with interests in the same reservoir (e.g. the massive East Texas oil field in the early 1930s).

    Any operator willing to produce as rapidly as possible (at the cost of prematurely reducing gas pressure in the reservoir, thereby losing what would have been significant volumes of future oil production) would draw oil away from surrounding lease interests. In the early 20th century this was known as the “rule of capture.”

    This created a type of Prisoner’s Dilemma for operators in the common pool. If they produced at the rate that would have maximized the net present value of their pro rata share of the reservoir, other opportunistic producers would produce at the highest rate possible to drain the reservoir to their particular advantage but to the detriment of the whole.

    The political solution to this problem in Texas in the 1930s was “forced unitization”, overseen by the Texas Railroad Commission. The Commission had the power to determine maximum allowable rates of production from different interests in the same reservoir.

    Other US states followed suit. Production of oil and gas volumes is regulated by virtually every producing US state.

    A market-solution to the same problem would have involved some entrepreneur tendering for all the interests in the same reservoir with the proviso that all interests in a reservoir would have to be tendered for the deal to be completed. This might have resulted with one entrepreneur owning the whole field or a single corporation whose shareholders were the original fractional owners of that field.

    Regrettably, there are few large scale examples of the market-solution in US energy history. There are examples of such market-solutions in other minerals businesses involving many interests to huge resource bases.

    Cecil Rhodes (founder of Rhodesia, endower of Rhodes Scholarships) made his fortune “market-unitizing” the Kimberly diamond fields in just such a manner.

    Comment by John McCormack — September 4, 2008 @ 1:21 am

  3. As another non-economist I would hazard the guess that the “common pool problem” is pretty much the same as Harding’s “Tragedy of the Commons.” That is, if you and I can capture private gains from withdrawing value from a shared asset, we will race each other to do so. The best case, if we do so, is we drain the asset as quickly as possible. The more likely case, in assets which (if husbanded properly) are self-renewing or whose ultimate content depends on how they are drained, is that our celerity will impoverish us both, compared to what we could have gained by cooperating to get the most from the asset over time. An oil field is certainly a pool, in the sense that its contents are distributed based on geology rather than the accidents of where a concession line is drawn. And I believe that oil fields can yield much more, or much less, depending on the pattern and pace of extraction.

    Comment by oMan — September 5, 2008 @ 7:58 am

  4. The common pool problem in the US oil industry arose in the early 20th century when different operators (some corporations, some sole proprietorships, some partnerships) had interests in the same large oil and gas fields whose physical dimensions overlapped the plots of land that each operator had leased.

    The problem was especially significant when there were a large number of leaseholders with interests in the same reservoir (e.g. the massive East Texas oil field in the early 1930s).

    Any operator willing to produce as rapidly as possible (at the cost of prematurely reducing gas pressure in the reservoir, thereby losing what would have been significant volumes of future oil production) would draw oil away from surrounding lease interests. In the early 20th century this was known as the “rule of capture.”

    This created a type of Prisoner’s Dilemma for operators in the common pool. If they produced at the rate that would have maximized the net present value of their pro rata share of the reservoir, other opportunistic producers would produce at the highest rate possible to drain the reservoir to their particular advantage but to the detriment of the whole.

    The political solution to this problem in Texas in the 1930s was “forced unitization”, overseen by the Texas Railroad Commission. The Commission had the power to determine maximum allowable rates of production from different interests in the same reservoir.

    Other US states followed suit. Production of oil and gas volumes is regulated by virtually every producing US state.

    A market-solution to the same problem would have involved some entrepreneur tendering for all the interests in the same reservoir with the proviso that all interests in a reservoir would have to be tendered for the deal to be completed. This might have resulted with one entrepreneur owning the whole field or a single corporation whose shareholders were the original fractional owners of that field.

    Regrettably, there are few large scale examples of the market-solution in US energy history. There are examples of such market-solutions in other minerals businesses involving many interests to huge resource bases.

    Cecil Rhodes (founder of Rhodesia, endower of Rhodes Scholarships) made his fortune “market-unitizing” the Kimberly diamond fields in just such a manner.

    Comment by John McCormack — September 4, 2008 @ 1:21 am

    Comment by John McCormack — September 9, 2008 @ 1:02 am

  5. […] are insecure, it makes eminent sense to focus on the here and now, rather than the future.  (Here’s another post that explores this theme.) […]

    Pingback by Streetwise Professor » Medvedev Channels SWP — May 16, 2009 @ 5:09 pm

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