Streetwise Professor

October 21, 2012

Coase Visits Haynesville

Filed under: Commodities,Energy — The Professor @ 3:48 pm

The NYT has a very long piece on how E&P companies are singing the blues about the low prices following on the unexpected surge in natural gas production.  Stop the presses.

What’s interesting to me is a point made in the article that I’ve seen raised repeatedly, and which I find curious, given my Coasean bent.  Specifically, that lease terms force companies to continue drilling to maintain leases, even if the wells can’t make money in a low price environment.  That is, the leases have use-it-or-lose-it-clauses:

The land that the natural gas companies had leased, in most cases, came with “use it or lose it” clauses that required them to start drilling within three years and begin paying royalties to the landowners or lose the leases.

. . . .

Exco, Chesapeake and others initially boasted about how many acres they had managed to lock up. But after paying bonuses of up to $20,000 an acre to the landowners, the companies could not afford to lose the leases, even if the low price of natural gas meant that drilling more wells was a losing proposition.

. . . .

The bust has certainly hit the Haynesville hard. Some local landowners, having spent their initial lease bonuses, are now deeply in debt. Local restaurants and other businesses are suffering steep losses now that so many drillers have left town.

The Coasean reply is to say: if drilling is inefficient, why not negotiate out of the use-it-or-lose-it-clauses?  There is a pot of money-the costs of excessive or premature drilling-that could be divided between the company and the lessor.  Why can’t the lessors and the lessees strike a deal to split that pot of money?  What are the transactions costs that preclude renegotiations that reduce excessive and premature drilling/production?  Is it the large number of lessors?  That is, are the costs of renegotiating each lease bigger than the benefit to be gained from rationalizing drilling and production?  Then why don’t companies like Cheseapeake just offer a standard deal to lessors, such as a fixed payment, or a fixed fraction of the original lease, or a fraction of the royalties from production, and let lessors take it or leave it?  Why are these clauses in the leases in the first place?

Interesting TCE questions.  I’d love to hear some answers, because I’m stumped.

Speaking of Haynesville, Gregory Kallenberg, the director of the movie Haynesville, has produced a series of short films (sponsored by Shell) about the future of energy.  The series is called “The Rational Middle.”  I appear-briefly-in several of the films, which can be viewed at the link.  I participated in a screening/panel discussion in Houston last Wednesday, and recorded material on conservation and efficiency that may appear in the next round of pieces.

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2 Comments »

  1. I think Pelosi, Obama, etc think the leases were granted at below market terms as subsidies to drillers, and now want to re-cut old deals on better terms for the government. I imagine one could learn a lot from Pelosi and co’s valuation analysis.

    Comment by vbounded — October 21, 2012 @ 4:48 pm

  2. I started my career as a landman buying gas leases up in the Anadarko basin. Remember that the initial payment to the landowner (the “bonus”) is a sizable payment. As you stated, in the Haynesville hit $20k/ acre. The landowner is hoping the lease expires so they can sign another lease and pocket another bonus check. If a well is drilled and doesn’t hit, the value of their mineral rights is diminished considerably, so pocketing bonus checks is not a bad way to add to one’s income.

    Also, remember the depletion rates for hydrofracked gas wells is extreme. Hitting a well, having it produce for a year and then being capped also diminishes the value of a landowner’s mineral rights.

    Currently, there is no economic incentive for a landowner to want to extend a lease. The landowner would rather have a lease expire so the land can be leased again and the landowner can receive another bonus check. If the well is drilled, a dry hole costs the landowner money. If the well hits, with current prices the well gets shut in with no royalty check to the landowner. There is only an incentive for the landowner to renegotiate the lease when bonus payments are low and market rates for gas are high so the royalty checks roll in.

    Also, the writer of that article doesn’t understand the energy business. Production companies don’t have any of their rigs drilling wells because production companies don’t havbe any rigs. Drilling companies have their rigs drilling for the production wells. Chesapeake didn’t have any of its rigs drilling gas wells. Probably Noble or Patterson/ UTI had their rigs drilling on Chesapeake’s leases.

    Comment by Charles — October 21, 2012 @ 8:24 pm

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