Streetwise Professor

June 4, 2011

Test Time, Class

Filed under: Commodities,Economics,Energy — The Professor @ 12:22 am

From The Oil and the Glory, inspiration for a great test question:

Shale gas is the main fashion. Companies are in a drilling frenzy in Texas, Oklahoma, Pennsylvania. This is not so much because the market demands so much of their product — there is in fact a glut — but because drilling is required by many of the leases. U.S. natural gas prices are below $5 per thousand cubic feet, and the futures market expects the price even five years from now to rise to just $6 per thousand cubic feet — insufficient for most of the fields to break even. So when those leases expire, the boom could shrivel — the companies could look forward in time and decide the risk simply doesn’t justify continued production. [Emphasis added.]

What conditions must hold for the italicized statement to be true? ย That is, what must exist in order for the contractual requirement in gas leases identified in the article lead to the claimed inefficient excess production of gas?

For extra credit, at the risk of giving away the answer to the above questions, and presumably directed at people in the real world: (a) what transactions costs, if any, impede the renegotiation of leases?, and (b) are leaseholders attempting to renegotiate?

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  1. There is no way I can pass up a challenge like this with the opportunity to amply demonstrate my ignorance and so here goes-

    Conditions Necessary For True Statement
    1) Demand for gas is relatively inelastic
    2) Gas is unable to compete/displace other fuels-no substitution
    3) The lessee sees more value in holding leases through minimal drilling than relinquishing those leases
    4) Leases cannot be renegotiated more cheaply then they can be held by drilling ๐Ÿ™‚
    5) Lessees are unable to find a purchaser for leases at a price that is attractive with respect to their valuation of these leases

    In general lessees find “drill and hold” their optimum business strategy. They will hold as much acreage with as few wells as possible. They expect that gas prices will rise sometime and that drilling at that time on their leases will be profitable and that even with current unprofitable drilling the NPV of the lease is positive.

    Lessors while benefiting from higher gas prices bear no expenditures for drilling and so will prefer expedited drilling no matter that drilling has expected negative net present value. The lessor received a bonus for conveying the lease and has little incentive to renegotiate and to defer royalty payments. The current lessee likely does not provide any substantive benefit with respect to other potential lessee’s should the lease expire. At a minimum he will receive another cash payment for re leasing an expired lease with some other company.

    Comment by pahoben — June 6, 2011 @ 1:53 pm

  2. Okay I understand the delay in grading-this was done under the Russian grading system. How much do you want for an excellent?

    Comment by pahoben — June 8, 2011 @ 6:05 pm

  3. Sorry, pahoben . . . I’m a slow grader (the registrar is always hounding me for my grades:) If it were a Russian grading system, I would be waiting for the bribe! Or is that what you mean by “what [I] want for excellent”? ๐Ÿ™‚

    You’ve overcomplicated things. In the absence of transactions costs, the original assignment of rights and obligations in a contract is irrelevant. Parties would renegotiate and extend the lease in order to avoid value destruction. There is money on the table to be split between the lessor and the lessee by avoiding inefficient drilling.

    Therefore, for inefficient drilling to be occurring, there must be some transaction cost precluding this win-win negotiation. I’d be very interested in hearing ideas as to the source(s) of said transactions costs.

    The ProfessorComment by The Professor — June 10, 2011 @ 2:00 pm

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