No such thing as neutral

on Oct 08 in Oil Exploration, Politics tagged by Trevor Hicks

Anadarko won its case against the US government regarding royalty payments from production in some deepwater oil wells in the Gulf of Mexico.  The case stems back to a Congressional policy in the late 90s to forego royalty payments on new wells in the Gulf as an incentive for companies to drill.  The dispute comes from the fact that the Department of Energy made a serious error in the lease contracts it signed in that it failed to reinstate the royalties in the case that prices reached above certain threshholds. I think this is the correct decision. Rep. Markey may bluster about it:

(He) said the decision means “the oil industry now stands to see a geyser of tens of billions of dollars in windfall profits at the expense of American taxpayers.”

Markey added: “This lawsuit means that oil companies can drill here, drill now and pay never.”

But there is another important principle at stake here.  It’s called “A deal’s a deal.” Venezuela’s plummeting production is caused in part by the unwillingness of foreign companies to invest capital or technology there since they do not trust that their contracts will be honored. It may feel good to stick it to the oil companies but you’d pay for it later when domestic production continues to decline, raising retail prices and capital flows outside the country.

The more interesting topic this raises is the fact that a neutral energy policy just isn’t possible. As much as I would favor a government policy of creating a “level playing field” between competing energy sources, it doesn’t exist. Consider production royalties, what is the level of royalty payments the government should collect that is neutral between oil and solar or wind power? The first answer that comes to my mind is 0, the government would raise all of its revenue from public auctions of the lease rights, eliminating royalties would certainly increase the amount exploration companies would be willing to pay for drilling rights. In that case, the government hasn’t influenced any prices, it has merely accepted the will of the marketplace. But that is probably not the best public policy, for a couple of reasons. And it might not even be considered really neutral either.

First, there is always great uncertainty about the quality and quantity of reserves before wells are drilled. This imperfect information means that all of the risk would be pushed on to the drillers under a royalty-free regime.  Here’s the bad news for the government, this risk lowers the price drillers are willing to pay for a lease and also means that the driller collects all of the upside. This isn’t a good deal for the government, particularly considering the skewed distribution of payoffs.  A dry hole has a fairly fixed and known cost.  A giant discovery can be worth untold billions which the government would not share in.  And this matters because the endowment of natural resources can rightfully be thought of as a possession of the collective citizenry and it is reasonable to expect that the public receive fair compensation for them.

Another reason to want royalty payments is the time inconsistency of the value of the oil. Today the oil is worth $70.  Last year it was $140.  Next year, who knows? A policy of relying solely on lease auctions as compensation to the public for the right to extract resources locks the public’s compensation in at prevailing valuations of the commodity, again shutting the public out of the value of any upside.

Finally imagine that you are a property owner fortunate enough to own the mineral rights and you are approached by an exploration company that wishes to drill on your land. Would you be willing to accept a deal that sets a one-time payment for the right to drill but shuts you out of any portion of future production? Probably not, we shouldn’t expect the government to accept such a deal either.

This leaves us with a tension between ensuring fair compensation to the government for public resources against the very legitimate desire to have the government strike a neutral stance between the various competing sources of energy in the marketplace. The government should collect royalties. But how to set the rates? Simple, because the government is acting as a resource holder selling its property, it should set royalties at a revenue maximizing level. If you are familiar with the Laffer curve, you know that as rates increase, economic activity decreases. The most neutral “selling price” or royalty rate is the one that forces the driller to pay the market clearing royalty rate in exchange for drilling rights. This is no different than if they were contracting with a private landowner.