Earth Rights Institute - Types of Lease Payments

Types of Lease Payments (excerpt)

by Mason Gaffney

When we combine this pattern of waste with the pattern of improper timing described earlier, they tend to reinforce each other in a general pattern of overdecentralization. Too much is applied too early to expand exploration allied transportation lines. Too little is applied and too late to more intensive development in and around proven reserves. The overall pattern has much in common with imperialism. All of this can be avoided by hewing faithfully to the concept of businesslike management with maximum DCF. That will be our lodestar.

5. External impacts
To allow for the externalities of oil and gas production both positive and negative the State seems evenly divided between those who perceive more pluses than those who perceive more minuses. This is appropriate since there are both kinds. The issue between the polarized parties is sharper, however, than can be resolved by such devices as measuring the value of the sports fishery, for example, and trading off these values for equivalent energy values because some of the very things, seen as positive by some like added payrolls, added spending, increased property values seem negative to others. Change viewed as progress by some is seen as retrogression by others. To measure and then reconcile these attitudes would be far beyond our scope.
We need not, however, leave the matter completely unresolved.
A key to reconciliation is in the distribution of gains and losses.
There are probably more gains than losses from general economic development since the actors reinforce one another, but the gains are not equally distributed. One man's windfa11 is another man's wipeout. Many gains are unearned and received by absentee investors. As the problem is distributive so is the probable solution. Wide distribution of the benefits of oil and gas development will make it much more acceptable. Leasing policy can contribute to this solution, although it is by no means the whole story.
Another externa1 cost imposed on society by extractive industries is frequently instability, and many people fear the boom and bust characteristics of oil and gas and other mining industries. This consideration argues for leases that yield steady revenues and encourage steady activity and it also may argue for a steady flow of lease sales. Neither of these is an absolute, obviously, and must be balanced against the question of getting top dollar by turning production and sales on and off.
6. Coordination with leasing on federal and native lands
Federal and native lands will share common transportation lines and support bases with State lands. They may be on the same structures. State and federal lands especially have -extraordinarily long common boundaries in oil-prone areas. The State evinces strong desires not to be led by federal policy and to have some input into federal policy. At the same time, there is no drainage treaty or compact between the different landowners even though England and Norway have managed to work this out in an international basis. Until this is done, clearly a strike near the boundary will force a drainage sale on the other side. If the Feds and the natives get and keep ahead of the State, the State might do very well by specializing in drainage sales, a policy favored by many. But there is an uncomfortable feeling that this loss of initiative might also impose high costs by letting others determine the location of activity as well as timing. There is also some fear that division among the three kinds of landlords might divide them for easier conquest by the industry. The State’s objective therefore is clearly to achieve a higher degree of cooperation.

C. Elements of Leasing
There are several elements in a lease, most of which are optional and variable along a wide spectrum. Kinds of leases are frequently distinguished by identifying the bid variable; but the constant elements may be more important than the bid variable where they are set at very high rates. Thus we discuss the pros and cons of each element in leasing first, and only at the end discuss the choice of a bid variable.

1. Prior claim: the noncompetitive system
A substantial acreage in Alaska remains under noncompetitive lease. Figures forwarded by Mr. Denton of the DNR for noncompetitive acreage of "oil companies" totaled to 625,000 acres. In addition there is acreage held by individuals. Ranking the companies in order of their net acreage held, we find that the top 10 percent hold 58.9 percent of the noncompetitive net acreage. This compares with 64 percent when we do the same thing for competitive net acreage. Major holders of noncompetitive acreage are Texaco, Union, Cities' Service, Amoco, and Atlantic Richfield. (Major holders of competitive acreage are the same firms plus Sohio, Phillips, BP Alaska, Exxon, Standard of California, and Mobil.) (See Appendix C.)
Noncompetitive systems are widespread outside the United States. Major faults appear to be that they give away State property without payment, and so encourage premature claims and, where there is a work requirement, premature use. The claim-staker rather than the State gets in on the ground floor of the elevator and holds the resource while it appreciates from a zero value up to whatever value its natural richness warrants. Any rate of return beginning from a base equal to 0 is mathematically infinitely high and therefore not to be lightly given away.
We append an analysis by Professor Michael Crommelin, Faculty of Law, University of Melbourne, Australia (Appendix D).
2. The bonus
There are several advantages to using a high bonus in allocating leases and it has many staunch advocates, including Walter Mead and Milton Lipton. Advantages of a high bonus include:

a. Large commitment by the lessee -- he will not walk away.
b. There is no marginal disincentive imposed on the lessee.
c. The State receives its money up front.
d. Major corporations have access to market funds at rock bottom interest rates, about 7.5 percent on bonds today, and therefore presumably will discount future expectations at correspondingly low rates. Some of them have access to internal funds whose opportunity cost or alternative use may be even lower in the event the management is embarrassed with more assets than it can manage effectively. Some utilities, in seeking to support their rate bases, have advanced money to invest in leases. This last kind of investment is being cross-subsidized by the profit-making parts of the firm and may yield extremely low marginal rates to the company. Historical evidence presented by Mead from the Gulf of Mexico indicates rates of return of about 7.5 percent.
e. If the State should be exploited inadvertently it can use the tax mechanism later on to compensate.
f. The transfer is complete and there is no need for policing prices later on, auditing costs and so on.

On the con side, major problems with high bonus payments are the following:
a. High capital barrier to entry, reducing the number of bidders. This is undesirable both because of the concentration of wealth and power which it implies but also because reduced competition might prevent the State's receiving fair value. Data supplied by Mr. Denton when ranked by net acreage indicate that the top 10 percent of the holders of competitive net acreage have 64 percent of the acreage. These top 10 percent consist of Arco, Phillips, Union, SoCal, Exxon, Sohio, Mobil, and Cities' Service. While this degree of concentrated control is not unusual in other places and other industries, it is still higher than many would consider socially desirable.
b. As low as the industry's internal cost of capital may be, the State's effective rate is probably lower. This is a considerable change from the past and calls for a change in policy. The State is no longer desperate for front money but on the contrary is looking for outlets for its permanent fund. The industry, on the other hand, may be entering an era of higher internal interest rates. It is freely alleged that figures like 20 percent are used in determining bonus bids although this is difficult to nail down. It is certain, however, that monumental capital requirements are projected for oil and gas related investment requirements in the next decade, presaging increasing tightness of capital and therefore lower bonus bids relative to resource values.
c. The bonus aggravates the cash crunch since it is synchronized with the need to find capital for drilling and equipping. This may result in underallocation of money to the latter, especially for small firms.
d. The time preference and therefore the production scheduling of different firms is ruled by their internal interest rates which vary from one firm to another. The allocation of credit among companies is based not on marginal productivity but on collateral security. The result is too much time pressure on some lessees and too little on others. The one may depend on extremely rapid use while the other may depend on speculation and delay above and beyond the social interests.
e. The payment is determined and made before enough is known about actual reserves. There is a large lottery element in the outcome and the outcome is not closely correlated with the price paid. The State might sell $10 billion worth of oil for $6 million as it apparently did at the 1965 auction at Prudhoe Bay. At the same time it sells some barren land for a high price. The rule of caveat emptor is applied, frequently intentionally by the seller. This constitutes a fraud with malice aforethought, which would not be tolerated in private business dealings and it is questionable if the State should observe a lower level of elementary morality than is expected of private sellers.
f. The distribution of petroleum reserves in nature is extremely unequal as among different deposits and tracts. The result is extreme inequality in the distribution of gains to wealth when all the payments are made up front and the results of successful and unsuccessful gambles fall entirely on the lessee.
g. If, as is generally believed, most investors are risk-averse, then the lottery element in having a high bonus acts as an additional filter screening out possible entrants. This leads to higher concentration and less active competition in the bidding for State property. Also, to the extent that accumulated wealth and a positive attitude towards gambling are factors determining the high bidder, productivity and cost control are less determinant.
h. Use of bonus bidding lends itself to preemptive, preclusive buying by wealthier firms concerned with controlling the market and discouraging competitors.
i. Once a bonus is paid and then a discovery made it is hard and costly to deny production if the environmental damage turns out to be high relative to the value of production. We have just lucked out of one such trap; we might do worse another time.
j. Transfer or sale of lease for a high bonus is a de facto sale of land but without much property tax liability imposed on capital or land (notably excepting the special Alaskan reserves tax). The capital invested in drilling and equipping is partly exempt and the intangible capital developed from exploratory drilling is not taxed. The leasehold interest itself is not always taxed. While such tax relief should result in higher bonus bids, this exacerbates the problem of the front-end filter.
k. The front-end filter becomes even tighter when lease sales are large and there is no slide bidding and the usual 20 percent advance bonus is required.
l. If oil and gas prices are regulated, and of course they are vulnerable to this risk, a bonus paid in the past is not treated as a current cost and not rolled in, resulting in lower prices received, whereas certain kinds of subsequent participation demands by the State might be treated in the regulatory mechanism as costs. In distinguishing between old oil and new oil, regulation may also distinguish between old costs and new costs.
Our worst suspicions of bonus bidding are confirmed by the brilliant, succinct and damning analysis of Alaska's past experience researched and written by my associate, Professor Richard Norgaard of the School of Resource Economics, University of California, Berkeley (Appendix E). Bonuses captured only from 9 percent to 16 percent of the surplus DCF value above costs and royalties in Cook Inlet. There were too few bidders to assure effective competition. Outcomes were wildly unrelated to bonuses bid and paid. Bidders have successfully used advanced gaming strategies and statistical analyses to take advantage of a State without expert staff in these fields. The State has not set adequate reservation prices or screened out fishing bids and overnominations: only 2 percent of the offshore Cook Inlet tracts leased through 1968 have produced. Dr. Norgaard recommends drastic changes.
3. The delay rental
Delay rentals are the smallest of the three major payments in the usual bid, the other two being bonus and royalty. They have been by no means negligible, however, and in Alberta, for example, have run at 50 percent as much as royalties and bonuses at various times. In addition, as compared with royalties they come earlier, and when we figure compound interest are blown up into an even larger figure.
Delay rentals are usually an annual yearly payment that ceases when production and royalties begin but there is room for many variations. They might continue until production ends, for one. For another, they need not be at a fixed level but might increase in proportion to some index such as cost of living or they might be made proportional to the assessed value of reserves, giving them the character of a property tax on reserves. Another possibility is to pay the bonus on the installment plan over several years. Yet another possibility is the production bonus, a contingent payment which is due only when and if commercial pay-rock is struck. This has some of the character of a bonus and some of the character of a rental and will be treated here.
The advantages of delay rentals and other rentals are the following:

a. Payment is deferred. This has the same effect as extending credit to payers of bonuses and letting them pay on the installment plan. This is of greater advantage to the leaner interloping firms and tends to increase competition.
b. The payment is fixed with respect to production and places no drag on it therefore. Thus it achieves two goals at once that the State is seeking. It shifts payments into the future and it does so without disincentive effect. If anything, it applies positive leverage to accelerate production.
c. At present when the firms need more time they simply request that leases be extended and the request is frequently granted. This involves arbitrary exercise of judgment by officials. It would be better for lessees to pay so much a year and make their own decisions. The pressure would be on them, of course, to accelerate production once the lease was signed. Firms would be less anxious to nominate acreage and insist on lease sales many years in advance of the availability of transportation.
d. Alaska has millions of acres out under lease. It could all be returning more money each year or else be relinquished for future sale at a more propitious time. Alaska is getting $1.00 per acre year for these lands. OCS lands are yielding $3.00 per acre year in practice and go higher on drainage and development tracts. Norwegian rentals go up to $21 per acre year.
e. Most capital is subject to property taxation and must therefore yield a return high enough to cover both interest and property taxes. The investment in withholding oil reserves from production, however, need only yield a competitive interest rate. A delay rental serves to compensate for the lack of property taxation so that the same discount rate is applied in both cases.
f. A rental is terminable in practice when a lease is dropped due to lack of interest. This reduces the risk imposed on the lessee considerably and should result in higher bids on the bid variable, whatever that might be.
g. A delay rental is smoothly convertible to an ad valorem base at such time as enough is known about the reservoir and its contents to allow reasonably accurate assessment. Thus, instead of being a fixed amount per year it would be a fixed percentage of the assessed value of the reserves, still retaining its key qualities of shifting payments into the future and not varying as a function of production.

On the negative side are the following considerations:

a. Early shutdown. This traditional argument against fixed charges would apply only to one of the several alternative forms of rental, the nonterminable level payment. It can be prevented by adopting one of the declining forms. Professor Rooney's studies (Appendix F) indicate that the problem of early shutdown is not a serious one in general unless there is a substantial bias against investments in pressure maintenance. A constant rental contains no such bias. An ad valorem rental based on the value of as yet unproduced minerals would exempt the value of capital in place and therefore leave the lessee with a substantial investment even at such time as the rental charge approached zero.
b. Rentals are traditionally lowest of the three kinds of lease payments. This suggests that the industry doesn't like them and would not accept them readily. While this point is often made, this consultant discounts it because of other evidence, presented later (Section 7c).
c. Some federal tax provisions favor delayed production, advantages which might be lost by any lease provision which promotes early production.

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