Relative Gain From Using Auctions

Source: Relinquishing Riches: Auctions vs Informal Negotiations in Texas Oil and Gas Leasing, BFI Working Paper, April 2019

For the last decade and a half, U.S. oil and gas companies have relentlessly improved the efficiency of the wells they drill. They’ve applied hydraulic fracturing technologies in newly discovered shale formations, are continuously learning how to use these technologies better, and many of the biggest producers invest hundreds of millions of dollars into research and development every year. However, firms with the best technology can only get value out of it if they have places to drill. Unfortunately, the market for mineral leases (contracts between landowners and oil and gas companies) is surprisingly inefficient. Why? The vast majority of mineral leases are concluded in informal and decentralized negotiations, rather than in centralized auctions like those state and federal governments use for leases on public lands.

Thomas Covert, an assistant professor at the Booth School of Business, compared thousands of auctioned and negotiated leases that were signed in Texas between 2005 and 2016. He and his coauthor discovered that auctioned leases do a better job at matching landowners to the most efficient firms, making auctioned leases more productive than negotiated leases. Auctioned leases are 22 percent more likely to be drilled and produce 44 percent more oil and gas for the industry. 

Auctions also deliver sizable economic benefits to private landowners in the form of upfront payments that are 67 percent higher than those from similar negotiated leases. This difference is worth more than $200,000 for the average landowner, and, surprisingly, is not offset by lower royalty rates. Over the course of a decade, it adds up to hundreds of millions of dollars more in upfront payments that landowners could have collectively earned if they had used auctions.