Insight·May 18, 2020

The Economics of Time-Limited Development Options: The Case of Oil and Gas Leases

Are oil and gas companies drilling wells that – based on fundamentals like prices, costs, and production – they wouldn’t normally be drilling, but for the need to preserve their leased acreage? And if so, why do firms and landowners write leases with primary terms that wind up forcing firms to drill wells they’d prefer not to drill?

Evan Herrnstadt, Ryan Kellogg, and Eric Lewis

Key Findings

  • The authors’ empirical analysis shows that there is substantial bunching of Haynesville drilling in the months just prior to lease expiration. That is, the probability any given pooling unit is drilled is sharply higher just before the unit’s first lease expiration than it is at any other time. In cases where the first expiring lease includes a built-in two-year extension clause, the bunching occurs just prior to the end of the extension rather than at the end of the primary term itself.
  • Many leases — especially those in less productive areas of the Haynesville — are characterized by having only a single well that was drilled just before lease expiration, suggesting that drilling in these areas was primarily motivated by holding acreage for future wells rather than by immediate profits.
  • Despite the ex-post inefficient bunching of drilling that is induced by primary terms, the model reveals that including a primary term in a lease can actually increase both the landowner’s expected revenue and the total (landowner + firm) expected surplus from a lease. The primary term is beneficial because it counteracts the delay incentives generated by the royalty, which would otherwise cause firms to drill too late. Ultimately, the royalty and primary term serve as complements to one another. The royalty helps the landowner recover the value of the resource rather than leave that value with the firm, and the primary term mitigates the incentive problems caused by the royalty.
  • Primary terms are most beneficial to landowners when pooling units can accommodate at most a single well. In contrast, when drilling one well allows the firm to hold a unit that is large enough to drill several follow-up wells in the future (as is the case in the Louisiana Haynesville), primary terms do not substantially improve landowners’ take. A key problem is that primary terms only counteract the royalty-induced delay for the first well, but not future wells. This result may help explain why mineral owners in Louisiana have litigated over Louisiana’s unitization policies and why mineral owners in other states are adopting lease clauses that prevent firms from holding large amounts of acreage with a single well.