The Option to Hold a Petroleum Lease by Production: A User's Guide to the Shale Gas Drilling Boom

48 Pages Posted: 30 Nov 2014

See all articles by James L. Smith

James L. Smith

affiliation not provided to SSRN

Date Written: November 28, 2014

Abstract

Most oil and gas leases allow the operator to extend possession for an indefinite period by establishing production in paying quantities. We show how this option to “hold by production” (HBP) stimulates the drilling of many wells that would otherwise be uneconomic. Although such wells may superficially appear to be poor investments, in fact they contribute to shareholder value. We also show, however, that the HBP provision delays the drilling of other economic wells, an outcome that has become a frequent point of conflict between lessees and lessors in this industry. We provide a simple method to value the HBP lease provision as a compound option, and estimate that it has increased the value of typical shale gas leases in the U.S. by 25%-250% in recent years, depending on location. The HBP provision appears very likely to have increased drilling in certain areas, but even more likely to have decreased drilling elsewhere. Understanding the incentives created by the HBP option is fundamental to understanding the rate and pattern of drilling in U.S. shale gas plays. Our analysis does not support industry critics who allege that continued drilling of many sub-marginal gas wells has been a mistake.

Keywords: real options, shale gas, compound options, petroleum leasing, resource valuation

JEL Classification: D86, G13, Q33, Q35

Suggested Citation

Smith, James L., The Option to Hold a Petroleum Lease by Production: A User's Guide to the Shale Gas Drilling Boom (November 28, 2014). Available at SSRN: https://ssrn.com/abstract=2531997 or http://dx.doi.org/10.2139/ssrn.2531997

James L. Smith (Contact Author)

affiliation not provided to SSRN

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