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

71 Pages Posted: 18 May 2020 Last revised: 24 Mar 2021

See all articles by Evan Herrnstadt

Evan Herrnstadt

Government of the United States of America - Congressional Budget Office (CBO)

Ryan Kellogg

University of Chicago - Harris School of Public Policy

Eric Lewis

Texas A&M University - George Bush School of Government and Public Service

Multiple version iconThere are 2 versions of this paper

Date Written: May 2020

Abstract

Oil and gas leases between mineral owners and extraction firms ubiquitously include royalty and primary term clauses. The royalty denotes the share of revenue that is paid to the mineral owner, and the primary term specifies the date by which the firm must complete a well, lest it lose the lease. Using data from the Louisiana shale boom, we first show that wells' drilling timing is substantially bunched just before lease expiration, raising the question of why leases include development deadlines that distort drilling decisions. We then develop a contracting model in which mineral owners face firms with private information and have the ability to contract on both realized revenue and drilling timing. We show that primary terms can increase both the owner's expected revenue and total surplus because they counteract the delay incentives imposed by the royalty.

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Suggested Citation

Herrnstadt, Evan and Kellogg, Ryan and Lewis, Eric, The Economics of Time-Limited Development Options: The Case of Oil and Gas Leases (May 2020). NBER Working Paper No. w27165, Available at SSRN: https://ssrn.com/abstract=3603795

Evan Herrnstadt (Contact Author)

Government of the United States of America - Congressional Budget Office (CBO) ( email )

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Ryan Kellogg

University of Chicago - Harris School of Public Policy ( email )

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Eric Lewis

Texas A&M University - George Bush School of Government and Public Service ( email )

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