When an oil company comes knocking, hold an auction

Brian Wallheimer | Jan 27, 2020

Sections Economics

Discoveries of natural gas and oil in shale formations, coupled with improved technology to remove the deposits, have created demand for property or mineral rights in places such as west Texas and rural North Dakota. 

Much of that land has been barren, undeveloped, and worth little until now, so it would be easy to understand a landowner jumping on a six-figure offer from the first oil company that comes knocking. But Chicago Booth’s Thomas Covert and Boston College’s Richard L. Sweeney suggest those landowners would do well to consider formalizing the process with auctions.

A quirk in Texas law afforded Covert and Sweeney an opportunity to compare auctions against negotiated leases. Long before the discovery of oil, the Texas Constitution of 1876 allowed the state to sell millions of acres of lands, with proceeds benefiting the Texas Permanent School Fund—but buyers received only the surface rights. Following the discovery of oil, the Relinquishment Act of 1919 allowed these landowners to negotiate with oil and gas companies for drilling and mining rights on behalf of the state, with the landowners and the state splitting the revenues equally. The state’s underlying ownership of the mineral rights made public the otherwise private contracts between landowners and oil and gas companies. In 1973, the state began formally retaining all mineral rights on the lands sold from the Permanent School Fund. It uses auctions to award leases on this land. 

For landowners, auctions beat private dealing

In a study of Texas oil-drilling deals, the researchers find that auctioned leases were substantially more lucrative for sellers than privately negotiated leases.

Negotiated leases
Auctions

Covert and Sweeney, 2019

The researchers analyzed the prices and productivity of 846 privately negotiated leases and 428 auctioned leases during the recent shale boom, from 2005 to 2016. They find that auctioned leases earned about 40 percent larger up-front payments than negotiated leases did, and that auctioned leases produced 60 percent more output. 

While it might seem intuitive that companies bidding against each other in a formal process would raise the final lease price, it isn’t a foregone conclusion that auctions necessarily perform better. In theory, a savvy landowner could get a similar price by simply using private offers as bargaining chips in private negotiations, the researchers point out. Auctions also introduce costs that could keep some companies from entering the fray.

“If it takes time to figure out how valuable a lease is, it effectively costs money for firms to enter an auction. The highest-value bidder might not participate,” which could result in a lower price than in a negotiation, Covert says.

Nevertheless, the data show that auctions performed substantially better. Combining the effects of increased up-front payments and royalties on higher output, the researchers find that auctioned leases ultimately paid landowners about $350,000 more than the average, similarly sized negotiated leases did—$1.2 million, rather than $850,000.

The researchers also find that much of this effect came from the fact that auctions did a better job of matching the oil and gas companies with the lands that were best suited to their individual strengths.

“One theoretically appealing feature of a well-designed auction is that it should allocate an asset to its highest-value user,” the researchers write. “Texas mineral leases allocated by auctions generate more revenue for mineral rights owners and are better matched to firms who can use these minerals productively, relative to leases allocated by informal, decentralized negotiations.”