December 22, 2006 2:05PM

An Oil Royalty Mystery

With oil prices still above $60 a barrel, do oil companies need inducements to find and produce more oil? That's the underlying question of today's NYT front-page article about an Interior Department report questioning the value of royalty rebates and tax breaks for gas and oil production.

The rebates are targeted at expensive and difficult exploration, usually in deep water or that requires deep drilling. The intention is to incentivize that exploration, allowing the United States to increase its domestic reserves using "unconventional oil."

But it's unclear how effective the incentive is, given the expense of producing such oil. Here's the article's punchline:

[The report] estimates that current inducements could allow drilling companies in the Gulf of Mexico to escape tens of billions of dollars in royalties that they would otherwise pay the government for oil and gas produced in areas that belong to American taxpayers.

But the study predicts that the inducements would cause only a tiny increase in production even if they were offered without some of the limitations now in place.

The article notes that royalties and corporate taxes deliver into federal coffers about 40 percent of the revenue produced from oil and gas extracted from federal property. The worldwide average government take is about 60–65 percent. A 40 percent federal take may have been fair at a time when oil prices and profits were lower, the article suggests, but the government should be getting a much higher cut from today's prices.

Reading the article, I thought about a question that my colleague (and boss) Peter Van Doren has often asked: Why do we have federal royalty payments at all? Why not, instead, use the initial mineral rights auction as the sole source of government revenue from extracting oil or gas? 

A switch to auction-only taxation would yield much more money to the federal government up-front, as oil and gas companies would bid heavily for the leases. (I'll be agnostic on whether the government receiving more money is a good thing.) An auction-only process would also be much more transparent and would do away with the "gaming" of royalty payments. And, perhaps most importantly, an auction-only process would better align oil companies' incentives with consumers, vis-a-vis the current system.

In essence, the federal government uses a two-step tax process on oil and gas: up-front payment from the auctioning of the right to extract from a certain reserve, and ongoing royalty payments calculated from the amount of hydrocarbons extracted. To participate in the auction, oil and gas companies must estimate the value of the hydrocarbons they expect to extract over time, subtract the royalty payments they would have to make, and then determine how much of the remainder they would be willing to offer to the government as an auction price.

This system gives a decided advantage to oil companies that are willing to "game" the royalty system. Those firms can outbid competitors, because the gamers know their royalty payments would be lower than the other firms' payments would be.

To get rid of the gamers' advantage, the feds need only scrap the royalties scheme. That would force oil companies to bid heavily during the lease auction, where cheating is much more difficult. The brilliant feature of an auction is that it forces all parties to reveal exactly how much they value the product that is up for bid.

That feature would do away with the need to incentivize firms to tap into expensive but worthwhile unconventional gas and oil. Suppose there are two gas reserves up for auction: one an easy-to-tap reserve on government land in Wyoming and the other a similar-size reserve in the deep waters of the Gulf of Mexico. Extraction firms would bid heavily on the Wyoming reserves, but they would also bid (albeit not as much) on the Gulf reserve if they thought it worthwhile. No explicit incentive system would be needed — the firms would simply reveal to the auctioneer their own estimates of the Gulf reserve's value.

Switching from an auction & royalty system to a straight royalty system would also better align oil and gas companies' interests with consumers. Currently, as a well nears the end of its productive life, royalties would encourage the operator to take the well out of production sooner, because each hydrocarbon produced means more revenue taken from the oil or gas company and given to the government. By changing the tax to an up-front auction payment, oil and gas companies would have the incentive to continue operating the well until every profitable hydrocarbon has been extracted. That incentive change would be especially beneficial to consumers in times of tight supply and high prices.

As the NYT article notes, members of the incoming Democratic congressional majority are declaring that they will cut back on the royalty relief and tax cuts given to oil and gas companies. They would do the nation's taxpayers and consumers an even bigger service if they would reconsider the royalty system altogether.