“oil field unitization in theory and practice“oil field unitization in theoryand practice” by...

“Oil Field Unitization in Theory and Practice”

by

Dr. James L. Smith

Cary M. Maguire Chair in Oil & Gas Management

Department of Finance

Southern Methodist University

Dallas, TX 75275 USA

EPGE/FGV International Workshop on Microeconomics

Applied to the Energy Industry

jsmith@smu.edu

Rio de Janeiro, December 15, 2011

Theory versus Practice

• In Theory:

An ideal solution to an important problem.

Theory versus Practice

• In Theory:

An ideal solution to an important problem.

• In Practice:

Imperfect adaptations are unavoidable, but

may jeopardize success.

Outline of My Talk

• Unitization in theory:

– Aligns incentives

Outline of My Talk

• Unitization in theory:

– Aligns incentives

– Eliminates waste

Outline of My Talk

• Unitization in theory:

– Aligns incentives

– Eliminates waste

– Simplifies conservation regulation

Outline of My Talk

• Unitization in practice:

– Difficulties in forming the unit.• Inherent bargaining power

• Uncertain terms of trade

• The role of government vs. voluntary action

Outline of My Talk

• Unitization in practice:

– Difficulties in forming the unit.• Inherent bargaining power

• Uncertain terms of trade

• The role of government vs. voluntary action

– Difficulties in operating the unit.• Early gas sales vs. enhanced oil production

• Primary vs. secondary recovery

• Concessions vs. production sharing?

Outline of My Talk

• Unitization in practice:

– Difficulties in forming the unit.• Inherent bargaining power

• Uncertain terms of trade

• The role of government vs. voluntary action

– Difficulties in operating the unit.• Early gas sales vs. enhanced oil production

• Primary vs. secondary recovery

• Concessions vs. production sharing?

– How the former difficulties lead to the

latter.

The “Rule of Capture”…

… as explained by:

Excerpt from “Who Shot Mr. Burns? (Part One), aired May 21, 1995.

The “Rule of Capture,” as Explained by Law

• The well bore may not cross property lines.

– Mr. Burns is breaking the law.

The “Rule of Capture,” as Explained by Law

• The well bore may not cross property lines.

– Mr. Burns is breaking the law.

• But hydrocarbons may (and will) cross

property lines.

– Your neighbor’s vertical well is not breaking the

law.

– Without unitization, your neighbor will drill many

wells that exploit your property.

Overhead View of the Ranger, Texas, Oil Field

Map of a Section of the Burkburnett, Texas Oil Field

Los Angeles, Rule of Capture, 1901

Huntington Beach, California

That Was Then. This is Now.

Prudhoe Bay Oil Field, Alaska North Slope

Satellite View: Sparse Wells, Small Footprint

Prudhoe Bay Oil Field, Alaska North Slope

And Much Closer to the Ground

Prudhoe Bay Oil Field, Alaska North Slope

How Unitization “Solves” the Problem

• Each producer owns a share of the common

pie.

How Unitization “Solves” the Problem

• Each producer owns a share of the common

pie.

• Incentives are aligned; each producer want

to maximize the value of the pie, which in

turn maximizes the value of his share.

How Unitization “Solves” the Problem

• Each producer owns a share of the common

pie.

• Incentives are aligned; each producer want

to maximize the value of the pie, which in

turn maximizes the value of his share.

• Waste that hurts any one producer, hurts all.

How Unitization “Solves” the Problem

• Each producer owns a share of the common

pie.

• Incentives are aligned; each producer want

to maximize the value of the pie, which in

turn maximizes the value of his share.

• Waste that hurts any one producer, hurts all.

• Unit governance is simple: wise decisions

receive unanimous support.

Problems That Remain to be Solved

• Difficulties in forming the unit…

– Bargaining and the inherent bargaining power of

small interest holders.

Problems That Remain to be Solved

• Difficulties in forming the unit…

– Bargaining and the inherent bargaining power of

small interest holders.

– Price and technological uncertainties, as they

affect the “terms of trade.”

Problems That Remain to be Solved

• Difficulties in forming the unit…

– Bargaining and the inherent bargaining power of

small interest holders.

– Price and technological uncertainties, as they

affect the “terms of trade.”

– Creation of multiple “participating areas” to

sidestep hard decisions.

Problems That Remain to be Solved

• Difficulties in forming the unit…

– Bargaining and the inherent bargaining power of

small interest holders.

– Price and technological uncertainties, as they

affect the “terms of trade.”

– Creation of multiple “participating areas” to

sidestep hard decisions.

• … lead to difficulties in operating the unit:

– Interests are misaligned.

Problems That Remain to be Solved

• Difficulties in forming the unit…

– Bargaining and the inherent bargaining power of

small interest holders.

– Price and technological uncertainties, as they

affect the “terms of trade.”

– Creation of multiple “participating areas” to

sidestep hard decisions.

• … lead to difficulties in operating the unit:

– Interests are misaligned.

– Conflict replaces unanimity.

Problems That Remain to be Solved

• Difficulties in forming the unit…

– Bargaining and the inherent bargaining power of

small interest holders.

– Price and technological uncertainties, as they

affect the “terms of trade.”

– Creation of multiple “participating areas” to

sidestep hard decisions.

• … lead to difficulties in operating the unit:

– Interests are misaligned.

– Conflict replaces unanimity.

– Waste destroys wealth.

Economic Analysis of Bargaining Power

• Simplified model of two owners producing

from one field.

Economic Analysis of Bargaining Power

• Simplified model of two owners producing

from one field.

• Voluntary unitization is possible, but only if

the owners reach mutual agreement on:

– equity shares

– operational plan (well locations, etc.)

Economic Analysis of Bargaining Power

• Simplified model of two owners producing

from one field.

• Voluntary unitization is possible, but only if

the owners reach mutual agreement on:

– equity shares

– operational plan (well locations, etc.)

• This situation “favors” the small interest

holder.

Economic Analysis of Bargaining Power

• Simplified model of two owners producing

from one field.

• Voluntary unitization is possible, but only if

the owners reach mutual agreement on:

– equity shares

– operational plan (well locations, etc.)

• This situation “favors” the small interest

holder.

(John Nash, Noble Laureate, 1994)

Company 1: Minority Interest

Co

mp

an

y 2

: M

ajo

rity

In

tere

st

P1max

P2max

The curved line bounds the set of attainable

operating profits from respective sectors of the field.

Profit Line

Bargaining to Form a Unit

J. L. Smith, “The Common Pool, Bargaining, and

the Rule of Capture, Economic Inquiry, 25:4, 1987.

Company 1: Minority Interest

Co

mp

an

y 2

: M

ajo

rity

In

tere

st

P1max

P2max

P1X

Interior points represent inefficient drilling patterns.

Alternatives exist under which both companies gain.

Point “X”

Any point

in this

quadrant

is better

than “X”

P2X

Profit Line

Interior points represent inefficient drilling patterns.

Alternatives exist under which both owners gain.

Profit Line

Optimal Exploitation (Max Joint Profit)

Company 1: Minority Interest

Co

mp

an

y 2

: M

ajo

rity

In

tere

st

P1max

P2max

P2

P1

Payoff Line

Profit Line

Optimal Exploitation (Max Joint Profit)

Company 1: Minority Interest

Co

mp

an

y 2

: M

ajo

rity

In

tere

st

P1max

P2max

P2

P1

45o

Payoff Line

Profit Line

Optimal Exploitation (Max Joint Profit)

Company 1: Minority Interest

Co

mp

an

y 2

: M

ajo

rity

In

tere

st

P1max

Disagreement

(Anarchy)

P2max

P2

P1

45o

Payoff Line

Profit Line

Optimal Exploitation (Max Joint Profit)

Company 1: Minority Interest

Co

mp

an

y 2

: M

ajo

rity

In

tere

st

P1max

Disagreement

(Anarchy)

P2max

P2

P1

45o

Payoff Line

Profit Line

Optimal Exploitation (Max Joint Profit)

Company 1: Minority Interest

Co

mp

an

y 2

: M

ajo

rity

In

tere

st

P1max

Disagreement

(Anarchy)

P2max

P2

P1

45o

Payoff Line

Profit Line

Optimal Exploitation (Max Joint Profit)

Company 1: Minority Interest

Co

mp

an

y 2

: M

ajo

rity

In

tere

st

P1max

Disagreement

(Anarchy)

P2max

P2

P1

45o

Payoff Line

Profit Line

Optimal Exploitation (Max Joint Profit)

Negotiated Profit Distribution

Company 1: Minority Interest

Co

mp

an

y 2

: M

ajo

rity

In

tere

st

P1max

Disagreement

(Anarchy)

P2max

P2

P1 P1+S

P2-S

45o

Government Intervention

• Well spacing and permitting regulations

replace anarchy (in the event of

disagreement) with order. This limits the

bargaining power of smaller interests.

Government Intervention

• Well spacing and permitting regulations

replace anarchy (in the event of

disagreement) with order. This limits the

bargaining power of smaller interests.

• So-called “unitization assistance” laws may

marginalize small interests.

Government Intervention

• Well spacing and permitting regulations

replace anarchy (in the event of

disagreement) with order. This limits the

bargaining power of smaller interests.

• So-called “unitization assistance” laws may

marginalize small interests.

• Arbitration may fine-tune both of these to the

circumstances of a specific field.

Government Intervention

• Well spacing and permitting regulations

replace anarchy (in the event of

disagreement) with order. This limits the

bargaining power of smaller interests.

• So-called “unitization assistance” laws may

marginalize small interests.

• Arbitration may fine-tune both of these to the

circumstances of a specific field.

• The bargaining problem is mitigated, not

eliminated!

Payoff Line

Profit Line

Optimal Exploitation (Max Joint Profit)

Negotiated Profit Distribution

Company 1: Minority Interest

Co

mp

an

y 2

: M

ajo

rity

In

tere

st

P1max

Disagreement

(Anarchy)

P2max

P2

P1 P1+S

P2-S

45o

Payoff Line

Profit Line

Optimal Exploitation (Max Joint Profit)

Negotiated Profit Distribution

Company 1: Minority Interest

Co

mp

an

y 2

: M

ajo

rity

In

tere

st

P1max

Disagreement

(Anarchy)

P2max

P2

P1 P1+S

P2-S

45o

Disagreement

(Arbitration)

Payoff Line

Profit Line

Optimal Exploitation (Max Joint Profit)

Negotiated Profit Distribution

Company 1: Minority Interest

Co

mp

an

y 2

: M

ajo

rity

In

tere

st

P1max

Disagreement

(Anarchy)

P2max

P2

P1P1+S

P2-S

45o

Disagreement

(Arbitration)

Uncertainty Compounds the Problem

• Uncertainty and disagreement may exist

regarding the relative value of reservoir

fluids.

Uncertainty Compounds the Problem

• Uncertainty and disagreement may exist

regarding the relative value of reservoir

fluids.

– gas vs. oil

Uncertainty Compounds the Problem

• Uncertainty and disagreement may exist

regarding the relative value of reservoir

fluids.

– gas vs. oil

– primary recovery vs. secondary recovery

Uncertainty Compounds the Problem

• Uncertainty and disagreement may exist

regarding the relative value of reservoir

fluids.

– gas vs. oil

– primary recovery vs. secondary recovery

– royalty leases vs. production sharing contracts??

Uncertainty Compounds the Problem

• Uncertainty and disagreement may exist

regarding the relative value of reservoir

fluids.

– gas vs. oil

– primary recovery vs. secondary recovery

– royalty leases vs. production sharing contracts??

• These may prevent agreement on “terms of

trade” by which individual holdings are

exchanged for shares of the unitized field.

How Many “Participating Areas” in the Unit?

• Dual “Participating Areas” are created to help

owners reach agreement on equity shares.

How Many “Participating Areas” in the Unit?

• Dual “Participating Areas” are created to help

owners reach agreement on equity shares.

• Common Examples

– “Oil Rim vs. “Gas Cap” participating areas

– “Primary” vs. “Secondary” participating areas

How Many “Participating Areas” in the Unit?

• Dual “Participating Areas” are created to help

owners reach agreement on equity shares.

• Common Examples

– “Oil Rim vs. “Gas Cap” participating areas

– “Primary” vs. “Secondary” participating areas

• Intended benefit: to circumvent conflict over the

“terms of trade” (by avoiding the trade)

How Many “Participating Areas” in the Unit?

• Dual “Participating Areas” are created to help

owners reach agreement on equity shares.

• Common Examples

– “Oil Rim vs. “Gas Cap” participating areas

– “Primary” vs. “Secondary” participating areas

• Intended benefit: to circumvent conflict over the

“terms of trade” (by avoiding the trade)

• Relevant only if there is both uncertainty and

disagreement about the relative value of the

dissimilar assets (oil vs. gas)

Negative Impact of Dual Participating Areas

• Creates competition among owners.

Negative Impact of Dual Participating Areas

• Creates competition among owners.

• Imposes conflicting perspectives on a shared

investment problem.

Negative Impact of Dual Participating Areas

• Creates competition among owners.

• Imposes conflicting perspectives on a shared

investment problem.

• Exposes owners to the “hold up” problem: pressure

to alter agreements after costs have been sunk and

bargaining leverage lost.

Negative Impact of Dual Participating Areas

• Creates competition among owners.

• Imposes conflicting perspectives on a shared

investment problem.

• Exposes owners to the “hold up” problem: pressure

to alter agreements after costs have been sunk and

bargaining leverage lost.

• Only postpones hard decisions, and may increase

the cost of reaching ultimate agreement.

Gas

OilWater

Source: American Petroleum Institute, 1986

Gas Cap vs. Oil Rim

Ex. 1: Reservoir Development Dilemma:

Gas Cycling vs. Early Gas Sales

Oil NPV$600

Gas NPV$400

Combined NPV = $1,000

Gas Cycling

Oil NPV$200

Gas NPV$700

Combined NPV = $900

Early Gas Sales

Ex. 1: Reservoir Development Dilemma:

Gas Cycling vs. Early Gas Sales

Oil NPV$200

Gas NPV$700

Combined NPV = $900

Early Gas Sales

Oil NPV$600

Gas NPV$400

Combined NPV = $1,000

Gas Cycling

Ex. 1: Reservoir Development Dilemma:

Gas Cycling vs. Early Gas Sales

Oil NPV$600

Gas NPV$400

Combined NPV = $1,000

Oil NPV$200

Gas NPV$700

Combined NPV = $900

Gas Cycling Early Gas Sales

Ex. 1: Reservoir Development Dilemma:

Gas Cycling vs. Early Gas Sales

Oil NPV$600

Gas NPV$400

Combined NPV = $1,000

Oil NPV$200

Gas NPV$700

Combined NPV = $900

Gas Cycling Early Gas Sales

Dual Participating Areas Create Conflict

Assume the holdings of one company are

concentrated in the Gas Cap (gas-prone

leases).

If the owners form two PA’s, their interests

will be misaligned.

Oil Rim PA

Example: Co. A 30%

Co. B 70%

Dual Participating Areas Create Conflict

Assume the holdings of one company are

concentrated in the Gas Cap (gas-prone

leases).

If the owners form two PA’s, their interests

will be misaligned.

Oil Rim PA Gas Cap PA

Example: Co. A 30% 70%

Co. B 70% 30%

+ =

Co. A, $180, 30%

Co. B, $420, 70%

Oil NPV = $600

Co. A, $280, 70%

Co. B, $120, 30%

Gas NPV = $400

Co. A, $460, 46%

Co. B, $540, 54%

Combined NPV = $1,000

Plan A (Gas Cycling)

+ =

+ =

Co. A, $180, 30%

Co. B, $420, 70%

Oil NPV = $600

Co. A, $280, 70%

Co. B, $120, 30%

Gas NPV = $400

Co. A, $460, 46%

Co. B, $540, 54%

Combined NPV = $1,000

Co. A, $60, 30%

Co. B, $140, 70%

Oil NPV = $200

Co. A, $490, 70%

Co. B, $210, 30%

Gas NPV = $700

Co. A, $550, 61%

Co. B, $350, 39%

Combined NPV = $900

Plan B (Early Gas Sales)

Plan A (Gas Cycling)

+ =

+ =

Co. A, $180, 30%

Co. B, $420, 70%

Oil NPV = $600

Co. A, $280, 70%

Co. B, $120, 30%

Gas NPV = $400

Co. A, $460, 46%

Co. B, $540, 54%

Combined NPV = $1,000

Co. A, $60, 30%

Co. B, $140, 70%

Oil NPV = $200

Co. A, $490, 70%

Co. B, $210, 30%

Gas NPV = $700

Co. A, $550, 61%

Co. B, $350, 39%

Combined NPV = $900

Plan B (Early Gas Sales)

Plan A (Gas Cycling)

Company B wants to cycle

+ =

+ =

Co. A, $180, 30%

Co. B, $420, 70%

Oil NPV = $600

Co. A, $280, 70%

Co. B, $120, 30%

Gas NPV = $400

Co. A, $460, 46%

Co. B, $540, 54%

Combined NPV = $1,000

Co. A, $60, 30%

Co. B, $140, 70%

Oil NPV = $200

Co. A, $490, 70%

Co. B, $210, 30%

Gas NPV = $700

Co. A, $550, 61%

Co. B, $350, 39%

Combined NPV = $900

Plan B (Early Gas Sales)

Plan A (Gas Cycling)

Company B wants to cycle

Company A wants to sell

Ex. 2: Reservoir Development Dilemma:

When to Initiate Secondary Recovery?

Normal Timing

NPV I$500

NPV II$200

Overall NPV = $700

NPV I$300

NPV II$300

Overall NPV = $600

Premature Timing

Ex. 2: Reservoir Development Dilemma:

When to Initiate Secondary Recovery?

Normal Timing Premature Timing

NPV I$500

NPV II$200

Overall NPV = $700

NPV I$300

NPV II$300

Overall NPV = $600

Dual Participating Areas Create Conflict

Assume the holdings of one company are

concentrated on the shoulder of the field,

tending more to benefit from secondary

recovery.

If the owners form two PA’s, their interests will

be misaligned.

Primary PA

Example: Co. A 30%

Co. B 70%

Dual Participating Areas Create Conflict

Assume the holdings of one company are

concentrated on the shoulder of the field,

tending more to benefit from secondary

recovery.

If the owners form two PA’s, their interests will

be misaligned.

Primary PA Secondary PA

Example: Co. A 30% 70%

Co. B 70% 30%

+ =Co. A, $140, 70%

Co. B, $60, 30%

Secondary NPV = $200

Co. A, $290, 41%Co. B,

$410, 59%

Overall NPV = $700

Co. A, $150, 30%

Co. B, $350, 70%

Primary NPV = $500

Plan A: Efficient Reservoir Development

+ =

+

Co. A, $140, 70%

Co. B, $60, 30%

Secondary NPV = $200

Co. A, $290, 41%Co. B,

$410, 59%

Overall NPV = $700

Co. A, $150, 30%

Co. B, $350, 70%

Primary NPV = $500

Co. A, $90, 30%

Co. B, $210, 70%

Primary NPV = $300

Co. A, $210, 70%

Co. B, $90, 30%

Secondary NPV = $300

Co. A, $300, 50%

Co. B, $300, 50%

Overall NPV = $600

=

Plan A: Efficient Reservoir Development

Plan B: Premature Secondary Recovery

+ =

+

Co. A, $140, 70%

Co. B, $60, 30%

Secondary NPV = $200

Co. A, $290, 41%Co. B,

$410, 59%

Overall NPV = $700

Co. A, $150, 30%

Co. B, $350, 70%

Primary NPV = $500

Co. A, $90, 30%

Co. B, $210, 70%

Primary NPV = $300

Co. A, $210, 70%

Co. B, $90, 30%

Secondary NPV = $300

Co. A, $300, 50%

Co. B, $300, 50%

Overall NPV = $600

=

Plan A: Efficient Reservoir Development

Plan B: Premature Secondary Recovery

Company B favors efficient transition

+ =

+

Co. A, $140, 70%

Co. B, $60, 30%

Secondary NPV = $200

Co. A, $290, 41%Co. B,

$410, 59%

Overall NPV = $700

Co. A, $150, 30%

Co. B, $350, 70%

Primary NPV = $500

Co. A, $90, 30%

Co. B, $210, 70%

Primary NPV = $300

Co. A, $210, 70%

Co. B, $90, 30%

Secondary NPV = $300

Co. A, $300, 50%

Co. B, $300, 50%

Overall NPV = $600

=

Plan A: Efficient Reservoir Development

Plan B: Premature Secondary Recovery

Company B favors efficient transition

Company A favors premature transition

Ex. 3: Divergent Fiscal Regimes ??

• Question: Can royalty and production-sharing leases be

combined (voluntarily) into one unit?

Ex. 3: Divergent Fiscal Regimes ??

• Question: Can royalty and production-sharing leases be

combined (voluntarily) into one unit?

• Answer: It depends; problems arise only if:

– There is uncertainty re: specific terms or application of the

two regimes. (probably not)

Ex. 3: Divergent Fiscal Regimes ??

• Question: Can royalty and production-sharing leases be

combined (voluntarily) into one unit?

• Answer: It depends; problems arise only if:

– There is uncertainty re: specific terms or application of the

two regimes. (probably not)

– There is uncertainty re: the fiscal burden that each regime

will impose on affected production streams. (maybe, if

variations in future oil prices influence the R-factor)

Ex. 3: Divergent Fiscal Regimes ??

• Question: Can royalty and production-sharing leases be

combined (voluntarily) into one unit?

• Answer: It depends; problems arise only if:

– There is uncertainty re: specific terms or application of the

two regimes. (probably not)

– There is uncertainty re: the fiscal burden that each regime

will impose on affected production streams. (maybe, if

variations in future oil prices influence the R-factor)

– That uncertainty fosters disagreement among owners re:

future fiscal burdens under the two regimes. (don’t know,

but this is conceivable)

Ex. 3: Divergent Fiscal Regimes ??

• Question: Can royalty and production-sharing leases be

combined (voluntarily) into one unit?

• Answer: It depends; problems arise only if:

– There is uncertainty re: specific terms or application of the

two regimes. (probably not)

– There is uncertainty re: the fiscal burden that each regime

will impose on affected production streams. (maybe, if

variations in future oil prices influence the R-factor)

– That uncertainty fosters disagreement among owners re:

future fiscal burdens under the two regimes. (don’t know,

but this is conceivable)

• In confronting this question, Brazil is on a new frontier in the

development and adaptation of unitization schemes to an

imperfect world.

Thank

You!