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