In Depth: Natural Resource Leasing Basics
Because so many energy minerals lie on public lands, how governments grant access to those resources can have important impacts on whether subsidized or market-based access results. Selling public resources to companies below fair market value reduces producers' production costs. This policy write-up provides a broad overview of natural resource leasing using the example of oil to illustrate the manner in which governments provide subsidies to producers through their leasing processes.
In most cases, individual lease decisions will have little or no impact on world oil prices. Rather, subsidized leases increase producers' profits at the taxpayer's expense or allow otherwise uneconomic reserves to be developed. In the extreme (or in the aggregate), however, a major producing country can affect the global price of oil by allowing widespread leasing below fair market value.1
The environmental implications of poor leasing practices can be substantial. Even without affecting world oil prices, subsidized access to oil tends to accelerate the development of particular oil fields, amplifying the direct environmental impacts of production. If the subsidized fields happen to be in parts of the world with weak central governments and poor environmental enforcement, leasing subsidies can also displace more responsible producers in the marketplace. Similarly, if the fields are located in areas of high biological value, the environmental costs of extraction can be driven up. In addition, to the extent that lease terms do contribute to declining prices, oil consumption rises with all of its concomitant environmental impacts. Finally, subsidies in one country may put pressure on competing nations to increase subsidies to their own industries in order to maintain their competitiveness, exacerbating the problem.
A General Overview of Leasing
A lease is a sale of rights held by the public to another party for exploration and development. Leases allow the buyer to look for a particular natural resource within a particular geographic area, to hold the rights for a limited period of time without producing, and to extract and sell the resource(s) it has been given lease rights to. The following are the core elements of leases:
- Location/Size. Leases carefully stipulate the location in which the purchaser may look for resources. Larger leases have higher probabilities (other things being equal) of containing the desired resources. However, leases that are too large (or the combination of too many small ones) are considered monopolistic by the federal government and regulated.
- Duration. A lease is an option to look for resources in a certain place for a certain period of time. In the case of oil within the US, the owner can generally hold the lease without developing it for up to ten years. Terms in other countries or other resources may be very different. Once resource development has begun, the lessee typically retains the lease rights until the reserve is exhausted. The time cap on the period a lease can be held without producing ensures that valuable public resources are not held inaccessible by the lessee.
- Financial Assurance. The development of leases can create liabilities for the public sector owner in the form of environmental contamination and site closure/post-closure requirements. To protect the public sector against this risk, lessees must normally post an acceptable form of financial assurance to convince the government of their ability to pay for any necessary cleanup. These assurance requirements are not always set at an adequate level.
- Payment Terms. There are three main components of lease pricing: royalties, rentals and bonuses.
- Royalties. Royalties are a percentage of the value of production that is paid to the lease owner. They represent risk sharing between the seller and the buyer. If the well does not produce, the buyer pays no royalties. If the price of the resource being extracted rises or falls, the royalty payments adjust automatically. Royalty rates vary by lease area and lessor.
- Rentals. Lease rentals are “holding” charges that are paid to owners until lessees begin producing oil (or other resource). Rental payments compensate owners for the time their resources are not being produced, and help to prevent firms from speculatively holding too many lease tracts. Rental rates sometimes rise as the number of years without development increases, and are sometimes recoverable against royalties owed once production begins. On federal leases, rental payments stop once production and royalties begin.2
- Bonuses. Where the value of a lease appears particularly large, buyers may agree to make an additional cash payment to the seller for rights to a tract. These payments are in addition to rents and royalties. Bonus payments help ensure that the seller is adequately compensated for especially valuable reserves. There is some interplay between royalty levels and bonus levels. For example, lower royalties make tracts more valuable, potentially resulting in higher bonus bids.
Interactions Between Payment Terms
Lease value is primarily driven by three factors: the size of the reserve, the market price of the resource, and the cost of extracting it from the lease and getting it to market. Using oil as an example, the projected gross revenues from a particular lease are equal to the quantity of oil to be extracted multiplied by the anticipated price per barrel. To determine the lease value, all direct costs to develop the field, extract the oil, and transport it to market must be deducted from the projected gross revenues. In addition, all levies on production, including local, state, and federal taxes, and all royalty, rental, and bonus payments are figured into the equation. Unless the residual profit is high enough, firms will not be interested in developing a lease.
This simplified overview of leasing illustrates two important points. First, the amount a firm will pay for a lease (generally reflected in the bonus payment since all other terms are fixed by the government) is determined by expected profits after all levies. Thus, in a competitive bidding market, charging a higher royalty rate may simply reduce the bid prices by an approximately equal amount. Second, nearly every component in the calculation of expected profits is uncertain. Oil prices may decline, or the actual oil on a site may be less than expected, both reducing the value of the field. Alternatively, extraction costs may be higher than anticipated, or government levies may change (if they have not been fixed for the life of the property in the original lease agreement).
To protect against uncertainties, bidders employ a number of strategies. First, they require a rate of return that adequately compensates them for their risks. Second, they use a portfolio approach, using high profits on successful wells to offset losses on dry ones. Third, they share risks whenever possible with the seller.
The payment terms described above represent a mix of variable payments (royalties and some bonuses) and fixed payments (rentals and some bonuses) that share the risk and rewards from exploration between the lessor and the lessee (i.e., the government and private companies). However, this method of risk sharing does not always guarantee an optimal outcome for either party. For example, larger fixed costs increase the risks to the buyer, but reduce the variability in revenues to the government. If a lease has less oil than anticipated, the buyer may lose money on the well.
Lease issues also extend beyond the composition of variable and fixed costs. Royalties themselves can introduce distortions in development. Although royalties rise and fall in dollar terms, they remain a fixed percentage of the price of the resource. As a well is depleted and the cost of extraction rises, the required royalty payments do not change. Thus, well production may be stopped prematurely because the cost of production plus fixed royalties is too high to allow a return on the remaining recoverable resource. Reducing the royalty rate, it is argued, would allow this “marginal” production to continue until additional resources are depleted. Within the United States, such reductions are commonly implemented at both the state and federal levels.
To avoid premature well closures, another oft-suggested modification to leasing rules is to use variable rather than fixed royalties, linking payments to profitability rather than sale price. Royalties would be set at lower percentages when profits from a particular well are low, and rise to higher than normal percentages when profits rise.
While variable royalties theoretically encourage more complete oil extraction from a reserve, their practical use is challenging. Although production is easy to measure, profits are much more difficult. A profit-based approach allows well operators to deduct a host of expenses from their revenues to calculate the basis of their royalty payments. They have tremendous opportunities to manipulate the calculation in order to reduce their royalties owed. This problem is demonstrated in other sectors of the economy. For example, there have been numerous legal suits in the movie picture industry over movies with hundreds of millions of dollars in “revenues” but zero “profits.” To avoid this problem, industries (such as fast food) generally stick to fixed royalty structures in defining payment rates between franchises and parent companies.3
Subsidies to leasing can come in many forms. Terms may be excessively generous (artificially low royalties, bonus payments reduce later royalties owed, etc.) Specific leases may be exempt (in part or full) from taxes owned on produced resources. Financial assurance levels may be too low or not enforced. Rate reductions for "marginal" production may be applied too broadly, subsidizing all production instead. Oversight and audit functions of the government to ensure that the statutory payments are accurately calculated and paid may be weak. The largest subsidy to leasing generally comes not through lease terms directly, but through a bidding process for access rights that is rigged, uncompetitive, or otherwise hindered. Many countries in the world have liquidated natural resource endowments for pennies on the dollar because of corrupt leadership transferring the value to political cronies. In all of these cases, the end result is oversupply and/or reduced costs for virgin energy and materials. The artificially low costs hamper the ability and incentive to shift to alternative sources of supply.
Source: Derived from Doug Koplow and Aaron Martin, "Chapter 6: Cost of Access to Oil Resources," Fueling Global Warming: Federal Subsidies to Oil in the United States (Washington, DC: Greenpeace), June 1998.
- 1. Market prices regularly react to changes in the supply of oil. When Saudi Arabia cuts production, prices often rise. When large new oil fields come on line, prices fall. The terms of access to large new oil regions such as Kazakhstan will affect their supply costs, potentially impacting both the equilibrium price for oil and determining which fields in other parts of the world become relative high cost producers.
- 2. Ross Gorte, Federal Sales of Natural Resources: Allocation and Pricing, Washington, DC: Congressional Research Service, December 16, 1993, obtained from http://cnie.org/NLE/CRSreports/Natural/nrgen-2.cfm on October 7, 1997.
- 3. The general issue underlying these examples -- the ability for corporations to artificially manipulate profit levels to reduce their financial obligations to other parties -- also plays a central role in the taxation of international corporations. Because these firms buy and sell large quantities of goods and services among their various divisions, and can set the prices for these transactions, they can decide which part of their operations should show the profits. These prices are often set to minimize the firms' tax (or royalty) burden. See U.S. General Accounting Office, International Taxation: Problems Persist in Determining Tax Effects of Intercompany Prices, June 1992, and U.S. General Accounting Office, Tax Administration: Compliance Measures and Audits of Large Corporations Need Improvement, September 1994.