risk sharing

Natural gas fracking well in Louisiana

Taxpayers for Common Sense (TCS), a Washington, DC-based organization focused on improved transparency in government budgeting and spending, has just completed a nice summary of the state-of-play in federal oil and gas royalty subsidies

Royalties are the payments that private firms make to the government to compensate the states owning the resources for natural resource wealth the firms have extracted from public lands.  They are normally a percentage of the market value of the resources extracted, so inherently adjust to changing market conditions.

While many countries have far worse transparency than the US in terms of who gets access to resources and what they pay, the US system continues to have its fair share of problems. These have spanned decades, and include problems with calculating the proper amounts, auditing the payment systems, and even some basic soap opera sleeping around messing with royalty collections.

Poor wording (assumedly unintentional, though at one point there was talk of a criminal inquiry though I'm not sure where it ended up) in lease agreements for production in the Gulf of Mexico has led to royalty-free extraction of billions of dollars of oil and gas even in periods of very high energy prices.  A lower court ruling in favor of oil companies was let stand by the US Supreme Court in October, and will result in an estimated $53 billion in lost royalties over the next 25 years.

Basic rules of risk sharing are routinely ignored in these contracts, with absolute royalty reductions granted rather than contingent reductions available only in adverse market conditions.  Won't happen again?  The Gulf incident was not the first time the feds have been tripped up on proper risk sharing for complex contracts.  The core issue is that legislators focused on changing rules for current market conditions have a hard time viewing technologies and markets as dynamic, or trying to plan for the wide array of potential outcomes as basic facts and conditions change. 

Foolishly worded contract agreements to provide a federally-run, break-even, repository for civilian nuclear wastes with little risk sharing by the private firms is another example of this generic problem.  As with the royalty scandal in the Gulf of Mexico, poor risk sharing on the nuclear waste repository is already starting to cost taxpayers dearly.

These two examples should be cautionary tales of how expensive simple mistakes in statutory wording can be.  Energy legislation running thousands of pages is becoming ever more frequent while the language and concepts contained in these bills are growing increasingly complex.  It should be expected that gaffes or intentional loopholes such as the Gulf royalty-free zone and the lack of risk sharing on nuclear waste contracts will sneak into the murky depths of this new legislation as well.  Yet, even as the public financial commitments keep growing, few people have read and understood the details of what is being proposed.

At least in the area of royalty relief, fixes seem straightforward.  New types of fuels in harder to reach locations are regularly trotted out as deserving of royalty relief.  Yet every industry has emerging technologies and applications with higher costs than existing products.  It is not surprising that the oil and gas sector, too, has a rising cost supply curve where some types of deposits are not economic with existing technologies or at current market conditions.  This is not a defect; it is a routine part of market functioning.  Oil and gas producers should be treated more like a routine industry, forced to innovate on their own dime towards making these emerging resources competitive, rather than continually seeking subsidy.  It hardly makes sense spending large amounts of public money to clamp down on carbon emissions on the one hand while subsidizing carbon extraction with the other.