David R. Henderson  

Would You Pay $43 for the Right to Extract a Barrel of Oil When the Market Price is $43?

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The title of this post is not a trick question. I think the obvious answer is no. But William P. Shughart II, co-author of a recent policy analysis, says yes.

In "Liquidating Federal Assets: A Promising Tool for Ending the U.S. Debt Crisis," published by the Independent Institute, Shughart and co-author Carl P. Close write:

The Federal Real Property Council in 2006 appraised the value of federal land, buildings, and infrastructure at $1.3 trillion. As large as this estimate is, one class of assets not included in that inventory would likely bring in far more revenue: deposits of oil, natural gas, and coal on federal property, onshore and offshore. This includes technically recoverable resources totaling 1,194 billion barrels of oil and 2,150 trillion cubic feet of natural gas. At 2016 average prices (oil: $43 per barrel; natural gas: $2.42 per thousand cubic feet) this amounts to about $55.6 trillion, or almost 2.8 times the size of the U.S. national debt.

Any estimate of revenues from federal asset liquidation is, of course, problematic: A large and rapid sell-off would significantly affect asset prices; moreover, prices don't exist in the absence of buyers and sellers. Nevertheless, revenue estimates may help policymakers by proving a rough indication of the potential value of various assets in relation to one another.


They make it sound as if, at those prices for oil and natural gas, the government would get $55.6 trillion.

But wait. If a company thinks it can sell a barrel of oil at $43, then it would be foolish to buy the right to recover for $43. The oil is sitting there, in situ, and has not been extracted. So let's say that the cost of recovery is $30. Then the company would not be willing to pay more than $13 ($43 minus $30) for the right to the oil.

I had wondered if the authors were simply giving the $55.6 trillion as a way to signal the reader that the number is big and were not meaning to imply that the government could get the full $43 for a barrel of oil. But Shughart confirms by email that he indeed is saying that if the market price of oil is $43, someone would be willing to pay $43 for the right to recover the oil.

To be clear, I'm not saying that their proposal is not a good one. It is. But Shughart and Close have substantially overstated the expected federal revenues from selling oil and natural gas.


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COMMENTS (9 to date)
Ak Mike writes:

When petroleum resources are on private lands, producers rarely purchase the property - overwhelmingly, they instead enter into leases that allow extraction in return for a royalty. That is already the way federal oil and gas resources are used, so actually little would change under a divestment scenario.

Leasing frees the producers from having to deal with disposal of the land after extraction is completed, and allows the landowner to use the surface for other things (e.g., farming) even while the producers are drilling and pumping.

Ak Mike writes:

Sorry, but to follow up: If oil and gas properties were sold by the feds, I would expect the value to be whatever the value of the surface use is, plus the present value of the expected stream of royalty payments, an amount much much less than the volume of recoverable oil reserves times the current price.

Trevor H writes:

What's worse is that the federal government does indeed regularly sell the rights to recover hydrocarbon assets in lease auctions. It's not difficult to find the actual market prices for those rights.

As I was casually searching for that price data I found a very recent CBO report that addresses exactly how the Feds could raise more money: https://www.cbo.gov/sites/default/files/114th-congress-2015-2016/reports/51421-oil_and_gas_options-OneCol-3.pdf

James Hanley writes:

1. How would the oil and gas industry raise that kind of money?

2. If it was all sold at once wouldn't that drive down the price?

3. If oil prices are expected to rise in the future, wouldn't it potentially make sense to not sell it all now (with all the appropriate computational caveats).

4. It sounds like a short term solution that does nothing to address the underlying problem, like debt relief for kleptocratic countries.

WRD writes:

Why does the current spot price matter at all? The forward price matters, in the tenure in which production is expected to materialize.

If the market is in strong contango, it is extremely rational to buy at current spot price but sell at the higher future price.

Buy today at $43/bbl, develop the field over the course of two years, and sell at the higher price.

(Or hedge, like anyone in reality would do)

Andrew_FL writes:

WRD raises a good point-If you expect the price to be much higher by the time you actually sell the oil, it would be a smart buy. This was my first thought too. But to do that, you'd need to be able to forecast the price of oil several years into the future.

Thaomas writes:

But if someone were willing to pay $X for a Federal asset, is it not likely that they would have a higher discount rate for the future income than the Federal Government does and so it would probably be worth more to the Government than to the buyer?

Seth writes:

I also thought gas stations sat on top of gas reserves tapping into them directly and that cities grew up around these gas stations because people wanted convenient fueling. That's not how it works?

Plucky writes:

You are right and Shughart/Close are wrong, plain and simple.

Pricing of oil reserves has 3 main components:
- The value of the oil on the forward curve (keeping in mind that there are locational and quality differentals involved)
- The cost to develop and market the oil, which will also vary locationally
- The option value of undeveloped reserves, which is not at all trivial

There is a very, very well developed, highly efficient market for oil & gas properties. The number one complaint of private equity people in the space is exactly that the market is too efficient to get good deals. It is not highly visible to people outside of the sector, but there is always an active market in oil leases, mineral rights, etc. Typically, they are quoted in $ per acre of land, since the actual amount of oil/gas is somewhat indeterminate and a difference of opinion on that matter is often exactly what motivates the buyer & seller.

If Shughart/Close think that the government will receive $X/bbl because that's where prompt-month futures are trading, then they are vastly too ignorant of the oil industry to be publishing those sorts of estimates.

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