Lecture Notes for Economics 435: Economics of Resources
                   Prepared by Gunnar Knapp, Professor of Economics
                                     January 30, 2001

                                   RESOURCE LEASING
An important issue for both public and private resource owners and managers is how to realize
maximum economic rents from their resources. There are three broad alternatives:

      1.       Develop the resources themselves.
      2.       Pay someone to develop the resources.
      3.       Sell the resources.

There are advantages and disadvantages associated with each of these alternatives.

If the resource owners develop the resources themselves, they will not realize maximum
economic rents unless they are knowledgeable about the business of resource development. An
oil company is presumably reasonably skilled at developing oil resources. But a public entity
such as the Alaska Department of Natural Resources or the U.S. Department of the Interior may
not have much experience in oil development and may not want to get into the business of
buying oil rigs, hiring new public employees to work in the drilling fields, and so on. Publicly
managed resource development is also likely to let political considerations get in the way of
sound business considerations. Similarly, private individuals (such as the Beverly Hillbillies)
may not particularly want to become oil managers, either. Despite these problems, a number of
countries such as Brazil and Mexico have established state oil corporations to develop their oil
resources themselves (such as PEMEX in Mexico).

If the resource owners pay someone to develop the resources for them, the problems are similar
to those of trying to develop the resources themselves. Although the companies that they hire
may be skilled in resource development, the owners still have the problem of monitoring the
activities of these companies to make sure that what they are doing is in the owners' interests.
For instance, suppose the government pays a company a fixed sum per barrel that it develops.
The company may then have an incentive to go ahead and develop uneconomic resources.
Generally, the best arrangement is to have the company which is developing the resource share in
the profits from the resource development, so that its incentives are similar to those of the
resource owner.

The preferred alternative for most resource owners is to sell or lease the resource (or sell the
rights to develop the resource). There are a number of ways in which a resource can be sold. It
can be sold outright, or it can be sold for an agreed-upon share of the revenues to be produced
from the resource, or by some combination of these methods. We discuss the advantages and
disadvantages associated with several different leasing methods below.

                                         Leasing Methods

                 Economics of Resources Lecture Notes: Resource Leasing, page 1
There are a variety of different methods for leasing or selling resources which have been used or
proposed. Most of these involve either open or sealed bidding at a competitive auction. Some of
the more common methods include the following:

       1.       Bonus bidding: Selling the resource rights to the highest bidder. The payment is
referred to as a "cash bonus."

      2.        Royalty bidding: Selling the resource to whoever offers to pay the highest
"royalty," or share of the value of production.

       3.         Profit-share bidding: Similar to royalty bidding, except the bidders pay a share
of total profits.

       4.       Combinations of the above: A common method (that used by the U.S.
Department of the Interior for offshore oil leasing and by the State of Alaska for oil leasing prior
to 1979) involves bidding for the highest up-front cash bonus, along with agreement to pay a
fixed royalty share (generally one-eighth or one- sixth). A different scheme uses a fixed cash
bonus which must be paid, with the bid going to the highest royalty share or profit share bid.

                Advantages and Disadvantages of Different Leasing Methods

In evaluating different leasing methods, resource owners are generally interested in maximizing
the pure economic rent which they receive from the resource. Different schemes may have
different amounts of risk associated with them, so resource owners may also wish to consider the
uncertainty associated with their revenues under different schemes. In general, there will be a
tradeoff between the economic rent which the resource owner can capture, on average, for a
given scheme and the uncertainty associated with the receipt of that revenue.

In general, the economic rent which the seller of the resource receives will be higher, the more
competitive the bidding, the less uncertainty that the leasing methods involves for the bidders,
and the smaller the extent to which the bidding scheme affects the economic profitability for the
bidder of developing the resources. Unfortunately, the schemes which reduce uncertainty for the
bidders tend to increase uncertainty for the seller.

Bonus Bidding

Under ideal competitive circumstances, bonus bidding schemes result in the seller's receiving the
present value of the expected economic rents produced by the resource since different buyers, in
trying to win the lease, would bid up to the point where they had offered to pay all the economic
rent they expected to receive in order to obtain the right to develop the resource. But the more
uncertain they are about the actual value of the resource, the more they are likely to discount the
value of the resource (reduce their bids).

The advantage to the seller of bonus bidding is that the value of the resource is received
immediately. Bonus bidding is low risk--the seller gets the money even if it turns out there is no
oil at all. On the other hand, if it turns out that there was oil, the seller may get much less money
than might have been received under a royalty scheme.

                 Economics of Resources Lecture Notes: Resource Leasing, page 2
There are a number of disadvantages associated with pure bonus bidding. If the bidding is not
competitive, the seller may not get bids for the full value of the economic rent (this is why the
federal and state governments generally estimate minimum values that they will accept for tracts
that they lease to make sure that bonus bids provide at least this minimum economic
rent--although they are careful not to reveal what this minimum value estimate is before the lease

Generally, the fewer bidders, the less competitive the bidding is likely to be. This would tend to
reduce cash bonus bids. A problem with bonus bidding for high-value resources such as oil and
gas is that it may reduce competition because it calls for a large front-end payment, which many
smaller firms may not be able to afford to pay outright and which they may not be able to borrow.
This problem can be partially overcome by allowing joint bidding of several different firms.

Royalty Bidding

Royalty bidding does away with much of the uncertainty associated with bonus bidding since a
large up-front payment is not required, and what the firm has to actually pay will depend upon
what it discovers. This tends to allow smaller firms to enter the bidding and may result in more
competitive bidding. Whereas under bonus bidding firms stood to lose both their bonus
payments and their exploration expenses if they found nothing, under royalty bidding they stand
to lose only their exploration expenses.

The problem with royalty bidding is that if the firm has to pay part of what it earns from
developing the resource to the seller, it may have an incentive to develop less of the resource.
The firm which offers to pay the highest share of total revenues from the resource to the seller is
not necessarily the firm which would end up actually paying the highest total revenues to the
seller--since a firm which was paying a lower revenue share might actually end up developing
more of the resource, resulting in greater, rather than lower, royalty payments.

As an extreme example, a firm which offered to pay a 99 percent royalty share might never
develop any of the resource since it would have an incentive to do so only if the resource deposit
proved to be extremely rich. On the other hand, a firm which offered to pay only a 1 percent
royalty share might have an incentive to develop a large amount of the resource even if it were
not a particularly rich deposit since its royalty costs would be low. Even a low royalty payment
on some resource production is better than a high royalty payment on no resource production.

Profit-Share Bidding

The advantages and disadvantages of profit-share bidding are similar to those of royalty bidding.
The requirement to pay a share of profits is less likely to distort production decisions than the
requirement to pay a share of total value of production. However, it is much more difficult to
monitor a firm's profits than it is to monitor the total value of production.

                                       Monte-Carlo Analysis

                 Economics of Resources Lecture Notes: Resource Leasing, page 3
Resource sellers face a complicated problem in figuring out what will be the best method of
resource bidding to meet their objectives. Similarly, companies face a complicated problem in
figuring out what is the best amount to bid, given all the uncertainties associated with how much
of the resource might be discovered, what it will cost to produce the resource, and what the value
of the resource will be when produced.

One method of analysis that is frequently used in making these kinds of decisions where
uncertainty is involved is "Monte Carlo Analysis." In effect, the researcher attempts to assign
probabilities to the different possible outcomes in the areas in which there is uncertainty. For
instance, he or she might decide that there is a 75 percent chance that no oil will be found, a
20 percent chance that 2 billion barrels will be found, and a 5 percent chance that 4 billion barrels
will be found. Similar probabilities may be assigned to other areas of uncertainty.

Next, the researcher writes a computer program which calculates how much is earned from the
lease sale, or from developing the resource, depending on how the uncertain variables come out.
The computer then randomly assigns different outcomes in accordance with their assigned
probabilities, over and over again. For each outcome, it calculates the total earnings which
would result. By doing this over and over, it is possible to see which strategy will be more
favorable, on average. In effect, the computer plays a game over and over, and on the basis of
the "experience" that it gains from doing this, determines which is the most effective strategy.

                 Economics of Resources Lecture Notes: Resource Leasing, page 4

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