Oil Field Unitization in Theory and Practice
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1 EPGE/FGV International Workshop on Microeconomics Applied to the Energy Industry 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 USA Rio de Janeiro, December 15, 2011
2 Theory versus Practice In Theory: An ideal solution to an important problem.
3 Theory versus Practice In Theory: An ideal solution to an important problem. In Practice: Imperfect adaptations are unavoidable, but may jeopardize success.
4 Outline of My Talk Unitization in theory: Aligns incentives
5 Outline of My Talk Unitization in theory: Aligns incentives Eliminates waste
6 Outline of My Talk Unitization in theory: Aligns incentives Eliminates waste Simplifies conservation regulation
7 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
8 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?
9 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.
10 The Rule of Capture as explained by:
11 Excerpt from Who Shot Mr. Burns? (Part One), aired May 21, 1995.
12 The Rule of Capture, as Explained by Law The well bore may not cross property lines. Mr. Burns is breaking the law.
13 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.
14 Overhead View of the Ranger, Texas, Oil Field
15 Map of a Section of the Burkburnett, Texas Oil Field
16 Los Angeles, Rule of Capture, 1901
17 Huntington Beach, California
18 That Was Then. This is Now. Prudhoe Bay Oil Field, Alaska North Slope
19 Satellite View: Sparse Wells, Small Footprint Prudhoe Bay Oil Field, Alaska North Slope
20 And Much Closer to the Ground Prudhoe Bay Oil Field, Alaska North Slope
21 How Unitization Solves the Problem Each producer owns a share of the common pie.
22 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.
23 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.
24 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.
25 Problems That Remain to be Solved Difficulties in forming the unit Bargaining and the inherent bargaining power of small interest holders.
26 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.
27 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.
28 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.
29 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.
30 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.
31 Economic Analysis of Bargaining Power Simplified model of two owners producing from one field.
32 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.)
33 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.
34 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)
35 J. L. Smith, The Common Pool, Bargaining, and the Rule of Capture, Economic Inquiry, 25:4, P 2 max Bargaining to Form a Unit Company 2: Majority Interest The curved line bounds the set of attainable operating profits from respective sectors of the field. Profit Line P 1 max Company 1: Minority Interest
36 P 2 max Interior points represent inefficient drilling patterns. Alternatives exist under which both owners gain. Interior points represent inefficient drilling patterns. Alternatives exist under which both companies gain. Company 2: Majority Interest P 2 X Point X Any point in this quadrant is better than X Profit Line P 1 X P 1 max Company 1: Minority Interest
37 P 2 max Optimal Exploitation (Max Joint Profit) P 2 Company 2: Majority Interest Profit Line P 1 P 1 max Company 1: Minority Interest
38 45 o P 2 max Optimal Exploitation (Max Joint Profit) P 2 Company 2: Majority Interest Payoff Line Profit Line P 1 P 1 max Company 1: Minority Interest
39 45 o P 2 max Optimal Exploitation (Max Joint Profit) P 2 Company 2: Majority Interest Disagreement (Anarchy) P 1 P 1 max Company 1: Minority Interest Payoff Line Profit Line
40 45 o P 2 max Optimal Exploitation (Max Joint Profit) P 2 Company 2: Majority Interest Disagreement (Anarchy) P 1 P 1 max Company 1: Minority Interest Payoff Line Profit Line
41 45 o P 2 max Optimal Exploitation (Max Joint Profit) P 2 Company 2: Majority Interest Disagreement (Anarchy) P 1 P 1 max Company 1: Minority Interest Payoff Line Profit Line
42 45 o P 2 max Optimal Exploitation (Max Joint Profit) P 2 Company 2: Majority Interest Payoff Line Profit Line Disagreement (Anarchy) P 1 P 1 max Company 1: Minority Interest
43 45 o P 2 max Optimal Exploitation (Max Joint Profit) Company 2: Majority Interest P 2 P 2 -S Negotiated Profit Distribution Payoff Line Profit Line Disagreement (Anarchy) P 1 P 1 +S P 1 max Company 1: Minority Interest
44 Government Intervention Well spacing and permitting regulations replace anarchy (in the event of disagreement) with order. This limits the bargaining power of smaller interests.
45 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.
46 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.
47 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!
48 45 o P 2 max Optimal Exploitation (Max Joint Profit) Company 2: Majority Interest P 2 P 2 -S Negotiated Profit Distribution Payoff Line Profit Line Disagreement (Anarchy) P 1 P 1 +S P 1 max Company 1: Minority Interest
49 45 o P 2 max Optimal Exploitation (Max Joint Profit) Company 2: Majority Interest P 2 P 2 -S Disagreement (Arbitration) Negotiated Profit Distribution Payoff Line Profit Line Disagreement (Anarchy) P 1 P 1 +S P 1 max Company 1: Minority Interest
50 45 o P 2 max Optimal Exploitation (Max Joint Profit) Company 2: Majority Interest P 2 P 2 -S Disagreement (Arbitration) Negotiated Profit Distribution Payoff Line Profit Line Disagreement (Anarchy) P 1 P 1 +S P 1 max Company 1: Minority Interest
51 Uncertainty Compounds the Problem Uncertainty and disagreement may exist regarding the relative value of reservoir fluids.
52 Uncertainty Compounds the Problem Uncertainty and disagreement may exist regarding the relative value of reservoir fluids. gas vs. oil
53 Uncertainty Compounds the Problem Uncertainty and disagreement may exist regarding the relative value of reservoir fluids. gas vs. oil primary recovery vs. secondary recovery
54 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??
55 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.
56 How Many Participating Areas in the Unit? Dual Participating Areas are created to help owners reach agreement on equity shares.
57 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
58 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)
59 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)
60 Negative Impact of Dual Participating Areas Creates competition among owners.
61 Negative Impact of Dual Participating Areas Creates competition among owners. Imposes conflicting perspectives on a shared investment problem.
62 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.
63 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.
64 Gas Cap vs. Oil Rim Gas Water Oil Source: American Petroleum Institute, 1986
65 Ex. 1: Reservoir Development Dilemma: Gas Cycling vs. Early Gas Sales Gas Cycling Early Gas Sales Gas NPV $400 Oil NPV $600 Gas NPV $700 Oil NPV $200 Combined NPV = $1,000 Combined NPV = $900
66 Ex. 1: Reservoir Development Dilemma: Gas Cycling vs. Early Gas Sales Gas Cycling Early Gas Sales Gas NPV $400 Oil NPV $600 Gas NPV $700 Oil NPV $200 Combined NPV = $1,000 Combined NPV = $900
67 Ex. 1: Reservoir Development Dilemma: Gas Cycling vs. Early Gas Sales Gas Cycling Early Gas Sales Gas NPV $400 Oil NPV $600 Gas NPV $700 Oil NPV $200 Combined NPV = $1,000 Combined NPV = $900
68 Ex. 1: Reservoir Development Dilemma: Gas Cycling vs. Early Gas Sales Gas Cycling Early Gas Sales Gas NPV $400 Oil NPV $600 Gas NPV $700 Oil NPV $200 Combined NPV = $1,000 Combined NPV = $900
69 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%
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%
71 Plan A (Gas Cycling) Co. B, $420, 70% Co. A, $180, 30% Co. B, $120, 30% + = Co. A, $280, 70% Co. B, $540, 54% Co. A, $460, 46% Oil NPV = $600 Gas NPV = $400 Combined NPV = $1,000
72 Plan A (Gas Cycling) Co. B, $420, 70% Co. A, $180, 30% Co. B, $120, 30% + = Co. A, $280, 70% Co. B, $540, 54% Co. A, $460, 46% Oil NPV = $600 Gas NPV = $400 Combined NPV = $1,000 Plan B (Early Gas Sales) Co. B, $140, 70% Co. A, $60, 30% Co. B, $210, 30% + Co. A, = $490, 70% Co. B, $350, 39% Co. A, $550, 61% Oil NPV = $200 Gas NPV = $700 Combined NPV = $900
73 Plan A (Gas Cycling) Co. B, $420, 70% Co. A, $180, 30% Company B wants to cycle Co. B, $120, 30% + = Co. A, $280, 70% Co. B, $540, 54% Co. A, $460, 46% Oil NPV = $600 Gas NPV = $400 Combined NPV = $1,000 Plan B (Early Gas Sales) Co. B, $140, 70% Co. A, $60, 30% Co. B, $210, 30% + Co. A, = $490, 70% Co. B, $350, 39% Co. A, $550, 61% Oil NPV = $200 Gas NPV = $700 Combined NPV = $900
74 Plan A (Gas Cycling) Co. B, $420, 70% Co. A, $180, 30% Company B wants to cycle Co. B, $120, 30% + = Co. A, $280, 70% Co. B, $540, 54% Co. A, $460, 46% Oil NPV = $600 Gas NPV = $400 Combined NPV = $1,000 Plan B (Early Gas Sales) Co. B, $140, 70% Co. A, $60, 30% Co. B, $210, 30% + Co. A, = $490, 70% Co. B, $350, 39% Company A wants to sell Co. A, $550, 61% Oil NPV = $200 Gas NPV = $700 Combined NPV = $900
75 Ex. 2: Reservoir Development Dilemma: When to Initiate Secondary Recovery? Normal Timing Premature Timing NPV II $200 NPV I $500 NPV II $300 NPV I $300 Overall NPV = $700 Overall NPV = $600
76 Ex. 2: Reservoir Development Dilemma: When to Initiate Secondary Recovery? Normal Timing Premature Timing NPV II $200 NPV I $500 NPV II $300 NPV I $300 Overall NPV = $700 Overall NPV = $600
77 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%
78 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%
79 Plan A: Efficient Reservoir Development Co. B, $350, 70% Co. A, $150, 30% Co. B, $60, 30% + Co. A, = $140, 70% Co. B, $410, 59% Co. A, $290, 41% Primary NPV = $500 Secondary NPV = $200 Overall NPV = $700
80 Plan A: Efficient Reservoir Development Co. B, $350, 70% Co. A, $150, 30% Co. B, $60, 30% + Co. A, = $140, 70% Co. B, $410, 59% Co. A, $290, 41% Primary NPV = $500 Secondary NPV = $200 Overall NPV = $700 Plan B: Premature Secondary Recovery Co. B, $210, 70% Co. A, $90, 30% + Co. B, $90, 30% Co. A, $210, 70% = Co. B, $300, 50% Co. A, $300, 50% Primary NPV = $300 Secondary NPV = $300 Overall NPV = $600
81 Plan A: Efficient Reservoir Development Co. B, $350, 70% Company B favors efficient transition Co. A, $150, 30% Co. B, $60, 30% + Co. A, = $140, 70% Co. B, $410, 59% Co. A, $290, 41% Primary NPV = $500 Secondary NPV = $200 Overall NPV = $700 Plan B: Premature Secondary Recovery Co. B, $210, 70% Co. A, $90, 30% + Co. B, $90, 30% Co. A, $210, 70% = Co. B, $300, 50% Co. A, $300, 50% Primary NPV = $300 Secondary NPV = $300 Overall NPV = $600
82 Plan A: Efficient Reservoir Development Co. B, $350, 70% Company B favors efficient transition Co. A, $150, 30% Co. B, $60, 30% + Co. A, = $140, 70% Co. B, $410, 59% Co. A, $290, 41% Primary NPV = $500 Secondary NPV = $200 Overall NPV = $700 Plan B: Premature Secondary Recovery Co. B, $210, 70% Co. A, $90, 30% + Co. B, $90, 30% Co. A, $210, 70% Co. B, $300, 50% Company A favors premature transition = Co. A, $300, 50% Primary NPV = $300 Secondary NPV = $300 Overall NPV = $600
83 Ex. 3: Divergent Fiscal Regimes?? Question: Can royalty and production-sharing leases be combined (voluntarily) into one unit?
84 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)
85 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)
86 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)
87 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.
88 Thank You!
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