NBER Study Analyzes Oil & Gas Leases in Marcellus Shale Play

The National Bureau of Economic Research (NBER) has produced a working paper studying the impact of auxiliary clauses on royalty compensation in oil and gas (O&G) leases. The results of the study show that including auxiliary clauses in a lease agreement impacts compensation for the mineral owner, but not in the way originally believed. Auxiliary clauses are additional agreements between the mineral owner and the O&G company. Typically, these clauses are environmental or human health-related, such as requiring the O&G company conduct regular air quality tests or other precautionary measures. These types of clauses usually result in increased operating costs for the O&G company. Researchers hypothesized that mineral owners forgo the addition of auxiliary clauses when negotiating their leasing agreements in order to receive increased compensation. In the study, optical character recognition (OCR) was used to scan approximately 60,000 unique O&G lease agreements. OCR technology allows printed text to be readable by computers. The technology was employed in this study to look at the rate and nature of various auxiliary clauses included within the leases. NBER researchers hypothesized that “mineral owners treat royalty rates and auxiliary clauses as substitutes when negotiating”. That is, mineral owners may be willing to make trade-offs in the form of forgoing certain auxiliary clauses within their lease agreements, which may benefit them but economically hinder the O&G company, if their leases have higher royalty returns. However, the study did not yield results consistent with their hypothesis, but rather the opposite. In fact, the study finds “no such trade-offs exist between health-protective clauses and royalty rates.” That is, including more auxiliary clauses within a lease did not negatively impact royalty payments, but rather, as the researchers argue, have the opposite effect. The paper outlines three key findings: a positive relationship between royalty payments and clauses; leases were more likely to include higher royalty compensation agreements and auxiliary leases as development of the shale play progressed; and, a weak relationship between the compensation and the presence of clauses and the geologic productivity of nearby wells. Their findings indicate that O&G companies are willing to make concessions in the means of increasing compensation agreements and other auxiliary clauses, and are “not contingent upon or proportionate to the productivity of the mineral resource” of the land. However, researchers explain that though leases signed later into development include more clauses that would benefit the mineral owner, there is no strong relationship between the productivity of neighboring properties with lease agreements and royalty rate. What this means, according to the study, is that some mineral owners receive “atypically” favorable leases regardless of their land’s potential productivity. The study explains their results further, arguing that this inequity in lease agreements is caused by a knowledge gap and the financial situation of the mineral owner prior to signing an agreement. Those willing to “hold out”, and wait to sign a lease agreement, typically wealthier individuals with lower “marginal utility” of that income and a better understanding of lease agreements indeed negotiate better agreements, according to the study. Their research suggests that informational material related to O&G lease agreements should be produced and widely distributed in communities with development, as it seems that mineral owners who are knowledgeable about the industry and leasing process negotiate more beneficial agreements.