How the Trump Administration Should Structure Gulf Oil Royalty Relief

How the Trump Administration Should Structure Gulf Oil Royalty Relief
(AP Photo/Vita Jureviciene)
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The Trump administration reportedly is considering a proposal to reduce the royalty rate on the future oil and gas production from forthcoming sales of leases for exploration and production in the Gulf of Mexico. That proposal is ill-conceived; a far better approach would be a temporary suspension of royalty payments from existing operations, and it is clear that such temporary royalty relief would increase total royalty receipts for the federal government even over a mere five-year period.

The royalty rate is 18.75 percent of the value of the oil and gas produced from Gulf offshore wells located at depths of 200 meters or greater; for shallower wells it is 12.5 percent, the same as the rate that is applied to onshore wells located on federal land.

The motivation underlying the proposal is that a lower royalty rate would “spur interest in production in federal water after its Gulf of Mexico lease sale [in March] drew limited interest.” That theory is utterly incorrect, a classic example of muddled Beltway thinking: The amount that a bidder is willing to offer for a lease is the present value of the net revenues expected after deducting the amount paid for the lease, amortization of capital outlays, production and labor costs, royalty payments, and other costs. A reduction in the royalty rate for production from forthcoming lease sales would increase the amount that a given bidder would bid for the lease itself; whether the announced royalty rate is higher or lower, the maximum amount that a bidder is willing to bid is that present value.

So for new leases, a lower royalty rate means a higher bid for the lease, and vice versa.  A reduction in the royalty rate for new leases creates only a change in the timing of federal revenues: a higher lease bid now and lower royalty payments later. The lower royalty rate shifts some of the risk of future fluctuations in oil prices toward the producers, and might increase future production from a given lease, as the royalty rate in effect is an excise tax on production and sales.

Events sometimes overwhelm mere words, and the recent temporary decline of oil price futures into negative territory represents a blinding example of that reality: The economic pain in the U.S. oil sector is excruciating. Caused narrowly by disappearing storage capacity for crude oil, the price collapse more broadly is the result of a sharp decline in petroleum demand attendant upon the COVID-19 pandemic, combined with the recent price/production war between Russia and the Saudis. Despite claims that those two producers had resolved their differences, however temporarily, the international oil market has not been impressed, as illustrated by the overall decline in futures prices for Brent crude oil.   

And so royalty relief for the offshore production sector in the U.S. Gulf of Mexico is as appropriate as the massive federal efforts to aid the economy writ large, as embodied in the CARES legislation and related actions by the Treasury Department and the Federal Reserve System, as well as other actions aimed at various sectors. But an approach far better than that under consideration would be a reduction in the royalty rate for sales from existing leases, which would impose far fewer inefficiencies than other proposals now being discussed to aid the oil and gas sector, while not violating the free-market principles that drive the preeminent long-run growth of the American economy. And: Such royalty relief would be likely to increase the present value of royalty payments from Gulf operations.

Those other proposals are ubiquitous. Mandated production cuts (“prorationing”) in Texas and elsewhere. A tariff on imported crude oil and refined products. U.S. coordination of a global production cut with OPEC and other important producers not formally members of OPEC (“OPEC Plus”).

The common denominator among these proposals is their inherent economic inefficiency: distortion of the market through government meddling in production decisions and/or price outcomes, whether domestically or internationally. Prorationing by government agencies would be, literally, a cartelization of the U.S. oil sector, and thus would politicize production decisions ordinarily driven by market incentives to achieve efficiencies. A tariff on oil imports would generate revenues that would be spent, creating interest groups demanding that the tariff never end, and over the longer term imposing real economic losses on the broad U.S. economy by increasing energy costs. Participation by the U.S. in OPEC (or OPEC-plus) output decisions---already an informal feature of the Trump administration response to the economic crisis in the oil patch---would make it vastly more difficult to defend traditional U.S. arguments for greater resource allocation by markets rather than government. Can anyone believe that a shift away from market competition toward not merely the federal bureaucracy but an international bureaucracy would yield salutary outcomes over time?

In contrast, temporary royalty relief for Gulf oil production would avoid the adverse efficiency impacts of the other proposals now under discussion, and would preserve the longer-term stream of federal royalty receipts. Oil production from federal leases in the Gulf last year was about1.9 million barrels per day. Assume, conservatively, a return to a historical price of $40 per barreland an average royalty rate of 15 percent. Annual royalty payments would be about $4.2 billion; assuming a 25-year life for the wells and a discount rate of 5 percent, the present value of the revenue stream would be about $59 billion.

Already there are reports that some Gulf production is being shut down in the face of the collapse in oil prices. If we assume a current price of $15, annual royalty payments given production of 1.9 million barrels per day would be about $1.6 billion per year. If only 10 percent of Gulf production is shut down, the reduction in annual royalty payments would be about $160 million. If the shutdown lasts for, say, five years---it is not cheap to restart offshore wells---the present value of the reduction in royalty payments would be about $690 million.

Suppose that temporary---say, one year---royalty relief were granted, so that the price realized by the Gulf producers increased by 15 percent. Under a conservative assumption about supply conditions (the supply “elasticity”), the production shutdown would be cut in half. The one-year reduction in royalty payments: about $80 million. For the ensuing four years, royalty payments for the production thus preserved, based upon a price of $15 per barrel, would total $320 million, with a present value of $270 million. But if we assume, reasonably, a return to a $40 price per barrel as the global economy recovers from the COVIS-19 collapse in demand, annual royalty payments for the production thus preserved would be about $200 million, with a present value of about $675 million.

Notice that we have said nothing about royalty payments for sales of natural gas from the Gulf leases. Accordingly, it is easy to construct a numerical scenario in which temporary royalty relief for the Gulf producers would yield a substantial net increase in federal royalty receipts over the medium- and longer terms, precisely because the royalty payments are a tax on production, with proportionately greater effects as prices decline.

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