Profitabilities on Federal Offshore Oil and Gas Leases: A Review
Authors: Lohrenz John 
Published: December 2007

Summary.
Bonus paid for leases is a controllable factor that delivers a coup de grace to acceptable profits. Elimination of bonus may not make profits robust, but closer to the average for all industries. For profits closer to satisfactory levels, bonuses paid should be lower.

Introduction
Mistrust of U.S. oil and gas company data and studies has been a fact of life for some time. The highly charged political world of Washington, DC has been the arena where this mistrust has been most evident. Mistrust peaked when the cost of oil to refiners more than tripled between 1973 and 1974 resulting in higher gasoline prices.
Issues involving the federal outer continental shelf (OCS) were a frequent focus of this mistrust. Bonuses paid for OCS leases also peaked in the early 1970's. In the minds of the mistrustful, an industry willing to pay more money for OCS leases indicated an industry making too much money from them.
Impasse aptly describes the status between industry and government regarding OCS profits in 1975. Industry's statements that profits were low were simply not believed. Technically, no effort was made to resolve the impasse, in spite of publicly available data to do so. No study by industry or government had actually examined the revenues and costs of individual OCS leases to assess profitabilities. Yet annual gross revenues for each lease were available; the date of spudding, depth, and classification of each well on each lease were in the public record, along with the water depth, size, and the installation date of each OCS production facility: and each bonus paid, a major cost, of course was known. These data, along with cost information, are all that is necessary to prepare annual net cash flow tables for individual OCS leases. Unavailability of data was no bar to completing a technical study of profita-bitities on OCS leases.
The lease production and revenue (LPR) data base included all the aforementioned data for each OCS lease issued. The LPR data base, in fact, was originated to collect these data and to make technically supportable and defensible estimates of OCS profitability while mistrust reigned.
The first purpose of this paper is to summarize profitability studies performed with the LPR data base. Secondly, a recent study projecting aggregated OCS costs and revenues through the year 2000 is analyzed for the profits implied. This study also points to a bleak performance. Finally, while no prescription can remedy the past, the future is shown to be less bleak if that wholly controllable ex-penditure, bonus, is kept in check.

Profitability In the Gulf of Mexico
The Gulf of Mexico remains the most active OCS area. From 1954, when federal leasing started, through 1969, exactly 1,223 leases covering 5.2 million acres [2.1 × 10 ha] were issued. These 1,223 leases with production and gross revenue data through 1976 were used for the first lease-by-lease studies of OCS profits. Production after 1976 was estimated by extrapolating prior production. The horizon year was 2010. Gross revenue from post-1976 production was determined with projected oil and gas prices. Annual exploration, development, and production costs were estimated for each lease with the cost information and the well and production facility data in the LPR data base. Annual net cash flow tables (in nominal dollars) through 2010 (unaffected by taxes) were generated for each lease. Leases with production that reverted to a calculated negative annual net cash flow were considered abandoned after such reversion. The table of annual net cash flows was the input to a pretax rate of return calculation for each lease. For any defined aggregation of leases, annual net cash flows were summed and a pretax rate or return calculated for that aggregation.
The hard data of the LPR data base gave credibility to the study's results. To some extent, results depended on uncertain assessments and estimates, especially those pertaining to the future. Sensitivity analyses to the projected rate of decline, horizon year, projected oil and gas prices, and the year beyond which production was predicted showed reasonable bounds.
The implicit assumption was that all oil and gas production that would be found on the 1,223 leases had been found and developed before the end of 1976. Only leases at least 7 years old were considered, making that assumption reasonable. An alternative would have been to consider more recently issued leases, but would add the huge uncertainty involved in projecting the frequency of future leases becoming productive and, if so, the amounts. These results were not subject to that uncertainty.
Table 1 summarizes the economic outcomes for the 1,223 leases. About one-third of the leases had hydrocarbon production. Of that one-third, only about one-third (about one-ninth of the 1,223) projected a pretax rate of return that exceeded 15%. Presuming that no investor would have purchased a lease knowing that the rate of return would be less than 15%, this means 88.2 % of the 1,223 leases were economic failures.
These results, reported in 1978, technically focused the arguments about OCS profits. The results were both good and bad news to companies investing in the OCS. The good news was that the results were evidence that vindicated them of charges of conspiracies leading to undeserved profit. To the companies' stockholders, however, the results were bad news.
Table 2 shows that the profitability appears inversely correlated with the number of competing bids for a lease. A more highly competitive lease that attracted more bids tended to receive a higher bonus per acre. That higher bonus "bought" a higher frequency of a lease attaining any production and, generally, a higher amount of production. These desirable outcomes did not, however, compensate for the higher bonuses. Table 2 shows the pretax rate of return tended to be down as the number of bids per lease and bonus paid went up. The rate of return, not considering bonus, did not show this trend.
When OCS bidders do not follow strategies to avoid the winner's curse, one can expect exactly this result. The more sought-for and hotly contested leases actually performed worse overall than those less sought for.
One internal federal government study that indicates that OCS investors were not excessively profitable cannot be expected to erase years of mistrust and suspicion. That takes a campaign. A federal government contract for another independent study was issued to Walter J. Mead.
JPT
P. 760^