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The Texas economy: compulsary unitization of Texas oil reservoirs.

Iraq's recent military invasion of Kuwait was triggered largely by a belief that Kuwait was effectively "stealing" Iraqi oil reserves from a single large reservoir underlying the border of the two nations. During the Iran-Iraq war, when Iraq was not producing from the field, Kuwait allegedly overproduced oil from its end of the reservoir, thereby siphoning valuable reserves from under Iraqi soil. This issue remains for postwar resolution.

Although the stakes are not so high, a similar problem exists in Texas where oil and natural gas reservoirs stretch under the land or rights of numerous private parties. The allocation of oil production among those parties presents serious economic problems that today's legal structures have proved incapable of fairly and efficiently resolving.

Oil is found in large underground reservoirs and in tandem with natural gas or water, which conveniently provide the pressure necessary to expel the oil. Each reservoir may underlie the surface land of hundreds or thousands of property owners, and the historic principles of property law grant each landowner the rights to the oil found beneath his or her land. This legal structure works well for minerals such as silver or coal.

However, petroleum geology does not cooperate with traditional principles of property law and free enterprise. Oil can readily migrate throughout the underground reservoir. Asserting ownership in the oil beneath one's land means little more than claiming ownership of a migratory bird temporarily resident at one's feeder. The landholder lacks meaningful vested ownership over the bird, or the oil, until it is captured.

The common law employes this rule of capture, giving ownership to whoever extracts the oil. This means that one landowner theoretically could drain all the recoverable oil from beneath his neighbors' lands. The neighbors' only legal defense is to extract it quickly themselves. The rule of capture thus creates an incentive for each landowner to produce as much oil as possible and as rapidly as possible.

For several reasons this rush to produce has proved highly wasteful for society and, ultimately, for each landowner as well. First, the rush to produce yields unnecessarily high production costs. To maximize individual gain, each surface owner has an incentive to drill as many wells as practicable. The result is many wore wells than necessary to extract a finite amount of oil. The unnecessary wells represents a net social loss that also cuts into profit rates of the producers.

Second, overproduction reduces the total amount of oil that can be recovered from a given reservoir. Achieving the maximum primary production from an oil field (called a maximum efficient rate or "MER") requires a limited rate or production and careful well location. Otherwise, the pressure necessary for recovery is needlessly dissipated and potentially recoverable oil is left in the ground. Overproduction may cause total recovery to decline to as little as 10 percent of reservoir capacity.

Some studies suggest that the traditional rule of capture has caused hundreds of millions of dollars of unnecessary excess production costs and billions of dollars of lost reserves. The Texas government began to respond to this problem as early as 1919 when the Railroad Commission promulgated its first well spacing rule, requiring that oil wells be at least three hundred feet apart. Subsequent laws enabled the commission to set production rates for producers (to approximate MER) and to encourage voluntary private cooperation in production from a reservoir (known as pooling or unitization).

However, the state laws that attempt to remedy the inefficiencies of the rule of capture address only the symptoms and not the causes, like a bandage on a broken arm. No government regulatory regime, however capable and well intentioned, can achieve the disciplining efficiency of the market. For example, the prorationing of production in Texas has incidentally encouraged production from established fields at the expense of new exploration, particularly the costly deep exploratory drilling that appears to be necessary to discover major new fields in the state. Regulation has its own substantial administrative costs, has distorted efficient production patterns, and has left in place the fundamentals of the rule of capture.

Inefficiencies of the present system also produce adverse secondary effects. For example, exploratory drilling is discouraged. The costs and risks of wildcatting are notorious. With the rule of capture, however, the promised rewards are also reduced. Other landowners can "free ride" on the risk-taking wildcatter, and the profits, even those from a "gusher," will be reduced by the high production costs and reduced recovery resultant from the incentives of the rule of capture.

Enhanced recovery operations are also adversely affected. Even efficient primary recovery, using natural pressure, collects only about 25 percent of the total oil in a reservoir. A vast resource therefore remains to be tapped through enhanced recovery operations. The National Petroleum Council estimates that enhanced recovery can increase our oil reserves by more than twice as much as all future discoveries of new oil fields. However, enhanced recovery typically involves the potentially costly repressurization of oil reservoirs, by means such as the reinjection of water, steam, or gas. Once a single producer bears all the costs of reinvigorating a reservoir, anyone with property overlying a reservoir, anyone with property production. Once again, the traditional rule of capture produces disincentives to vital expansion of domestic oil supplies.

Fortunately, there is a simple alternative to regulation and the rule of capture, an alternative that maximizes production efficiency and encourages greater exploration and enhanced recovery from depleted fields. This alternative is compulsory unitization, which simply means the cooperative unitary development of an entire reservoir. Under unitization, the various owners with claims to a reservoir join together to select an agent to manage production in the best interests of the unit as a whole. Costs and receipts are apportioned by a formula based on the relative ownership rights of the participating parties. The entire reservoir becomes a single economic unit.

Unitization has many advantages. It eliminates the economically perverse rush to drill, prompts the unit to hold production costs as low as economically efficient, and provides an incentive to steward recoverable oil so as to maximize the ultimate recovery. Unitization enables optimal well location and optimal adjustment of production in response to market conditions. Unit operation can promote use of enhanced recovery, and the promise of unitization will reduce disincentives to new exploration for oil and natural gas.

Unfortunately, unitization must be governmentally compelled. Much of the resistance to this alternative results from the misperception that compulsory unitization is a "socialistic" intrusion on free enterprise. This definition of "free enterprise," however, is already seriously distorted by the legal rule of capture and by the state's convoluted regulatory structure. Unitization would supplant the rule of capture and eliminate the need for most regulation of oil production. Efficiency would increase, as would producer freedom and control over decision making.

Many Texas oil fields have at least partially unitized, representing about half the state's total production. The Railroad Commission, recognizing the merits of unitization, manipulates its regulatory powers to pressure producers into "voluntary" unitization, a procedure that is costly, slow, and often produces only partial, rather than fieldwide unitization.

Compulsory unitization authority for the commission offers greater benefits. The authority must be carefully structured, however. Some states, such as Oklahoma, have compulsory unitization statutes that actually obstruct unitization through elaborate procedural prerequisites. An effective compulsory unitization statute should neither limit the purposes for unitization nor require a specific minimum level of private consent. The statute should be structured to encourage early and fieldwide unitization and to free unitized fields from state production regulations.

Although diminished, the importance of oil to the Texas economy remains substantial. The oil and natural gas industry still accodunts for about 15 percent of the state's gross domestic product, and in sosme subregions the percentage is even greater. Natural gas use seems likely to grow and could well assume a greater share of the state's economy. An effective compulsory unitization statute can help invigorate this economic sector and contribute to economic growth in Texas.

-- Frank B. Cross Associate Director Center for Legal and Regulatory Studies
COPYRIGHT 1991 University of Texas at Austin, Bureau of Business Research
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Author:Cross, Frank B.
Publication:Texas Business Review
Date:Apr 1, 1991
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