The self-enforcing provisions of oil and gas unit operating agreements: theory and evidence

This article extends the existing theory and empirical investigationof unitization contracts. It highlights the importance of incentive-compatibilityand self-enforcement and the bargaining problems faced in achievingviable, long-term contracts. We argue that only if the partiesto a unitization contract have unit production shares that arethe same as their cost shares will the contract be incentivecompatible. Using a database of 60 unit operating agreements,we measure the industry's actual behavior against the principlesof production from a common pool. Our survey of units that haveonly one production phase and that are relatively homogeneousreveals that such equal sharing rules are always found and theyappear to encourage the parties to behave optimally. In morecomplex units with multiple production phases and/or separateconcentrations of oil and gas (gas caps) we find deviationsfrom the theoretical ideal. In the case of multiphase units,we find equal cost and production shares within phases, butnot across phases. A preset trigger for shifting from one productionphase to the next helps to maintain optimal behavior. For gascap units, however, we generally do not find the equal sharingrule. Conflicts and rent dissipation follow as illustrated bythe case of the Prudhoe Bay Unit. The article describes thedesirable contract rules for avoiding moral hazard. It alsoshows how the effects of those rules can be replicated in difficultsituations.