Transaction costs, risk sharing, and contract choice in petroleum exploration

In the exploration for new oil and gas reserves, considerable uncertainty exists regarding the value of potential petroleum deposits. One type of market response to the presence of uncertainty is found in the design of the payment structure of contracts between buyers and sellers. A model of optimal contract design is developed based on an analysis of the transaction costs involved in the exchange of property rights to potential new petroleum reserves. A combination of conditional type royalty payments and lump-sum type bonus payments is seen as a means to minimize the sum of the transaction costs involved.;An alternative model of contract choice based on optimal risk sharing is explored. The combination of royalty and bonus payments is seen in this model as a means to impose the risk of uncertain resource value differentially on buyers and sellers. While many of the implications of the two models regarding optimal contract design coincide in the context of offshore leasing contracts, the models yield opposing predictions in the context of onshore leasing contracts between oil producers and private landowners. This affords an opportunity to compare the predictive power of the two models. An examination of leasing contracts in several western states reveals a pattern consistent with the transaction costs model.