Will raising the minimum bid in federal oil and gas lease auctions boost auction revenue?

The short answer to the title question is probably not.

In the Department of the Interior’s rulemaking docket concerning the financial terms governing oil and gas leasing on federal lands, a handful of comments endorsed the idea of raising the minimum bid in lease auctions as a way to increase federal revenues. But, as explained below, under current law raising the minimum bid could increase or decrease total government revenue generated.

Raising the minimum bid can have the effect of increasing the winning bid on some properties, so generating a higher bonus payment from the successful bidder. Presumably this is the direct effect that proponents of the idea have in mind. At the same time, a higher minimum bid means that some properties will not attract bids in the auction and instead be offered for non-competitive leasing after the auction. Parties securing non-competitive leases do not pay a bonus, so these properties yield lower federal revenues. Under existing regulations, royalty rates and other terms are mostly identical whether the lease is sold at auction or the property is leased non-competitively. Depending on whether the increased revenues from higher bonus bids is greater than the lost revenues from more properties becoming leased non-competitively, total revenue will either rise or fall.

In any case, relatively few properties likely would be affected by an increased minimum bid. Good prospects already sell at auction for higher than the current minimum bid or any likely raised minimum bid—often much, much higher—so bonus payments on those properties would be unchanged. Marginal properties already do not sell in auction at the existing minimum bid and become offered non-competitively. Revenue from those properties would also be unchanged. Only in the narrow range between “good” and “marginal” as described will the higher minimum have an effect, sometimes increasing revenue and other times decreasing it.

The narrowness of the opportunity to increase federal revenues by raising the minimum bid can be emphasized by noting that revenues only increase for cases in which the minimum bid is increased to a point higher than the second highest willingness to pay among bidders but lower than the highest willingness to pay. In cases in which the existing minimum bid is below the highest willingness to pay but the increased minimum bid is higher than that value, revenue will fall. In other cases revenue is unaffected by the change in minimum bid.

We can pin down the various effects on revenue analytically.

Call the existing minimum bid “MB” and the proposed higher minimum bid “MB+”. Assume each potential bidder comes to the auction with a maximum willingness to pay in mind for each property. Call the bidder with the highest maximum willingness to pay bidder A and the bidder with the second highest willingness to pay bidder B. Assume non-strategic bidding (i.e., bidders A and B are willing to bid up to their maximum willingness to pay in any auction in which that maximum is greater than the minimum bid). Leases are offered in an ascending price auction.

Therefore, so long as bidder A values the lease at a value greater than or equal to the minimum bid, bidder A wins the auction at a bid fractionally higher than bidder B’s maximum willingness to pay or at the minimum bid level, whichever is higher. If bidder A wins the auction, then bidder A pays the winning bid (termed the “bonus payment”). If bidder A’s value is below the minimum bid level, the lease is not sold at auction and becomes available for non-competitive leasing and no bonus payment is made.

We can describe the possibilities in the following way (simplifying by using A to stand for the maximum willingness to pay of bidder A, and similarly for bidder B).

  1. If B < A < MB < MB+, then the lease is not sold by auction and becomes available for non-competitive leasing both under the existing minimum bid and under the higher minimum. Revenue is unaffected.
  2. If MB < MB+ < B < A, then the lease is sold at auction at fractionally above B, both with the existing minimum and with the higher minimum. Again, revenue is unaffected.
  3. If MB < B < A < MB+, then the lease would have sold at auction at fractionally above B under the existing minimum bid, but would be leased non-competitively at the higher minimum bid. These properties will yield less revenue.
  4. If MB < B < MB+ < A, then the lease would be sold to bidder A at just above B under the existing minimum bid, but will be sold to bidder A at the higher MB+ under the raised minimum bid. These properties yield higher revenue.
  5. If B < MB < A < MB+, then the lease would have sold to bidder A at MB but now will be leased noncompetitively. These properties will yield less revenue.
  6. If B < MB < MB+ < A, then the lease would be sold to bidder A at MB under the lower minimum and at MB+ under the higher minimum. These properties yield higher revenue.

These six cases exhaust the possibilities. We can conclude that revenue will increase if added revenues from cases 4 and 6 are greater than the reduction in revenues from cases 3 and 5.

That is to say, revenue will increase in cases in which MB+ is greater than B but less than A, but revenue will decrease in cases in which MB is less than A but MB+ is greater than A. Or, restating the “narrowness” conclusion from above, revenues increase only in cases in which the minimum is raised to a level that is higher than B but below A—in all other cases revenues are unchanged or reduced.

We can estimate the net revenue effects of a higher minimum bid.

Or rather, if we had detailed auction data from recent lease auctions, then we would be in the position to estimate the net revenue consequences of a higher minimum bid. With sufficient information from auctions values for A and B could be estimated for various properties and the effects of higher minimum bids could then be simulated.

NOTES

Related earlier posts

Information on the rulemaking process

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