Will lower royalty rates boost offshore leasing in the United States?

Recently, the US Secretary of the Interior Ryan Zinke received a recommendation from the Royalty Policy Committee (RPC) to consider offering a 12.5% royalty rate across the board for upcoming lease sales in the next Five Year Offshore Leasing Program. A 12.5% royalty rate was made available for shallow-water leases last year, however, an 18.75% royalty rate remains and has been in effect for deepwater leases for approximately 10 years.

Predictably, before the ink had even dried on the recommendation, oil and gas opponents cried foul, claiming that the newly recommended royalty rate reduction would “fleece the American taxpayer” and “line the pockets of Big Oil.” In the face of such wild speculation, a closer look at the RPC’s recommendation is warranted.

Let’s examine royalties first; what exactly are they? Royalties are a part of the overall government take when oil and gas leases are sold in federal waters offshore. Since the federal government owns and regulates offshore lands on the outer continental shelf (OCS), it is logical and expected that a fair market value will be received for those leases. Bonus bids, received through a sealed bid competitive process, are the up-front payment a company bids to purchase an offshore lease. Bonus bids generally range from hundreds of thousands of dollars to millions of dollars. Regardless of the number of bonus bids received on a single lease, the highest bid must pass the federal government’s evaluation that market value was received. Once deemed to meet the market value standard, bonus bids are non-refundable, regardless of the eventual success or failure of actual exploration activities.

A company that submits a successful bonus bid must also pay a rental fee on the lease. This rental fee is paid whether or not the company is actively completing exploration plans, permitting and other activities, and is also paid for as long as the lease is in effect, subject to royalty payments. If a company finds recoverable resources and begins commercial production, it must pay royalty payments throughout the life of the lease.

Offshore royalty and other payments are very important to the federal government and state governments. Traditionally, offshore payments to the United States Treasury are second only to what the Internal Revenue Service collects from individual taxpayers and companies. Offshore royalty payments fund the Land and Water Conservation Fund and the National Historic Preservation Fund, with a portion also going to coastal states along the Gulf of Mexico, in accordance with the Gulf of Mexico Energy Security Act. Since these payments are so vital to the federal government and states, there is understandable concern that a lower royalty rate could reduce the amount of money going into to these to funds and the Gulf states.

Due to low commodity prices and the regulatory burden, revenues from offshore oil and gas operations have plummeted from billions of dollars in 2008 to millions of dollars today, making the overall royalty pie smaller. What can be done about this? The easy answer is to increase exploration.

However, the number of deepwater well starts in the Gulf of Mexico has been approaching an 18-year low. The lowest number of deepwater well starts occurred in 2011 as a result of the federal drilling moratorium following the 2010 Macondo well accident. The next lowest number of deepwater well starts was recorded in 2017. Houston, we have a problem.

During the previous administration, the Department of the Interior commissioned IHS-CERA to conduct a study of the total federal government take, meaning an evaluation of all the costs of doing business with the federal government. Among the findings were some interesting insights. The study indicated that when looking at the total government take, US policies suggest a regressive fiscal system that penalizes marginal fields. In fact, the US take for the Gulf of Mexico is among the most expensive and the nominal royalty rate of 12.5% is higher than all oil and gas jurisdictions outside of the United States.

As Mexico and Brazil actively compete for companies to head south, the US federal government must counter to attract companies to US waters. Earlier this year, Mexico sold the rights to 19 offshore oilfields for $525 million. Policymakers should recognize that even in the Gulf of Mexico, the United States is no longer the only country at the table. A lower royalty rate might be the tipping factor that allows a company to invest its limited capital in the United States rather than overseas.

Finally, let’s look at some simple math. An unsold lease brings in no money. That means zero dollars to the US Treasury, zero dollars to Gulf coast states, and zero dollars to the Land and Water Conservation fund and National Historic Preservation Fund.

To be clear, recommendations from the Royalty Policy Committee may or may not be acted upon by the Secretary of the Interior. The Secretary also has the authority to change the royalty rate for each sale. Thus, if conditions improve and oil and gas prices become substantially higher, the Secretary could decide to adjust royalty rates accordingly.

With the recommendation of the Royalty Policy Committee now before him, Secretary Zinke has an opportunity to encourage more American jobs and revenue by incentivizing companies, through a lower royalty rate, to once again invest in the US OCS and in America’s energy future.