One for You, Three for Me... Optimal Production Sharing Rules for a Petroleum Exploration Venture

This is a case study in the design of the production sharing rule used in an oil exploration partnership contract. The contract was negotiated in mid-1986 when a state-owned oil resources authority hired a U.S. oil company to explore and develop a defined territory owned by the authority. The company was given a share in production so that it would have a financial incentive to pursue an exploration and development program that maximizes the net return to the authority. We use the Grossman and Hart (1983) principal-agent model to improve on the shape and calibration of the sharing rule. In comparison with the actual contract, the optimal rule assigns the company a larger share of the small discoveries and the company's share decreases significantly as the size of the discoveries increases. The optimal sharing rule increases the expected return on the project to the authority by $7.8 million, or 6% of the $129 million net present value that the authority would enjoy under the actual contract. The increased NPV is a result of improving incentives for the choice of an optimal exploration program on the part of the company, and ensuring that the company enjoys an interest in completing marginally profitable wells.