Property institutions

A property right is a bundle of rights that can be divided or subdivided as society sees fit. The surface and mineral estates are often divided, or severed (Ellickson, Reference Ellickson1993). Once the surface and mineral estate are severed, the mineral estate may be owned individually, by a community or by the government.

One of the defining features of the property institutions governing oil and gas in the United States is that much of the mineral wealth of the nation is privately owned (Bradley, Reference Bradley1996). In contrast, the state owns minerals in much of the rest of the world. However, there is substantial state ownership of minerals even in the United States, especially in the American west.

One of the main reasons for the persistence of state ownership in the United States is an important change in federal land disposal policies in the early 20th century. The federal government acquired over a billion acres of the land in the 19th century. Initially, the federal government did not make much of an effort to retain mineral rights as it sought to transfer state-owned land to individuals, in part because squatters asserted de facto ownership rights to land and minerals (Murtazashvili, Reference Murtazashvili2013). This situation eventually changed, as the federal government began to reserve mineral lands, such as with the Stock Raising Homestead Act of 1916 (Gates, Reference Gates1977). This act extended the homestead principle of free land to additional western states but added the provision that the federal government would retain all rights to mineral lands, mainly to coal, which was viewed as increasingly important to national security. One of the consequences of this change in policy is that there are many federal split estates in the west, which refers to situations in which surface land is privately owned and the government owns the mineral estate (Fitzgerald, Reference Fitzgerald2012). Split estates are also common in the east, but most are private split estates, whereby different private parties own the surface and mineral estates. A study of drilling on the Marcellus shale found that between a third and two-thirds of land in counties where there has been drilling are private split estates, while the rest are private unified estates (Collins and Nkansah, Reference Collins and Nkansah2015).

These institutional features are important because one expects the strongest link between private ownership and drilling in the case of private unified estates. Private split estates may make contracting more challenging in comparison to a unified estate because the gas companies do not have to worry about opposition from surface owners, although institutionalized dominance of the mineral estate, discussed below, eases the ability of gas companies to contract with mineral rights owners in the case of private split estates. When the federal government owns the mineral estate, contracting is expected to be less rapid, North's perspective expects less innovation or production (or both).

One of the reasons for innovation appears to be private ownership of minerals. The Texas lands where fracking was developed known as the ‘Wildcatter's Graveyard’. It was in many ways like the wastelands on the English countryside in the sense most thought them to be of little economic value before they were brought into production. George Mitchell earned his reputation as the ‘father of fracking’ for investing in these lands that nobody else wanted (The Economist, 2013b). Mitchell Energy spent $250 million drilling shale over sixteen years but had almost nothing to show for it until 1997, when drillers almost by accident figured out that they could use chemicals to make the fracturing fluid work more efficiently to extract shale (Zuckerman, Reference Zuckerman2013a). These investments paid off, as several wildcatters, including Mitchell, became billionaires after selling their companies (Zuckerman, Reference Zuckerman2013a, Reference Zuckerman2013b).

Private ownership of mineral lands ultimately paid off for Mitchell, who did not patent his inventions. Rather, he made fortunes buying vast amounts of cheap land and then selling them at higher prices (Golden and Wiseman, Reference Golden and Wiseman2015). His story is one of innovation, purchase of property and development that was made possible because he could acquire vast amounts of land that he could then sell to others at a high price once his company developed the right combination of technologies to make fracking profitable. In this regard, fracking technology supports Moser's (Reference Moser2013) contention that patents may not drive innovation and growth. Yet private property rights are important in this story – even if it is not a story about intellectual private property – because the opportunity to own vast amounts of lands and the minerals is what made Mitchell and a few others their riches.

Private ownership of minerals also created incentives for the owners of mineral rights to contract with gas companies. The major economic reason why owners of minerals have incentives to contract with gas companies is because they can receive an up-front bonus along with a royalty payment. In Texas, many became rich quickly as a result of the shale boom, which increased support for hydraulic fracturing in the region (The Wall Street Journal, 2012). During the height of the shale boom in Pennsylvania, more than $1 billion a year was transferred to mineral rights owners (The Economist, 2013a).

The importance of private ownership is also illustrated by considering hydraulic fracturing when the government owns the mineral estate. Theoretically, federal ownership of mineral lands increases the transaction costs of production (Fitzgerald, Reference Fitzgerald2010). Indeed, there is less shale production when the federal government owns the surface lands or the mineral estate (Humphries, Reference Humphries2013; Mason Reference Mason2013).

There are also a number of legal institutions that encouraged drilling by strengthening the property rights of mineral owners. Institutional economists have long recognized that courts create new property rights when they decide conflicts between owners and others in society (Bromley, Reference Bromley2006; Commons, Reference Commons1924). One is dominance of the mineral estate. In mineral-rich states, surface owners generally have to allow reasonable access to minerals. This has its origins in the common law, which held that the mineral estate would not be worth much unless the owners have reasonable rights to access those minerals (Walker Jr, Reference Walker1928). The mineral estate remains dominant in Texas (Fry et al., Reference Fry, Briggle and Kincaid2015). Texas courts have also sided with industry in trespass cases. Coastal Oil & Gas Corp. v. Garza Energy Trust (Tex. 2008) applied the rule of capture to subsurface trespass caused by hydraulic fracturing, which protects the interests of those who sign leases, rather than the landowners who have not (Wiseman, Reference Wiseman2009). Finally, most states have adopted, and courts have supported, compulsory pooling, including Texas (Fry et al., Reference Fry, Briggle and Kincaid2015; Holahan and Arnold, Reference Holahan and Arnold2013). Compulsory pooling encourages drilling because it forces mineral rights owners to participate in drilling.

The structure of private property rights also provides insight into why states maintain low rates of taxation on shale production. In many contexts, the state is unable to secure much of the scarcity rent from natural resource extraction (Bromley, Reference Bromley2009; Libecap, Reference Libecap2007). One of the defining features of shale extraction is the effective tax rate in all shale-producing states is very low (Weber et al., Reference Weber, Burnett and Xiarchos2016). Distributive theories of institutional change have long emphasized bargaining power as an explanation for who gets what in politics (Knight, Reference Knight1992; Knight and North, Reference Knight, North and Weimer1997). Private ownership and accumulation of wealth are each sources of bargaining power that likely constrain the ability of the state to extract more of the scarcity rent from shale production.

The challenge of adopting a severance tax in Pennsylvania illustrates the distributive logic. Pennsylvania initially established an impact fee on hydraulic fracturing that amounted to an extremely low tax on production – in fact, lower than in any other state (Rabe and Borick, Reference Rabe and Borick2013). The perception that the state was not receiving its fair share led to a prolonged conflict to replace the impact fee with a severance tax that would represent a boon to the central government and a much larger tax on industry (Legere, Reference Legere2016). Although the severance tax would amount to 6.5% of production and is estimated to bring in over $200 million annually in revenue, it has yet to be adopted and had been the subject of major political controversy (Phillips, Reference Phillips2016).

Entrepreneurs

Productive entrepreneurs, as exemplified by George Mitchell, had an important role in the shale boom for reasons noted above. North's framework complements studies of entrepreneurship by pointing out that their incentives reflect the institutions of society, in particular private property rights to minerals. Institutional entrepreneurs, in particular landmen and lawyers, also played an important role. Their role in the shale boom is to alleviate the transaction costs that could have undermined the contracting process. Shale production requires assembling large amounts of land to achieve economies of scale. The well pad for a fracking operation is fairly small – around five acres – which reduces it ecological footprint (Sovacool, Reference Sovacool2014). However, drillers have to accumulate vast amounts of land to achieve economies of scale. For example, Chesapeake Energy holds least acres in the United States (15 million lease acres), including 1.5 million lease acres of the Marcellus shale. Drillers also have to file royalty-sharing agreements for a ‘unit’ to ensure some equity of distribution of the gains from drilling. In Pennsylvania, units are usually between 100 and 500 acres, with royalties prorated based on shares of acreage in a unit, subject to a minimum royalty of 12.5% of the value of hydrocarbons produced (Kelly-Detwiler, Reference Kelly-Detwiler2013).

Fracking thus involves large amounts of land. The size of the land areas associated with fracking ensures that gas companies will have to negotiate with a large number of people, not only for some of whom own the surface and mineral estate, but also many for whom the surface and mineral estate are severed. The Garza case, although it was ultimately supportive of drillers, nonetheless affirmed that the gas companies in general require permission from all owners before drilling or else they may be trespassing on land. All of this amounts to substantial transaction costs of contracting.

Landmen, who can be both independent and work for gas companies, are a solution to these transaction costs. Landmen search the deeds records in a community to understand who owns what mineral rights and then inform any mineral rights owners of their rights (Wilber, Reference Wilber2012). Although landmen are depicted as unscrupulous in the Hollywood's 2012 blockbuster about the rush to drill, Promised Land, they also have an important economic function, which is to facilitate contracting for property rights.

To the extent that landmen often work for gas companies, they cannot be expected to produce an ‘efficient’ bargaining solution. Indeed, in many instances, land owners do not understand the value of their land and feel at a disadvantage in dealing with gas companies (Timmins and Vissing, Reference Timmins and Vissing2014). There is also some evidence that minorities and poorer individuals negotiate deals with gas companies that are less likely to include provisions to protect surface land or also the payment for land (Vissing, Reference Vissing2015). To the extent, these are simply distributive consequences, they do not undermine social surplus from contracting – it must means a transfer of rents from consumers to producers (Tullock, Reference Tullock1967). However, these distributive issues are important questions of public policy even if they are not necessarily a source of inefficiency (Bromley, Reference Bromley1991). In addition, the bargains over surface damages involve externalities – as source of social surplus losses – and so if certain groups are less likely to bargain with gas companies to get them to internalize these costs, then there are social surplus losses arising from disparities in the bargaining process. Thus, even though landmen may serve an important economic function, it would be unwise to view them uncritically as a source of efficiency in the bargaining process. Nonetheless, landmen are typically independent contractors who are trained by agricultural outreach programs at many of the nation's major universities (Etter, Reference Etter2015). They also have their own association that certifies them as experts in a trade. Regardless of whether they are efficiency-enhancing or not, it seems reasonable to conclude that they facilitated the contracting process necessary for the shale boom.

Wallis and North (Reference Wallis and North1986) conceptualized of lawyers as a response to transaction costs. In the context of contracting for shale rights, one of the ways that lawyers economize on transaction costs is by organizing landowners. In a number of communities in the Marcellus region, lawyers informed citizens of the process of leasing land and came up with a generalized lease with provisions favorable to landowners (Wilber, Reference Wilber2012). By providing information to landowners about provisions that are important to include in a lease, lawyers may reduce the social costs arising from insufficient regulations protecting surface owners. They also facilitate contracting by reducing the bargaining problem from many to one player. When many owners bargain separately, costly delates in contracting for property rights are more likely (Libecap, Reference Libecap2005, Reference Libecap2009). By organizing landowners, lawyers can reduce the bargaining problem from many parties with many opportunities for breakdown to a bilateral bargaining situation between a firm and a single bargaining entity. Of course, landowners may also assemble on their own, without lawyers (Fry et al., Reference Fry, Briggle and Kincaid2015). In such cases, the lawyers serve a more conventional function of providing a service for landowners, rather than as a solution to a coordination problem.

Ideology

The discussion above suggests that private property rights created a constituency to support drilling. However, the U.S. states have varied tremendously in their response. In fact, there are over 30 different efforts to regulate hydraulic fracturing (Richardson et al., Reference Richardson, Gottlieb, Krupnick and Wiseman2013). North suggested that ideology may explain variation in public policies. Although North (Reference North2005) emphasized the mental models of policymakers as an explanation for mistakes in the process of institutional change, the theory also suggests that variation in ideologies of citizens will explain differences in the choice of institutions.

A comparison of New York and Pennsylvania is a particularly useful to evaluate the hypothesis that ideology influences the process of institutional change. The main reason is because property rights and economic incentives to frack were similar in these two states but the regulatory responses were quite different. In New York, individuals signed thousands of leases with gas companies (Navarro, Reference Navarro2011). Yet the government of New York responded with a moratorium because of uncertainty associated with hydraulic fracturing (McKinley, Reference McKinley2013). In addition, many local governments in New York banned fracking (Arnold and Holahan, Reference Arnold and Holahan2014). Pennsylvania, in contrast, became a worldwide leader in shale production.

Economic studies seeking to isolate the impact of property rights often select cases where geography, culture and ideology are similar but property rights and growth outcomes differ (Acemoglu et al., Reference Acemoglu, Johnson and Robinson2002, Reference Acemoglu, Johnson, Robinson and Rodrik2003). The purpose of doing this is to isolate the role of property rights on economic outcomes. A similar logic can be used to show how ideology influences the political response to the shale boom. Geography, economic benefits and private ownership of minerals are similar in these states but the regulatory response to shale has different dramatically. Thus, if ideologies in these states differ, then it is a plausible explanation for variation in the regulatory response.

The available evidence is consistent with the hypothesis that ideology explains difference in policies in these states. Public opinion polls show that people in Pennsylvania prefer fracking more than in New York (Cusick, Reference Cusick2014). Such polls suggest that policy preferences differ, but ideology refers to deeply held beliefs. For this reason, it is necessary to consider whether liberals are more likely to oppose fracking and whether New York has more liberals than Pennsylvania.

It is also fairly clear that New York is a more liberal state than Pennsylvania (Gelman, Reference Gelman2009). Popular accounts suggest that opposition to hydraulic fracturing is driven in part by liberal politics, in particular emanating from New York City (Gabriel and Davenport, Reference Gabriel and Davenport2016). The journalistic narrative is often one of a liberal gentry and socialites against rural landowners (Siegel, Reference Siegel2013). Public opinion research finds that liberals are more likely to oppose fracking in New York (Kriesky et al., Reference Kriesky, Goldstein, Zell and Beach2013). Ideology also appears to influence adoption of local policies governing shale in New York (Arnold and Holahan, Reference Arnold and Holahan2014). Polling data from the United States also shows that liberals are less supportive of fracking. (Boudet et al., Reference Boudet, Clarke, Bugden, Maibach, Roser-Renouf and Leiserowitz2014). In light of this evidence, it is at least plausible that differences in ideology may explain variation in the political response to fracking.

Although the reasons above suggest ideology matters, it may also be the case that private property rights also matter, even in these two states. One interesting possibility is that people who signed leases now realize that if the leases expire because of regulatory delay, they could sign better deals (Navarro, Reference Navarro2011). Those who signed leases may want to wait to overturn the ban until their leases expire so that they can then seek better terms. In addition, those who signed leases in New York and Pennsylvania are more likely to support fracking, which suggests property interests are an important explanation for support for policies governing fracking (Kriesky et al., Reference Kriesky, Goldstein, Zell and Beach2013). It therefore seems reasonable to conclude that private property rights and ideology each contribute to divergent responses to fracking.