T C A Srinivasa-Raghavan: Drilling, racing and the Tote

Drilling for oil and gas is exactly like horse racing and the Tote betting method is the best suited for it

Old practices die hard. So, no one will take the idea in this column seriously for some more years.

Nevertheless, looking at the fuss that has been going on over the gas-pricing issue, it should be obvious that drilling for gas and oil is not unlike the horse races and the betting that goes on in them.

One form of betting in horse racing is called parimutuel betting and practised the most in the UK. It is also called the Tote there.

Tote betting, which is government-supervised, pools all the bets into a single bucket. The government then takes out its share - commission and taxes - and whatever is left is the prize money.

In this kind of betting there are no fixed odds, offered and accepted, at the time of betting. Here the size of the final payout becomes known when betting closes.

The winning horse gets this money, which is then divided between those who bet on it on a proportionate basis. The more you had bet, the higher is your payoff.

Drilling same as racing

Just as in racing you don't know which horse will "win", in drilling for gas and oil also you don't know which hole will "win". But in both, you do have an idea of the odds. So you bet accordingly.

Now apply the system of parimutuel betting to drilling. The underlying principle is that both racing and drilling are gambles.

In the simplest version of this approach, the block is owned by the government. Instead of allocating blocks to one company - which is like allowing just one horse owner to own the entire racecourse where he runs all his suitable horses and thus hugely reduces his risk - it auctions the rights to drill one hole only per company, corresponding to one horse per owner. In a more complicated model, each company can dig a minimum of, say, 10 holes and can dig multiples of some number just as a horse owner can run several horses.

Then the usual Tote process is followed, where the proceeds of the auction go into a pool. Then, after the government has taken its share, the remainder is given to the company that strikes gas. In this way, it is the other bidders - and not the government - that partially subsidises the cost of drilling.

Of course, this will not be a one-on-one mapping to racing because: (a) in drilling, no holes may "win", whereas in racing one horse must always win except when the whole race is scrubbed for some reason; and (b) in drilling, more than one hole may "win", which is not the case in racing where there can be only one winner.

If the parimutuel system is followed, thanks to the cross-subsidy from the "losers" to the "winner/s", there will be no incentive, as currently happens, to gold-plate costs. This is critical for pricing because every bidder will want to keep his contribution to the winners' costs to a minimum.

Gold plating, which happens under the current system, makes it possible for the winners to put forth cost-related arguments that cannot be easily disproved.

Pricing issues

For pricing, however, the racing analogy breaks down because, as noted above, there are three possible outcomes: no winner, one winner and more than one winner.

The "no winner" outcome is the simplest to handle because the bet money will be fully refunded to ensure that auctions attract bidders. No one may turn up otherwise.

The pricing issue, therefore, comes up only when there is at least one winner. If there is only one winner, a different set of consequences follow than if there is more than one winner. But in both cases, the import price becomes the ceiling.

This leaves two issues to be sorted out: the floor price, on the one hand, and the difference between it and the import price, on the other. While it is reasonable to assume that the winner/s will seek to minimise the difference, which means they will seek the highest possible price, the government will want to maximise it.

Solving this problem is very hard when there is a single winner because of the monopoly power that firm will enjoy. But if, as is far more likely, there is more than one winner, it can lead to intra-field competition between different well owners and, thus, lower the wellhead price.

A prior condition for this to happen is that the government must not set gas prices. That should be left to the local or regional market.

One final issue: since there is a high probability that well-owning firms will collude, a system needs to be devised to prevent it. To see what that system is, you will have to wait for the detailed paper I propose to write on it.