GEOL 115: The Earth’s Energy Resources

It’s worth looking a little more closely at the Winner’s Curse. The term Winner’s Curse describes the phenomenon that the winner of an item in an auction is usually the individual that has most egregiously overvalued the item. Although the best examples are sealed bid auctions (apparently the term was coined to describe the phenomena that occur in OCS lease sales), the behavior isn’t limited to sealed bid auctions. Consider free agent athletic contracts (google Derek Sanderson sometime), or political celebrity book contracts.

A classic example of the Winner’s Curse is the Point Arguello saga. In 1981 a partnership consisting of Chevron and Phillips purchased a number of leases. Three of these leases were over the north end of the Point Arguello field. The Chevron-Phillips partnership was one of two groups participating in this lease sale that knew that there was oil in the Pt Arguello structure. Despite having more information than the other groups Chevron still overpaid for the leases quite dramatically. The second highest bid on the tract for which the Chevron-Phillips group paid $333 million was $161.1 million; less than half of Chevron’s winning bid. Irrespective of whether the investment paid off in the long-run (and it didn’t) the Chevron group was successful winning the leases because they valued the leases far differently than their competitors. You can sort through the results of a lease sale from this year and find examples of the Winner’s Curse. This phenomenon doesn’t disappear.
Other countries typically have larger lease blocks (hundreds of sq miles in area) and require that exploration entities present an exploration plan. This exploration plan must list in detail the prospects that they identify and how they expect to produce those prospects. The quality of the exploration plan is evaluated rather than a specific dollar bid.

As long as exploration costs are significant, companies will form partnerships to spread their risk during exploration irrespective of the type of system that is sued for awarding acreage. The basic idea is to prevent the future viability of the business from being dependent on the success or failure of a single venture. This is kind of hard for most people to understand at first and I blame professional football. I touched on this in a blog post last winter. In the NFL, the worst team gets the first pick of all the collegiate players the following year. This pick is guarded jealously and almost never traded away. This behavior occurs despite the fact that a single player almost never lifts an NFL team from bad to even mediocre. Moreover almost all bad teams are bad because they typically make bad decisions. No matter, they roll the dice on a single high stakes bet and almost always lose, again. Oil companies don’t operate that way. They spread their risk, avoid Gambler’s Ruin, and try to keep in business.