Competitive Bidding in High-Risk Situations
Authors: Capen E.C. , Clapp R.V. , Campbell W.M. 
Published: December 2007

If it is true, as common sense tells us, that a lease winner tends to be the bidder who most overestimates reserves potential, it follows that the "successful" bidders may not have been so successful after all. Studies of the industry's rate of return support that conclusion. By simulating the bidding game we can increase our understanding and thus decrease our chance for investment error.

Introduction

We would like to share with you our thoughts on the theory of competitive bidding. It is a tough business. We are not sure we understand as much as we ought to about the subject. As in most scientific endeavors, we think there is more knowledge to be gained by talking with others than by keeping quiet. Our first attempt at actually using a probability model approach to bidding was in 1962. We borrowed heavily from Lawrence Friedman's fine paper on the subject. But the further our studies went, the more problems we noticed for our particular application. problems we noticed for our particular application. We decided to strike out on our own. By 1965 we had our model just as it is today. But having a model and completely understanding its workings are not the same thing. We are still Teaming. While we refer to the "model" as though it were some inanimate object, it is not. What we want to describe to you is a system for taking the best judgments of people - properly mixed, of course, with historical evidence - and putting those judgments together in a rational way so they may be used to advantage. Lest the reader be too casual thinking that since he is not personally involved in lease sales he need not pay the closest attention, we offer this thought. There is a somewhat subtle interaction between competition and property evaluation, and this phenomenon - this culprit - works quietly within and phenomenon - this culprit - works quietly within and without the specific lease sale environment. We would venture that many times when one purchases property it is because someone else has already looked at it and said, "Nix." The sober man must consider, "Was he right? Or am I right?" The method of analysis we will describe is strictly for sealed bid competitive lease sales, but the phenomenon we will be talking about pervades all competitive situations.

Industry's Record in Competitive Bidding

In recent years, several major companies have taken a rather careful look at their records and those of the industry in areas where sealed competitive bidding is the method of acquiring leases. The most notable of these areas, and perhaps the most interesting, is the Gulf of Mexico. Most analysts turn up with the rather shocking result that, while there seems to be a lot of oil and gas in the region, the industry probably is not making as much return on its investment there as it intended. In fact, if one ignores the era before 1950, when land was a good deal cheaper, he finds that the Gulf has paid off at something less than the local credit union. Why? Have we been poor estimators of hydrocarbon potential? Have our original cost estimates been too potential? Have our original cost estimates been too conservative? Have we not predicted allowables well? Was our timing off? Or have we just been unlucky?

JPT

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