You
won an auction with the high bid?
Too bad.
Even today,
auction theory says the highest bidder probably will experience
the "Winner's Curse."
It's a
concept straight out of the oil industry, and a big reason a number
of industries call on auction theory when devising bids.
Auction
theory can't tell you what to bid, but it may help you avoid the
trap of paying too much.
In fact,
"the usefulness of auction theory is the Winner's Curse," said John
Morgan, professor of economics in the University of California-Berkeley's
Haas School of Business.
A number
of bidding strategies exist for different types of auctions.
In the
end, they all come down to two rules for winning an auction without
overpaying.
The Winner's
Curse
The seminal
paper on the Winner's Curse was written almost 35 years ago by three
employees of Arco — Ed Capen (an AAPG member who has taught several
courses for AAPG and wrote articles for the AAPG Treatise book the
Business of Exploration), Robert Clapp and William Campbell. The
paper was "Competitive Bidding in High Risk Situations" in the Journal
of Petroleum Technology, in 1971. That article coined the term "winner's
curse."
The researchers
were charged with avoiding a repeat of a sale in which Arco bought
everthing it bid on and put the company in budgetary straights for
a couple of years.
And the
reason for those low returns? The authors suggested that the winning
bids for leases were too high to allow for a decent profit.
Consider
the range of bids in a lease sale, said John Kagel, professor of
economics at Ohio State University.
"Suppose
those are unbiased estimates. Some are going to be too high, some
too low. Some are going to be right in the middle. It's a standard
distribution," he explained.
Everyone
will estimate a value for the lease and then make a bid below that,
leaving room for profit.
"If everybody
uses the same rule of thumb — say they all take off 30 percent
from their estimate — then the one who's going to win is going
to have the highest estimated value," Kagel said.
Some bids
will undervalue the lease, and some will overvalue it. Whoever errs
the most on the high side will win the auction. In many cases, this
also means that the winner is the person who has overestimated the
most.
"That's
the Winner's Curse," Kagel noted.
The curse
is still with us, even after all those years, and even though everyone
knows it exists.
Morgan
cited the stock market's reaction to company acquisitions as a real-world
example.
"When a
company announces it has succeeded in acquiring another company
in a bidding war, the stock price of the company that makes the
acquisition suffers negative abnormal profit," Morgan said.
That means
its stock price goes down. The market perceives the acquirer must
have overpaid, simply because it was the high bidder.
"You want
evidence that the Winner's Curse is with us today, and that there's
a huge amount of information out there in the fact you've won? This
is Exhibit A," Morgan said.
Auction
Action?
Google
generated plenty of media coverage when it chose an auction to value
its initial public offering of shares.
It used
a form of Dutch auction, in which more bidders buy in as the share
price drops from a high level.
Those first
buyers got a bargain, as it turned out. Google's stock price went
up by 50 percent within a few weeks.
What can
the petroleum industry learn from the Google experience?
"Nothing,"
agreed Kagel. But the Wall Street Journal wrote that bidders were
reading up on the Winner's Curse as they readied their strategies.
Still,
it's helpful to understand the main types of auction.
▸
English Auction.
In an English auction,
bidders bid against each other as the price rises. When only one
bidder remains and no other bidder will raise the bid price, the
auction is over.
Notice that all of
the bidders know exactly what others are bidding in a typical
English auction.
▸ First-Price Sealed-Bid Auction.
In this auction, everyone
makes one bid according to each bidder's estimate of value. The
highest bid wins and pays the bid price.
No one knows what
anyone else is bidding, so the highest bidder isn't aware of winning
until the bids are opened. That's "a huge piece of information,"
Morgan said.
▸ Second-Price Sealed-Bid Auction.
The winner pays the
second highest bid price in a second-price auction. Other rules
are similar to the first-price auction.
"Knowing you will
pay the second bid should force you to bid a higher amount than
in a first-price auciton," Capen said. The goal is to maximize
net present value.
▸ Dutch Auction.
The general form of
the Dutch auction starts with the auctioneer setting a high price
and then lowering it until a bidder agrees to pay the price.
You'll find many variations
of this idea. Car sales begin with a high list price, and buyers
pay progressively lower prices until the lot is cleared.
Strategy
Lesson 1
Morgan
said almost any oil company can draw on seismic studies, evaluate
a lease bloc and arrive at a net present value (NPV) number in a
lease sale.
"You might
think if you are bidding, a sensible strategy would be (to start
with) that NPV and then take an amount below that to allow for a
reasonable profit," he said.
But that
won't work, because, depending on the opponent's strategy, the most
optimistic valuation always wins, he noted.
"That's
not good, because there's noise in these seismic studies, and you've
just found out that you bid too high," Morgan said.
"The right
bidding strategies in these auctions is knowing other people's bidding,"
he added. "Know thy enemy."
Since you
don't know the amount of the other bids in a sealed-bid auction,
you have to understand your opponents' bidding practices and motivations.
Luckily
for bidders, the petroleum industry has built up a significant history
of lease sales and other property auctions, Morgan said.
"The one
thing about the oil business is that there's a rich empirical literature
about how these auctions work," he noted.
Auction
theory says to consider the bidding situation and reduce your bid
by an appropriate amount, a practice called "hedging" the bid.
"How much
to shade (hedge) depends on how many other bidders there are and
what strategies they might employ," Morgan said.
But bidding
strategy gets a little quirky in lease sales and other industry
auctions, according to Kagel.
You might
think you should hedge your bid less when a large number of bidders
participate. Having more bidders will force the winner toward full
value and reduce the chance for profit.
That makes
perfect sense, but it's all wrong.
"In petroleum
auctions, after you get more than two or three bidders, you should
shade your bid a little more," Kagel said. "That's one of the odd
characteristics of mineral rights auctions."
Strategy
Lesson 2
Again,
consider the range of bids as a standard distribution, Kagel said.
With more bidders you have a wider distribution of bids.
That gives
you more chance of bidding too high.
To compensate,
you should take a little more off your bid price, Kagel explained.
Governments
offering mineral leases also call on auction theory to choose the
right strategy.
The most
basic choice is the type of auction to hold. Timing and the structure
of the offer also make a difference, according to Morgan.
"One big
issue is the ordering of the lots," he said. "If a small-time guy
wins a bid early on, he's out of the picture."
In revealing
information about leases in an auction, you might think the leaser
should hold something back. When bidders are forced to guess about
real value, they might guess too high.
But that's
all wrong, too, Kagel said.
"It's the
lack of information that creates the opportunity for profit," he
said.
"The best
thing to do would be to try to provide maximum information about
what's under the ground," he added. "That reduces the companies'
expected profit."
If everyone
follows the right bidding strategy, Kagel explained, they will compensate
for lack of information by reducing their bids.
Suppose
you are bidding on something that might have a value of $1. If you
can't be sure of the value, you will bid well below $1, Kagel noted.
But what
if you find out the auction is for a $1 bill? Then all of the bids
will tend to rise toward $1, because the exact value is known, he
observed.
Can lease
auctions be fixed? Probably not, at least not without difficulty
— and not by the bidders.
"In a first-price
auction, the way that most oil tracts are auctioned, it's not really
going to work," Morgan noted.
"The only
way that you're really going to affect the price is if you bid the
most, but in that case you're on the hook for the tract, and you
don't particularly want that," he said.
Auctions
combine knowledge, gamesmanship, game theory, expertise, experience
and intuition.
In the
end, auction theory appears to come down to just two rules for winning
an auction without overpaying.
Rule 1:
Don't bid too high.
Rule 2:
Don't bid too low, either.