Bidding Science Saved $$

The Tale of the 'Winner's Curse'

Ed Capen, AAPG member and co-author of the paper that coined the term "winner's curse," remembers well the birth of Atlantic Refining Co.'s interest in bidding science.

It was in the early 1960s. In the Philadelphia and Dallas offices of Atlantic Refining there was dread spreading. They had got just what they wanted — they thought.

Atlantic, which had been active in the Gulf of Mexico since the mid-1950s, bought virtually everything it had bid on at a Gulf lease sale. But their bidding "success" put the company in a budgetary bind for a couple of years. They had overbid.

"Management did not want to repeat that experience," Capen recalled, "and asked R&D to see if there were some operations research-type solution available."

The task fell to R&D's Bill Campbell, who was applying management science methodology to exploration decisions. Lawrence Friedman had recently got the first doctorate in Operations Research using bidding as his topic. Campbell used this work as his starting place.

Another Gulf lease sale came along soon — giving R&D a chance to apply Friedman's theories.

Friedman's work turned out to be in error, but it did suggest bidding less than one's value estimate.

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Ed Capen, AAPG member and co-author of the paper that coined the term "winner's curse," remembers well the birth of Atlantic Refining Co.'s interest in bidding science.

It was in the early 1960s. In the Philadelphia and Dallas offices of Atlantic Refining there was dread spreading. They had got just what they wanted — they thought.

Atlantic, which had been active in the Gulf of Mexico since the mid-1950s, bought virtually everything it had bid on at a Gulf lease sale. But their bidding "success" put the company in a budgetary bind for a couple of years. They had overbid.

"Management did not want to repeat that experience," Capen recalled, "and asked R&D to see if there were some operations research-type solution available."

The task fell to R&D's Bill Campbell, who was applying management science methodology to exploration decisions. Lawrence Friedman had recently got the first doctorate in Operations Research using bidding as his topic. Campbell used this work as his starting place.

Another Gulf lease sale came along soon — giving R&D a chance to apply Friedman's theories.

Friedman's work turned out to be in error, but it did suggest bidding less than one's value estimate.

"In our case the rest of the company was also working on the problem in ignorance of other similar efforts," Capen said. "Everyone knew that we had to reduce our bids. The geologists lowered their estimates of success ratio. Geophysicists decreased the size of the targets. I don't remember, but the bookkeepers may have raised the discount rate. And, of course, Campbell had already hedged by 30 percent or so.

"By the time everyone was through subtracting value, our bids were so low we didn't buy anything," he said.

After correcting the error in Friedman's work, Campbell and Bob Clapp, an MIT Sloan School graduate who joined Campbell about that time, designed a 20,000-trial Monte Carlo model of the bidding process. It worked. R&D began to "sell" its bidding strategy to operating management.

Reasonable Projections

Capen had joined Atlantic's R&D in 1957 as a research geophysicist. A few years after his arrival at Atlantic he sensed that the repeated trials and high uncertainty so characteristic of petroleum exploration made statistics an under-appreciated but very powerful tool.

Capen returned to school (Southern Methodist University) part time to study statistics. In 1965 Capen took over Campbell's work, and with Clapp continued the bidding effort.

To basically describe Arco's bid strategy, a value is placed on a lease based on the promise of the geology. Companies should then bid about 30 percent of their value estimate (depending on competition and uncertainty). Bids are then handed to the government on sale day. On a given tract, some company value estimates will be too high and others too low. The winner will tend to be the one who estimated too high. Bidding only 30 percent of value protects a company that wins because of an inflated value estimate.

Many managers do not like this strategy because the reduced bids also lower the chance of winning. Emotionalism usually carries the day. Managers would rather buy leases than maximize profit. Often it will be five to 10 years before the results are known so that the guilty, having been promoted and/or transferred, are never punished, Capen said.

In 1967 Capen was transferred to operations staff with the principal task of implementing the new bidding strategy for all Outer Continental Shelf lease sales. Clapp rejoined Capen a year or so later.

The overbid difficulty was not confined to Atlantic. Virtually every company placing the bids was aware of the pitfalls — the industry's OCS rate of return was miserable.

Atlantic was careful in releasing information about its system. Over time, however, Capen was allowed to give oral presentations and finally a published paper. The lawyers and some in management were reluctant to share the company's strategy. R&D players saw the obvious advantages of telling the whole world. The R&D VP recognized the ploy as "legalized collusion."

"If everyone lowered their bids to protect from the curse, the entire industry would be better off," he said. "The sellers would suffer a reduction in bonuses. The sellers, however, were doing far better than they should have."

Capen recalled that when he made an oral presentation to an overflow audience at the 1970 SPE annual meeting, "I invited the audience to guess my weight, and then by polling the 600 people I was able to show clearly that some overestimated and more underestimated. The demonstration worked perfectly.

"We used the bidding strategy from 1967 (Atlantic merged with Richfield in 1966) until the merger with BP 30-plus years later precisely to generate bids," he said. "The work is quantitative, not qualitative. Arco management was pretty faithful in using the recommendations made by either Bob Clapp or myself.

"However, it is Campbell who deserves much of the credit because of his original assessment that the big leverage in economic decisions would be in exploration," Capen said. "He was poised to take advantage of that fact when the bidding opportunity came along. I recall just one sale where using our bidding strategy saved the company about $300 million.

"The only change we made over the next 35 years was a move to numerical integration rather than Monte Carlo," he continued. "I had reduced the problem to an expected value integral for the publication in 1971, but we did not have the computer power for numerical integration. Monte Carlo was easier, and with enough trials (it) worked very well.

"We had decided that the lognormal distribution was the proper one to use in the analyses," Capen said. "We observed it in the bidding, and we knew the Central Limit Theorem would lead to lognormal. We were very comfortable with these assumptions. The proof was that we were able to make reasonable projections of how many leases we would buy and how much we would spend."

To Coin a Phrase

It was in 1971 that Capen, Clapp and Campbell (all began as physicists) authored the paper "Competitive Bidding in High Risk Situations" in the Journal of Petroleum Technology. It was that article that the term "winner's curse" first appeared.

The practical approach has been applied to situations beyond the oil industry — including mergers and bidding for baseball players in the free agent market (see The Winner's Curse by Richard Thaler, Free Press, 1991).

Capen's work has been published widely in SPE literature. AAPG published The Business of Petroleum Exploration Treatise publication (1992), where he presented all the statistical formulae involved with estimating prospect reserves.

Also he was part of the team instructing AAPG's "Managing and Assessing Petroleum Risk" education course for 14 years.

Since retiring in 1992 from his position as Distinguished Management Adviser at Atlantic Richfield, he has been an active consultant.

In 2001, AIME-SPE recognized him with its highest award, Honorary Member — "For Profound and Lasting Contributions in Advancing the Industry's Understanding of Risk Assessment." He is now mostly retired and divides his time between homes in Georgetown, Texas and Durango, Colo.

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