Introduction
As promised last week, in today’s column I shall introduce readers to the second of two studies that focus on the evaluation of public auctioning of oil rights. That is, Professor Cramton’s famed assessment entitled, “How to Auction Oil Rights, 2005”. This is a synthesizing survey of the research work on the topic and is aimed at emerging petrostates like Guyana. It blends together well with the Sen and Chakravarty empirical evaluation of India’s experience with oil block auctions over an extended period. Similar to last week I rely closely on this study in my presentation, mainly in order to avoid errors in translation, as it were.
General Propositions
The following four general propositions emerged from the Cramton study;
First, good auction design promotes efficient assignment of rights and competitive revenues for the seller.
Second, the factors determining this outcome are 1] the structure of bidder preferences and 2] the degree of competition.
Third, with weak competition and “additive values,” a simultaneous first-price sealed-bid auction may suffice
Fourth, with more complex value structures, a dynamic auction with package bids, such as the clock-proxy auction, is likely needed to increase efficiency and maximize revenues. Bidding on production shares, [rather than] bonuses, typically increase Government Take by reducing oil company risks
DEFINITION: CLOCK-PROXY AUCTION
The clock proxy phase, like a simultaneous multiple round, SMR auction, consists of discrete multiple rounds of bidding for all items, which continue until there is a round in which bidding stops for all items. The assignment phase then follows, with a single round of bidding for each geographic grouping to assign specific licenses.
Principles
There are many ways for states to assign oil rights. Thus, for example, rights can be assigned via informal processes, [first-come-first-serve, “beauty contests,” submitted exploration and development plans]. The study examines design auctions for oil rights, focusing especially on developing countries issues. The assumption is that revenue maximization is the overriding objective. Other objectives [timing of revenues, employment and investment] exist. However, since revenue is the main objective. The advantage of an auction is that it is a transparent method of assignment, which if well designed, is capable of maximizing the revenues that a developing country can receive from its oil and gas endowments.
Nonetheless, there remain advantages and disadvantages of different auction designs for oil-and gas-producing developing countries. And the study shows design and process issues are crucial for developing countries. Further, while it is always best to tailor design to its specific setting, several insights can be drawn from recent auction theory and practice.
For a start, the study recommends defining the product; the license, the block size, fiscal metrics, and so on. Next, a number of basic design issues must be resolved: such as if to sell rights sequentially or simultaneously, if to use a dynamic or a static auction, what information policy should be used, and whether and how reserve prices should be set. In considering these questions, risks of collusion and corruption must also be examined. Much depends on the structure of bidder preferences (or “values”).
Two aspects of bidder preferences are especially important. The first is that the values to a bidder of a particular item might depend on what other items are already owned. The second is that, unlike in many settings, the values that the bidders place on oil and gas rights may be interdependent across the different bidders, since each bidder has private information, from surveys and seismic tests, that is relevant in determining the overall value of a block. Bidders have “common values” if it is the case that the ex post value of the block is the same for all bidders. This ex post value is unknown at the time of the auction; bidders have only estimates of the common value from the surveys, seismic tests, and expert analysis they have conducted. Auction theory suggests that when bidders have preference structures like this—viewing blocks as substitutes or as complements and having common values with private information, then some version of a simultaneous proxy format obtains.
Professor Cramton concluded with wise words 1] auctions are a desirable method of assigning and pricing scarce oil rights. 2] a well-designed auction encourages participation through a transparent competitive process. 3] good design promotes efficiency and competitive revenues 4] a variety of auction formats are available and the best depends on the specific setting, especially the structure of bidder preferences and the degree of competition.
His final observation is to emphasize that, regardless of the auction format, a critical element of the design is defining what is being bid. The what element is just as important as the how element. Possibilities include bonus bids, royalty rates, or production shares. Bidding on production shares, rather than bonuses, for example, typically increases Government Take by reducing oil company risk and fears of expropriation. More generally, these contract terms determine key features such as the allocation of between country and oil company, the cash flows over time, and the incentives for exploration and development
Conclusion
Going forward I offer a wrap-up of this extended discussion of Guyana oil block options.
