Striking Black Gold: Oil Field Auction in the Gulf of Mexico The US Department of Energy will be auctioning the drilling rights to an oil field in the Gulf of Mexico in the near future. This oil field is likely to be extremely productive, based on the successes of nearby fields whose rights are owned by Exxon’s competitor Chevron-Texaco. The DOE has yet to determine whether to use a sealed bid first price auction, or a sealed bid second price auction. The bidding for this oil field is limited to Exxon and three of its competitors: Amoco, BP, and Chevron-Texaco. In this report, we will determine what Exxon’s optimum bid should be for the two auction methods the DOE may employ. We will also calculate the respective maximum payoffs of the optimum bids, and examine scenarios where it would be more prudent to renege on our bid. Finally, we will determine the impact of John Daniels’s possible acquisition of Oil Vision, a company that owns a tool that can gauge the exact amount of oil in a given field. In order to determine what Exxon should bid, we must first know the possible values of the highest competing bid. To determine these values, we computed:

F(Xmax) = P(X1>=x)*P(X2>=x)*P(X3>=x) F(Xmax) = x*x*x F(Xmax)=x3

Using this function in terms of y^1/3=x to compute the medians in the third column of Table 1, we were able to confirm the highest competing bid values that Julia Hernandez, risk analyst for Exxon’s Strategic Planning Department, computed. More in-depth calculations can be found on C.1 in the Appendix.
Table 1 | y medians | x medians (in $B) | 1st Quartile (Y1) | 0.125 | 0.5 | 2nd Quartile (Y2) | 0.375 | 0.721 | 3rd Quartile (Y3) | 0.625 | 0.855 | 4th Quartile (Y4) | 0.875 | 0.956 |

Knowing the highest possible values Exxon’s competitors are likely to bid, in concert with Exxon making one of four bids ($0.4B, $0.6B, $0.8B and $1.0B), we can determine Exxon’s optimum bid and potential payoff. Exxon’s research department values the oil field at $0.8B.
Under the terms of the sealed bid first price auction, Exxon’s optimum bid is $0.6B. As shown on DT.1 in the Appendix, a $0.6B bid yields a $.05B return, the only positive expected return of the four bids Exxon could make. A $0.4B and $0.8B bid yields a $0.00 payoff, while bidding $1.0B results in a -$0.2B loss. While it seems counterintuitive to bid $0.6B knowing that Exxon’s competitors are bidding exactly what they value the oil field at, Exxon’s bid of $0.6B instead of their $0.8B valuation in this case yields the maximum payoff under the constraints of the first price auction method. Because of the constraints of having to pay what you bid, the only way to have the potential profit is to bid lower than the company’s valuation, but yet bid high enough to beat your competitor’s bid.
Under the terms of the sealed bid second price auction, Exxon’s optimum bid is $0.8B, the same as Exxon’s valuation of the oil field. As shown in DT.2 of the Appendix, a $0.8B bid yields a $94,750,000 return, the highest amount of Exxon’s four possible bids. When comparing DT.2 to DT.1, the most striking difference is that every winning bid has a positive expected return on DT.2. This is due to paying the second highest bid amount if your winning bid is the highest. The difference is built-in profit, so to speak. The terms of this auction method favor bidding the true valuation of the oil field because it is the highest amount Exxon will bid and still earn a payoff. If Exxon bids above the $0.8 valuation, it is possible it will incur a loss by winning the bid. As shown on DT.2, if Exxon bids $1.0B it will win the bid 100% of the time, but incur a loss half of the time. Thus to ensure Exxon’s bid yields a positive return while maximizing its payoff, Exxon should bid its valuation of $0.8B knowing that it will pay the next highest bid’s amount to the US DOE, and consider the difference its profit potential.