Winner’s Curse and Guessing the U.S Inventory of Natural Gas

Asymmetric information and fundamental uncertainty raise interesting issues in economics.  Suppose that a natural gas company owns 10 plots of adjacent land and reports the “provable” quantity of natural gas that it can access at one of the plots.   It is tempting to multiply this by 10 as optimists extrapolate that all of the plots are of equal quality.   But, how do you know if the company is “cherry picking” and simply reporting the truth about its best plot (and hoping you will extrapolate) or is simply lying even about that plot?  Do the executives of the firm have the right incentives to tell the truth?  Their company’s stock price increases with announcements of “new proven reserves”.   The NY Times is very concerned about this new case of winner’s curse.    New accounting rules make it easier for gas companies to overstate their reserves and the NY Times is playing a useful role in spreading information about this point.  Natural gas is the new thing as it offers domestic energy security and lower GHG emissions than fossil fuels.   But, how much of this resource do we really have?

Nuanced investors know that they “do not know” how much gas these companies really can access and they do not know the future price of natural gas yet both are crucial in determining the price dynamics of shares of gas companies.    Winner’s Curse arises when the most optimistic asset buyers purchase the stock because they overestimate the true reserves of gas that the company really owns (the average valuation is the best guess).   For some technical discussion read Milgrom’s paper.  

So, naive investors will lose money investing in these risky assets.  What will nuanced investors do?   Trusted geologists could be identified and they could conduct an independent investigation.    If the public is skeptical about the claims the energy companies are making, then the stock prices will not rise with their own announcements of discoveries (because the information is not trusted). In this case, the natural gas companies who do indeed have parcels with natural gas would have an incentive to pay for independent verifiers to step in and conduct their own analysis to verify the truth.   A separating equilibrium would take place as the truth would be revealed.  Now, it is costly to reveal the truth (because the gas is trapped hundreds of feet down in the rocks) — then the outcome will still be a random variable but experts must have ways to elicit a “good guess”.  The key here is that investors know “that they do not know” how much of a discovery has been made.  Only, naive investors can be burned here but if the investors know they are naive why did they make the bet?

Author: Matthew E. Kahn

Professor of Economics at UCLA.

5 thoughts on “Winner’s Curse and Guessing the U.S Inventory of Natural Gas”

  1. Just to pick a nit, this hardly seems like the usual winner’s curse. It looks more like some investors falling for an outright deception.

    I guess it might be a sort of second order case, where the investors are over-optimistic not about the reserves, but about the honesty of the company.

  2. I see two economic issues.

    The first is what kind of kind of arrangements will tend to make the company stock price “accurate” or efficient. A critically important question is whether and what kinds of strategies exist for the “nuanced investor” to make use of superior information, and how those strategies affect the market price. If only the naive investors buy the stock, in response to company PR of exaggerated optimism, then the price will be too high — too much money and too many resources will be invested in the venture, and a crash will occur when the fraud and the bad investment outcome is realized. If there are opportunities to get better information in advance of outcomes, and there is some mechanism for shorting the stock, and hedging or diversifying against other companies, then the shorting will tend to force down the market price of the company stock, limiting investment in the venture.

    The second issue has more to do with the general problems posed by “peak oil”. The excessive optimism, here, may have more to do with natural gas and frakking in general. “Peak oil” does not mean that we will run out of oil and gas; only that the costs of extraction will rise. Frakking has enormous environmental costs, which are being denied. That denial is the Big Lie, here, not a mis-estimate of potential reserves. The exercise of political power — as in the recent election of Conservatives in Canada, supported by Albertans determined to destroy their environment and suburban Ontario desperate to hold onto their housing bubble — will aid the denial and externalization of environmental costs.

    And, just as Ponzi finance creates financial market crashes, where the costs are imposed on innocent non-investors, so Ponzi environmentalism will create a crash, as well.

  3. To pick another nit, natural gas is a fossil fuel, derived from ancient biota just like coal and oil. And its carbon footprint is only slightly smaller (because of slightly higher heat-to-work conversion efficiencies).

  4. DB – its carbon footprint is smaller than that of coal because it’s mostly hydrogen, while coal is almost all carbon. One source puts the “carbon efficiency” of natural gas at just under 1.8x that of coal. That’s more than “slightly” smaller. Though perhaps not enough to save us from climate change if we convert all coal burning plants to gas without also making other changes.

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