Why land prices fell 97% in two years

Chesapeake Energy Corp and its Canadian rival Encana are being investigated following claims that they colluded to avoid bidding against each other for land in Michigan.

In May 2010 Michigan State made $178 million from an auction of oil and gas leases. It was by far their most successful auction ever making nearly as much in a day as all the auctions in the previous 81 years had made. Prices per acre before the auction had averaged $26 but the average in the 2010 auction reached $1,507, over 50 times higher. The highest bid reached $5,500 per acre.

Rebecca Humphries, a director from the Michigan Department of Natural Resources, said:

“The future of oil and gas exploration in Michigan looks very bright. The wise use and management of our natural resources, such as oil and natural gas, will help lead Michigan’s economic recovery, create jobs and provide diversity for our state’s economy.”

Unfortunately it seems that not everyone was so happy with the outcome of the auction.

Emails seen by Reuters started to pass between Chesapeake and Encana not long after the auctions took place. Chesapeake CEO, Aubrey McClennan sent an email to one of his vice presidents saying that it was “time to smoke a peace pipe…if we are bidding each other up”. The vice president replied that he had contacted Encana and “we are both working to avoid us bidding each other up in the interim”

By the time of the 2012 auctions, prices were back down to just $45 per acre, a fall of 97% from two years before, and Chesapeake were no longer bidding in the Michigan area at all.

Whether anything illegal happened will have to be decided by the courts but changing the method of the auction could have made collusion more difficult.

In a normal English auction bids are made openly by bidders, this compares to a sealed bid auction where all bidders submit a single sealed bid for the item. An open auction is more susceptible to collusion than one with sealed bids.

Imagine two companies are bidding for rights to drill for gas, there are two parcels of land available both worth $1 million. The two companies agree to bid up to $900,000 only and take one parcel of land each.

If there is an open auction then if one of the bidders decides to break the agreement and go above the agreed $900,000 bid then it will be immediately obvious to the other company who can then continue to bid up to the true value of the land. Both the companies will end up paying full price for the land. If they had stuck to their (illegal) deal then they would both have paid $900,000 and been $100,000 better off. Collusion is beneficial in an open auction.

However, in a sealed bid auction there is much greater temptation to break the agreement. As there are sealed bids then if one company decides to break the deal and bid $900,001 then the other company will not find out about it until it is too late for them to do anything about it. The company that breaks the deal can get both parcels of land for $900,001, saving nearly $200,000 on the true value of the land. Honouring the deal would have meant being $100,000 better off than the true price, but if one company breaks the deal then they can be $200,000 better off.

This means that colluding in a sealed bid auction is not an equilibrium so it is unlikely to happen, but it is an equilibrium in an open auction so it is more likely.

Use sealed bids if you want to make it harder for bidders to collude.

Image: FreeDigitalPhotos.net

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