The modeling of uncertainty is fundamental to board approvals of energy investments. Technical teams analyze data, seeking to estimate (i) the likelihood of hydrocarbon accumulation (or chance of success) and (ii) how much oil and gas will be produced over time – including initial production rates, decline profiles, and recoverable reserves. Companies rely on these assessments to select acquisitions and to allocate capital among their portfolios. The closer a firm’s estimates to actual outcomes, the better its returns are likely to be over time.
Companies usually base their approval decisions on a technical committee report. Unfortunately, committee estimation is subject to the bias of its members and their personalities. Hess Corporation asked its geologists to evaluate the firm’s global exploration inventory, and the results showed a clear bias for each explorer’s own projects. In another experiment, “more than 200 geoscientists from the industry and academia were asked to interpret a seismic section generated synthetically from a known geological scenario. It was found that participants interpreted the seismic section as from the tectonic regime in which they were most experienced” (Pierre Delfiner, Uncertainty in Prospect Evaluation: Lessons from the Movie Industry).
Which person’s bias will prevail at any given committee meeting? It may depend on strength of personality. As economist Daniel Kahneman has explained, the “standard practice of open discussion gives too much weight to the opinions of those who speak early and assertively, causing others to line up behind them.” Undue weight also may be given to those in leadership positions or with more experience.
James Surowiecki’s The Wisdom of Crowds suggests another way to estimate uncertainty. In its opening pages, he describes a contest in which fairgoers guessed the weight of an ox. The average of these guesses was 1,197 pounds – only one pound less than its actual weight. Similar experiments have been made using jars full of pennies or gumballs. The same technique could be applied to a well’s chance of success, the amount of petroleum in a reservoir, or even, whether a particular lawsuit will be successful.
Why does independent voting work so well? Surowiecki argued that: “If you ask a large enough group of diverse, independent people to make a prediction or estimate a probability, and then average those estimates, the errors each of them makes in coming up with an answer will cancel themselves out. Each person’s guess, you might say, has two components: information and error. Subtract the error, and you’re left with the information.” This insight in some ways reflects the difference between capitalism and socialism. Whereas socialist governments tend to make economic decisions through committees (rather like oil companies’ risk assessment meetings), capitalist nations rely on the independent votes (sales and purchases) of dispersed individuals (similar to the Wisdom of Crowds approach).
One attractive aspect of independent voting is that it can supplement, rather than displace, existing approval processes. For example, each committee member’s views can be anonymously collected prior to the first meeting and analyzed as follows:
- Average of independent votes. How does the average of independent votes compare with the committee’s collective estimate?
- Range from lowest to highest independent vote. What is the best and worst estimate? Where does the committee’s estimate fall along this continuum?
- Dispersion of independent votes. Are the votes widely dispersed, or concentrated? Are there two clusters of votes, perhaps indicating different views on a fundamental assumption?
Technology has made it easier and cheaper for companies to gather this kind of data. The committee members already have analyzed the matter. Independent voting merely requires each to go online and fill out a secret ballot in advance of the meeting. Given the evidence of independent voting’s value – and of bias in committee reports – corporate boards should consider requiring independent voting as a supplement to major project AFEs.
About the Gaille Energy Blog. The Gaille Energy Blog discusses innovative proposals in the field of energy law, with a new issue being posted each Friday at http://www.gaillelaw.com. Scott Gaille is a Lecturer in Law at the University of Chicago Law School, an Adjunct Professor in Management at Rice University’s Graduate School of Business, and the author of two books on energy law (Shale Energy Development and International Energy Development).