In some (mostly developing) countries, oil companies compete for new exploration agreements by bidding the key economic parameters. Companies are faced with a trade off between profitability of potential discoveries and probability of winning the bid.
We believe that an increasing number of companies are making generous offers in order to win bids, in the expectation of being able to renegotiate economic terms if they make a discovery. This tactic is hard to recognise and may have a good chance of success, due to the strength of the oil company's bargaining position upon discovery. However, the tactic damages the performance of the E and P industry in developing countries - for governments and companies alike.
The means of combating "tactical underbidding" rest largely with governments and national oil companies in making better contracts and taking a cautious approach to the evaluation of bids. Reputable companies can contribute to the process by emphasising that their bids are formulated in good faith and based on sound commercial considerations.
Countries such as Angola, Ecuador, Nigeria, and India select oil companies for new exploration agreements on the basis of formal bidding rounds, for which one important criterion is the economic terms proposed by the companies. Most commonly, these involve Production Sharing Agreements where profit oil sharing ratios are the key biddable variables in setting economic terms. Other economic variables might be depreciation rates, cost oil limits, investment "uplifts" and the like.
Faced with a decision of what percent profit oil to propose, foreign oil companies* (FOCS) clearly must consider the trade off of profitability on prospective discoveries versus their chances of winning the bid and obtaining rights to the exploration acreage. Our contention is that some companies have focussed increasingly on first gaining the exploration agreement and then working out the profitability later.
Carried to an extreme, this might entail bidding terms based only on very optimistic future conditions: high oil prices, large discoveries and low development and operating costs.