Chapter 10 Supplement Wolfson 1985 Study of Oil

Chapter 10 Supplement Wolfson (1985) Study of Oil and Gas Limited Partnerships Copyright © 2009 by Pearson Education Canada 10 S - 1

10. 2 Empirical Evidence of Incentive Problems and Their Mitigation in Oil and Gas Tax Shelter Programs Mark A. Wolfson (1985) An application of agency theory Copyright © 2009 by Pearson Education Canada 10 S - 2

The Question to be Addressed • In a multi-period context, can market forces (i. e. , reputation effects) eliminate shirking? – If so, no need to motivate managers by means of incentive contracts Copyright © 2009 by Pearson Education Canada 3

Tax-Advantaged Limited Partnerships to Drill for Oil and Gas (U. S. ) • Principal: the limited partner, who invests and receives advantageous tax treatment • Agent: the general partner/manager – Conducts drilling and on basis of drilling results decides whether or not to complete the well Copyright © 2009 by Pearson Education Canada 4

Two Types of Drilling • Exploratory – Riskiest (low probability of high payoff) • Developmental – Least risky (high probability of low payoff) Copyright © 2009 by Pearson Education Canada 5

An Incentive Contract • A common sharing rule (contract) – – – – Tangible drilling costs: must be capitalized for tax purposes Intangible drilling costs: immediately tax deductible Agent (manager) pays tangible costs Principal (limited partner, investor) pays intangible costs Let revenue from well be R Manager gets, e. g. , . 40 R Investor gets. 60 R Copyright © 2009 by Pearson Education Canada 6

Information Asymmetry • Manager knows expected R, investor does not • This leads to incentive problems of moral hazard and possible shirking by manager – Noncompletion problem (manager shirks by not completing well) Copyright © 2009 by Pearson Education Canada 7

The Noncompletion Problem (Well is Drilled But Not Yet Completed) • A model of revenue from well: – E(R) = K(D + C) • D: drilling costs. Paid by investor • C: completion costs. To be paid by manager • K: manager’s skill (e. g. , K = 2) – Manager generates $2 in revenue for each dollar spent • Manager knows E(R) and C, investor does not » Continued Copyright © 2009 by Pearson Education Canada 8

The Noncompletion Problem (continued) • From standpoint of society (and investor) – Complete well if R ≥ KC, since D is sunk • From standpoint of manager – Complete well if. 40 R > KC • Thus manager may not complete well (i. e. , may shirk) when completion is in best interests of principal and society • NB: Noncompletion problem greater for development wells Copyright © 2009 by Pearson Education Canada 9

Controlling the Noncompletion Problem • Direct monitoring of manager drilling effort and results (too costly) • Manager establishes a reputation (multi-period) to convince principal that he/she will not shirk Copyright © 2009 by Pearson Education Canada 10

Testing For Reputation Effects • For each general partner (manager) in the sample of limited partnerships: – Expected return rating (ERR) • A measure of a manager’s reputation, based on past performance • Analogous to past income statements – Net return rating (NRR) • Expected oil and gas finding rate. A measure of the cost to “buy in” to the manager’s partnership. Lower NRR implies higher cost to buy in, since limited partners (investors) then get lower expected return • NRR analogous to a managerial labour market (i. e. , measures the manager’s worth) » Continued Copyright © 2009 by Pearson Education Canada 11

Testing For Reputation Effects (continued) • Is higher reputation associated with higher cost to buy in? – Yes: Wolfson reports statistically significant evidence that higher reputation (higher ERR) associated with higher cost to buy in (lower NRR) – It appears investors are willing to accept a lower expected return the higher the manager’s reputation • Conclude: reputation reduces the noncompletion problem of manager shirking » Continued Copyright © 2009 by Pearson Education Canada 12

Testing For Reputation Effects (continued) • Does reputation eliminate the noncompletion problem? – No: Wolfson reports higher NRR for development wells – Development wells • Average NRR for his sample = 2. 695 – Exploratory wells • Average NRR for his sample = 2. 357 • Thus lower price to buy into development wells » Continued Copyright © 2009 by Pearson Education Canada 13

Testing For Reputation Effects (continued) • Wells more subject to the noncompletion problem (development wells) are priced lower by investors than wells less subject to the noncompletion problem (exploratory wells) • If reputation completely eliminated the noncompletion problem, the prices would be the same Copyright © 2009 by Pearson Education Canada 14

Conclusion to Testing For Reputation Effects • Conclude: reputation effects do not completely eliminate the need for an incentive contract • Managerial labour market works, but not fully well Copyright © 2009 by Pearson Education Canada 15

Implications for Accountants • 2 roles for accounting information – Market forces of reputation reduce but do not eliminate manager shirking • Thus compensation contracts and performance measures such as net income still needed – Net income should be informative about manager effort • i. e. , the ability of market forces to motivate effort is improved as accountants reduce ability of managers to shirk through higher quality reporting – Both roles benefit society Copyright © 2009 by Pearson Education Canada 16