Chapter 10 Supplement

Wolfson (1985) Study of Oil and

Gas Limited Partnerships

10S - 1
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 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

10S - 2
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 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

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 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

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 Two Types of Drilling

• Exploratory
– Riskiest (low probability of high payoff)
• Developmental
– Least risky (high probability of low payoff)

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 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., .40R
– Investor gets .60R

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 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)

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 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

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 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 .40R > 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

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 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

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 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

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 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 non-
completion problem of manager shirking

» Continued

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 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

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 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

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 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

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 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

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