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Risk Analysis and Portfolio Management
Why should we rank our investment opportunities? The most intuitive answer is to minimize risk and optimize the timing of cashflows. As per Pete Rose's approach to Risk Analysis and Portfolio Management, the basic premise of portfolio management is that you can minimize your risk of investment if you can spread your risk across many investment opportunities…. i.e. don't put all your eggs in one basket! The second but yet very important aspect of portfolio management has to do with the timing of cashflows. Ideally, projects should be timed so that excess cash from production revenues will be available when large development projects are expected to begin, and large-scale exploration projects are available when the company has cash flows to use in increasing asset value. We should rank our portfolios to maximize value, and then if money is needed for development, it can be borrowed or derived by selling existing, less profitable properties.
Last month I agreed with those who use risked net present value for their ranking criteria because it will help maintain steady consistent corporate growth and a tolerable risk profile for the company's financial size and net asset value.
In attempting to optimize the portfolio, investment efficiency is the most discriminating form of profit/investment ratio, in which profit is the project's NPV and the investment is maximum negative net cash flow. An advantage of investment efficiency is that it can easily be risked. Exploration portfolios ranked using risked investment efficiency are optimized for the creation of value. Be aware though, portfolios ranked in this way, sometimes present unacceptable degrees of risk.
Optimizing the working interest percentage is another helpful aid when a company has limited prospects and limited capital. The optimum working interest can be determined by the following equation:
OWI = [(RT) / (Cost + PV)] x ln [(Pc x PV) / (Pf x Cost)] RT = Risk Tolerance = 1/r where r = 5/(Annual Expl Budget-$mm) PV = Prospect Present Value Cost = Cost of Failure Pc = Probability of Commercial Success Pf = Probability of Failure
Many companies do not have the luxury of assembling a full year's supply of prospects 12 months in advance. Instead they make decisions on prospects that appear throughout the program year. Using OWI calculations can ensure participation levels in multiple ventures for companies limited in both prospects and capital, but one must keep in mind that while OWI may allow a company to invest in a more risk-averse way, it also reduces portfolio value.
Back to December 2003 Newsletter
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