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During the time I have been in the petroleum industry, discounted cashflow analysis has always been used to value producing properties and drilling prospects. As we discussed in last month's newsletter, many companies place more emphasis on high return, short-life projects to maintain growth, partly because their discount rate is not representative of the company's actual cost of capital.
If a company uses payout, rate of return, or inflated discount rates to rank projects, the company in effect has a bias against large reserve, long-term projects which will make it difficult to maintain consistent, long-term growth. Many companies, in today's environment, prefer acquisition investment opportunities to exploration projects, primarily due to the perceived lower risk exposure. But in reality, many acquisition projects, which may be perceived as lower risk, may actually have a lower risked net present value than many drilling prospects, which are usually perceived as higher risk. Rate of return and payout can be used as a threshold requirement for a project to be considered for the company's investment portfolio, but the ranking of those investments should be done on the basis of risked net present value if the company is capital constrained.
My response to the survey is to agree with the 30% who use risked net present value as ranking criteria to include evaluating the risk of investment into the company's decision. Risked net present value will help maintain steady consistent corporate growth and a tolerable risk profile for the company's financial size and net asset value.
What exactly is risked net present value? Many companies refer to this type analysis as expected value economics. In simple terms Expected Value = (Chance of Success x Value of Success) - (Chance of Failure x Cost of Failure). There are many variables that could go into evaluating the chance of success aspect of this simple equation, some of which are source rocks, migration, reservoir rock, closure and containment, for drilling projects. If the result of the equation is a positive number, you are truly investing, while if the resultant is a negative number, you are essentially gambling or playing the Lotto with your investment dollars. All investment opportunities of a company's portfolio should be ranked on the basis of their risked or expected value economics.
Statistically, analyzing the sensitivity of investments with the various risk factors determines which risk factor has the greatest influence on the outcome. Distributions of reserve sizes in fields in a given trend, play or basin show a pronounced tendency to follow a conventional lognormal pattern. The best single representation of a lognormal distribution is the mean or average.
Single-value estimates of variables with uncertainty result in an outcome that is usually optimistic, and nearly always wrong. Triangular distributions (downside, most-likely and upside case scenarios) are a very poor estimate for the prevailing lognormal distribution and usually also lead to substantial overestimation. All of these ranges of sensitivities can be evaluated to determine the appropriate geologic chance of success and applied to the expected value equation by using Monte Carlo or Latin Hypercube simulation techniques. Evaluating all the ranges of sensitivities results in a risked NPV that can be expressed as a probability distribution to rank investments opportunities. Peter Rose's book Risk Analysis and Management of Petroleum Exploration Ventures is an excellent book that help you better understand how to utilize probability distributions in the ranking of investment opportunities.
Back to November 2003 Newsletter
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