Prospect Should Be Portfolio Fit

Petroleum exploration is a "repeated trials game." Whether you are a career prospector generating a succession of drilling deals, or exploration vice president of an oil and gas company overseeing an annual prospect portfolio, you are engaged in a series of risk ventures whose individual outcomes are each uncertain.

The uncertainties involve:

  • The chance of finding commercial reservoired hydrocarbons.
  • The range of recoverable HC-volumes present.
  • The range of annual cash flows and profits expected.

Some wells will turn out to be dry holes, whereas others will prove to be commercial discoveries -- but if each and every drilling venture has a positive expected value (and all projects have been estimated without bias), the final outcome of the full portfolio of wells will be profitable, given adequate sample size.

In this context, managing an E&P portfolio is like managing a casino. The casino operator knows that the odds on each gaming table are set to be slightly in his favor (EV = [+]). Thus the casino is a business, just as an insurance company is a business.

Petroleum exploration is a similar business. So is an investment portfolio.


Principles of portfolio management apply to all such businesses. Harry Markowitz is acknowledged to be the father of portfolio theory for his seminal work with portfolios of various investment vehicles. Markowitz not only recognized the importance of the expected value (EV) concept in portfolio management, he also defined the principles of the Efficient Frontier.

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Petroleum exploration is a "repeated trials game." Whether you are a career prospector generating a succession of drilling deals, or exploration vice president of an oil and gas company overseeing an annual prospect portfolio, you are engaged in a series of risk ventures whose individual outcomes are each uncertain.

The uncertainties involve:

  • The chance of finding commercial reservoired hydrocarbons.
  • The range of recoverable HC-volumes present.
  • The range of annual cash flows and profits expected.

Some wells will turn out to be dry holes, whereas others will prove to be commercial discoveries -- but if each and every drilling venture has a positive expected value (and all projects have been estimated without bias), the final outcome of the full portfolio of wells will be profitable, given adequate sample size.

In this context, managing an E&P portfolio is like managing a casino. The casino operator knows that the odds on each gaming table are set to be slightly in his favor (EV = [+]). Thus the casino is a business, just as an insurance company is a business.

Petroleum exploration is a similar business. So is an investment portfolio.


Principles of portfolio management apply to all such businesses. Harry Markowitz is acknowledged to be the father of portfolio theory for his seminal work with portfolios of various investment vehicles. Markowitz not only recognized the importance of the expected value (EV) concept in portfolio management, he also defined the principles of the Efficient Frontier.

But the most important aspect of portfolios that Markowitz emphasized was that different projects in the portfolio interacted.

For example, one stock might provide long-term growth, whereas another might generate needed short-term dividends. Some projects acted to insulate the portfolio from wide market fluctuations. A widely cited example is the investment couplet of airline stocks vs. oil stocks, whose trends tend to offset each other.

Thus one of Markowitz's well-known quotes:

"Don't tell me what a certain stock will do -- what will it do for my portfolio?"

The most common expression of portfolio theory for private investors has to do with the benefits of diversification in dampening severe market swings, hence the benefits of mutual funds and index funds.

The parallel between stock market portfolios and E&P investments is simple: both rely on selecting investments that interact appropriately. How an E&P project interacts with other projects in the business is often more important than the absolute project characteristics, when business performance is the standard of measure. Thus E&P decision-makers who make decisions on a project-by-project basis are tempting fate (but following their experience).

E&P decision-makers who intend to manage business performance (rather than manage assets) need to focus on the interactions between investments and select the projects that provide the strongest interactions, not just select the "best projects." History has shown that the "best projects" do not always add up to yield the "best business performance."

As petroleum E&P became a global activity during the 1990s, oil companies increasingly recognized the need to coordinate the selection of projects for their prospect inventories and annual drilling portfolios, so as to maximize investment efficiency and achieve corporate goals.

The inventory is the list of candidate opportunities, whereas the portfolio is the list of what gets drilled (Figure 1). The larger the inventory of prospects to select from, the better for portfolio performance. Increasingly, a well-managed, unbiased, centrally-coordinated E&P portfolio is seen to be the single most important attribute of stable top-performing companies. Expectably, under-performing E&P companies lack such a centralized portfolio.

Aside from choosing projects that collectively advance the firm's goals, an obvious appeal of the well-managed E&P portfolio is that it allows forecasting -- in a probabilistic sense -- of the results and consequences of a given combination of projects. That is, for a given investment in a specified portfolio, the outcome, as both value-growth and cash flow, can be predicted for the benefit of executive committees, board members -- and stockholders!

But, of course, this requires that all the constituent ventures have been estimated without bias. Bias is the mortal enemy of portfolio management.


That brings us back to the independent prospector and his corporate counterpart: Any prospect, if it is eventually drilled, will probably have been part of someone's portfolio -- or several different portfolios, if it was a joint venture!

At some point, considerable technical effort will have been expended to objectively assess its three key attributes:

  • Chance of success.
  • Range of recoverable reserves.
  • Distribution of NPVs (= profitability).

The independent prospector has the choice of objectively assessing the key parameters of his/her prospect -- or allowing someone else to do so.

Either way, objective assessment probably will take place.

In next month's column, John Howell will discuss principles of E&P management in more detail.

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