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.