All
experienced earth scientists, engineers and decision-makers will readily
admit that uncertainty is an inherent part of the oil business -- however,
they will debate whether uncertainty creates opportunity or creates problems.
Problems are
not created by uncertainty, but by how we perceive and manage uncertainty.
How can uncertainty
create opportunity?
Compare the performance
of a mutual fund manager and an individual investor in the stock market.
Both have access to similar "uncertainty" information on a given stock
or bond. Individual investors try to select the "good investments" while
the fund managers try to select investments that interact mutually and
beneficially, using portfolio management concepts.
At a given moment,
the individual investor's performance may look great. But long term, individual
investors rarely outperform disciplined fund managers.
In the E&P
business, decision-makers who select ventures on a project-by-project
basis, without assessing the interactions among their investments, are
managing their business like the individual investor.
Uncertainty is
a liability to these decision-makers, because by ignoring interactions
among investments they often unknowingly increase portfolio risk.
Decision-makers
who manage uncertainty typically use a portfolio management process to
describe uncertainty and characterize the complex interactions among their
investment options. Such decision-makers tend to produce consistent, predictable
business results, much like a mutual fund manager.
Here's a simple
example of complex interactions of uncertain investments:
Project cash flow
profiles for two projects are described in Figure 1 (above). Uncertainty
in Project 1 (exploration project) comes from chance of success (fail
and success), while the uncertainty in Project 2 (production project)
comes from different reserve volume realizations.
Ordinary investor
logic might choose Project 1, because of the large positive outcome that
is possible later in time, or it might lead to choice of the assured-but-modest
positive outcome of Project 2, because it is "safer."
Portfolio logic
would aid in finding appropriate ways to invest in a portion of both projects.
The near-term positive cash flows of Project 2 would be used to offset
the negative near-term cash flows associated with Project 1. The proportions
of each project required for the fund manager's "portfolio approach" would
be a function of the probabilities of each outcome for each project, the
magnitude of the cash flows, the cumulative cash flow requirements of
the investor and the level of uncertainty the investor can tolerate.
So uncertainties
in a given venture can be managed by combining projects that have different
yet complementary uncertainties. This suggests that our goal should not
be to eliminate all uncertainty from a project, but rather to reduce uncertainty
through technology and manage the uncertainty that remains through the
proper blending of projects.
The example also
shows that the best blend depends upon a number of factors. Consider that
this example has only two projects, two outcomes and one metric to consider.
Real E&P business problems require balancing across multiple metrics,
multiple time frames and related uncertainties that arise from different
sources.
Last month, Peter
Rose emphasized in this column ("Thinking About E&P Portfolios") the
importance of unbiased descriptions of each investment opportunity (technical
uncertainty). This is essential for characterizing the technical interactions
and the business performance interactions between projects -- it is fundamental
to the most basic portfolio modeling.
Technical interactions
impact business questions addressing the number of opportunities -- of
differing chances of success -- that must be drilled in a given time period
to gain a reasonable probability that a corporation will meet its business
performance goals. They also address investing in different geologic regions
where technologies may or may not impact technical uncertainty.
Other sources
of uncertainty arise from oil prices, market conditions and political
regimes. These sources are often correlated -- what happens in one project
may be related to another project. Oil prices, for example, correlate
for worldwide oil projects. However, oil prices may not have any relationship
to gas prices in some areas of the world. Gas prices are often related
to local market conditions. The global nature of the oil industry means
that events in distant markets or political arenas can significantly impact
the value of projects that are continents away.
Correlations
are often discussed, yet rarely systematically managed in our business,
even though the attendant mathematics are well understood.
Uncertainties
and correlations all have a profound impact on our business performance.
Industry's ability and willingness to describe these characteristics is
improving, as is our ability to manage these factors. The interactions
between projects across different performance metrics, different time
periods and through uncertainties and correlations are certainly too complex
to manage in our heads.
As decision-makers
we must choose either to leverage value from uncertainty (as the mutual
fund managers do), or charge ahead as an individual investor, victimized
by correlations and high uncertainty. Portfolio management processes allow
decision-makers in the oil and gas industry to become "fund managers."
They can properly
balance their investments to meet their corporate performance goal, thus
realizing opportunity -- rather than risk -- from the inherent uncertainties.