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'Fund' Blending Mitigates Risks

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.

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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.

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