Applying Modern Portfolio Theory to Upstream Investment Decision Making

Abstract

This paper (SPE 54774) was revised for publication from paper SPE 49095, prepared for the 1998 SPE Annual Technical Conference and Exhibition, New Orleans, 27–30 September. This paper has not been peer reviewed. Summary Nobel laureate Harry Markowitz provided investors with a framework to optimize risk and return of their portfolios of stocks and bonds. With a small portfolio of upstream investments as an example, this paper demonstrates how E&P companies can use similar portfolio-optimization methods to determine a mix of projects that provides the minimum risk for a given level of return. Contrasting this portfolio with investments selected by use of traditional capital-allocation techniques, the paper demonstrates how modern portfolio theory provides management with a superior setting for allocating capital by illuminating risk at the portfolio level. Introduction Only 1 year ago, E&P companies were forecasting a rise in capital spending and were recruiting technical staff to help generate those capital-spending opportunities. Today, the same companies are slashing their capital budgets because of depressed oil prices. Large numbers of potential projects are chasing increasingly limited budgets. Allocating shareholder capital across these projects constitutes senior management's principal responsibility. To create shareholder value, management must invest capital in a portfolio of projects that generates returns that exceed the firm's cost of capital. Oil and gas investment returns, however, are highly uncertain. Unique, diversifiable risks can disrupt cash flow, depress share prices, and compromise a company's ability to invest in the future. However, traditional capital-allocation techniques leave management blind to risk by focusing exclusively on return. By contrast, portfolio theory illuminates the tradeoffs between risk and return—tradeoffs that remain hidden when traditional techniques are used. By creating a series of portfolios that minimize risk for different levels of return, portfolio theory allows management to see how different projects drive portfolio-level risk and whether incremental expected return justifies incremental risk. By explicitly addressing risk throughout the portfolio-selection process, management can answer such basic questions as, "What is the likelihood that the company can achieve its key goals?" The Rise of Risk Management: Why Diversify? In a 1952 article, Markowitz1 highlighted the common practice of portfolio diversification and demonstrated how investors could minimize the standard deviation of their portfolio returns. According to Markowitz, investors could virtually eliminate their exposure to the risks unique to individual securities by choosing stocks that do not move precisely together. He calls those combinations of stocks and bonds that have the minimum risk for a given return efficient portfolios. When these optimized portfolios are plotted on an x-y axis for the full range of potential returns, the line they form is the efficient frontier. Markowitz proved that stocks and bonds should not be assessed individually but according to their contribution to the portfolio risk. If diversification is such a powerful tool for investors, does it make sense for a firm? From the 1950's through the 1970's, "modern finance" answered with an emphatic no. Corporate diversification was considered redundant because investors could diversify for themselves. Other forms of risk management were also seen as unnecessary at best. Capital-structure theory argued that value was created when a company's investments generated increased operating cash flows. Decisions about how to finance those investments were of almost no consequence in a well-functioning market. It follows that hedging and other financial-risk-management tools are also purely financial transactions that do not affect the value of the company. Modern finance's message to managers was quite simple: maximize value and let investors manage risks for themselves.2 Building on Markowitz's framework, the capital asset pricing model (CAPM) developed in the 1960's estimated the risk premium that investors demand from individual stocks. Using CAPM, managers could compare an investment's return with the return demanded by the firm's own sources of capital. A stock's expected risk premium is a function of its sensitivity to market movements, ß. ß is the ratio of the covariance between a stock's return and the market return and the variance of the market return. This ratio measures a stock's contribution to portfolio risk. Stocks with ß>1.0 amplify the movements in the market, while stocks with ß between 1.0 and 0 move in the same direction as the overall market but at a diminished rate. Using CAPM, managers could calculate their weighted-average cost of capital (WACC). By the 1970's, WACC-based discounted-cash-flow analysis had become the investment decision-making vehicle for most of the oil and gas industry as well as for the rest of corporate America.3 Investment opportunities were evaluated by assessing the most likely values for essential project parameters to forecast a deterministic cash flow over the life of the investment. With this method, the investment's worth equaled these cash flows discounted to present value at the WACC. If a project's return on invested capital (ROIC) was greater than the firm's cost of capital (ROIC>WACC), the project had a positive net present value (NPV) and created value for the firm. If it was less (ROIC