Portfolio Optimization : Systems vs. Sequential Approach

Abstract

Abstract Traditional investment decisions in the oil and gas industries ignore dependencies and interactions between parameters such as reserves, production and economics. In a previous paper1 we have shown that for a single project the system stochastic approach better captures the impact of dependencies and interactions among the components of decision parameters compared to the sequential approach and improves decision quality. In this paper we build on the previous work and investigate the impact of system stochastic and sequential stochastic modeling on the portfolio efficient frontier. We use a stochastic integrated model, which captures uncertainty for a mix of five hypothetical offshore oil field development projects. The model combines reserves, production, capital and operating costs into an integrated probabilistic economic evaluation. The output of the stochastic model is used as input into the Markowitz Mean-Variance model and varying our company's participation level in the five projects to compute the efficient frontier. The results show that the two approaches yield substantially different efficient frontiers. As expected the difference between the systems and sequential approach increases with increasing standard deviation of the portfolio NPV with the expected value of portfolio being greater in the systems approach. In our example, the difference in the computed expected NPV ranged from 8 % at lower level of risk to 15% at higher level. In conclusion, the system approach is superior in capturing intra- project dependence and its impact on the portfolio level is significant compared to the sequential approach. Both the systems approach and the portfolio methodology complement each other in capturing both intra-project and inter- project dependence at the portfolio level. Introduction Traditional investment decisions in the oil and gas industry often ignore modelling of dependencies and interactions among decision parameters such as reserves, production, facilities and costs. This limits the ability to examine how a change in one parameter may affect the others. In a previous paper1, it was demonstrated that for a single project, the systems approach better captures the impact of dependencies compared to the sequential approach. In reality, however, companies are not only faced with evaluating single projects but with many projects that compete for funds. The decision maker must choose a portfolio of projects, which balance risk and reward and together contribute most to the organization's profit. Harry Markowitz is known as the father of the portfolio theory. His work is built on the concept of diversification among stocks 2. The key idea of his work is that the interaction of the stocks is more important at the portfolio level than the value of the stock alone. The same analogy applies to petroleum projects. How projects interact with each other is more important than the evaluation of single project alone. This means that a single project should not be valued alone but the evaluation should be based on how it contributes to the firm's portfolio value maximization. The Markowtiz approach recognizes the importance of interaction among projects in the optimization of the firm's portfolio rather than the value of the project alone. This approach focuses on the interaction among projects as shown in Figure 1. Ball and Savage 3 discussed the main sources of interaction and dependencies among projects as follows: Places: The NPV's of two projects in a similar area, meaning similar geological setting, will produce positively correlated NPV's, which implies, according to the portfolio theory, less diversification. While two projects in different geological settings may be negatively correlated and hence lead to a more diversified portfolio. Prices: Oil prices in the world market tend to be the same and therefore positively correlated, which leads to less diversification. However, gas prices are not or at most weakly correlated with each other or with oil prices. So a portfolio with two oil projects will have less diversification compared to a portfolio with two projects when one is oil and the other is gas.