Even Optimists Should Optimize

Abstract

Abstract The industries interest in formal Decision and Risk Assessment (D&RA), including portfolio optimization, over the last few years has been quite amazing and somewhat surprising. Overcoming the barriers to adoption of these methods, including cultural change, continue to amaze even the most devout practitioners. Whether the drivers for accepting change emanate from the changing business climate that has been motivating recent mergers, political risks, a historical record of underperformance or just continued evolution of business practices, the desired objective remains the same - making good investment decisions. The growing popularity of D&RA - as indicated by the number of SPE sponsored forums and ATWs, alliances and industry courses on the subject and the general uptake of the language, like P10 and P90 - support the increasing awareness of D&RA methods as a mechanism for improving industry performance. The underperformance of petroleum stocks relative to the entire stock market has been cited by several to justify the even greater adoption of D&RA methods. Though artificial bubbles in telecommunications, dotcoms, and energy trading certainly explains part of the underperformance of traditional industry stocks, like petroleum, serious questions remain about the industrie's ability to actually achieve the performance in its investments that is promises in its evaluations. The gap between the promises and performances and possible causes for the gap form the foundation of this paper. As demonstrated by Campbell, Bratvold and Begg,1 trying to address complex portfolio issues with approximations may significantly overstate returns and mislead investors into selecting projects and portfolios that fail to deliver the promised performance. In this paper we are extending this work by pursuing the basic question of the impact of individual and corporate risk attitudes in the context of portfolio selections. We begin by briefly reviewing the basic approach to efficient frontier optimization for portfolio selection. The concept of utility is introduced and it's application for portfolio level decision is discussed. We then introduce the concept of indifference curves which, in combination with efficient frontier optimization, provides an elegant approach for identifying the optimal portfolio for a risk averse corporation. As in Campbell et al,1 we are addressing the portfolio selection issue with the intent of emphasizing that trying to address complex issues with a na ve or poor understanding of the impact of individual or corporate reaction to risk, may lead to overoptimistic expectations and subsequent failures to deliver on commitments. Budget Allocation Decisions Allocating shareholder capital across projects constitutes one of senior management's principal responsibilities and is a major budgeting decision. Budgeting decisions also occur at an asset level where there is a need to allocate capital or operational resources amongst a number of competing activities. To create shareholder value, management invests 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 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".