ARIES Portfolio Optimizer User Guide

Copyright 2005 by Landmark Graphics Corporation

TABLE OF CONTENTS
Overview . 3
Opening Portfolio Optimizer ... 4
Components of the Portfolio Builder ... 7
Portfolio Building with the Portfolio Optimizer ... . 7
Setting Up Objective using Define Objective Tab 8
Setting Up Goals & Constraints . 10
Selecting the Opportunity Set for the Portfolio .. 12
Mode and Participation Interests 14
Mutually Exclusive Groups 15
Setting Up Run Mode and Parameters 16
Portfolio Building with User Defined option ... 20
Function of the Portfolio Manager .. 22
Analyzing Portfolios Using Portfolio Managers Reports&Graphs 23
Reviewing Portfolio Manager Reports . 24
Cash Flow Elements (Non_Time) Report .. 25
Cash Flow Elements (Time Series) Report . 29
Portfolio Comparison Report .. 30
Summary of Optimization Problem 31
Reviewing Portfolio Manager Graphs . 32
Portfolio Performance Graph Time Series.... 33
Portfolio Performance Graph Non-time Series .34
Portfolio Comparison Asset Selection Graph ....34
Portfolio Comparison Cash Flow Elements / Overlay Graph ... 36
Portfolio Comparison Cash Flow Elements/ Cross Plots Non-Time and
Time Series Graphs ....37
Portfolio Comparison Goals/Targets vs Portfolio Value Time Series ....38
Conclusions ...40
Appendix SPE Paper 8200941

OVERVIEW;
ARIES Portfolio Optimizer uses all the information from multi-dimensional data cube
build with The ARIES Portfolio - Cube Tools and it helps you ask the right questions to
find the optimal choice of investment opportunities. It gives you ability to run what if
scenarios and identify tactical decisions in alignment with your goals, strategies and
identified investment opportunities.
It uses state of the art portfolio optimization algorithm (OptQuest) and evaluates
acceptability of projects based on its contribution to the portfolio as a whole and
identifies project mix that provides the corporation with the optimal risk and return
attributes given managements strategy, risk preferences and capital limitations.
Users could also create and test different scenarios by assigning participation interest to
the projects of choices manually using the option User Defined under the part of
Define Objective tab in the Portfolio Builder.
The Workflow for the ARIES Portfolio is as follows;
Open ARIES Portfolio Module, and enter security login
Goto the Tools, Portfolio Optimizer
Select the cube that you want to work with and connect to the express server by selecting
the express server and entering the user name and password for the server.
Build portfolios either by assigning participation interest to the projects of choices
manually. (Select User Defined) or by using Portfolio Optimizer (Select
Optimization).
Use manual portfolio building or User Defined to test what if scenarios and analyze
the volatility of cash flow elements for each scenario created.
Use Optimization to determine best project mix and volatility of cash flow elements for
the optimized portfolios. (For the theory of the state of the art optimization algorithm,
see the appendix)
Use Portfolio Manager Reports/Graphs to analyze optimized portfolio.

OPENING PORTFOLIO OPTIMIZER;

In the ARIES Portfolio Module, goto Tools, Portfolio Optimizer;
Select the portfolio data cube that you want to work with. You will use this cube for
selecting opportunities to create your portfolio;
On the Select the Cube you want to work with dialog box , select the cube by
highlighting it.

On the connection properties dialog box;

-

Select the express server that is going to be used

Then, enter the USER ID and password for the server ;

Click OK to confirm the selection of the express server.

The ARIES Portfolio Optimizer; Portfolio Builder and Portfolio Manager will
then show up on the screen.

In the ARIES Portfolio Optimizer, there are two main tabs; Portfolio Builder, and
Portfolio Manager.
The Portfolio Builder is the place where you are going to define your optimization
problem. You could define an optimization problem either using User Defined by
manually assigning the participation interests to the projects
Or Optimization option to use optimizer to define participation interests.
Under Portfolio Builder, there are four main tabs; Define Objective, Set Goal(s)
&Constraint(s), Select Data, and Run Optimization.
When you select to use Optimization, first step is to define optimization problem by
selecting Define Objective and Set Goal(s) &Constraint(s) tabs. Next step is to
select
The data for optimization and to set project level specifications at optimization such as
must do, optional, omit flags, or mutually exclusive groups among the projects using
Asset Selections tab. You should then define the run mode and parameters for running
optimization at Run Optimization tab as final step.

When you select to use User Defined option to build a manual portfolio, you should
define the variable of interest as objective measure, introduce global goals and targets,
and then select the data and assign participation interest in the Asset Selection tab.
Even though you are not using optimizer, you should still use Run Optimization tab to
save and to give a description to the manual portfolio.
Under the Portfolio Manager, there are two main tabs; Portfolio(s), and Report(s)
&Graph(s).
The Portfolio(s) tab is the place where all your different scenarios/portfolios are saved.
When you build different portfolios, you could select to pursue in two ways; either you
could save portfolios and run optimizer later, or you could run optimization when you
build the portfolio. If you would like to run them later as batch job, you could use
Portfolio(s) tab and select the portfolios to be run and click on the Optimize tab. If
you would like to open up an existing optimization problem, you could use Portfolio(s)
tab and click on the Load. This function will load existing portfolio with all the specs.
When you run optimization, results are saved in the database. You could then use
Report(s) &Graph(s) part of Portfolio Manager and display, compare and contrast
different portfolio(s)s results. All the given report(s)/graph(s) templates could easily be
modified to include different measures and dimensions of portfolio. Their format could
easily be changed and all components could be analyzed on the fly.
In the next section, we will introduce components and workflows of building and
optimizing, and analyzing portfolio(s).

COMPONENTS OF THE PORTFOLIO BUILDER

Portfolio Builder is the first tab shows up when you open the ARIES Portfolio Optimizer.
It is the place where user could selectUser Defined or Optimization option for
building portfolios. There are four main components of Portfolio Builder; Define
Objective, Set Goals&Constraints, Select Data, and Run Optimization.
To be able to select either User Defined or Optimizer to define objective function,
click on the Define Objective Tab, and make your selection by clicking on the radio
button;

In the next section, we will introduce components and workflows of portfolio building by
using portfolio optimizer.

PORTFOLIO BUILDING with the PORTFOLIO OPTIMIZER

In this section, you will use optimizer to select best opportunity mix. You will first
define your optimization problem by selecting an objective measure. You will then set
goals and constraints at the portfolio level and select your opportunity set for portfolio
and define project level requirements. An optimum solution will then be determined by
optimizer given the conditions specified; you could then use reports and graphs to
analyze the optimized portfolio.

Setting up Objective Using Define Objective Tab

In every optimization problem, you should first define whether the optimization problem
is a minimization or maximization problem by clicking the choice from the radio buttons.
You should then select the decision variable as objective function measure. In the
ARIES Portfolio Optimizer, since you have a dynamic connection to the portfolio level
data with all granularities captured in the ARIES Portfolio cube, you could choose any
elements of your cash flow as decision variable.
To select the measure from the cube data, click on the single arrow key.

Clicking on single arrow key brings Measure Selector box with the drop down box of
groupings of cash flow elements the same as the cube. In this example, lets select AFIT
PW at RATE 3# as our decision variable.

The objective measure is then displayed as follows;

You could also define a ratio as a decision variable if this is your choice by clicking on
ratio and selecting related numerator and denominator elements.

If your objective is related to the data in certain year, you could also select a decision
variable with specified year.

Setting Up Goals &Constraints

After setting up objective function, click on Set Goal(s) & Constraint(s) tab. At the
following display, you could enter the measures (variables) for goals/constraints. These
variables could be time series, non-time series, or ratio type of data. Again, you could
choose any elements of your cash flow as goals/constraints since you have dynamic link
to ARIES Portfolio Cube and all its data. To select the measure, click on the single arrow
key.

If you are entering goals/constraints for each year, enter the year in the box given for
Start Year or select the year from the drop down box. Then select the bound depending
on the nature of the targets /constraints (Min or Max), and enter the value for it in the box
given below the bound.
For example, if you have capital constraint, you will have maximum bound for a given
amount of available budget. (Example below shows a max of $18MM Capital.) With the
maximum bound, optimizer will find a solution for this variable between minus infinity
to the value entered as maximum bound if there is solution. If there is a production
target, you should at least meet the target so that minimum bound will be the choice of
selection. With the minimum bound, optimizer will find a solution for this variable
between minimum levels (value entered) to positive infinity if there is solution.

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You could also define a percentage increase or decrease for a selected variable with an
initial value given at the start year over a selected period of time. In the following
example, a minimum requirement of a 2% increase in appraised sold volume for oil over
nine years starting from year 2002 and ending at year 2010 is introduced as follows;

After data entered, click on ADD to write goals/constraints to the inputs files of
optimizer. Data is also summarized on the screen as follows;

For changing an entry, in the summary part of the screen (upper pane), highlight the line,
this brings the existing entry and then make the change and click on Modify to confirm
the change on the screen.
To delete, you should also highlight the line and click on DELETE button.

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Selecting the Opportunity Set for the Portfolio

To determine the data set for the portfolio optimization click on the Select Data tab.
Following display then pops up on your screen.

User is able to use any level of organizational structure with the preferred scenario for
optimization. You might select to include all properties or part of them in the portfolio
and in this case then decision level in the portfolio optimization will be property level.
You could also select aggregated data for portfolio optimization such as field level, or
business unit level.
In the screen above, the left pane shows all cube data. If you do right click on mouse and
select expand list, you could show how the data is laid out in the cube according to
organizational tree. If you would like to collapse the tree, click on Collapse.

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You could also select all or partial data for the portfolio optimization by either right
clicking on Select or clicking on single arrow key (>). If you would like to remove a
property or any level, highlight it then use left single arrow (<) key) to take it out from
portfolio optimization or right click and click on remove. You could also use left
double arrow key to empty the selected properties from optimization and start over again
(<<) or right click and click on remove all.
The right pane below shows the selected opportunity set for the portfolio optimization.

In the selected opportunity set, you could also introduce opportunity specific constraints.
There are three types of opportunity specific information that you could input such as
mode, ranges for participation interest and mutually exclusive groups as summarized the
screen below:

13

Mode and Participation Interests:

The mode shows the status of each opportunity in the opportunity set of the optimization.
When clicking on the drop down box for mode, there are three options; optional, must
do, and omit. Optional is the default choice for each opportunity in the
optimization with the ranges of min of 25% and maximum of 100% unless otherwise
defined. When optional is selected for the project, the optimizer could either select that
opportunity or not depending on the conditions of optimization problem. If must do is
selected for an opportunity, you could either select the default range for participation
interest for the opportunity, or you could even define a certain participation interest to
project by setting up min and max level to the same number. Optimizer will then always
pick up that opportunity in the solution with given participation interest or with a
participation interest in the range selected. Selecting omit will result in leaving out the
opportunity from the solution.
Hints: To assign same flags for multiple projects, highlight multiple projects by holding
control key and assign the mode and range then click on update. After all the selections
made, click on View to see the all selected choices. Following report then shows up
summarizing all the entries.

14

Mutually Exclusive Groups;

In the opportunity set, if there are surrogates, or different versions of same opportunities
representing delays, some technological enhancements, you could create mutually
exclusive groups for these opportunities. Optimizer is then going to select only one
opportunity from each mutually exclusive group in the solution in addition to other
selected opportunities.
Hint: To create mutually exclusive groups, build surrogates or different scenarios of same
model and include in your cube. In the right pane, highlight multiple projects of mutually
exclusive group and select yes to confirm creating mutually exclusive group, and give
a name for the group in the space given next to group and click on Update. When you
create a group, this group will then be displayed on the drop down box to modify or
update.

15

After creating mutually exclusive groups, click on view to see the summary of all
opportunity specific information that is going to be used in the optimization.

Setting up Run Mode & Parameters;

After defining optimization problem by selecting objective function, goals/constraints,
and data, you should set up the run mode and parameters by clicking on the tab Run
Optimization.
Run mode defines the range in which optimizer will look for a solution. Lower limit
represents the range from a given or defaulted value to positive infinity.
Upper limit represents the range from minus infinity to given or defaulted value.

16

After describing the run mode, you could define the Run Parameters to run optimizer.
Since a simulation optimization approach (OptQuest) is used in the optimization
algorithm, you could run any optimization problem either by choosing time or number of
iterations. Optimizer is then start to a solution with a vector of combinations of the
opportunities and it goes through every possible solution for each additional iteration or
time period.
(See appendix for the details of third part optimization algorithm OptQuest and
methodology of Opt Quest).

When automatic stop is selected, optimizer will stop after the number of iterations where
the objective value is almost the same.
After setting up the run parameter, you should give a description to the portfolio. If you
would like to run optimizations right the way, then click on optimize. This function
will also save the portfolio automatically. If you would like to run optimization later,
click on save, then optimization problem will be saved with the given description to be
run later.

17

When you click on Optimize, the Optimization Performance Graph shows the
objective function value for each iteration dynamically. In the example below,
optimization stops at 5000 iterations. If automatic stop was selected, optimizer would go
through iterations, and it would automatically stop when it could not find much different
result for the objective value.

When clicked on optimize, above screen shows all entries and output during the
optimization at the Run Optimization section.

18

After total number of iterations or time is reached in the optimization, following report is
produced automatically. Optimization Report gives the participation interest for each
opportunity and also gives the contribution of each opportunity in objective value.

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PORTFOLIO BUILDING with the USER DEFINED OPTION

In this section, you will use User Defined option to create portfolios by assigning
participation interest to the opportunities of choices manually. You could then analyze
what if scenarios and the volatility of cash flow elements for each scenario created.
In this approach, first, you should define the objective by selecting a measure. In the
example below, P/I Ratio (PWof AFIT NET/ APPRAISED TOTALINVESTMENT
W/O RISK) are used as objective measure.

In the user defined (manual) portfolio, you could still input the goals/constraints. These
are then used in the Reports&Graphs of the Portfolio Manager to show the values
achieved in the manual portfolio vs. goals&constraints. In the example above, in addition
to using P/I ratio as objective, we would like to see this portfolios performance against
2% increase for gas production. Therefore, following constraints are entered for each
year between the years 2002 and 2010.

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You could then click on the Select Data Tab and build your manual portfolio by
assigning participation interests to the opportunities. If you use single arrow key (>),
100% will be assigned to the selected opportunities. If you would like assign partial
ownership, use (1/x) key and Set Percentage and click on ok.

You could also click on view to see the assigned participation interests for the
opportunities.

Portfolio Managers, Reports&Graphs are then used to test feasibility of these

portfolios.

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Functions of the Portfolio Manager;

Under the Portfolio Manager, there are two main sections; Portfolio(s) and
Reports&Graphs.
In the Portfolio(s), there are list of list portfolios either grouped under Single which
is built using optimizer or Manual which is built manually. Click on expand to see
all available portfolios. Then, highlight the portfolio of interest. You could load this
portfolio or delete or rename it.
If the portfolio optimization is not run yet, you could highlight these portfolios and bring
to the right pane, and then you could summit a batch optimization for selected
optimization problems.

In the Report(s) & Graph(s), standard reports/graphs are provided for selected
portfolio or group of portfolios. The reports and graphs assure consistency in
presentation and reporting and also make it easier to compare portfolio results and define
what the best portfolio is for the company given goals and constraints and available
opportunities.

22

Analyzing Portfolios Using Portfolio Managers - Reports & Graphs;

Portfolio Manager Reports and Graphs are the outputs of an optimized portfolio(s) or a
manual portfolio. For all the reports and graphs, the source data resides at the cube and
either manually assigned participation interests or optimizers solution is applied to
source data to produce reports and graphs.
To have access to the reports and graphs, click on the Portfolio Manager, and then click
on the Report(s) & Graph(s). From the list of optimized portfolios, select the
optimized portfolio that needs to be displayed, and then click on OK.

When click on OK, the Reports & Graphs part of the Portfolio Manager is opened
with the summary information about the selected optimized portfolio from the list;

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Following summary information is then displayed for the portfolio of choice;

Reviewing Portfolio Manager Reports;

To review Portfolio Manager Reports, click on the reports.

There are four different types of reports available as follows: Cash Flow Elements (nontime), Cash Flow Elements (Time-Series), Portfolio Comparison, and Summary of
Optimization Problem.
These reports will be analyzed in more detail in the following section;
24

Cash Flow Elements (Non-Time) Report;

This report is designed to pull the data from one-line table of ARIES. In the template
below, the rows show the selected elements from the one-line table, the columns show
the selected scenarios. Any selection in the reports can be modified very easily. The
selection for rows are made by double clicking on the account and then double clicking
on the list on the selector box and selecting measures of interest under the economic
summary listing. The selection for columns are also made by double clicking on
Economic Scenario and double clicking on List on the selector box, selecting
scenarios of interest under the economic summary listing.

To change the list of cash flow elements, double click on Account;

25

On the selector box, click on the list, and from the Selected Accounts, highlight
accounts that you would like to remove and click on Remove, then highlight the
accounts needs to be displayed from the Available Accounts list and click on Add.
And then click on Ok to confirm the selection.

In addition to above changes, in the selector box for scenarios, only three scenarios are
selected and following format is observed for the report.

The format is very flexible both in the reports and graphs. You could drag and drop any
other dimension either under the rows or under the columns. To drag and drop, single
click on the dimension and hold it and then drop it either under the row or under the
column when you see an arrow.

26

When the different product types are included under the rows, the format of the report is
as follows;

You could also swap the rows and columns or with any other dimension. Click on the
dimension and hold it and bring on top of the dimension to be swapped. When you see
the sign, drop it.)

The rows and columns are swapped in the following example.

Economic Scenario is swapped with Portfolios in the default template.

27

You could also transfer the data to excel with all the details. To do this, click on the
corner of the template and hit on Control+C and paste in the excel.

When pasted to excel, the data is transferred with all the details;

28

Cash Flow Elements (Time Series) Report;

Cash Flow Element- Time Series Report is designed to pull the time series data from
detail table of Aries database. You could select any optimized portfolio from the drop
down box, and select the time frame and cash flow elements of interests from the time
and account lists for a scenario and reserve category of the interest. An example
template is as follows;

29

Portfolio Comparison Report

With this report, it is easy to compare participation interests for different portfolio
optimizations as well as selected objective measure, level of optimization, scenario.
Comparison of three different portfolios is displayed in the example below;

30

Summary of Optimization Problem;

This report summarizes the optimization problem and some of its results. Selected
column shows the details of optimization problem such as objective function, entries for
goals and constraints, mutually exclusive groups if there is any, and entries for asset level
requirements such as must do, optional, omit flags.
Calculated column on the other hand summarizes computed values for optimized
portfolios such as return values, and computed values of all the goals and constraints as
displayed in the example below;

31

Reviewing Portfolio Manager Graphs

To review Portfolio Manager Graphs, on the menu click on the graphs.
There are two main groups of graphs available for any portfolio.
Portfolio Performance Graphs includes the templates for non-time and time series data.

Portfolio Comparison Graphs includes following subcategories which will be given in

more detail below;

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Portfolio Performance Graph Time Series

Values of any cash flow element for the selected time period is displayed in the 3D
format in the template given below as one of the example of portfolio performance
graphs with the time series data. The format of the graphs is flexible. One could right
click on the white area of the graph and find Graph Type and then could select any
graph type desired.

33

Portfolio Performance Graph Non-Time Series

Values of selected one-line table elements for the selected portfolios are displayed in the
bar graph format in the template given below as one of the example of portfolio
performance graphs with non-time series data. The format of the graphs is flexible. One
could select any graph type from the list to change the graph format. The graph could
show different categories of reserves by choosing different levels from the drop down
box for reserve categories.

Portfolio Comparison Asset Selection Graph;

Asset Selection graph shows the selected participation interests of the projects for each
portfolio. You could then easily compare how projects are selected in different
portfolios.

34

To set of the format of this graph, double click on PORTFOLIO dimension and on the
selector box, goto the list, and from the list of optimized portfolios highlight the
portfolios that you want to compare and click on select. You could also double click
on Organization and goto the list and Select all or partial projects for the comparison.

35

Portfolio Comparison Cash Flow Elements /Overlay Graph;

Cash Flow Elements/Overlay Graph is designed to compare the trend in the cash flow
elements for different optimizations.
If you double click on ACCT and goto the selector box and double click on list, you
should be able to see all the available elements that you captured at the cube as a choice
of selection for display of account.
In the following example, 6 accounts are selected to be compared for 5 different
portfolios over 10 years for 9 economic scenarios. Keep in mind that you could drill
down any of the dimensions by selecting from the drop down box related to the
dimension.

36

Portfolio Comparison Cash Flow Elements /

Cross Plots- Non-Time and Time Series Graphs
Cash Flow Elements - Cross Plot graphs are designed to overlay result of cross plots of
different portfolios in one space. The data used could be either time series or non-time
series type of data from the cash flow elements captured.
Non-Time Series data is used in the following example ;( Double click on Portfolio and
from the list, select the choice of portfolios to be compared, Double click on account to
select two cash flow elements; AFIT PW at 12%discount rate, and WI Total Operating
.Cost_ AD Valorem Tax)

37

Next example shows the comparison of portfolios for Gross Input Schedule for Oil vs.
Gross Input Schedule for Gas at year 2004 for base scenario with total reserves.

Portfolio Performance Goals/Targets vs. Estimated /

Value Graph
In this graph, you could display your goals/constraints versus the values achieved for the
optimized portfolio in the same space.

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In the following example, for the three optimization problems (portfolios), Appraised
Oil Sold vs. Target Production Growth which is a minimum requirement of 2% over
8 years are displayed. Production growth expected to be as 2% over nine years starting
60,000 MBarrels at 1998 and ending at the rate of 70,298 MBarrels at 2006. (Notice that
scale is different for the portfolio values and the target values.) When the results of
three optimization problems are compared, it is concluded that optimizer finds project
mix for each portfolio over 9 years with much higher production than minimum
production requirement. On the other hand, when optimizer is not used, the manual
portfolio selected using P/I ranking can not meet the minimum production requirements
for any of the eight years.

39

CONCLUSIONS
ARIES Portfolio Optimizer helps managers to make better and more efficient decisions
by aligning goals, strategies and opportunities of the company. There is a dynamic link
between the multi-dimensional data cube build with The ARIES Portfolio - Cube Tools
and the ARIES Portfolio Optimizer. Due to this seamless integration, it is easy to
define and pull any data for defining the optimization problem
ARIES Portfolio Optimizer uses state of the art portfolio optimization algorithm (Opt
Quest) and evaluates acceptability of projects based on its contribution to the portfolio as
a whole and identifies optimum project mix given corporations strategy, risk preferences
and capital limitations. In the Appendix, a SPE paper is attached as reference for the
theory and methodology of the state of the art optimization algorithm, Opt Quest.
Users could also create and test different scenarios by assigning participation interest to
the projects of choices using the option user defined under the section building
portfolio.
Using ARIES Portfolio Optimizers flexibilities and reporting and graphing capabilities,
you could ask the right questions to find the optimal choice of investment opportunities
and run what if scenarios and identify tactical decisions in alignment with your goals,
strategies and identified investment opportunities.
End result will be better and more efficient decisions for the corporations.

40

APPENDIX
SPE 82009
Advanced Optimization Methodology in the Oil and Gas Industry:
The Theory of Scatter Search Techniques with Simple Examples

J.April1, F. Glover1, J. Kelly1, M. Laguna1 M. Erdogan2, B. Mudford2, D. Stegemeier2

1
OptTek Systems, Inc.
2
Landmark Graphics Corporation

Copyright 2003, Society of Petroleum Engineers Inc.

This paper was prepared for presentation at the SPE Hydrocarbon Economics and Evaluation Symposium held in Dallas, Texas, U.S.A., 58 April 2003.
This paper was selected for presentation by an SPE Program Committee following review of information contained in an abstract submitted by the author(s).
Contents of the paper, as presented, have not been reviewed by the Society of Petroleum Engineers and are subject to correction by the author(s). The material,
as presented, does not necessarily reflect any position of the Society of Petroleum Engineers, its officers, or members. Papers presented at SPE meetings are
subject to publication review by Editorial Committees of the Society of Petroleum Engineers. Electronic reproduction, distribution, or storage of any part of this
paper for commercial purposes without the written consent of the Society of Petroleum Engineers is prohibited. Permission to reproduce in print is restricted to an
abstract of not more than 300 words; illustrations may not be copied. The abstract must contain conspicuous acknowledgment of where and by whom the paper
was presented. Write Librarian, SPE, P.O. Box 833836, Richardson, TX 75083-3836 U.S.A., fax 01-972-952-9435.

Abstract
A primary purpose of senior management is to make decisions around capital allocation that will improve
the performance of the corporation. Portfolio analysis tools are designed to aid senior management in the
development and analysis of portfolio strategies, by giving them the capability to assess the impact on the
corporation of various investment decisions. To date most of the commercial portfolio optimization
packages have been relatively inflexible and are often not able to answer the key questions asked by senior
management. In this paper we will present new techniques that increase the flexibility of optimization tools
and deepen the types of portfolio analysis that can be carried out. A new optimization engine, which
contains state-of-the-art optimization functionality, allows users to simultaneously address financial return
goals, catastrophic loss avoidance, and performance probability. These innovations enable users to
confidently design effective plans for achieving financial goals, by employing accurate analysis based on
real data. Traditional analysis and prediction methods are based on mean variance analysis, which is known
to be faulty. The new techniques take a more sophisticated and strategic direction. State-of-the-art
technology integrates optimization and simulation techniques into a global system that guides a series of
evaluations to reveal truly optimal investment scenarios. Specifically, the new optimization techniques use
an evolutionary approach called scatter search, reinforced by the adaptive memory strategies of tabu search.
The software integrates state-of-the-art metaheuristic procedures, including Tabu Search, Neural Networks,
and Scatter Search, into a single composite method. We will give some examples that highlight the
importance and flexibility of the techniques applied to E&P portfolios.
Introduction
Portfolio optimization for capital investment is often too complex to allow for tractable mathematical
formulations. Nonetheless, many analysts force these problems into standard forms that can utilize
traditional optimization technologies such as linear and quadratic programming. Unfortunately, such
formulations omit key aspects of real world settings resulting in flawed solutions based on invalid
assumptions. In this paper we focus on a flexible modeling and solution approach that overcomes these
limitations.

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Background
The beneficiaries of the technology discussed here include C level executives responsible for deciding
capital investments and accountable for their performance, finance department analysts charged with
developing the capital budget analysis and a project portfolio management plan, and technology managers
responsible for planning and implementing projects. Their needs, which provide compelling reasons to use
the technology, are:
Technology managers and corporate financial executives are dissatisfied with current way they
address risk tolerance.
They are under continual pressure to improve capital investment performance.
They need technology that improves the understanding of the analysis and clearly identifies the
reasons to make specific investment decisions.
They are concerned that their competition may be adopting a new and more advanced technology.
Capital investment within commercial firms is primarily accomplished with traditional analyses that
include net present value analysis and mean-variance analysis. Although there are many methods being
used to enable capital decisions, there are certain conventions that have become standardized through
implementation practices. Consequently, many organizations use similar methods to evaluate and select
capital spending options and monitor their performance.
Many organizations evaluate their capital projects by estimating their "net present value." Net present
value (NPV) is calculated by projecting the future cash flows the investment is likely to generate,
"discounting" the future cash flows by the cost of capital, and then subtracting the initial investment.
According to conventional wisdom, it makes economic sense to undertake projects if their NPVs are
positive. But this does not guarantee they will be funded. Organizations typically take other factors into
consideration, which incorporate their ability to fund the initial investment given their debt position, their
current operating expenses and cash flow positions, and their strategic considerations including financial
performance expectations.
Determining how to allocate investment capital in order to maximize returns is a ubiquitous challenge
where approaches to solutions cover a very wide spectrum. In organizations both public and private, the
decisions of committing limited resources to a variety of uses can either strengthen or deteriorate the very
financial foundation of the organization itself. On one end of the spectrum, and at the core of sophisticated
financial manuals, capital budgeting procedures many times employ traditional operations research theories
and techniques to guide and support decisions. On the other end, and anecdotally, many executives admit
that selections come down to mustering intuition, combined with seat-of-the-pants guestimates, and
peppered with squeaky wheel assignments.
Typically, however, what is common in this arena is building models, which employ pro forma plans
centering around measures of the benefits of the investments- the returns, time horizons over which the
investments are being made, and estimates of the risks or uncertainty involved. The list of measures
expands to include such considerations as cash flow, cost of capital, market share, etc.
Evaluations of alternatives are made as well in a variety of ways. From one-at-a-time comparisons of
returns and risks to more sophisticated portfolio optimization and real option theories, organizations run the
gamut in the ways they decide to allocate capital. In the companies using these sophisticated methods,
which go beyond single project net present value analysis, many portfolio management methods include
mean variance analysis.
In a seminal paper in 1952 in the Journal of Finance, Harry Markowitz laid down the basis for the
modern portfolio theory (Markowitz, H., 1952). For his path-breaking work that has revolutionized
investment practice, he was awarded the Nobel Prize in 1990. Markowitz focused the investment
profession's attention to mean-variance efficient portfolios. A portfolio is defined as mean-variance
efficient if it has the highest expected return for a given variance, or, equivalently, a portfolio is defined as
mean-variance efficient if it has smallest variance for a given expected return.
In Figure 1, the curve is known as the efficient frontier and contains the mean-variance efficient
portfolios. The area below and to the right of this mean-variance efficient frontier contains various risky
assets or projects. The mean-variance efficient portfolios are combinations of these risky projects.

42

Why are mean-variance portfolios important? Decision makers are risk-averse.

They prefer portfolios with high expected returns and low risk. Another important
question: How is the risk of a portfolio measured? If portfolio returns are normally
distributed, then its risk can be measured by its variance. However, a substantial body of
empirical evidence suggests that actual portfolio returns are not normally distributed
(McVean, J.R., 2000).
If actual portfolio returns are not normally distributed, then variance is not the appropriate risk measure
for a portfolio. If not variance, what is an appropriate risk measure for a portfolio?

Expected
Return

Efficient
Frontier

Variance of Return
Fig. 1- Efficient Frontier

In practice, mean-variance efficient portfolios have been found to be quite unstable: small changes in
the estimated parameter inputs lead to large changes in the implied portfolio holdings. The practical
implementation of the mean-variance efficient paradigm requires determination of the efficient frontier.
This requires three inputs: expected returns of the projects, expected correlation among these projects, and
expected variance of these projects (individually). Typically, these input parameters are estimated using
either historical data or forecasts. Researchers have found that estimation errors in these input parameters
overwhelm the theoretical benefits of the mean-variance paradigm.
Now, as cracks in the foundation are becoming too conspicuous to ignore and capital budgeting
participants have been dedicated to traditional ideas for so long that they are not able to pull away, even at
the expense of policies that severely hamper their financial growth.
Efforts by more progressive analysts to sound the alert about the crumbling structure underlying
mainstream capital budgeting and investment strategies have not been lacking. Still, the best response has
been to cobble together various ad-hoc measures in an attempt to shore up the framework, or erect a
makeshift alternative. Recognition that this response is far from ideal has persuaded many to cling to the
old ways, in spite of their apparent defects. The inability to devise a more effective alternative has been
due in large part to limitations in the technology of decision-making and analysis, not only in the area of
investments but in other areas of business alike, which has offered no reliable method to conquer the
complexity of problems attended by uncertainty. As a result, the goal of evaluating investments
effectively, and to account appropriately for tradeoffs between risk and potential return, has remained
incompletely realized and ripe for innovation.
Over the last several years, alternative technologies (methods) have emerged for optimizing decisions
under uncertainty. The outcome of this development has begun to penetrate planning and decision-making

43

in many business disciplines, making it possible to study viable solutions to models that are much more
flexible and realistic than those treated in the past. In application to the areas of capital budgeting and
investment, these alternative technologies are being implemented to create portfolio and asset-allocation
strategies to improve performance. Included in these alternative technologies are agent-based modeling for
portfolio optimization, genetic algorithms for portfolio optimization, and real options analysis for capital
spending. All of these technologies seek to improve on the traditional methods by introducing more
flexible, robust, and realistic assumptions and providing more powerful and sophisticated analysis and
forecasting tools. Companies marketing these alternative technologies include The Bios Group, Insightful,
Merak, United Management Technologies, Glomark, and Portfolio Decisions, Inc.
To date the largest penetration for these technologies have been in academic circles while achieving
only a modicum of success in the marketplace. This indicates that commercial applications of alternative
technologies are still in the early adoption stages.
Optimization Methods
The complexities and uncertainties in complex systems are the primary reason that simulation is often
chosen as a basis for handling the decision problems associated with those systems. Consequently,
decision makers must deal with the dilemma that many important types of real world optimization
problems can only be treated by the use of simulation models, but once these problems are submitted to
simulation there are no optimization methods that can adequately cope with them.
Advances in the field of metaheuristicsthe domain of optimization that augments traditional
mathematics with artificial intelligence and methods based on analogs to physical, biological, or
evolutionary processeshave led to the creation of optimization engines that successfully guide a series of
complex evaluations with the goal of finding optimal values for the decision variables. One of those
engines is the search algorithm embedded in the OptQuest optimization system developed by OptTek
System, Inc.. OptQuest is designed to search for optimal solutions to the following class of optimization
problems:
Max or Min F(x)
Subject to
Ax b
(Constraints)
gl G(x) gu (Requirements)
lxu
(Bounds)
where x can be continuous or discrete.
The objective F(x) may be any mapping from a set of values x to a real value. The set of constraints
must be linear and the coefficient matrix A and the right-hand-side values b must be known. The
requirements are simple upper and/or lower bounds imposed on a function that can be linear or non-linear.
The values of the bounds gl and gu must be known constants. All the variables must be bounded and
some may be restricted to be discrete with an arbitrary step size.
A typical example might be to maximize the net present value for a portfolio by judiciously choosing
projects subject to budget restriction and a limit on risk. In this case, x represents the specific project
participation levels F(x) is the expected net present value. The budget restriction is modeled as Ax b and
the limit on risk is achieved by a requirement modeled as G(x) gu where G(x) is percentile value. Each
evaluation, of F(x) and G(x) requires a Monte Carlo simulation of the portfolio. By combining simulation
and optimization, a powerful design tool results.
The optimization procedure uses the outputs from the system evaluator, which measures the merit of the
inputs that were fed into the model. On the basis of both current and past evaluations, the optimization
procedure decides upon a new set of input values (see Figure 2).
The optimization procedure is designed to carry out a special non-monotonic search, where the
successively generated inputs produce varying evaluations, not all of them improving, but which over time
provide a highly efficient trajectory to the best solutions. The process continues until an appropriate
termination criterion is satisfied (usually based on the users preference for the amount of time to be
devoted to the search).

44

Output

Optimization
Procedure

Input

System
Evaluator

Fig. 2- Coordination Between Optimization and Evaluation

Project Portfolio Optimization

In many industries, strategic planning requires executives to select a portfolio of projects for funding that
will likely advance the corporate goals. In general, there are many more projects than funding can support
so the selection process must intelligently choose a subset of projects that meet the companies profit goals
while obeying budgetary restrictions. Additionally, executives wish to manage the overall risk of a
portfolio of projects and ensure that cash flow and other such accounting type constraints are satisfied.
The Petroleum and Energy (P&E) industry uses project portfolio optimization to manage its
investments in the exploration and production of oil and gas. Each projects proforma is modeled as a
simulation capturing the uncertainties of production and sales.
The application illustrated here involves five potential projects with ten year models that incorporate
multiple types of uncertainty in drilling, production, and market conditions. We examined multiple cases to
demonstrate the flexibility of the software to enable a variety of decision alternatives. We present a
standard case and one that utilizes the power of simulation optimization.

Case 1

In case 1, the decision was to determine participation levels [0,1] in each of the five
projects with the objective of maximizing expected net present value of the portfolio
while keeping the standard deviation of the net present value of the investment below a
specified threshold. This is the traditional Markowitz approach. In this case, all projects
must begin in the first year.
Maximize E(NPV)
While keeping 10,000 M$
All projects must start in year 1

In this case, the best investment decision resulted in an expected net present value of
approximately $37,400 M with a standard deviation of $9,500 M. Figure 3 shows the
corresponding non-normal NPV distribution.
Forecast: NPV
1,000 Trials

Frequency Chart

16 Outliers

.028

28

.021

21

.014

14

.007

7
Mean = $37,393.13

.000
$15,382.13

$27,100.03

$38,817.92
M$

$50,535.82

0
$62,253.71

Fig. 3- Case 1 NPV Distribution

45

Case 2
The goal was to determine participation levels in each project where starting times for each project
could vary and we would maximize the probability of exceeding the expected net present value of $47,500
M (which was achieved in a previous analysis). Risk was controlled by limiting the 10th Percentile of
NPV.

Maximize Probability(E(NPV) 47,455 M$)

While keeping 10th Percentile of NPV 36,096 M$
All projects may start in year 1, year 2, or year 3

Forecast: NPV
1,000 Trials

Frequency Chart

13 Outliers

.032

32

.024

24

.016

16

.008

8
Mean = $83,971.65

.000
$43,258.81

Fig. 4-

$65,476.45

$87,694.09
M$

$109,911.73

0
$132,129.38

Case 2 NPV Distribution

In this case, where starting times could vary, and we wanted to maximize the chance of exceeding
the net present value of $47,500 M, the best investment decision resulted in an expected net present value
of approximately $84,000 M with a standard deviation of $18,500 M. The NPV had a 99% probability of
exceeding $47,500 M (see Figure 4). This case demonstrates that adopting measures of risk other than
standard deviation can result in superior portfolios. Simulation optimization is the only technology that can
offer these types of analyses.

Scatter Search
The optimization technology used here is the metaheuristic known as scatter search. Scatter search has
some interesting commonalties with genetic algorithms (GA), although it also has a number of quite
distinct features. Several of these features have come to be incorporated into GA approaches after an
intervening period of approximately a decade, while others remain largely unexplored in the GA context.
Scatter search is designed to operate on a set of points, called reference points, which constitute good
solutions obtained from previous solution efforts. Notably, the basis for defining good includes special
criteria such as diversity that purposefully go beyond the objective function value. The approach
systematically generates combinations of the reference points to create new points, each of which is
mapped into an associated feasible point. The combinations are generalized forms of linear combinations,
accompanied by processes to adaptively enforce constraint-feasibility and encourage requirementfeasibility.
The scatter search process is organized to (1) capture information not contained separately in the
original points, (2) take advantage of auxiliary heuristic solution methods (to evaluate the combinations
produced and to actively generate
new points), and (3) make dedicated use of strategy instead of randomization to carry out component steps.
Figure 5 sketches the scatter search approach in its original form. Extensions can be created to take
advantage of memory-based designs typical of tabu search (Glover and Laguna, 1997). Two particular
features of the scatter search proposal deserve mention. The use of clustering strategies has been suggested

46

for selecting subsets of points in step 2, which allows different blends of intensification and diversification
by generating new points within clusters and across clusters. Also, the solutions generated by the
combination method in step 2 are often subjected to an improvement method, which typically consists of a
local search procedure. The improvement method is capable of starting from a feasible or an infeasible
solution created by the combination method.

1. Apply a diversification generation

method to build a starting set of
solutions. Designate a subset of
the best points (judged by quality
and diversity) to be reference
points.
while (stopping criteria are not
satisfied) {
2. Form combinations of subsets
of the current reference points
to create new points. The
combinations are (a) chosen
to produce points both inside
and outside the convex region
spanned by the reference
points, and (b) modified by
generalized mapping
processes to yield feasible
points according to the
constraints in the problem
(both linear and integrality
constraints).
3. Update the reference set by
selecting points that can
improve the quality and/or
diversity of the set.
Fig. 5- Scatter search outline

It is interesting to observe similarities and contrasts between scatter search and the original GA
proposals. Both are instances of what are sometimes called population based or evolutionary
approaches. Both incorporate the idea that a key aspect of producing new elements is to generate some
form of combination of existing elements. However, GA approaches are predicated on the idea of choosing
parents randomly to produce offspring, and further on introducing randomization to determine which
components of the parents should be combined. By contrast, the scatter search approach does not

47

emphasize randomization, particularly in the sense of being indifferent to choices among alternatives.
Instead, the approach is designed to incorporate strategic responses, both deterministic and probabilistic,
that take account of evaluations and history. Scatter search focuses on generating relevant outcomes
without losing the ability to produce diverse solutions, due to the way the generation process is
implemented. For example, the approach includes the generation of new points that are not convex
combinations of the original points. The new points constitute forms of extrapolations, endowing them
with the ability to contain information that is not contained in the original reference points.
Scatter search is an information-driven approach, exploiting knowledge derived from the search space,
high-quality solutions found within the space, and trajectories through the space over time. The
incorporation of such designs is responsible for enabling the optimizer (which is called OptQuest) to
efficiently search the solution space of optimization problems in complex systems.
To learn more about scatter search refer to the tutorial articles by Glover (1998), Glover, Laguna and
Mart (1999 and 2000), Laguna (2000) and Laguna and Armentano (2001). Recent applications of scatter
search include the linear ordering problem (Campos, et al. 1999 and Campos, Laguna and Mart 1999),
permutation problems (Campos, Laguna and Mart 2001), transportation (Corbern, et al. 2000), nonlinear
optimization (Laguna and Mart 2000) and machine scheduling (Laguna, et al. 2000).
The Optimizer
The optimizer seeks to find an optimal solution to a problem defined on a vector x of bounded variables.
That is, the user can define several types of optimization problems depending on the combination of
variables:

Pure continuous
Pure discrete (including pure binary problems)
Mixed problems (continuous-discrete, continuous-permutation, discretepermutation or continuous-discrete-permutation)

Also, the optimization problem may be unconstrained, include linear constraints and/or requirements.
The optimizer detects small pure discrete or permutation problems to trigger a complete enumeration
routine that guarantees optimality of the best solution found.
The optimizer employs special mechanisms to search for optimal solutions to problems defined with
continuous and discrete variables. Similar mechanisms are used to tackle pure or mixed permutation
problems and details can be found in Campos, Laguna and Mart (2001). The scatter search method
implemented in the optimizer begins by generating a starting set of diverse points. This is accomplished by
dividing the range of each variable into 4 sub-ranges of equal size. Then, a solution is constructed in two
steps. First, a sub-range is randomly selected. The probability of selecting a sub-range is inversely
proportional to its frequency count (which keeps track of the number of times the sub-range has been
selected). Second, a value is randomly chosen from the selected sub-range. The starting set of points also
includes the following solutions:

All variables are set to the lower bound

All variables are set to the upper bound
All variables are set to the midpoint x = l + (u-l)/2
Other solutions suggested by the user

A subset of diverse points is chosen as members of the reference set. A set of points is considered
diverse if its elements are significantly different from one another. The optimizer uses a Euclidean
distance measure to determine how close a potential new point is from the points already in the reference
set, in order to decide whether the point is included or discarded.
When the optimization model includes discrete variables, a rounding procedure is used to map
fractional values to discrete values. When the model includes linear constraints newly created points are
subjected to a feasibility test before they are sent to the evaluator (i.e., before the objective function value
F(x) and the requirements G(x) are evaluated).

48

Note that the evaluation of the objective function may entail the execution of a simulation, and
therefore it is important to be sure to evaluate only those solutions that are feasible with respect to the set of
constraints. For ease of notation, we represent the set of constraints as Ax b, although equality
constraints are also allowed. The feasibility test consists of checking (one by one) whether the linear
constraints are satisfied. If the solution is infeasible with respect to one or more constraints, the optimizer
formulates and solves a linear programming (LP) problem. The LP (or mixed-integer program, when x
contains discrete variables) has the goal of finding a feasible solution x* that minimizes a deviation between
x and x*. Conceptually, the problem can be formulated as:
Minimize

d +d+

subject to

Ax* b

x x* d + d + = 0
l x* u
d, d+ 0

where d and d + are, respectively, negative and positive deviations of x* from the
infeasible point x. The implementation of this mechanism within the optimizerincludes a
scaling procedure to account for the relative magnitude of the variables and adds a term
to the objective function to penalize maximum deviation. Also, the optimizer treats pure
binary problems differently, penalizing deviations without adding deviation variables or
constraints. When the optimization problem does not include constraints, infeasible
points are made feasible by simply adjusting variable values to their closest bound and
rounding when appropriately. That is, if x > u then x* = u and if x < l then x* = l.
Once the reference set has been created, a combination method is applied to initiate
the search for optimal solutions. The method consists of finding linear combinations of
reference solutions. The combinations are based on the following three types, which
assume that the reference solutions are x and x :
x = x d
x = x + d
x = x d

Where d = r

x x
and r is a random number in the range (0, 1). Because a different
2

value of r is used for each element in x, the combination method can be viewed as a
sampling procedure in a rectangle instead of a line in a two dimensional space (see
Ugray, et al. 2001). The number of solutions created from the linear combination of two
reference solutions depends on the quality of the solutions being combined. Specifically,
when the best two reference solutions are combined, they generate up to 5 new solutions,
while when the worst two solutions are combined they generate only one.
In the process of searching for a global optimum, the combination method may not be
able to generate solutions of enough quality to become members of the reference set. If
the reference set does not change and all the combinations of solutions have been
explored, a diversification step is triggered (see step 4 in Figure 4). This step consists of
rebuilding the reference set to create a balance between solution quality and diversity. To
preserve quality, a small set of the best (elite) solutions in the current reference set is used

49

to seed the new reference set. The remaining solutions are eliminated from the reference
set. Then, the diversification generation method is used to repopulate the reference set
with solutions that are diverse with respect to the elite set. This reference set is used as
the starting point for a new round of combinations.
Conclusions
The approach discussed here brings intelligence to software for corporate decision-making, and gives a new
dimension to optimization and simulation models in business and industry. The system empowers decision
makers to look beyond conventional decision-making approaches and actually pinpoint the most effective
choices in uncertain situations. The concepts discussed in this paper should allow senior management to
maximize financial return while accurately measuring and controlling risk.
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