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Issue : Vol. 4 - issue 1 May 2006

Application of Portfolio Management to Optimize Capital Allocation in Oil and Gas Projects by B. Lubiantara

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APPLICATION OF P ORTFOLIO M ANAGEMENT TO OPTIMIZE C APITAL ALLOCATION IN OIL AND G AS PROJECTS
BENNY L UBIANTARA

ABSTRACT Oil and gas companies are constantly faced with decisions on how to invest limited amounts of capital in order to maximize return. The traditional approach to select the projects is usually to rank all available projects using common measures such as NPV, IRR, or Profit to Investment ratio (PI) until all the available capital is exhausted. The main weakness of this traditional approach is that it maximizes expected value but ignores risk. In the capital market world, one method of capital allocation that takes explicit account of risk is the modern portfolio theory, which was initially developed by Markowitz in the 1950s and has been used extensively in stock market investment. The modern portfolio theory allows one to choose sets of efficient portfolios with either the highest level of expected return for a given level of risk, or the lowest level of risk for a given expected return. This paper shows how to apply the modern portfolio theory concept to the problem of capital allocation in oil and gas projects.

INTRODUCTION Generally, the term “portfolio” refers to an investment mix in the financial market. In the case of real assets, a portfolio is defined as a set of possible funding opportunities. The portfolio optimization problem in practice is to select an investment mix to optimize the satisfaction of the investors. Traditionally, the portfolio selection problem is modeled by two different approaches. The first one is based on an axiomatic model of risk-averse preferences, where decision makers are assumed to possess an expected utility function and the portfolio choice
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consists in maximizing the expected utility over the set of feasible portfolios. The second approach, first proposed by Markowitz, is very intuitive and reduces the portfolio choice to a set of two criteria – reward and risk – with possible tradeoff analysis. This paper will discuss the second approach. P ORTFOLIO THEORY In practice, a business will normally invest in a portfolio of investment projects rather than in a single project. The problem with investing all available funds in a single project is, of course, that an unfavorable outcome could have disastrous consequences for the business.

By investing in a spread of projects, an adverse outcome from a single project is unlikely to have major repercussions. Investing in a range of different projects is referred to as diversification, and by holding a diversified portfolio of investment projects, the total risk associated with the business can be reduced. Many finance textbooks explain the total risk relating to a particular project into two elements: diversifiable risk and non-diversifiable risk (Figure 1). • Diversifiable risk is that part of the total risk which is specific to the project, such as reserves, changes in key personnel, legal regulations, the degree of competition, and so on. By spreading the available funds between investment projects, it is possible to offset adverse outcomes occurring in one project against beneficial outcomes in another. Non-diversifiable risk is that part of the total risk that is common to all projects and which, therefore, cannot be diversified away. This element of risk arises from general market conditions and will be affected by such factors as rate of inflation, the general level of interest rates, exchange rate movements, and so on. The most critical non-diversifiable risk for exploration companies is the oil price.

assets. It holds that if a company invests in many independent assets of similar size, the risk will tend asymptotically towards zero. For example, as companies drill more exploration wells, the risk of not finding oil reduces towards zero. Consequently, companies that endorse a strategy of taking a small equity in many wells are adopting a lower risk strategy than those that take a large equity in a small number of wells. However, the economic returns on independent assets are, to a greater or lesser extent, dependent on the general economic conditions and are non-diversifiable. Under these conditions, simple diversification will not reduce the risk to zero but to the non-diversifiable level. Markowitz diversification relies on combining assets that are less than perfectly correlated to each other in order to reduce portfolio risk. Markowitz diversification is less intuitive than simple diversification and uses analytical portfolio techniques to maximize portfolio returns for a particular level of risk. This approach also incorporates the fact that assets with low correlation to each other, when combined, have a much lower risk relative to their return. Using these principles, portfolio optimization is a methodology from finance theory for determining the investment program and asset weightings that give the maximum expected value for a given level of risk or the minimum level of risk for a given expected value. This is achieved by varying the level of investment in the available set of assets. The efficient frontier is a line that plots the portfolio, or asset mix, which gives the maximum return for a given level of risk for the available set of assets. Portfolios that do not lie within the efficient frontier are inefficient in that for

There are two types of diversification: simple and Markowitz. Simple diversification (commonly referred to as market or systematic diversification in the stock market) occurs by holding many

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the level of risk they exhibit, there is a feasible combination of assets that results in a higher expected value and another which gives the same return at lower risk (Figure 2).

The first step: Collect information about all the variables that affect the calculation of the cash flow of one of the projects, and estimate their probability distributions. The second step: For each project, using the Monte Carlo simulation, a number of cumulative discounted cash flows and their matching discounted investments can be generated simultaneously. From these points, the NPV and the semistandard deviation of the NPV of each project can be calculated. The third step: Determine the coefficient of correlation between projects. (The value of this coefficient can range from +1 in the case of perfect correlation, where the two assets move together, to –1 in the case of perfect negative correlation, where the two assets always move in opposite directions. The coefficient is 0 when there is no association between the assets and they are said to be independent.) The fourth step: Perform the optimization using the algorithm explained below and create the efficient frontier curve. P ORTFOLIO OPTIMIZATION Markowitz introduced an intuitive model of risk and return for portfolio selection. This model is useful to guide one’s intuition, and because of its simplicity, it is also commonly used in practical investment decisions. Given a set of n assets, A=(a1, a2,…an) such that each represents a kind of asset (it could be projects, wells, fields, prospects, etc.), each asset ai has associated a real valued expected return (per period) ri, and each pair of assets <ai, aj> has a real-valued covariance sij.

MEASURES OF RISK When “risk” is discussed in relation to the overall return on an investment, the word has come to mean the anticipated potential variability of the actual return from its expected value. Other things being equal, the investment with the greatest range of possible results is said to be the riskiest (Figure 3). The most widely used measure for risk is the variance (sometime standard deviation is used). In a risky environment, variables are not known with certainty but follow probability distributions. With risk, the outcome of a capital investment decision will be a particular value, but that value cannot be known in advance. When risk is present, only the range of values and the associated probabilities can be known or predicted.

P ROPOSED METHODOLOGY The variance is a useful approximation of risk: the aim is to maximize the expected return under a certain level of variance, which is equivalent to minimizing the variance under a certain level of expected return. In order to determine the variance, the Monte Carlo simulation is used. In the case of upstream oil and gas investment, instead of using the variance or standard deviation, the semi-standard deviation is preferable to use as a measure of risk. The proposed methodology is as follows:

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The matrix s n*n is symmetric and each diagonal element s ij represents the variance of asset ai. A positive value D represents the maximum acceptable risk. (Or a positive value R represents the desired expected return.) A portfolio is a set of real values X=(x 1,x2,…xn) such that each x i represents the fraction invested in asset ai. The value Sni=1Snj=1s ijx ixj represents the variance of the portfolio. The formulation problems are: OP1: Given risk, maximize return. The basic problem: max Srix i s.t. Sni=1Snj=1s ijxixj <=D Sxi = 1 0<= xi <= 1 (i=1,…n) OP2: Given return, minimize risk. Min Sni=1Snj=1s ijxixj s.t. Srix i = d Sxi = 1 0<= xi <= 1 (i=1,…n) OP3: Minimizing the risk and maximizing the return Min ?Sni=1Snj=1s ijxix j – (1-?) Sni=1rix i s.t. Sni=1xi = 1 0<= xi <= 1 (i=1,…n) where ? is a parameter 0<?<1. By varying the parameter ? between zero and one, the efficient frontier is computed. The optimization algorithm above is solved using Excel Solver. ILLUSTRATIVE CASE Assume there are 10 oil and gas projects (A to J) available with total investment equal to 3,610 MM $. Investment cost,

NPV, and Profit to Investment (P/I) of each project is shown in Table-1, the budget available is only 2,000 MM $, and the management needs to decide the allocation of this capital budget among the projects. Table-2 shows the approach using the traditional approach to select or rank the projects. Since the budget is only 2,000 MM $, therefore the projects selected are F, G, H, E, I, and C (note that project C is funded only 71%). As mentioned before, this traditional approach is to maximize the return but ignore the risk; Table-3 shows the risk of each project (the risk is the semistandard deviation of NPV obtained from the Monte Carlo Simulation). For illustrative purposes, the coefficient of correlation between projects is assumed to be zero (0), meaning that the projects are independent of each other. Portfolio optimization is performed using Excel Solver to create the efficient frontier curve (Figure 4). ANALYSIS In Figure 5, it can be seen that the portfolio X (maximized return), will have the NPV = 1,090.32 MM $ and Risk = 268.59 MM $; another portfolio (portfolio Y) will have the NPV = 1083.52 MM $ and Risk = 228.53 MM $. In this case, we can see that the management could choose portfolio Y by scarifying the NPV by only 6.8 MM $; meanwhile, the portfolio will significantly reduce the risk by 39.8 MM $. Furthermore, if the management has concerns about the risk, and can only accept a portfolio risk no higher than 200 MM $, then the management could

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consider portfolio Z, which has portfolio risk = 186.28 MM $. The percentages funded of projects in each portfolio (X, Y, Z) can be seen in Table-4. CONCLUSION • Portfolio optimization will provide a trade-off between risk and return. This approach can also quantitatively measure the risk versus return and its implications on the portfolio selection. The creation of the efficient frontier curve from the portfolio optimization does not provide the “final answer.” It provides a perspective for management to make better longterm decisions in line with the corporate strategy. Portfolio optimization empowers the decision makers to measure and manage the project risks.

Chemical Engineers, New York, 1991. 4. Carter, David; Dare, William; Elliot, William, Determination of Mean-Variant Efficient Portfolios Using an Electronic Spreadsheet, Oklahoma State University, 2001. 5. McMillan, Fiona, Risk, Uncertainty and Investment Decision Making in Upstream Oil & Gas Industry, University of Aberdeen, 2000.

REFERENCES 1. Bodie, Z.; Kane, A.; Marcus, A.J, Essentials of Investments. 3rd ed. McGraw-Hill, 1997. 2. Adam, S.T.; Albers, J.A.; Howell, J.L.; Lung, J. and McVean, J., “Portfolio Management for Strategic Growth,” Oilfield Review, Vol. 12, No. 4 (Winter 2000/2001). 3. Herbst, Anthony, “The Many Facets of Risk in Capital Investment Evaluation,” in Investment Appraisal for

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TABLES
Table-1 Project A B C D E F G H I J Total Investment Cost MM $ 300 450 325 400 250 300 385 385 450 365 3610 NPV MM $ 100 200 146 166 127 200 250 200 210 150 P/I 0.33 0.44 0.45 0.42 0.51 0.67 0.65 0.52 0.47 0.41

Table-2 (project ranking) Investment Project Cost MM $ F 300 G 385 H 385 E 250 I 450 C 325 B 450 D 400 J 365 A 300 Total 3610

NPV MM $ 200 250 200 127 210 146 200 166 150 100

P/I 0.67 0.65 0.52 0.51 0.47 0.45 0.44 0.42 0.41 0.33

Table-3 : Project Risk Measures Semi-Std Project Deviation MM $ A 20 B 40 C 35 D 25 E 30 F 150 G 125 H 100 I 150 J 125 Total 800

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Table-4 : Portfolio (based on Budget 2,000 MM $) % funded Portfolio X Project A 0 B 0 C 71 D 0 E 100 F 100 G 100 H 100 I 100 J 0 NPV (MM $) Risk (MM $) 1090.32 268.59

% funded Portfolio Y 0 51 100 0 100 100 100 100 27 0 1083.52 228.83

% funded Portfolio Z 0 100 100 6 100 63 100 75 19 0 1049.95 186.28

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PICTURES
Figure-1 : The effect of Diversification

Total risk Risk

Diversifiable risk Non-diversifiable risk Number of assets

Figure-2 : Efficient Frontier

Efficient Frontier for Alternative Portfolios

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Figure 3 : Measures of Risk

Measures of Risk

Probability

Low risk High risk

0

Return

Figure 4 : Efficient Frontier Curve

Efficient Frontier
1150 1100 1050 1000 950 900 850 800 50 100 150 200 250 300

Return (MM $)

Risk (MM $)

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Figure 5 : Portfolio Alternatives

Efficient Frontier
1400 1300 1200 1100 1000 900 800 50 100 150 200 250 300
Portfolio Z : Return = 1,049.95 MM $ Risk = 186.28 MM $ Portfolio Y : Return = 1,083.52 MM $ Risk = 228.83 MM $

Return (MM $)

Portfolio X : Return = 1,090.32 MM $ Risk = 268.59 MM $

Risk (MM $)

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FIGURES
Figure-1 : The effect of Diversification Figure 3 : Measures of Risk

Total risk Risk

Measures of Risk

Probability
Diversifiable risk Non-diversifiable risk Number of assets

Low risk

High ri

0

Figure-2 : Efficient Frontier

Efficient Frontier for Alternative Portfolios Figure 4 : Efficient Frontier Curve
Efficient Frontier
1150 1100 1050 1000 950 900 850 800 50 100 150 200 250

Return (MM $)

Risk (MM $)

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Figure 5 : Portfolio Alternatives

Efficient Frontier
1400 1300 1200 1100 1000 900 800 50 100 150 200 250 300
Portfolio Z : Return = 1,049.95 MM $ Risk = 186.28 MM $ Portfolio Y : Return = 1,083.52 MM $ Risk = 228.83 MM $

Return (MM $)

Portfolio X : Return = 1,090.32 MM $ Risk = 268.59 MM $

Risk (MM $)

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