Where Have All the Profits Gone?

Abstract

0M a n a g e m e n t Why Change? P e t roleum exploration and production is enjoying a "golden age" in technology. Over the past two decades, finding costs have fallen more than threefold and lifting costs by half or better (EIA, 1998). Three-dimensional seismic has improved exploration success rates by as much as 90% and development success rates by 30% (Bohi, 1997). Yet, at the same time, the re t u rn on net assets by the largest U.S.-based companies in the E&P sector has averaged 7% for both integrated majors and large independents. (Original analysis based on Simpson et al., 1999). This re t u rn is the result of projects selected because they all exceeded the minimum estimated internal rate of re t u rn "hurdle rates," generally set at 15% or more, and were all financed with capital that generally costs in the range of 9-12% or more. This would appear to indicate long-term destruction of shareholder value. The re c e n t period of high oil and gas prices has ameliorated these results but not enough to offset the long-term tre n d .

The Value of Assessing Uncertainty

“…As stated earlier, Brashear et al (2001) reported that in the 1990s the return on net assets by the largest U.S.-based E&P companies was only 7%, after selecting projects with hurdle rates of generally 15% or more, which were all financed with cost of capital generally in the range of 9-12%. Using our simple cash-flow analysis, we can achieve a 7% IRR by reducing the actual annual cash flows to $713MM, which results in a true NPV of -$619MM and an ED%E of 155%.…”

“…Brashear et al (2001) reported that the return on net assets by the largest U.S.-based E&P companies was only 7%, after selecting projects with hurdle rates of generally 15% or more, which were all financed with cost of capital generally in the range of 9-12%. According to Rose (2004) While performance may have improved in the last decade, this may be due more to high oil prices during this period rather than systematic improvement in business processes.…”

“…Why does the industry underperform? Brashear et al (2001) attributed it, at least in part, to use of evaluation methods that do not account for the "full" uncertainty. Rose (2004) indicated that "by far, the dominant cause of E&P underperformance is an internal problem…: Chronic bias in estimating key geotechnical parameters that control our evaluation of E&P projects."…”

The Value of Assessing Uncertainty in Oil and Gas Portfolio Optimization

“…Markowitz pointed out that a rational investor would seek a portfolio for which no other combination would have a higher return without increased risk or lower risk without loss of return. The choice of the portfolios along the efficient frontier depends on the decision-maker's tolerance for risk (Brashear et al 2001). This technique ensures that value is maximized for a certain level of risk.…”

“…Choosing the right set of projects that would return the highest Net Present Value (NPV) and meet the performance criteria and budget constraints of a company is a task that requires not only familiarity with technical and financial concepts, but also a considerable awareness of the impact of biases. Brashear et al (2001) reported that in the 1990's the largest US based E&P companies, both integrated majors and large independents, selected projects with hurdle rates that are generally set to 15% or more, but realized an average return on projects of 7% only. The authors explain that this is a result of using evaluation methods that do not account for full uncertainties and risk.…”