In many oil and gas companies, capital allocation decisions typically involve the ranking of proposed projects by net present value and/or internal rates of return along with some subjective criteria. However, traditional present value or discounted cash flow (DCF) analysis methods used in petroleum economics do not properly account for risks associated with commodity price volatility and how they affect the particular project under analysis. Commodity price sensitivity can differ widely from project to project, due to the inherent cost structure, extent of product price hedging, tax and royalty structures, etc. These are issues which directly affect the risk of project cash flows and are difficult to address with the use of constant discount rates for all analyses. This presentation will outline a methodology based on techniques which are used in securities markets to evaluate some simple resource development example projects. The results will show that a constant discount rate analysis can potentially provide a misleading bias n project selection. In particular, we show how, under circumstances where costs are less risky than revenue, discounted cash-flow (DCF) methods, that use the same discount rate in the valuation of all projects, undervalue low cost natural gas relative to high cost natural gas, may undervalue long life natural gas relative to short life natural gas; and how DCF methods tend to undervalue (or not value) the advantages of risk absorbing activities such as price risk management or hedging.
Consulting experiences suggest that many managers in the petroleum industry would like better financial analysis methods to assist in the management of their business opportunities. Some believe that discounted cash-flow (DCF) methods, at least as they are currently used, tend to hamper long term or strategic decision making by discounting the future excessively or arbitrarily and by undervaluing the effects of the active management of future contingencies. Moreover, many organizations do not understand (for good reasons) the issues behind their choice of discount rates, which is crucial to the use of DCF methods. Finally, current DCF methods lead managers to consider risk in ad hoc ways through some combination of their choice of a discount rate and their opinion of the spread in valuation results across "sensitivity" scenarios.
Some managers would like an integrated approach to risk and its effects on value. There has been speculation that modem asset pricing (MAP) methods (sometimes called "option pricing" methods or "synthetic valuation" methods) can provide organizations with better tools for financial analysis. Some managers believe (quite rightly) that the use of these methods may allow more precise comparative analyses of the effects of:
time;
uncertainty;
project structure; and
the potential for active management on the value of the decision alternatives that they face.
Indeed, modem asset pricing can provide petroleum producers with better tools for financial analysis by making possible more precise comparative analyses of the effects of time, uncertainty, project structure, and the potential for active management on the value of the decision alternatives that managers face.
