This paper investigates the economic relationship that exists between oil price and the operating costs in the E&P industry and its implications for the capital budgeting process and decision- making. We present empirical evidence that there is a positive correlation between price and operating costs, and that overlooking this relationship has severe implications on the valuation of investment projects, both using a traditional Net Present Value (NPV) methodology or a Real Options approach. In the traditional NPV method, overlooking price-cost correlation results in undervalues projects, and under Real Option Analysis, projects tend to be overvalued if correlation is ignored.
Any oil company manager involved in capital budgeting and decision-making is aware that the costs of exploration, appraisal, development and production have skyrocketed in the last five years, due to increased demand for drilling rigs, specialized labor force and other resources.
Ultimately, this dramatic change in costs is related to the increased activity in the E&P industry, reflecting the impacts of the rise in oil prices observed in the last years.
This paper shows empirical evidence that the operating costs in the E&P industry are highly correlated to the price of oil. In the capital budgeting process, however, this correlation is often overlooked. When costs correlate to oil price, an increase or decrease in revenues is at least partially offset by a comovement in costs. When this offsetting effect is ignored, the volatility of cash flows tends to be overestimated. This paper indicates how this problem affects the valuation of oil prospects, both under the traditional-NPV approach and a realoption valuation technique, and analyzing how decision-making processes may be flawed when the correlation between oil price, capital and operational expenditures are ignored.
Under traditional NPV approach, the overestimation of the volatility of cash flows causes projects to be seen as riskier than they really might be. This causes a misperception of the firm's costs of financial distress and, after all, the cost of capital is overestimated and thus NPV is underestimated. If a real-options approach is used, overestimated volatility results in an overvalued project since, as seen in the next section, project value is an increasing function of the volatility of its cash flows.
This paper is structured as follows: the next section shows briefly how projects are evaluated under traditional-NPV and real-option approaches. Section 2 presents empirical evidence that costs correlate to oil prices, section 3 discusses the differences between project valuation when cost-price correlation is taken into account or not, and the last section brings some findings, conclusions and general implications of the results obtained for the decision-making process.
This section discusses briefly how projects are evaluated both under the traditional-NPV approach and using a realoptions technique.
The Net Present Value (NPV) of a project is given by the sum of cash flows yielded by the projects, each one discounted at a proper rate that reflects the systematic risks associated to these cash flows, i.e.: