Maximizing Expected Present Value predicts that firms will seek 100% working interest in attractive ventures. However, firms frequently desire less than the entire working interest, and clearly pay much less than EPV to participate, management behavior often explained as a result of firms’ risk aversion.
Although there is little published evidence that firms routinely calculate Risk Adjusted Values (RAV), they provide a useful way to quantify risk aversion. This is not a new tool, as methods of deriving RAV and an Optimum Working Interest have been available in the literature for some time. Previous studies, which we review, have concentrated on defining a firm's Risk Tolerance, a necessary input in determining RAV.
We have expanded the use of RAV in a number of ways. Firstly, we believe that a firm's RT is not constant, but varies by business unit to match the strategic direction of the firm. Secondly, we use actual and hypothetical examples to illustrate the use of RAV in (a) rationalizing the Fair Market Value of exploration portfolios, (b) defining the relative contributions of firms’ exploration assets in mergers and acquisitions, (c) assessing farm-out values and targeting potential farminees, (d) selecting aligned partners for bidding groups and (e) government use for designing license rounds.
Existing applications of RAV have usually been restricted to a simple lottery in which a single success leg is represented by mean success. This ignores the uncertainty in the success leg, with RAV being independent of the variance of the underlying reserves distribution. Through analysis and simulation, we review the sensitivity of RAV to reserves and value uncertainty.