The meaning of risk or the characteristics that make a particular opportunity or decision ‘risky’ may vary widely from company to company and even within a company depending on the perspectives of the individuals involved. The perceived risk of a deal as viewed by operations or drilling executives might vary significantly from those in geoscience or human resource roles. The CFO might bring an entirely different perspective on the risk of an opportunity, as company level metrics, credit ratings, and investor guidance are considered. Each of these individuals or groups brings their unique domain expertise and understanding of risks to a particular decision. The challenge for any organization is in tapping into this knowledge and aggregating these points of view into a sound and consistent description of the risks to the company.
Stochastic portfolio analysis provides an ideal structure for ensuring that risks are adequately considered from a corporate perspective, by capturing individual uncertainties, aggregating these into a common whole, and assessing aggregate uncertainty against the metrics relevant to company performance. When employed effectively, these techniques make it possible to assess each decision or opportunity in the context of company objectives, normalizing disparate risk measures into a common frame of company impact. Financial considerations and drivers that are key to the CFO may be assessed and optimized in tandem with consideration of drilling delays, dry hole probabilities, or variations in production decline characteristics. Many of the risks or areas of concern to the CFO are ideally evaluated during opportunity evaluations and business plan development. These questions might include:
Is the depth of the inventory sufficient to exploit additional financing potential?
Can a specific acquisition be funded internally? How would this acquisition compare to development of the existing opportunity inventory?
How sustainable is the plan? Would financing support sustainable growth or will additional financing be needed?
Should additional shares be issued? Will the value gained by developing certain assets offset share dilution effects?
What working interest or scale of investment should be targeted for acquisition, given current balance sheet considerations?
While many of these questions can be addressed with expected value data, the use of stochastic descriptions provides additional insight into the confidence that specific performance metrics (cash flow, debt ratios, earnings growth, etc.) may be achieved. Evaluating the portfolio performance and risks holistically, makes it possible to exploit the full range of options within the portfolio in mitigating specific risks and delivering targeted performance. As contrasted to methods that purport to compute corporate utility functions (Bickel, 2006), stochastic portfolio analysis establishes a practical and transparent frame for assessing company risks.
This paper provides a high level overview of the way in which stochastic portfolio analysis may be applied to assess risks at a company level. This includes integration of financial and operational risks in the evaluation of specific opportunities or as part of a typical strategic planning cycle. A case study is used to demonstrate both the methodology as well as the value and insights gained from application of these techniques. This example clearly shows how assessing the full spectrum of uncertainties at an aggregate level contributes to more effective portfolio allocations, leading to increased valuations and reduced exposure to risks.