In the past three decades, much work has been conducted in the development and application of various analytical techniques used in investment decisions. Two of the most powerful of these techniques include risk analysis and portfolio analysis. Because of the speculative nature of the petroleum industry, risk analysis has become readily acceptable and widely used by most oil and gas investors. Meanwhile, portfolio analysis has gained little acceptance and remains a mystery to most of the petroleum sector. Like risk analysis, portfolio analysis evaluates projects based upon the investment's expected return and its perceived risk or uncertainty. However, while risk analysis limits its perspective to the merits of the individual project, portfolio analysis expands this view to include the effects and contributions that potential projects will have on the investor's entire portfolio. In turn, portfolio analysis broadens the restrictive, myopic view of selecting projects based solely on individual merit and criteria and allows the investor to determine how potential investments will affect the goals and objectives of his overall portfolio.

This analytical technique is based upon modern portfolio theory which provides a conceptual framework for selecting projects in order to create portfolios that offer the best combination of risk and return. Within this framework, Harry Markowitz proposed a mathematical model that utilizes quantifiable risk/return parameters to create efficient and optimal portfolios designed to meet the goals and risk preferences of the large private or institutional investor. While sophisticated investment managers have successfully applied this portfolio model to the capital markets, this quantitative method has obtained little exposure in the oil industry. Earlier studies have shown, however, that the conceptual application of portfolio analysis has much merit and utility in the decision process employed by oil and gas investors. Yet none of these qualitative applications utilize the full potential that the Markowitz model provides.

While not applicable in its original form, the portfolio model needs modification to meet the investment objectives and information limitations characteristic of the oil industry. It is the objective of this paper to demonstrate how a modified model can be effectively applied to the selection process of petroleum ventures. To illustrate its applicability, this modeling technique is applied to an investment decision involving the construction of an exploratory drilling program. In this example, this analytical technique predicts how an efficient and optimal portfolio can be constructed given an opportunity set of investments and the goals of the oil and gas investor. It is believed that from this illustration investors will be able to effectively apply portfolio modeling as a tool to optimize their own selection of petroleum investments.

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