Abstract

The use of portfolio theory has been appointed as an important tool for economic risk management in the O&G industry. There are only 3 input parameters: (a) mean return; (b) standard deviation of return; (c) correlation between pairs of assets, projects, prospects, etc. Although simple, one practical problem with the application of this model is the estimation of correlation because there is no historical data as in the case of financial assets.

This paper presents a methodology for the estimation of linear and rank correlation between E&P oil and gas projects through the following steps: 1) Estimate the mean and risk of each project; 2) Identify the variables that are common to two projects such as oil price, fiscal regime, etc; 3) Simulate the return of each project; 4) Estimate the correlation between projects.

This model is applied to estimate the mean and risk of a portfolio of 3 projects typical from the deep-water in Brazil with reserves of 346, 629 and 694 million barrels. The fiscal model is based on Tax & Royalty. For all these projects, production strategy and production curve come from reservoir simulation.

Alternatively, correlation between return of projects is assumed subjectively (a typical number is 70%) but with this model it can be estimated in a much more sound way. Results indicate that main determinants of correlation are fixed cost, variable cost and oil quality. With this information, managers are able to select best portfolios – for example, by means of farm-in and farm-out – in order to create value for stakeholders considering not only means, but also risk and possible benefits from diversification.

You can access this article if you purchase or spend a download.