If money is lost shareholder confidence is forfeited

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Unformatted text preview: e 5.7. Outcome Dry hole ($million) -10 Probability (%) 40 50 60 Dry hole -10 60 Success RISKY Independent Success SAFE NPV 80 40 Table 5.7: Safe and risky projects (source: Ball and Savage, 1999) The EMVs of each project are the same: EMVsafe=60%*$50+40%*($-10)=$26 million EMVrisky=40%*$80+60%*($-10)=$26 million A complication is now added. If money is lost, shareholder confidence is forfeited. There is a 40% chance of forfeiting shareholder confidence with the safe project, and a 60% chance with the risky project. Since the EMV for both projects is $26 million, 109 there is no way of increasing that by choosing the risky over the safe project. Under both circumstances the safe project is obviously the better choice. A further complication is added. Suppose it is possible to split the investment evenly between the two projects. Intuitively it would seem a bad idea to take a 50% out of the safe project and put it into the risky one. However, intuition is not always the best guide. There are now four possible outcomes and these are shown in table 5.8. The EMV of portfolio is still $26 million (24% *$65+36%*$20+16%*$35+24%*(-$10)=$26 million) but the only way to forfeit shareholder confidence is to drill two dry wells (Scenario 4), for which the probability is 24%. That cuts the risk of forfeiting shareholder confidence by almost half. So, moving money from a safe project to a risky one, which, of course, seems counter-intuitive, reduces risk and is the effect of diversification. SCENARIO SAFE RISKY PROBABILITY 1 Success Success 0.6*0.4=0.24 50%*$50+50%*$80=$65 2 Success 0.6*0.6=0.36 50%*$50+50%*($-10)=$20 3 Dry hole Dry hole Dry hole Success 0.4*0.4=0.16 50%*($10)+50%*($80)=$35 Success 0.4*0.4=0.24 50%*(-$10)+50%*(-$10)=-$10 4 RETURN($million) RESULT Shareholder confidence retained Shareholder confidence retained Shareholder confidence retained Shareholder confidence lost Table 5.8: All possible outcomes of investing 50% in each project (source: Ball and Savage, 1999) Most companies that do not use portfolio theory rank their exploration projects based on EMV and then choose the project with the highest EMV (Section 6.2 of Chapter 6). This ignores the diversification effect and in the example above would have led to allocating all the funds to the safe project, with nearly twice the risk of the best portfolio (Bailey et al., in press). Publications from Whiteside (1997) and Ross (1997) provide further details of how portfolio theory can be applied to the industry. Software companies such as Merak and Indeva produce tools that allow upstream companies to use the technique easily. 110 Recently the application of another technique from finance theory, option theory, has been gaining attention in the literature as a tool for valuing undeveloped oil reserves. However, currently the discussion raises more questions than it answers, and the method has yet to be shown to be a viable method for evaluating these reserves (see, for example, Lohrenz and Dickens, 1993; Mar...
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This document was uploaded on 03/30/2014.

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