Many exploration and production companies impose a risk threshold on major capital projects (one common such hurdle is a maximum acceptable probability of negative NPV). Projects which fail to meet the threshold are not usually rejected outright; rather, the project team is instructed to gather more information and perform more analyses to reduce the range of economic uncertainty associated with the project. Projects are routinely delayed while unnecessary appraisal wells are drilled and analyses are conducted, thus eroding millions of dollars from the NPV of these projects. The primary arena in which risk tolerance is applied is the development stage of a project. Companies are comfortable with the notion of failed exploration wells, but not failed developments. Stringent probability-of-success hurdles often result. Unless the failure of a single project could put a firm into financial distress, companies should be risk neutral when making decisions at the project level – i.e., they should make decisions based on the mean values of the economic metrics of interest (NPV, P/I, etc.) with no further consideration taken of the probability of success. Value-of-information (VOI) analyses should be used to determine when additional information or analysis adds value to a project and when it does not.
The key concept is this: Risk tolerance should be applied at the portfolio level, not the project level. The question to ask is not, “Am I comfortable with the risk associated with this project?”; rather, it is, “Am I comfortable with the risk associated with my portfolio of assets when this project is included?”
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