An Approach to the Evaluation of Oil - Production Capital Investment Risks

Abstract

Abstract Methods of analyzing the profitability of proposed capital investments have received considerable attention in recent literature. The discounted-cash-flow rate of return, particularly, has been advocated as a means for discriminating among new investment opportunities. Examination of the characteristics of this rate of return led to the conclusion that such rate is seriously misleading at rates of return which are higher than an appropriate interest rate used to determine the present value of future income. Such relatively high rates of return are ordinarily encountered in the oil and gas production industry and are commensurate with the high risk of normal industry ventures. The difficulty inherent in this use of the discounted-cash-flow rate of return stems from the fact that the relative value of each future year's income from a project is weighted according to the discount-factor characteristic of the rate of return determined from the project. If this rate of return is higher than the realistic present-value interest rate, income from the later years in the life of the project is penalized at a rate which is higher than is needed to compensate for the deferment of this income. A method of evaluating new capital investments of unequal risk on a commensurable basis is suggested. This method provides a rational framework into which an estimate of the probabilities of success or failure of each facet of a given project may be fitted. General The objective of investment evaluation is to provide a measure of the ability of an investment to generate profits. If a quantitative measure of this ability is available, all opportunities for investment can be measured, and an optimum disposition of the funds available for investment can be made. In the opinion of the writer, the most serious obstacles to be overcome in providing such a measure are encountered, first, in adequately measuring the value today of cash to be received at some future date and, second, in measuring (on a commensurable basis) investments which involve different degrees of risk. These problems are of particular importance in the petroleum production field. This industry provides investment opportunities which yield patterns of cash flow vs. time which vary over a wide range. Individual risks to which investors are exposed cover a continuous spectrum from rank wildcat to interior development well.