Combining decision analysis and portfolio management to improve project selection in the exploration and production firm

Abstract

Recent advances in modern finance theory and decision science are being utilized in a more systematic fashion by the upstream petroleum industry. Corporate planning groups as well as business units in oil companies are increasingly applying techniques such as decision analysis, simulation, portfolio management, and real options analysis to improve the overall decision making and capital allocation process. An important element of improving the practice of risk management in the E&P setting is to ensure the proper integration of these analytical techniques in order to leverage their overall capabilities. The Markowitz optimization approach to portfolio analysis, for example, provides the E&P decision maker an efficient set of portfolios, based on minimizing risk subject to a particular return. However, without some guidance as to what level of risk-taking is appropriate for the E&P firm, the portfolio analysis alone does not provide managerial guidance about which of these efficient portfolios is best for the firm. There are, however, important attributes of the decision analysis paradigm that link directly to choices made by the firm regarding modern portfolio analysis. Preference analysis, an important element of a comprehensive decision analysis, provides us a mechanism for measuring and applying a corporate risk-taking policy. Knowing the firm's attitude about taking financial risk is important in terms of selecting the appropriate portfolio of activities. These linkages between decision analysis and portfolio management can improve the overall decision process, and ultimately, firm performance.