Corporate Risk Tolerance and Capital Allocation: A Practical Approach to Implementing an Exploration Risk Policy

Abstract

Petroleum exploration companies are confronted regularly with the issue of allocating scarce capital among a set of available exploration projects, which are generally characterized by a high degree of financial risk and uncertainty. Commonly used methods for evaluating alternative investments consider the amount and timing of the monetary flows associated with a project and ignore the firm`s ability or willingness to assume the business risk of the project. The preference-theory approach combines the traditional means of project valuation, net present value (NPV) analysis, with a decision-science-based approach to risk management. This integrated model provides a means for exploration firms to measure and to manage the financial risks associated with petroleum exploration, consistent with the firm`s desired risk policy.