Exponential utility functions aid upstream decision making

Abstract

Although the concepts and mathematics of utility theory and its application to adjusting valuations to reflect the perspectives of decision makers with a range of risk preferences have been established for decades, these concepts and numerical applications remain relatively rarely applied by decision makers in the upstream gas and oil industries. Utility functions are now extensively used to assist evaluation of oil and gas hedging and trading of financial and physical commodities from the risk preferences of the parties involved. This study makes the case for more extensive use of utility functions in the upstream gas and oil sectors by presenting cases that highlight both the conceptual and valuation benefits that result from their application.Exponential utility functions adequately describe the risk preferences of risk-averse and risk-prone decision makers for a wide range of upstream gas and oil asset types and circumstances. Simple equations for the calculation of utility factors and expected utility factors, i.e., taking into account probabilities of a range of outcomes being realised, are presented and compared with the equivalent linear utility functions of a risk-neutral investor valuing assets based on unrisked discounted cash flow (i.e. net present value, NPV) and risked discounted cash flow (i.e., expected monetary value, EMV). The additional insight gained from applying utility functions is considered with examples for high-uncertainty exploration assets, decision makers constrained by various loss tolerances and selection of optimum gas field development plans from a number of distinct alternative plans. In all cases considered the utility functions provide decision makers with greater insight than just the consideration of NPV and/or EMV. A case is therefore made to justify more extensive use of utility functions by upstream decision makers.