Implications of Commodity Price Risk And Operating Leverage On Petroleum Project Economic Evaluations

Abstract

Abstract Managers in the petroleum industry often encounter adverse economic and operational issues associated with their assets and businesses, that on the surface, seem to be due to unfortunate choices made long ago regarding the structure of an investment, project, or commercial agreement. While the benefit of hindsight allows us to easily critique some past decisions, a more in-depth analysis of decision making tools and processes reveals that there are some systematic, fundamental problems with our economic analysis that in many cases lead the best of managers to make these choices. One of the key issues for a capital-intensive commodity business such as petroleum development is the use of discounted cash flow for evaluation of investments. The underlying issue is that traditional present value or discounted cash flow (DCP) analysis methods used in petroleum economics often represent an arbitrary or inappropriate treatment of the risk in individual project cash flows. Por example, commodity price sensitivity can differ widely from project to project, due to the inherent cost structure, extent of product price hedging, tax and royalty structures, etc. This paper will outline a methodology based on techniques which are used in securities markets to evaluate> some simple natural gas field development example projects. The results will show some of the reasons that a constant discount rate analysis can potentially provide a misleading bias on project selection. In these examples, where costs (capital and operating) are more certain than revenue, we show that discounted cash-flow (DCP) methods that use the same discount rate in the valuation of all projects may undervalue low cost natural gas relative to high cost natural gas, and long life natural gas relative to short life natural gas. We also show that DCP methods tend to undervalue (or not value) the advantages of risk absorbing activities such as price risk management or hedging. Introduction Discounted cash-flow (DCP) methods, at least as they are currently used, have the potential to hamper long-term or strategic decision making by discounting the future excessively or arbitrarily and by undervaluing or not valuing the effects of risk management arrangements and the active management of future contingencies. Moreover, many organizations do not understand (for good reasons) the issues behind their choice of discount rates which is crucial to the use of DCF methods. In addition, curren; DCF methods lead managers to consider risk in ad hoc ways through some combination of their choice of a discount rate and their opinion of the spread in valuation results across "sensitivity" scenarios. What is required is an integrated approach to risk and its effects on value. This paper will show that modem asset pricing (MAP) methods (sometimes called "option pricing" methods or "synthetic valuation" methods) can provide organizations with better tools for financial analysis, allowing more precise comparative analyses of the effects of:TimeUncertaintyProject structure Additionally, MAP can allow for more precise analysis of the potential for active management on the value of the decision alternatives that petroleum industry decision makers face.