Is International Exploration Really More Risky?

Abstract

Introduction This paper grows out of the author's experience in working with many of the major oil and gas companies in Canada and in the area of project evaluation and hurdle rate determination. Over the past few years, many Canadian oil producers have increasingly shirred their exploration efforts to finding larger reserves outside of Canada. This evolution in the industry has resulted in an increasing number of international or foreign projects being considered and evaluated relative [0 exploration prospects in western Canada. Evaluating these international projects requires the same type of economic analysis carried out for domestic projects; essentially discountedcash flow(DCF) or net present value (NPV) analysis. Applying this evaluation methodology requires two types of data: a series of forecasted cash flows (that include all special costs if oversea') projects are being evaluated) and an appropriate hurdle rate. In this paper, we focus on the hurdle rate. Conventional wisdom states that foreign projects should be evaluated at a higher discount rate than domestic projects. The authors question this conventional wisdom. While some overseas projects may indeed be higher risk than domestic projects, especially unconventional projects or projects located in politically unstable developing economies, It is not obvious that overseas projects in politically stable economies and comparable technically to domestic projects are indeed more risky. In addition to evaluating the market riskiness of overseas vs domestic projects, we also consider the extent to which the on-going globalization of world financial markets might impact the riskiness of both domestic and overseas investments in the energy industry. Our results indicate that it may be appropriate for Canadian oil and gas companies to revisit the methods used to measure their corporate hurdle rates in light of this globalization process. Where do Hurdle Rates Come From? Hurdle rate determination within an organization is an important part of the capital allocation process. It assists in and in some cases, unjustifiably dominates the process of deciding which projects receive funding and which projects do not. Theoretically, projects that are not expected to achieve the assigned hurdle rate should be rejected. This selection criterion rests on the presumption that management should pursue the goal of enhancing the wealth of the owners or the company. Hurdle rates represent the minimum required rates of return set by investors in the company considering the projects. Projects that exceed this minimum required rate are expected to increase the value of the company (and therefore the wealth of shareholders) because they will increase the demand for the company's shares. Those that do not exceed this rate are expected to decrease the value of the company or the wealth of the shareholders. The most common hurdle rate practice in the Canadian oil and gas industry is to measure the corporate weighted average cost of capital (WACC) and use this as the discount rate when evaluating projects, both exploration and development. WACC is measured as a weighted average of the cost of debt and the cost of equity with the weights reflecting the percentage of total capital coming from each source.