The Net-Present-Value Paradox: Criticized by Many, Applied by All

Abstract

Summary The exploration and production (E&P) industry is facing a net-present-value (NPV) paradox. Despite the fact that the NPV method is widely criticized by practitioners and academics alike, the NPV method remains the cornerstone of E&P project valuation. We posit that this contradiction, which we labeled the NPV paradox, is likely to be caused by a combination of limitations of the method, a lack of theoretical understanding, and ambiguity regarding the implementation of the NPV method. Even though the NPV method has been described in numerous papers and textbooks, rigorous and succinct guidance on how to determine risk premiums for systematic risk is not available. We demonstrate that risk-adjusted discount rates are very sensitive to the choice of the length of the periods over which returns are determined (daily, weekly, or monthly), length of the time horizons considered (such as 10 or 25 years), and start date (such as 1965 or 1990). We discuss the fundamental implications and rationale of choices and their effects on the variables that underpin the risk-adjusted discount rate: risk-free rate, company β, market-risk premium, and the cost of debt. Although not entirely satisfactory, we argue for a moderate downward revision of discount rates for projects with timelines exceeding 20 years. This recommendation is dependent on recent advancements in public finance and the reality that the exposure to systematic risk in the long run is significantly less in many real-life E&P projects than the capital-assessment-pricing model (CAPM) implies. The inflated discount rate that is currently used, combined with the extended investment horizons that are common in the upstream sector, will for example result in an underweighting of decommissioning and future legacy costs. In addition to a set of widely recognized shortcomings of the NPV model, there are also lesser well-known issues. For example, the failure of CAPM to capture bankruptcy risk has a bearing on the project-risk premium. Also, the application of the NPV model implies a set of probabilistic assumptions around market risks that are likely to be invalidated when evaluating a set of market scenarios or using a series of probability-weighted market scenarios.