Where Have All the Profits Gone?

Abstract

This paper (73141) was revised for publication from paper SPE 63056, first presented at the 2000 SPE Annual Technical Conference and Exhibition held in Dallas, Texas, 1–4 October 2000. Summary Despite massive improvements in productivity due to technology advances, the E&P industry has averaged a disappointing 7% return on net assets over the last decade (less than its cost of capital). Its market capitalization relative to the S&P 500, even at recent high oil and gas prices, is about half what it was a decade ago. A small-scale, very simple case study suggests that at least part of the reason for this disappointing perform-ance lies in the way that the industry conventionally allocates capital and selects portfolios of projects. Ranking of projects by deterministic estimates of value and even some of the so-called advanced methods significantly overstates value, understates risk, and misallocates capital by incurring unnecessary, uncompensated risks. Suggestions for improvements in the project selection/capital allocation prices are offered. Why Change? Petroleum exploration and production is enjoying a "golden age" in technology. Over the past two decades, finding costs have fallen more than threefold and lifting costs by half or better (EIA, 1998). Three-dimensional seismic has improved exploration success rates by as much as 90% and development success rates by 30% (Bohi, 1997). Yet, at the same time, the return on net assets by the largest U.S.-based companies in the E&P sector has averaged 7% for both integrated majors and large independents. (Original analysis based on Simpson et al., 1999). This return is the result of projects selected because they all exceeded the minimum estimated internal rate of return "hurdle rates," generally set at 15% or more, and were all financed with capital that generally costs in the range of 9-12% or more. This would appear to indicate long-term destruction of shareholder value. The recent period of high oil and gas prices has ameliorated these results but not enough to offset the long-term trend. Investors have noted these discouraging results and have responded accordingly. Relative to the Standard & Poor's 500 Index (the largest 500 U.S.-traded, nonfinancial companies), the Amex Oil Index (the 16 largest U.S.-traded oil companies) has fallen 50% between January 1990 and October 2000. This reflects real value loss relative to alternative directly comparable investments.