Risk Tolerance and Risk Neutrality (You Can Live with More Risk than You Think)

Tuesday, 05 February 2013 Read 4775 times
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Many exploration and production companies impose a risk threshold on major capital projects (one common such hurdle is a maximum acceptable probability of negative NPV). Projects which fail to meet the threshold are not usually rejected outright; rather, the project team is instructed to gather more information and perform more analyses, so as to reduce the range of economic uncertainty associated with the project.

Projects are routinely delayed while unnecessary appraisal wells are drilled and analyses are conducted, thus eroding millions of dollars from the NPV of these projects. The primary arena in which risk tolerance is applied is the development stage of a project. Companies are comfortable with the notion of failed exploration wells, but not failed developments. Stringent probability-of-success hurdles often result.

Unless the failure of a single project could put a firm into financial distress, companies should be risk neutral when making decisions at the project level – i.e., they should make decisions based on the mean values of the economic metrics of interest (NPV, P/I, etc.) with no further consideration taken of the probability of success. Value-of-information (VOI) analyses should be used to determine when additional information or analysis adds value to a project and when it does not.

The key concept is this: Risk tolerance should be applied at the portfolio level, not the project level. The question to ask is not, “Am I comfortable with the risk associated with this project?”; rather, it is, “Am I comfortable with the risk associated with my portfolio of assets when this project is included?”

Speaker
Patrick Leach has thirty years of experience in the energy industry, primarily in upstream oil & gas. He is the Chief Executive Officer of Decision Strategies, Inc., a leading management consulting firm in that industry. Mr. Leach has also been an independent consultant and worked for Texaco as a geophysicist, partner & government coordinator, and portfolio manager. He has lived and worked all over the world, from New Orleans to Sumatra to Aberdeen. Mr. Leach is the author of "Why Can't You Just Give Me the Number? - An executive's guide to using probabilistic thinking to manage risk and to make better decisions."

Mr. Leach has a B. Sci. degree from the University of Rochester and an MBA from the University of Houston. He is a Charter Fellow in the Society of Decision Professionals, and holds membership in the American Association of Petroleum Geologists, the Society of Petroleum Engineers, the Decision Analysis Affinity Group, and INFORMS.

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