Oil Project Selection By MetricsVW Staff
Oil Project Selection By Metrics
University of Stavanger; CESifo (Center for Economic Studies and Ifo Institute)
May 19, 2016
The recent fall in oil prices has led to extensive capital rationing, and thereby given rise to a renewed focus on parameters for project selection which supplement net present value. While the financial crisis was creating capital constraints, the oil industry seemed to be paying great attention to the net present value index. The metric most often referred to at present, given the prevailing uncertainty over the direction of future oil prices, seems to be the breakeven price of a project. Management and professionals in the oil and gas sector, as well as industry analysts, appear to be very concerned about which criteria in addition to net present value other companies are applying in their decision-making. Our findings indicate that they can be more relaxed here, since the various supplementary criteria provide very similar rankings. We examine the different investment metrics of a portfolio of oil projects. The analysis of project metrics shows that the overall grouping of projects is the same with the three supplementary metrics. The concentration by the companies on robustness related to oil prices means that particular attention is paid to the breakeven price and cost optimisation. Projects which are optimised and sanctioned may have a very high return with the realisation of an expected price scenario. We introduce a new metric, referred to as the complete net present value index, which improves the traditional net present value index by including operating expenditure and by treating taxes in a consistent manner.
Oil Project Selection By Metrics – Introduction
The fall in oil prices has once again imposed capital constraints, with cancellations and delays for project decisions in the oil industry as the result. In Norway, for example, Statoil as operator for the Snorre Extension and Johan Castberg oil projects has further postponed the decision to go ahead on the grounds that it needs to undertake additional optimization and evaluation. Other oil companies are also delaying and cancelling oil projects. This may be the correct approach, for the simple reason that these developments are not profitable with a new view on expected future oil prices. It may also be right because future price uncertainty has increased, enhancing the option value of waiting. On the other hand, the projects may all have positive NPVs but capital rationing has been introduced. See Osmundsen et al (2006).
In economic theory, when an investment regime with constraints is introduced, the correct solution is to apply a portfolio model in order to choose the combination of projects in the opportunity set with the highest overall net present value. This is often simplified in order to achieve decentralized evaluation in organizations which make investment decisions on a daily basis, as well as in different countries with varying fiscal regimes, by looking at key metrics such as the internal rate of return, the net present value index and the breakeven price of the projects. See Emhjellen et al (2006).
The reasoning behind this is that formal optimization of the project portfolio can only be undertaken at the highest corporate level, and that the organization thereby needs simplified metrics for testing project profitability. These also function as financial targets for the organization and create discipline, with a reduced number of projects being presented to management for decision.
We evaluate the three metrics most often used for the simplified selection of oil projects. We also introduce a new metric which we believe makes more economic sense in that it includes all costs, not only investment, and also reflects time value and risk. We examine the results and conclude that, for these four metrics, the most profitable projects are all in the highest ranked group and their individual ranking is also the same. Only when the capital rationing constraint is relaxed and the less profitable developments are included will the project selection metrics give somewhat different results.
In section 2, we describe the four different metrics we use to evaluate the projects in terms of ranking. Section 3 examines the portfolio ranking of model oil and gas projects on the basis of these metrics. We conclude in section 4.
The four metrics
For a discussion of current issues pertaining to petroleum investment projects, in absence of capital constraints, see Osmundsen et al. (2015). The investment decision when some constraint exists becomes rather more complicated than accepting all projects with an NPV greater than zero (Ingersoll and Ross, 1992). Myers, 1974, showed that the weighted average cost of capital is not correct when capital constraints apply and that a solution must be found at the corporate portfolio level.
Project metrics are often calculated to simplify this analysis below the corporate level so that individual divisions can promote their projects to central management with a degree of certainty.
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