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Introduction
1.1 Context
In the capital-intensive industries, a firm will normally invest in a portfolio of investment
projects rather than in a single project. The problem with investing all available funds in
a single project is, of course, that an unfavourable outcome could have disastrous
consequences for the company. In general, the funds are not sufficient to support all
available investment opportunities. So the selection of portfolio projects is important.
Copyright 2011 Inderscience Enterprises Ltd.
161
1.2 Motivations
Project portfolio management is a complex decision-making process involving the
unrelenting pressures of time in cost. This decision-making process is affected by many
critical factors such as the market conditions, raw materials availability, probability of
technical success and government regulations. The problem of project selection was
first developed in the field of engineering economy (DeGarmo and Canada, 1973). The
problem has been given full attention in engineering management (Martino, 1995;
Jafarizadeh and Khorshid, 2008; Wang et al., 2009).
The traditional approach considers corporate projects as being independent of each
other. Yet, the relations and correlation between projects within the uncertain environment
have been recognised as a major issue for corporations. Therefore, research in this field
has recently shifted towards project portfolio management (Jonas, 2010; Laslo, 2010).
The present paper focuses on the new project management approach.
For the petroleum industry, the development of the collection and analysis of seismic
data significantly reduced the risk of undiscovered oil. The geology and geophysics
resultant (G&G) have revolutionised oil and gas exploration. Decision analysis has
traditionally been applied to information derived from G&G for ranking projects hole by
162
F. Belaid
hole, determining on an individual basis whether they should be explored and developed.
This hole-istic approach is being challenged by a holistic one that takes into account the
entire portfolio of potential projects as well as current holdings. For Ball and Savage
(1999), this portfolio analysis starts with representations of the local uncertainties of the
individual projects provided by geology and geophysics. It then takes into account global
uncertainties by adding two additional Gs: geo-economics and geopolitics, thereby
reducing risks associated with price fluctuations and political events in addition to those
addressed by traditional G&G analysis.
This paper presents comments and some background on the use of risk analysis
methods in the selection of investment projects. We apply variant models of Modern
Portfolio Theory to determine the efficient project portfolio that maximise the expected
profit while simultaneously minimising risk. Our approach is generic while particular
attention is given to applications developed for exploration and production projects
selection.
Portfolio optimisation is a methodology from finance theory for determining the
investment programme that gives the maximum expected value for a given level of risk
or the minimum level of risk for a given expected value. In his seminal paper published
in 1952 in the Journal of Finance, Nobel laureate Harry Markowitz laid down the basis
for modern portfolio theory (Markowitz, 1952a). Markowitz focused the investment
professions attention on mean-variance efficient portfolios and opened the area of
modern investment theory. The methodology of the model presented in this paper is
derived from two sources: decision analysis and portfolio theory.
1.3 Contributions
The main contributions of this paper are as follows:
1
The model proposed illustrates how modern portfolio theory provides management
with a superior setting for allocating capital by illuminating risk at the portfolio
level. This method, contrary to the classical selection methods, analyses the projects
by considering the various aspects of the risk and the various correlations existing
between the projects.
The scenario method is proposed for the assessment of crude oil price volatility.
The proposed method is flexible in terms of input data and output results and simple
to implement.
The rest of the paper is organised as follows: Section 2 presents the state of the art
dealing with project selection and portfolio management. Section 3 details the proposed
model. Section 4 presents the details of the model with an illustrative example. Section 5
deals with the results of the proposed project selection example. Section 6 concludes the
paper.
Literature review
The problem of project selection was first introduced in the field of engineering
economy. According to Bussey (1978), the early practitioners had to consider the
problem of selecting the economic choice between executable alternative solutions. This
163
164
F. Belaid
2001). The original idea is that a portfolio may be worth more or less than the sum of its
component projects, and there is not a better portfolio, but a family of optimal portfolios
that allow for achieving a balance between risk and return. Jafarizadeh and Khorshid
(2008) proposed a method of project selection based on capital asset pricing theories in
framework of mean semi-deviation behaviour.
The research work presented in this paper shows the importance of the use of the
Modern Portfolio Theory in project portfolio management. The proposed model includes
a methodology to improve the quality and efficiency of the decision-making process of
project portfolio management.
Proposed model
Applying Monte Carlo simulations for the assessment of projects economic risk.
Building a portfolio optimisation model for the selection of the optimal portfolios.
Project Evaluation
Optimisation Process
The aim is to obtain an optimal rate of investment for each project to maximise the total
return of the portfolio taking into account the various risks and the constraints of the
company. To do this, we compare two methods: a model inspired by Modern Portfolio
Theory method with the variance as a risk measure and a model inspired by Modern
Portfolio Theory method with the semi-variance as risk measure.
165
We apply this process to a real problem of project evaluation and selection. The
selected projects for our problem are a group of 14 real petroleum projects. The decision
problem is: which ones of the mutually exclusive projects are the best for the company
considering their risk and return?
Index
Net present
value
(NPV)
Meaning of index
Excess of the total cash
income over the total
expenditures for the
given project with
regard for discounting
Internal rate Positive number IRR
of return
such that for the
(IRR)
discount rate E=IRR the
net discount income of
the project vanishes, for
E>IRR is negative, for
E<IRR is positive
Payback
Time from the beginning
period
of project realization to the
(PB)
instant when the current
discounted net income
becomes nonnegative
and remains so
Profit index
(PI)
IRR > E
K +
R ( t ) C (T )
(1 + IRR )
t =1
=0
t =1
R ( t ) C (T )
(1 + E )
t =1
Kt
(1 + E )
T R ( t ) C (T )
t =1
(1 + E )
PI =
K
In our case we use Net Present Value (NPV), the most popular index used in discount
cash flow project evaluation. This assumes that the values of input parameters are known,
namely:
166
F. Belaid
NPVi
t =1
it
1 + ( r + p ) + ( r p )
167
Step a: Creation of a distribution for each input parameter: first we must identify the
main risk factors, which are here production, opex, capex and assess their distributions
using the historical values and the expert judgements. In our example distributions
allocated to the main variables are:
1
Recall that these distributions are frequently used in the petroleum industry, e.g. (Rose,
1987; Orman and Duggan, 1998; Rodriguez and Oliveira, 2005).
Step b: Generation of a Monte Carlo simulation with 5000 trials.
Step c: Recording the results of the simulation (the distribution of the expected NPV, the
average of the NPV, its variance). Figure 5 shows the results of one particular projects
Monte Carlo simulation.
Figure 2
Distribution of production
Figure 3
168
F. Belaid
Figure 4
Figure 5
In the current context (the high volatility of crude prices), it is difficult to detect a longterm relationship that can describe the evolution of prices. Consequently, the forecasting
model will fail, knowing that petroleum projects have a long duration (530 years). To
overcome this problem, in calculating the NPV, the ideal would be to imagine a few price
scenarios (three) taking into account all factors of the current economic climate, and
possible future changes (continuously increasing the global demand, possible depletion
of reserves, discovery of new deposits, possible arrival of a new energy, etc.).
169
For our problem of the project portfolio evaluation, we use three different scenarios
for the crude price: a low price, an average price and a high price scenario. From these
scenarios, we build four models:
Model 1: This model corresponds to the low price scenario. This scenario assumes a
soft landing. The growth of world oil demand is slowing sharply because of
the transition to alternative energy, and oil prices fall to an average price of
$25/barrel.
Model 2: This model corresponds to the scenario of an average price. This scenario is
based on a continuity of supply of crude oil. Global demand remains strong
but begins to slow down. The price of a barrel of crude sells at around
$100/barrel.
Model 3: This model corresponds to the scenario of a high price. This crisis scenario
provides that the supply will be disrupted by terrorist attacks or political
unrest, and it will no longer be able to meet demand. Crude price increases to
$200 per barrel.
Model 4: a mixed model where we assign a subjective probability of occurrence of the
three price scenarios:
In the latter scenario, we calculate, for each project, the NPV for the three price scenarios.
Then, we calculate the expectation of NPV taking into account the probabilities of occurrence
of the three scenarios.
Since the seminal work of Markowitz (1952a, 1952b), mathematical analysis on portfolio
management has grown considerably. Variance has become the most popular mathematical
definition for the risk of portfolio selection. Markowitz shows how rational investors can
construct optimal portfolios under conditions of uncertainty. The mean and variance of a
portfolios return represent the benefit and risk associated with the investment. Several
researchers have developed a variety of models to handle risk using variance as risk
measure, e.g. Chopra and Ziemba (1998), Chow and Denning (1994) and Hlouskova (2000).
Variance is a useful measure of risk. In calculating variance, positive and negative
deviations from the mean are equally weighted. In fact, decision-makers are often more
pre-occupied with downside risk the risk of failure. A solution to this problem is to
determine the efficient set of portfolios by using another risk measure. Semi-variance
overcomes this problem by measuring the probability and distribution below the mean
return. Several models have been developed by using semi-variance as risk measure, e.g.
Homaifar and Graddy (1990), Huang (2008), Grootveld and Hallerbach (1999),
Markowitz et al. (1993), etc. In the mean downside risk investment models the variance
is replaced by a downside risk measure, then only outcomes below a certain point
contribute to risk.
170
F. Belaid
For our problem, a portfolio optimisation was conducted for our group of 14 petroleum
upstream projects under risk consideration, resulting in an efficient frontier. In this case,
risk was measured by the variance as calculated across Monte Carlo simulation. In this
model the objective function is a linear combination of net present value against risk
(variance).
4.1 Notations
For indices, we use, i and j to denote the different E&P projects and t for the years.
We used the following two sets:
N: the total number of projects (14 in our application)
E: the set of specific projects (5 in our application)
ENPVi: the expected return of project i
ij = coefficients of the covariance matrix defined for the NPV of projects i and j
(given by the Monte Carlo simulation)
ij = coefficients of the semi-covariance matrix for the NPV of projects i and j
(given by the Monte Carlo simulation)
Ri = reserves of project i for year t
Pit = production of project i
Ii = investment of project i
Pmin t = minimum targeted production for year t
Rmin = minimum reserves required from the selected portfolio (500 million barrels
in our example)
Imax = total capital available to investment (5000 $MM in our example)
= capital enrichment for the selected portfolio
min = the desired level of return for the selected portfolio (900 $MM in our example)
= coefficient reflecting the risk aversion factor of the investor (0 1)
= the minimal fraction of the total investment allocated to exploration product (20%)
Max Z1 = (1 ) X i ENPVi X i X j ij
i =1
i =1 j =1
171
X
i =1
I i I max
Ri Rmin
ENPVi min
X
i =1
N
X
i =1
X i Ii X i Ii 0
i =1
i =1,iE
X
i =1
Pit Pmin t
Its a quadratic model maximising the objective function (return risk). For each value
of , we determine the value Xi (fraction of each project invested in the portfolio) and the
corresponding portfolio return and risk. The latter are elements of the efficient frontier.
We get the efficient frontier point by point by solving this problem for different values of
. The values of are shown in Table 2.
Table 2
10
0.01
0.02
0.03
0.04
0.05
0.06
0.07
0.08
0.09
11
12
13
14
15
16
17
18
19
20
0.10
0.20
0.30
0.40
0.50
0.60
0.70
0.80
0.90
172
F. Belaid
Max Z1 = (1 ) X i ENPVi X i X j ij
i =1
i =1 j =1
X
i =1
I i I max
Ri Rmin
ENPVi min
X
i =1
N
X
i =1
X i Ii X i Ii 0
i =1
i =1,iE
X
i =1
Pit Pmin t
Economic evaluation models were created for each project in Excel file models and
evaluated under concession contracts. For simulation, we use the latest version of Crystal
Ball software version 7.3 (Charnes, 2007). The resolution of the different quadratic
optimisation models under Markowitzs method is obtained using GAMS software
(Brook et al., 1992).
As in Markowitz et al. (1993), we compute the portfolios semi-variance as follows:
N
SVi =
t =1
( NPVi ENPVi )
S ij =
N
i =1 j =1
173
this frontier is different from the one obtained with the use of the variance as
the measure of the risk. For a similar return we have a lower risk. It is due to
the fact that the semi-variance considers returns below the mean as risk,
contrary to the variance which does not distinguish between the returns below
and above the mean.
Scenario 2 (oil price of $100/barrel): The application of the method of Markowitz with
the semi-variance as risk measure provides 19 optimal portfolios for this
scenario. P1 is the riskiest portfolio with a semi-variance of 29,136, an output
of $13,326.95 million and an investment of $5000 million, while P19 is the
least risky portfolio with a semi-variance of 1938.45 and an expected NPV of
$3913.17 million and one investment of $1938.45 million. The efficient
frontier is presented in Figure 7.
Scenario 3 (oil price of $200 /barrel): The use of the semi-variance as the measure of
the risk on this scenario gives us 19 optimal portfolios with compositions close
to those obtained with the use of the variance. P1 is the riskiest portfolio
with a semi-variance of 97,956.37, a $29,489.20 million dollar return and a
$5000 million dollar investment. P19 is the safest portfolio, with a semivariance of 4927.53, a NPV of $8721.27 million, and an investment of
$1947.04 million. The efficient frontier is presented in Figure 8.
Scenario 4 (average NPV): This average scenario, gives us 19 optimal portfolios. Their
compositions are different from those obtained with the variance as risk
measure. On the other hand, the returns are close. P1 is the riskiest portfolio
with a semi-variance of 49,882, a NPV of $17,367 million, and an investment
of $5000 million (it is the same portfolio obtained with the classic method).
P19 is the least risky portfolio with a semi-variance of 2484, a NPV of
$5116 million, and an investment of $1952 million. This last portfolio reduces
the risk by 95% and the investment ($3047 million) by 60% with a loss of
70% return ($12,250 million). The efficient frontier with the average NPV is
presented in Figure 9. The results are presented in Table 3.
Figure 6
174
F. Belaid
Figure 7
Figure 8
Figure 9
5000
0.48
EXP1
EXP2
EXP3
EXP4
EXP5
EXP6
EXP7
EXP8
EXP9
EXP10
EXP11
EXP12
EXP13
EXP14
49,882.68
SV
Invest.
17,367.52
ENPV
P1
(1)
P2
0.25
0.89
0.51
5000
49,159.39
17,354.58
(2)
P3
0.87
0.84
0.84
0.56
5000
44,519.56
17,227.81
(3)
P4
0.74
0.95
0.92
0.67
5000
41,114.29
17,107.88
(4)
P5
0.67
0.9
0.98
0.76
4997.72
39,710.58
17,042.59
(5)
P6
0.62
0.89
0.84
5000
39,033.49
17,003.71
(6)
P7
0.57
0.83
0.08
0.95
0.07
0.82
5000
36,883.01
16,852.48
(7)
P8
0.52
0.78
0.17
0.89
0.96
0.17
0.79
5000
34,953.47
16,696.74
(8)
P9
0.49
0.74
0.23
0.84
0.93
0.24
0.77
4998.775
33,639.24
16,575.12
(9)
P10
0.46
0.71
0.97
0.29
0.81
0.91
0.3
0.76
5000
32,011.03
16,401.37
(10)
Table 3
Portfolio
5000
0.72
0.48
0.84
0.7
0.45
0.62
0.62
0.38
EXP1
EXP2
EXP3
EXP4
EXP5
EXP6
EXP7
EXP8
EXP9
EXP10
EXP11
EXP12
EXP13
EXP14
SV
Invest.
15,173.86
23,009.34
ENPV
P11
(11)
P12
0.34
0.58
0.44
0.53
0.65
0.81
0.58
0.71
0.92
5000
19,842.74
14,514.57
(12)
P13
0.26
0.47
0.89
0.26
0.51
0.88
0.52
0.67
0.56
0.6
0.66
4329.14
13,271.2
12,105.1
(13)
P14
0.17
0.3
0.58
0.17
0.32
0.97
0.57
0.33
0.43
0.36
0.38
0.43
2963.77
6060.44
8,340.04
(14)
P15
0.11
0.2
0.39
0.11
0.21
0.64
0.74
0.38
0.22
0.29
0.24
0.26
0.29
2020.513
2802.75
5721.47
(15)
P16
0.11
0.2
0.33
0.08
0.22
0.54
0.73
0.34
0.21
0.31
0.25
0.24
0.25
1986.934
2611.17
5498.01
(16)
P17
0.11
0.19
0.3
0.05
0.22
0.46
0.73
0.31
0.2
0.34
0.25
0.24
0.22
1967.705
2536.6
5361.83
(17)
P18
0.12
0.19
0.25
0.02
0.23
0.36
0.72
0.27
0.2
0.37
0.25
0.23
0.18
1963.717
2487.6
5180.26
(18)
P19
0.12
0.19
0.23
0.23
0.32
0.72
0.26
0.19
0.38
0.26
0.22
0.17
1952.749
2484.07
5116.71
(19. 20)
Table 3
Portfolio
176
F. Belaid
177
178
F. Belaid
Conclusions
Analysis of obtained solutions has shown that the given optimisation model based on
the modern portfolio theory method is robust and flexible in terms of input data and
output results. However, the model allows the decision-makers to specify the best rate
of participation in every project. Its modular architecture allows further inclusion of
complementary constraints and utilises different measures (than considered) of risk and
return as well as different input data formats. This method, contrary to the classical
selection methods, analyses the projects by considering the various aspects of the risk
and the various correlations between the projects, such as places, prices, profiles, politics,
and procedures. This allows to better take into account the risk of the projects, and
limiting the investment failures. More specifically the method allows determining:
the allocation of capital as well as the distribution of the production and the returns
for each project
the adequate strategies of investment, which answer the expected objectives, and
respect the budgetary constraints of the company.
179
The use of variance as risk measure in the optimisation process penalises projects for
upward as well as downward potential. We can overcome the problem by using semivariance in the definition of the optimisation problem. Semi-variance concentrates only
on the reduction of losses, without taking into account risks of the extreme potential
gains. This approach allows the portfolio managers to define the risk in an adequate way
according to the objectives and the constraints which concern their portfolio. This
study demonstrates that an explicit analysis of uncertainties and interdependencies in
evaluating the risks of E&P projects improves the quality of investment decision-making.
This paper is based on static evaluation of the risk of crude oil price and on a limited
number of case studies, e.g. Rodriguez and Oliveira (2005); Jafarizadeh and Khorshid
(2008). Therefore, empirical results cannot be generalised. Future researches to develop a
dynamic model for the optimal portfolio selection incorporating the crude price
uncertainty in a dynamic way are needed. Finally, we believe that the model proposed
does not provide a certain and unique answer for the problem of project portfolio
management but gives insights into what makes a desirable project portfolio for a
company rather than an undesirable one.
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