The Significance of Risk Definition on Portfolio Selection
- J.R. McVean (Merak Projects)
- Document ID
- Society of Petroleum Engineers
- SPE Annual Technical Conference and Exhibition, 1-4 October, Dallas, Texas
- Publication Date
- Document Type
- Conference Paper
- 2000. Society of Petroleum Engineers
- 4.1.5 Processing Equipment, 7.2.1 Risk, Uncertainty and Risk Assessment, 4.1.2 Separation and Treating
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Efficient frontier portfolio analysis considers the balance between value and risk in the selection of "optimal" portfolios. Efficient frontier theory was originally developed for the realm of securities portfolios, where considering risk and uncertainty as synonymous may be appropriate. However, the appropriateness of this assumption has come to be questioned for petroleum portfolios. By examining the possible portfolios made up of a subset of 30 fictional but realistic projects, the significance of the definition of risk is explored. For each project, several risk profiles were generated based on different measures of value using Monte Carlo simulations. The definitions of risk that are explored include the standard deviation of the portfolio's risk profile, the semi-standard deviation of the risk profile, the tenth percentile of the risk profile, and the probability of the measure of value being less than a specified threshold. The impact of risk being based on measures of value other than that used as the principal value measure is also explored. The conclusion is that the selection of an "optimal" portfolio is strongly dependent on which definition of risk is selected. Consequently, it is important to explore multiple risk definitions in order to more fully understand the quality of a portfolio, and ultimately make wise decisions as to which projects should be pursued.
Petroleum companies are continually faced with the decision of where capital should be spent. A subset of projects must be selected from what is generally a much larger selection of possible projects. Portfolio selection is obviously a crucial part of the business cycle, and hence it deserves careful consideration.
Of course, the goal of the portfolio selection process is to identify the "best" portfolio. However, it is generally not clear what the best portfolio is, or even how to define "best" in this context. There are many elements of the portfolio that must be considered:
Does it provide the most value?
Is it affordable?
Does it meet production requirements?
Does it satisfy development constraints?
These considerations and others form the basis for the non-trivial problem of portfolio selection. It is essentially an optimization problem and it can be tackled with a number of methods. However, before leaping into the optimization, the questions that define the problem should be reexamined.
Considering these questions should naturally lead to a whole other category of questions related to risk assessment:
What is the definition of value?
Is the Cost of a project ever precisely known?
Can one know how much a project will produce?
Is value independent of risk?
What is risk?
The last question is a very difficult question to answer, primarily because there is no real answer. Risk assessment is, to a large extent, a matter of personal judgement. Some view risk and uncertainty as synonymous, while others view only the downside of uncertainty as risk. Still others measure risk in terms of probability—the probability of losing money, or the probability of failing to make quotas.
Acknowledging this ambiguity, it seems that it is important to understand how the definition of risk can affect portfolio selection. This paper describes the investigation of this subject using a set of 30 fictional projects and some fairly simple portfolio goals to act as constraints for valid portfolio selection.
Theory and definitions
Harry Markowitz revolutionized the field of portfolio theory with his pioneering work in the 1950s (Markowitz, 1952, 1997). There are three important ideas that should act as starting points for the discussion of his efficient frontier theory:
A rational investor will prefer more value to less value, but will also prefer less risk to more risk.
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