Capital allocation plans are being analyzed within the exploration and production group of an integrated oil and gas company utilizing information from a mathematical model which determines optimal allocations of single and multi-year capital outlays to exploration and development projects.The optimization processes focus on key performance drivers which better relate to enhancing shareholder value than more traditional accounting measurements such as net income, earnings per share, and return on assets. Key strategies for successful implementation of the model are discussed.
Capital investment strategies are being analyzed within an integrated oil company utilizing information from a mathematical model which determines optimal allocations of single and multi year capital outlays that will maximize the net worth of the company over a long term horizon. The optimal processes focus on an economic profit measure which is closely related to net present value or market value added when applied to any business segment or operating level within the company. It provides a more robust and comprehensive measure of value created for the shareholder than more traditional financial and accounting measurements such as net income, cash flow, earnings per share, or return on assets. The optimization model is described and the theoretical aspects and application of the economic profit measure are discussed. Introduction Making selective and disciplined investments is one of the most challenging things for us. Each year our company allocates hundreds of millions of dollars to thousands of capital investment opportunities. Optimally allocating this capital is critical to the success of any company. However, those of us in businesses like E&P, refining, marketing, and petrochemicals have a much tougher job than those who work in less volatile and less capital intensive industries. In our business, we are faced with a multitude of investment opportunities with numerous uncertainties, constraints, and risk-return profiles. These opportunities can range between low-risk, quick-return projects such as oil field developments, plant debottlenecks, and facility expansions, to higher-risk, long-term projects such as deep water exploration or green field plant constructions. For many projects, returns can fluctuate widely due to price or margin swings and business cycles. Returns on investment can frequently take years to be realized. Furthermore, the optimal capital allocation decision has been clouded because of the discontintuity between economic measures of merit (such as rate of return, net present value, and profitability index) and performance measures that are accounting oriented (such as cash flow, net income, return on assets, etc.) Within our company, we are committed to provide value to our shareholder. It's in our Corporate Mission to deliver superior shareholder returns. We work very hard to maintain a discipline in our investment decision making. Like many others in the industry, we have a major emphasis on growth. We are looking at a wide range of opportunities across our business lines, many more opportunities than we have had in the past several years. We encounter a large selection of projects ranging from large scale growth projects, whose benefits are typically not realized until several years into the future, to shorter term projects to maintain our current operations or to exploit or enhance our existing assets, in determining which projects are funded, our overall objective is to maximize the value of the firm. To analyze and determine optimal capital investment strategies, our strategic planning group has developed a mathematical model which utilizes, within its objective function, an economic profit measure that has recently been defined within the company. This economic profit measure is a measure of a single period (e.g., annual), earnings-based performance. However, by its definition, it is also mathematically related to discounted cash flow and net present value. The model combines financial and other project related data from the company's long range planning systems. It uses mixed integer programming to maximize the expected present value of the future economic profit of all our future investment opportunities. In the optimization process, project selection is subject to limits on capital funding and the balance of risk preference between opportunities. Sensitivity analysis can be performed on variables and issues that impact the optimal solution such as delay of projects, commitments to other projects, and project deferral penalties. Decision Problem Definition Table 1 illustrates a simplified numerical example of the capital allocation decision problem in the form of sample data for 10 candidate investment opportunities. P. 165^
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