Hurdle-Rate Measurement for Non-U.S. Projects in the Energy Industry(includes associated papers 25287 and 25305 )
Authors: Chun Jess , Woodward Richard 
Published: December 2007

Over the past few years, U.S. energy producers have shifted exploration activities to areas outside the U.S. This paper focuses on which hurdle rate is appropriate for the evaluation of these particular energy projects. While conventional wisdom may suggest that these projects are riskier than equivalent domestic projects and therefore should be evaluated with a higher discountrate, this paper suggests that this may not be the case. Indeed, by uncovering the nature of risk embedded in the hurdle rates used in project analysis (that is, the risk faced by a fully diversified investor), we can see through a comparison of similar U.S. and non-U.S. investments that risk is not likely to be higher for non-U.S. projects. To examine this conjecture, this paper empirically evaluates the riskiness of investments in Canadian, U.K., and Australian energy companies from the perspective of a highly diversified U.S. investor. The results indicate that non-U.S. projects are unlikely to be riskier than comparable U.S. projects from this perspective.

Introduction

Within most large oil and gas companies, hurdle-rate selection for project evaluation is a critical component of the capitalal location process. These discount rates represent the minimum level of profitability that is acceptable for any project and therefore are critical to the evaluation process. As U.S. oil and gas firms increasingly look to non-U.S. markets to expand their exploration and drilling activity, they must decide whether to evaluate these projects with the same or different hurdle rates as comparable U.S. projects. Evaluating these international projects requires the same type of economic analysis carried out for U.S. projects, essentially discounted-cash-flow or net-present-value analysis. Applying this evaluation methodology requires two types of data: a series of forecasted cash flows and an appropriate hurdle rate. In this paper, we focus on the hurdle rate. This study first discusses the logic underlying financial-market-determined hurdle rates. In particular, we argue that financial riskiness of any project must be measured not in isolation, but by reference to a benchmark portfolio held by the representative investor. We then look at the conventional benchmark portfolios used in the measurement of hurdle rates by U.S. oil and gas producers. The hurdle-rate logic is then extended to evaluating non-U.S. projects. Conventional wisdom states that non-U. S. projects should be evaluated at a higher discount rate than U.S. projects. We question this conventional wisdom. While some non-U.S. projects may indeed pose higher risks, especially unconventional projects or projects located in politically unstable developing economies, it is not obvious that non-U.S. projects in politically stable economies that are comparable technically to U.S. projects are indeed riskier. In addition to evaluating the riskiness of non-U.S. vs. U.S. projects, we also consider the extent to which the ongoing globalization of world financial markets n-Light affect the riskiness of both U.S. and non-U.S. investments in the energy industry.

Logic of Hurdle Rates Used In Project Evaluation

Hurdle-rate selection within an organization is an important part of the capital allocation process. It assists in and, in some cases, dominates the process of deciding which projects receive funding. Theoretically, projects that are not expected to achieve the assigned hurdle rate should be rejected. This selection criterion rests on the presumption that management should pursue the goal of enhancing the wealth of the company owners. Hurdle rates represent the minimum required rates of return set by investors in the company considering the projects. Miller and Vasquez' noted that these discount rates attempt to measure the "cost of the last increment of capital obtained,"which in turn depends directly on the nature of the particular asset requiring funding. Lohrenz argued that for "each homogeneous class of assets, the market should display discount factors clustered within a limited range at any time. A common practice in the U.S. oil and gas industry is to measure the corporate weighted average cost of capital (WACC) and use this as the discount rate in evaluations of domestic projects. This rate is measured as a weighted average of the minimum rates of return required by those investors supplying equity and debtcapital, with the weights reflecting the percentage of totalcapital supplied by each group. The cost of debt is the minimum required rate of return set by investors providing the debtcapital; the cost of equity is that set by those investors providing equity capital. In general, suppliers of capital, both debt and equity, are risk-averse. Therefore, they require risk premium for riskier investments, with the premium demanded varying with the investor's perception of the investment's riskiness. Many risk are involved in an exploration venture. There is the risk associated with the states of nature-whether oil exists in the prospect. There is technological risk associated with the operator's ability to extract the oil and deliver it to market. There are force majeur risks and operational risks against which the operator can usually insure.

JPT

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