The Pitfalls of Capital Budgeting When Costs Correlate to Oil Price
Authors: Schiozer R.F. , Costa Lima G.A. , Suslick S.B. 
Published: March 2010

This paper investigates the economic relationship that exists between oil price and operating costs in the E&P industry and its implications for the capital budgeting and decision-making processes. We present empirical evidence that there is a positive correlation between price and operating costs, and that overlooking this relationship has severe implications for the valuation of investment projects, both using a traditional Net Present Value (NPV) methodology or a Real Option approach. In the traditional NPV method, overlooking a price-cost correlation results in undervalued projects, and under Real Option Analysis, projects tend to be overvalued if such correlation is ignored.

Introduction

Any oil company manager involved in capital budgeting and decision-making is aware that the costs of exploration, appraisal, development and production have skyrocketed in the last five years due to increased demand for drilling rigs, specialized labor force and other resources. This dramatic change in costs is ultimately related to the increased activity in the E&P industry, reflecting the impacts of the rise in oil prices observed in the last number of years.

This paper shows empirical evidence that the operating costs in the E&P industry are highly correlated to the price of oil. In the capital budgeting process, however, this correlation is often overlooked. When costs correlate to oil price, an increase or decrease in revenues is at least partially offset by a co-movement in costs. When this offsetting effect is ignored, the volatility of cash flow tends to be overestimated. This paper shows how this problem affects the valuation of oil prospects, both under the traditional NPV approach and a real option valuation technique, analyzing how decision-making processes may be flawed when the correlation between oil price, capital and operational expenditures are ignored.

Under the traditional NPV approach, the overestimation of the volatility of cash flow causes projects to be seen as riskier than they really are. This causes a misperception of the firm's costs of financial distress. As a result, NPV is underestimated and, thus, the firm may pass over some good investment opportunities. If a real option approach is used, overestimated volatility results in an overvalued project since, as seen in the next section, the value of an E&P project is an increasing function of the volatility of its cash flows.

This paper is structured as follows: the next section shows briefly how projects are evaluated under traditional NPV and real option approaches. Section 3 presents empirical evidence that costs correlate to oil prices. Section 4 discusses the differences between project valuation when a cost-price correlation is taken into account or not, including a numeric example. The last section brings some findings, conclusions and general implications of the results obtained for the decision-making process.

Project Evaluation Under Traditional NPV and Real Option Approaches

Valuation Using Traditional NPV

The Net Present Value (NPV) of a project is given by the sum of annual cash flows yielded by the projects; each one discounted at a proper rate that reflects the systematic risks associated to these cash flows, i.e.: