Where Have All the Profits Gone? Or, Evaluating Risk and Return of E&P Projects
Authors: Brashear J. P. , Becker A. B. , Faulder D. D. 
Published: December 2007

Abstract
Despite massive improvements in productivity due to technology advances, the E&P industry has averaged a disappointing 7% return on net assets (less than its cost of capital). Its market capitalization relative to the S&P 500, even at recent high oil and gas prices, is about half what it was a decade ago. A small scale, very simple case study suggests that at least part of the reason for this disappointing performance lies in the conventional way that the industry allocates capital and selects portfolios of projects. Conventional ranking of projects by deterministic estimates of value significantly overstates value, understates risk, and misallocates capital by incurring unnecessary, uncompensated risks. Suggestions for improvements in the project selection/capital allocation prices are offered.
Why Change?
Petroleum exploration and production is enjoying a "golden age" in technology. Over the past two decades, finding costs have fallen more than three fold and lifting costs by half or better (EIA, 1998). Three-D seismic has improved exploration success rates by as much as 90% and development success rates by 30% (Bohi, 1997). Yet, at the same time, the return on net assets by the largest U.S. based companies in the E&P sector has averaged 7% for both integrated majors and large independents (Figure 1, Simpson et al., 1999). This return is the result of projects selected because they all exceeded the minimum estimated internal rate of return "hurdle rates", generally set at 15% or more, and were all financed with capital that generally cost in the range of 10 – 12%. This would appear to indicate long-term destruction of shareholder value.
Investors have noted these discouraging results and have responded accordingly. Figure 2 illustrates the AMEX Oil Index (16 major and independent U.S.-traded companies) and the Standard and Poors (S&P) 500 Index (the largest 500 U.S.-traded, non-financial companies, of which many of the oil companies are a subset) since January of 1990. The two indices show a continuing and accelerating divergence. Almost any major equity index other than the S&P would show an even greater divergence with the oil index.
Some would argue that this was a period of volatile and often low oil prices. To examine if price variation accounts for the divergence, the Oil Index was "normalized" relative to the larger market for equities by dividing both by their 1990 values and then dividing the normalized oil index by the normalized S&P 500. If the two indexes moved together, the ratio would remain constant at unity. This normalized value is plotted against inflation-adjusted "real" oil prices (West Texas Intermediate in 2000 dollars) in Figure 3.
In January of 1990, oil prices in real terms were about where they were in June of 2000. The Gulf War caused a price "spike" to nearly $45/b (in 2000 dollars) in October, and, as a result, oil company stock prices rose about 10% more than the full market during the late summer and early autumn, followed by a steady decline in both relative share prices and oil prices. Over the period 1991 to 1997, oil prices ranged between $16 and $26/b, but share prices gradually drifted from about 80% of comparable index stocks to 70%. In 1998 began a collapse of oil prices to nearly $11/b in December 1998 before recovering to around $30 in the spring of 2000. During this latest oil price cycle, oil company shares have held constant at about 50% of their value in 1990 relative to the market value of the full S&P Index.
An interpretation of these data is that, despite significant technological advances, the E&P industry's performance over a sustained period has been such as to erode shareholder value and the confidence. Stock prices today are about half what they were a decade ago when adjusted for oil prices and the general market trend. Such a loss in investor confidence could have devastating consequences in the future for this capital-intensive industry.
A number of factors have contributed to this overall performance. The present paper questions whether part of the answer may lie in the way that projects are evaluated and selected. Specifically, a simple case study is used to examine whether conventional treatment of uncertainty contribute to over-estimation of returns, under-estimation of risk, and/or misallocation of capital.