Investment Appraisal and Risk Management in the Oil and Gas Industry - Research Proposal Example

INVESTMENT APPRAISAL AND RISK MANAGEMENT IN THE OIL AND GAS INDUSTRY Supervisor: Literature review The current problem or topic cannot be described as one that is new in terms of research. This is because there are several works of research that have been taken in this area, aimed at finding the best ways in which companies going into oil and gas investment can appraise their investment and management risk as a result. The essence of this literature review is basically to find literature about the topic in relation to the specific objectives set. By so doing, it will be possible to identify major gaps in literature and how the proposed research seeks to address the gaps. Commonest forms of risk associated with investment in the oil and gas industry Throughout literature, there seems to be a two-sided wave of discussion on the core forms of risk associated with the oil and gas industry. These are what may be referred to as historical risk factors and complex modern risk factors (Geman, 2005). Parigi and Guiso (1999) noted that the oil and gas industry has for long suffered from historical risk factors that have always seemed to be available, no matter the area of investment in the industry. Some of the specific historical risk factors are named to include commodity price volatility, geopolitics, cost risk, demand and supply risk, and political risk. In the estimation of Grenadier (2002) however, even though these historical risk factors cannot be pushed under the carpet, the industry continues to experience so much complexity that expands its risks beyond those mentioned earlier. In the light of this, the industry is said to be faced with complex modern risk factors which are directly focused on macroeconomic influences (Hansen, 1982). With this said, the industry can be said to be harboring a form of increasing proclivity of mega-projects at the national levels which account for a leveraged economies of scale, which have pushed for the existence of macroeconomic influences. Review on risk management techniques in oil and gas industry There are a number investment appraisal and risk management techniques used in the oil and gas industry today. This section of the review gives an overview of these techniques, when they are considered right for application, and the limitation that comes with each. The first technique is the accounting rate of return (ARR). Williams (2002) noted that this technique is appropriate in determining the profit an investor requires from an investment as against the amount invested. Its limitation however is that it is not considered suitable when dealing with competing projects as competing projects may have same rate of return but different net present value (Parigi and Guiso, 1999). There is also the use of payback period, which simply assesses the length of time it would take to repay an investment capital (Surbhi, 2012). Williams (2002) however criticized this technique as failing to forecast the real value of investment after repayment has been reached. Discounting cash flow is another important technique, used to work out the present day equivalent of the future cash flow (Parigi and Guiso, 1999). This comes in two forms which are net present value (NPV) and internal rate of return (IRR). Surbhi (2012) mentioned that even though discounting rate of cash flow overcomes the problem with payback period by giving an idea of cash flow after repayment, it also has a weakness of failing to guarantee the real repayment time based on which projected cash flow can be made. Weaknesses with the use of individual investment appraisal techniques Certainly, the approach to investment appraisal and risk management in the oil and gas industry can never be regarded as being the same after the global economic recession of 2007 and 2008. This is because oil and gas companies have come to realize the volatility with the global economy and how financial risk associated with such other industries such as the mortgage can affect global financial stability in its entirety (Fuss and Vermeulen, 2004). With this noted, a major gap is identified in terms of the availability and use of investment appraisal and risk management methods in the oil and gas industry, where most available forms of methods simply cater for how long before companies recoup their investment. Stonehill and Nathanson (1968) stressed that most investors heading towards the oil and gas industry are very much aware of the existence of investment appraisal techniques such as accounting rate of return (ARR), payback period, discounting cash flow, and return on investment (ROI). Because of this, there are several works of research that have treated these investment appraisal techniques very extensively. Regardless of the above, major gaps exist in literature with reference to a refusal to identifying the limitations associated with the use of any of these techniques as an individual or single investment appraisal technique. In Surbhi (2012), it was found that most forms of investment are mutually exclusive projects. Meanwhile, the forms of investment techniques named above can be seen as having the limitation of not considering the whole project period. Most of them are ROI and payback period (Tanaka, 2014). Because of this, most known forms of investment techniques, when used in isolation cannot be expected to answer the question of whether or not to consider a project that guarantees longer payback period that provides higher returns after payback period (Wicks and Philippatos, 1982). With this weakness, one gets the idea that combining two or more of the techniques with payback and rate of return included in each case will be ideal for the investors. Investment dynamics of oil and gas investment risks Investment in the oil and gas industry has never been the same after the industry failed to show robustness against global recession caused by the trigger of other industries such as the mortgage (Williams, 2005). From this time, investment dynamics has been a key word in oil and gas discourse as investors and financial analysts have come to be more proactive on the need to accommodating risk management that is not just about getting one’s capital investment back after a given period (Copeland and Tufano, 2004). Investment dynamics in the sector therefore borders on the need for investors to ensure that they can forecast beyond that point after return on investment has been made (Kemna, 1993). This is also another area with a major gap in literature because most forms of literature seem to acknowledge the existence of this investment dynamics but fail to address ways in which investment appraisal and risk management techniques can be used to tackle the investment dynamics. Another major investment dynamic is what was started earlier about the impact of macroeconomic influence on the industry. Today, investment outcomes are largely being predicted and influenced by the macroeconomic outlook of countries of origin (Williams, 2002). A major gap however is that even though this knowledge is known, approaches to addressing it with the use of investment appraisal and risk management techniques is lacking. The place of the eclectic investment technique in PPM Today, the need for centralization of the management of processes, methods and technologies involved in oil and gas investment continues to become popular (Merton, 1976). This is what has largely led to the popularization of project portfolio management (PPM) as PPM seeks to collect, analyze and manage current and proposed projects by the use of centralized management processes (Smith and McCardle, 1998). Certainly, PPM helps investment managers in the oil and gas industry to optimize resource mix that aim at achieving organizational operational and financial goals (Copeland and Tufano, 2004). But if the discussion is narrowed down to investment appraisal and risk management, one would find a major gap whereby the inability of individual investment appraisal techniques to create a centralized management processes has not been dealt with. This is because for there to be a centralized process, it is important to have series of methods or techniques, among which the centralized focus will be created (Stripe, Arisaka and Durandeau, 1993). Reference Copeland, T. and Tufano, P. (2004). A real world way to manage options. Harvard Business Review 83 (2). Fuss, C., Vermeulen, P. (2004). Firms investment decisions in response to demand and price uncertainty. ECB Working Paper No. 347. Geman, H. (2005). Commodities and Commodity Derivatives. John Wiley & Sons, London. Grenadier, S.R. (2002). Option exercise games, an application to the equilibrium investment strategies of firms. Review of Financial Studies 15 (3), 691–721. Hansen, L., (1982). Large sample properties of generalised method of moments estimators. Econometrica 50 (3), 1029–1054. Kemna, A.G.Z. (1993). Case studies on real options. Financial Management 22, 259–270. Merton, R. (1976). Option pricing when underlying stock prices are discontinuous. Journal of Financial Economics 3, 125–144. Parigi, G. and Guiso, L. (1999). Investment and demand uncertainty. Quarterly Journal of Economics 114, 185–227. Smith, J.E. and McCardle, K.F. (1998). Valuing oil properties: integrating option pricing and decision analysis approaches. Operations Research 46, 198–217. Stonehill, A.I., and Nathanson, L., (1968). Capital budgeting and the multinational corporation, California Management Review, Summer, pp39-54 Stripe, J.A., Arisaka, K. and Durandeau, M. (1993). Integrated field development planning using risk and decision analysis to minimize the impact of reservoir and other uncertainties: a case study. Society of Petroleum Engineers paper number 25529, presented at Middle Easst Oil Conference, Bahrain. Surbhi, A. (2012). Investment Decision Making in the Upstream Oil Industry: An Analysis. Tanaka, H. (2014). Toward Project and Program Management Paradigm in the Space of Complexity: A Case Study of Mega and Complex Oil and Gas Development and Infrastructure Projects, Procedia - Social and Behavioral Sciences, Volume 119, 19, Pages 65-74, ISSN 1877-0428 Wicks K.M.E. and Philippatos, G.C., (1982). Comparative analysis of foreign investment practices by US based manufacturing multinational companies, Journal of International Business Studies, 13(3), pp19-42 Williams, T.M. (2002). Modelling Complex Projects. John Wiley & Sons, London. Williams, T.M. (2005). Assessing and moving on from the dominant project management discourse in the light of project overruns. IEEE Transactions on Engineering Management 52 (4), 497–508. Read More