Inverted Hockey Stick Method Reveals Greater Uncertainty in Petroleum Investment Evaluations

Olsen, Grant Theodore (Devon Energy Corp.) | McVay, Duane Allen (Texas A&M University) | Lee, W. John (Texas A&M University)


Abstract Conventional oil price forecasting methods in the petroleum industry typically consider uncertainty by incorporating optimistic, pessimistic, and most-likely cases. Commonly, these price projections are "hockey stick" forecasts, i.e., forecasts that are initially flat or decline for some period of time and then increase monotonically. Review of historical forecasts by industry and governmental organizations show that conventional forecasting methods often fail to capture the true uncertainty associated with oil and gas prices. Performing discounted cash flow calculations using conventional oil and gas price forecasts will therefore underestimate the uncertainty associated with project economic performance indicators. Akilu et al. developed the Inverted Hockey Stick (IHS) Method to address these shortcomings. This new method for quantifying the uncertainty of price forecasts honors the historical extremes of oil and gas prices (on a constant dollar basis) along with the maximum positive and negative historical rates of change. To investigate the uncertainty associated with economic indicators (e.g., net present value, investment efficiency, and internal rate of return), we applied the IHS method to 23 completed or proposed projects from 12 operators. We found the P50 IHS value for these economic indicators is comparable to the most-likely value from conventional price forecasts. Across all 23 cases, however, the IHS method predicted a wider range of economic indicator values than conventional forecasts. The IHS method may be preferable over conventional methods due to its ability to quantify more realistic upside and/or downside risk associated with projects in the upstream petroleum industry. Introduction Investments throughout the oil and gas industry are subject to considerable uncertainty. Capen[1] reports that uncertainty is difficult to quantify and that there is an almost universal tendency to underestimate it. Garb[2] identified three classes of uncertainty for hydrocarbon-producing properties: technical, political, and economic. Many experts believe that economic uncertainty affects oil and gas investments at least as much as uncertainties in reservoir and technical data.[3] Unlike technical uncertainty, however, economic uncertainty does not decrease over the life of a petroleum investment. While we may not be able to reduce economic uncertainty, we can make better investment decisions if we are able to quantify it. Conventional oil price forecasting methods traditionally attempt to address uncertainty by including optimistic, pessimistic, and most-likely cases. Commonly, these price projections are "hockey stick" forecasts. Hockey stick price forecasts are initially flat or decline for some period of time and then increase monotonically.[3] Fig. 1 shows a natural gas price forecast published by the California Energy Commission (CEC) in 1998 that illustrates clearly the characteristic "hockey stick" shape of conventional price forecasts.[4] Fig. 2 shows a later CEC natural gas price forecast, published in 2003, upon which subsequent actual gas price data are plotted.[5] The figure shows that a significant portion of the actual gas price data fell well outside the price range represented by the pessimistic and optimistic cases during the first two years of the forecast. Another example further indicates the industry's tendency to underestimate the uncertainty in price forecasts. In the widely used textbook, Project Economics & Decision Analysis, Mian[6] predicts "oil prices [will] remain in the range of $18 to $30 per barrel for another decade." Only two years after the publication of this text, during 2004, crude oil spot prices exceeded $56/bbl and closed the year at over $43/bbl. Caldwell and Heather[7] noted, tongue in cheek, that nearly all conventional price forecasts are "wrong 100% of the time" and "nobody believe[s] the forecast anyway." Despite these observations and perceptions, conventional price forecasts are still widely used throughout the industry. According to Brashear et al.,[8] return on net assets averaged less than 7% for both majors and independents during the 1980's and 1990's. The apparent failure to recognize the true uncertainty in economic forecasting may have been a cause for these relatively low returns on investments in the petroleum industry.

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