One question: how useful do you think are portfolio optimization concepts like efficient frontier in the E&P world for companies to optimize their portfolio of assets in a given basin (or all of upstream) in order to avoid over capitalization?
Thank you Jitendra. Can you expand on your question? I suspect the answer is that it becomes very company specific and in part dependent on size and scope/scale of one's portfolio. But would be interested to hear more of what you are thinking of...
So let’s take Permian as an example. Majors that have significant acreage have a big decision on hand. First, what is the right level of capital for their Permian assets and second, how to allocate that capital optimally across each of those assets in order to avoid over-capitalization of any particular asset or the portfolio. This becomes a classic portfolio optimization problem where we have x number of assets each with a different expected return and risk and the goal being to come up with optimum portfolio options that maximize portfolio returns for a given level of risk. Mechanics of this will require coming up with expected return and risk for each asset at different capital level. But the idea is it would potentially prevent overcapitalizing the asset with highest expected return, which is typically what happened in the past decade.
Jitendra, What are you describing, in particular for those with large acreage positions, is precisely the analysis that needs to be done. In the past, especially the "growthy" E&Ps emphasized maximizing well IRR and accelerating NAV as the basis for spending. This led to the opposite of what might call optimal returns. There can be and often is a big difference in long-term return optimization versus simply solving for maximiizng NAV today. The latter led to massive value destruction. I have self-restricted myself from discussing COP publicly given my affiliation, but since it is a historic document from 2019, I think it is OK in responding to your question: you can look at I think it was their 2019 analyst meeting book for their explanation of the difference between optimization and NAV maximization. I am sure others (perhaps CVX?) have considered this, but I have only seen COP publish it.
Excellent post as always Arjun. So often professional analysts and investors, people who spend all their time analyzing energy companies, get caught up in the price fluctuations (it's an occupational hazard as the price is always in the headlines and always changing, whereas the core principles aren't in the headlines and don't change); we should always keep those core five principles in mind.
Thank you Investor. One thing I definitely don't miss from my Wall Street days is the excessive short-term-ism of everyone. I always tried to take a longer term view but hard not to get caught up with trying to call zigs and zags...one of the reasons I prefer writing for myself on Substack.
For so long I was irritated by short termism, then I came to like it and finally be thankful for it - if everyone took a careful, long view, with a solid appreciation of the fundamentals Exxon would never have been $39 and I'd have to get another job!
Really great article and great history lesson. I remember thinking at the time the XTO transaction looked terrible but, hey, it was Exxon. Those guys always know what they are doing. Famous last words.
Thank you J J. For me, XTO was the awakening of "whoa, this is no longer Lee Raymon's XOM". The tip off was the language changed to one of guessing nat gas was at a cyclical low, that net income or cash flow per bbl was the key metric (rather than ROCE)...the fact it didn't work on an ROCE basis without an absurdly high nat gas assumption...and the fact that XTO was a roll-up company...a good strategy for them, but not one you'd want to buy. Sad to see XOM's decline though perhaps a new cycle will give them new life...
I find your posts thoroughly insightful.
One question: how useful do you think are portfolio optimization concepts like efficient frontier in the E&P world for companies to optimize their portfolio of assets in a given basin (or all of upstream) in order to avoid over capitalization?
Thank you Jitendra. Can you expand on your question? I suspect the answer is that it becomes very company specific and in part dependent on size and scope/scale of one's portfolio. But would be interested to hear more of what you are thinking of...
So let’s take Permian as an example. Majors that have significant acreage have a big decision on hand. First, what is the right level of capital for their Permian assets and second, how to allocate that capital optimally across each of those assets in order to avoid over-capitalization of any particular asset or the portfolio. This becomes a classic portfolio optimization problem where we have x number of assets each with a different expected return and risk and the goal being to come up with optimum portfolio options that maximize portfolio returns for a given level of risk. Mechanics of this will require coming up with expected return and risk for each asset at different capital level. But the idea is it would potentially prevent overcapitalizing the asset with highest expected return, which is typically what happened in the past decade.
Jitendra, What are you describing, in particular for those with large acreage positions, is precisely the analysis that needs to be done. In the past, especially the "growthy" E&Ps emphasized maximizing well IRR and accelerating NAV as the basis for spending. This led to the opposite of what might call optimal returns. There can be and often is a big difference in long-term return optimization versus simply solving for maximiizng NAV today. The latter led to massive value destruction. I have self-restricted myself from discussing COP publicly given my affiliation, but since it is a historic document from 2019, I think it is OK in responding to your question: you can look at I think it was their 2019 analyst meeting book for their explanation of the difference between optimization and NAV maximization. I am sure others (perhaps CVX?) have considered this, but I have only seen COP publish it.
Thanks. Will check it out. To be more specific, I was referring to this: https://en.m.wikipedia.org/wiki/Efficient_frontier
Excellent post as always Arjun. So often professional analysts and investors, people who spend all their time analyzing energy companies, get caught up in the price fluctuations (it's an occupational hazard as the price is always in the headlines and always changing, whereas the core principles aren't in the headlines and don't change); we should always keep those core five principles in mind.
Thank you Investor. One thing I definitely don't miss from my Wall Street days is the excessive short-term-ism of everyone. I always tried to take a longer term view but hard not to get caught up with trying to call zigs and zags...one of the reasons I prefer writing for myself on Substack.
For so long I was irritated by short termism, then I came to like it and finally be thankful for it - if everyone took a careful, long view, with a solid appreciation of the fundamentals Exxon would never have been $39 and I'd have to get another job!
Another great piece - cutting through all the noise and focusing on what matters. Thanks a ton sir!
thank you Deepak!
Really great article and great history lesson. I remember thinking at the time the XTO transaction looked terrible but, hey, it was Exxon. Those guys always know what they are doing. Famous last words.
Thank you J J. For me, XTO was the awakening of "whoa, this is no longer Lee Raymon's XOM". The tip off was the language changed to one of guessing nat gas was at a cyclical low, that net income or cash flow per bbl was the key metric (rather than ROCE)...the fact it didn't work on an ROCE basis without an absurdly high nat gas assumption...and the fact that XTO was a roll-up company...a good strategy for them, but not one you'd want to buy. Sad to see XOM's decline though perhaps a new cycle will give them new life...