Using Risk Tolerance to Predict Optimum Working Interest

James A. Mackay

Utility theory can be combined with the Expected Value calculation to generate the Risk Adjusted Value if you have an assessment of the decision maker's Risk Tolerance. The Risk Tolerance can be calculated from prior working interest decisions or estimated from the amount of capital available for risky investments. The Risk Adjusted Value for risky ventures may be higher at less than 100% working interest, indicating the Optimum Working Interest is less than 100%. The distributions of Risk Adjusted Values for a venture or portfolio of ventures are calculated by varying the Working Interest at discrete intervals and recalculating the Risk Adjusted Value or the Optimum Working Interest can be calculated using the linear program included with most spreadsheet software to max mize the total Risk Adjusted Value of the venture or portfolio. The linear program can be further constrained to model a limited capital budget and then used as a portfolio optimizer.

Usually the concern for the loss of capital associated with the individual venture or the possible string of losses associated with a portfolio of ventures causes the decision maker to value a venture or portfolio at less, and sometimes considerably less than the expected value. The decision maker is then left with a subjective assessment of the value and best working interest for a venture. The Risk Adjusted Value calculation can address these concerns as well as portfolio balancing and capital allocation decisions.

AAPG Search and Discovery Article #91020©1995 AAPG Annual Convention, Houston, Texas, May 5-8, 1995