--> Abstract: Managing Diversification Using Risk Tolerance, by J. Mackay; #90942 (1997).

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Abstract: Managing Diversification Using Risk Tolerance

MACKAY, JAMES

Project selection at less than 100 percent working interest is a effort to diversify some of the project risk. The selection of the appropriate working interest is therefore a balance of two objectives; first to maximize value of the portfolio and second to minimize risk through participation in more projects. This second objective will both reduce the upside potential as well as the expected performance of the total investment so therefore should be managed effectively.

Once a portfolio is optimized by sorting on expected value per dollar invested, the expected value is maximized by selecting the top projects. The sum of the project expected values is the maximum expected value that can be attained for that level of investment. Any attempt to further diversify by taking less than 100 percent of a selected project will reserve funds for a project that has a lower expected value per dollar invested.

This problem of reduced portfolio performance is further amplified through decentralization. Divisions have smaller budgets than the corporation so they will make additional efforts to diversify than would have been considered at the corporate funding level. This "over diversification" can be managed through assigned division risk tolerance ratios that encourage divisions to invest in projects at the same level of risk tolerance that would be appropriate at the corporate funding level. This will allow divisions to both act autonomously with respect to decisions and cooperatively with respect to risk.

AAPG Search and Discovery Article #90942©1997 AAPG International Conference and Exhibition, Vienna, Austria