How to select the best portfolio of oil and gas projects?

Abstract

The traditional analytical tool for selecting portfolios of financial assets is Markowitz's mean-variance model. The final product of this model is the efficient frontier. Markowitz's approach comes up with an infinite set of optimal portfolios in terms of risk and return (called the efficient frontier), but the mean-variance model does not recommend the best portfolio. This paper proposes an extension of the mean-variance model by the inclusion of a three-step approach: i) an estimation of the risk and return of each project; ii) the estimation of a correlation between returns of each pair of selected prospects; and, iii) the i inclusion of corporate goals beyond simple economic return; that i is, budget and operational constraints. We show that the selection of the optimal portfolio depends on the diversification level, of the investor and the costs of financial distress faced by the oil company.