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Risk, Uncertainty and Investment Decision-

Making in the Upstream Oil and Gas Industry

Fiona Macmillan

MA ons !University o" A#erdeen$

Octo#er %&&&

A thesis presented "or the degree o" 'h(D( at the

University o" A#erdeen


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D)*+ARAIO

This thesis, and the research underpinning it, is entirely my own work. It has not been

submitted in any previous application for a degree. All quotations in the thesis have

been distinguished by quotation marks, and the sources of information specifically

acknowledged.

Signed:..

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A*.O/+)DG)M)0

!hilst this thesis is entirely my own work, many others have contributed to it and

shaped the end result in their own unique way and I would like to take this

opportunity to recognise them.

"irst, thanks must go to my sponsor, #SI$% Australia ommonwealth Scientific and

Industrial $esearch %rganisation', and supervisors for their enthusiasm, patience and

commitment, especially (rofessor )raeme Simpson, whose confidence in me and in

the value of my study never wavered even when I doubted it myself. Second, I would

like to acknowledge the respondents and the companies that they represented. "or

their time, honesty and encouragement I am e*tremely grateful. Special thanks must

go to Steven +c#oll of #onoco, on )luyas of -asmo, (at +ackintosh of /0 &et

/orske 0eritas' and )illian oyle of !ood +acken1ie for all their assistance. -ast

and most importantly, I would like to thank my husband, +ike, my parents and my

friends 2 especially )ill, 0anessa and /atalie, for their love, support and unshakeable

belief in me and in all that I do. !ithout them, there would be no thesis.

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A10RA*

The research presented in this thesis is rooted within the e*isting decision theory and

oil industry literatures. It contributes to one of the current debates in these literatures

by providing evidence that in the operators in the 3.4. upstream oil and gas industry

there is a link between the use of decision analysis in investment appraisal decision2

making by organisations and good business performance.

It is commonly acknowledged that decision analysis is not as widely used by

organisations as was predicted at its conception &for e*ample, Schuyler, 5667'. %ne

reason for this is that no study to date has shown that use of decision analysis

techniques and concepts can actually help individuals or organisations to fulfil their

ob8ectives. espite over four decades of research undertaken developing decision

analysis tools, understanding the behavioural and psychological aspects of decision2

making, and applying decision analysis in practice, no research has been able to show

conclusively what works and what does not lemen, 5666'.

The current study begins to fill this gap by using qualitative methods to establish the

following. "irstly, the research identifies which decision analysis techniques are

applicable for investment decision2making in the oil industry, and thereby produces a

description of current capability. Secondly, the study ascertains which decision

analysis tools oil and gas companies actually choose to use for investment appraisal,

and through this develops a model of current practice of capital investment decision2

making. -astly, using statistical analysis, it provides evidence that there is an

association between the use of decision analysis in investment decision2making by

companies and good organisational performance in the upstream oil and gas industry.

Such research not only contributes to the current theoretical debate in the oil industry

and decision theory literatures but also provides valuable insights to practitioners.

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*O)0

'AG)

Declaration i

Ackno2ledgements ii

A#stract iii

+ist o" "igures vii

+ist o" ta#les viii

*hapter 34 Introduction 3

5.5 Introduction 9

5.9 ackground to the thesis 9

5.; $esearch questions <

5.< %utline of thesis =

*hapter %4 +iterature Revie2 3&

9.5 Introduction 55

9.9 $isk and uncertainty 55

9.; #urrent practice in investment appraisal decision2making 5=

9.< The evolution of decision theory 9>

9.? ecision analysis and organisational performance ;5

9.@ #onclusion ;7

*hapter 54 he Oil Industry in the U(.( 56

;.5 Introduction

;.9 #urrent challenges in the global oil industry

;.; The oil industry in the 3.4.


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*hapter 74 Methodology 88


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7.9 The type of study 5?6

7.; $anking companies by use of decision analysis tools and concepts 5@5

7.< $anking companies by organisational performance 5@6

7.? (roposing the hypotheses and selecting the statistical tests 57?

7.@ $esults 577

7.7 iscussion 576

7.= #onclusion 5=>

*hapter ;4 *onclusion4 #et2een and 3;%

=.5 Introduction 5=;

=.9 The research questions revisited 5=;

=.; Theoretical contribution 5=6

=.< Implications of the study to practitioners 56;

=.? "uture research 56<

=.@ #onclusion 56@

Appendi= 34 Intervie2 0chedule 366

Appendi= %4 'resentations and 'apers %&:

Appendi= 54 he 0pearman *orrelation est %&;

Appendi= 74 he .ruskal /allis and /ilco=on Rank 0um tests %&6

Appendi= 84 *ritical values o" "or 0pearman tests %37

Appendi= :4 *ritical ?alues o" . "or .ruskal /allis test 2ith 5independent samples %38

Appendi= 94 *ritical ?alues o" *hi-0@uare at the &(&8 and

&(&3 level o" signi"icance %3:

Appendi= ;4 *ritical ?alues o" 0 "or the /ilco=on Rank 0um est %39

1i#liography %3;

vi


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+I0 OF FIGUR)0

'AG)

;.5 !orldwide giant fields


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?.5; #hoke model

59<

@.5 A model of current practice

5??

7.5 A decision tree 5@@

=.5 The relationship between decision analysis and behavioural decision

theory 569

=.9 est practices in organisationsB use of decision analysis 56;

+I0 OF A1+)0

'AG)

9.5 #onceptualisations of risk and uncertainty 59

?.5 iscounted cash flow concept 7=

?.9 Dypothetical field data 66

?.; Dypothetical field data for +onte #arlo simulation 66

?.< $esults from the +onte #arlo simulation 5>>

?.? ase value data and probability distribution assigned to each of the

reservoir parameters 5><

?.@ Table of the output generated using the base value data and input

distributions specified in table ?.?. 5><

?.7 Safe and risky pro8ects 5>6

?.= All possible outcomes of investing ?>E in each pro8ect 55>

?.6 The similarities between a stock call option and undeveloped reserves 55?

@.5 %rganisationsB use of decision analysis 5?>

7.5 $anking of companies by their use of decision analysis techniques

and concepts 5@=

7.9 $anking of companies by performance criteria 57<

7.; Spearman correlation coefficients between performance variables

and use of decision analysis 577

viii


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*hapter One

Introduction

5


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3(3 IRODU*IO

The aim of this chapter is to introduce the research pro8ect and to outline the research

themes that guide the study. The research presented in this thesis is rooted within the

e*isting decision theory and oil industry literatures. It contributes to one of the

current debates in these literatures by providing evidence that in the operators in the

3.4. upstream oil and gas industry there is a link between the use of decision analysis

in investment appraisal decision2making by organisations and good business

performance.

3(% 1A*.GROUD O ) )0I0

$esearch into decision2making has become increasingly popular over the last forty

years, and many published studies now e*ist &for e*ample, "ord and )ioia, 9>>>F

)unn, 9>>>F kenberg, 9>>>F +ilne and #hanF 5666F /utt, 5666, 5667 and 566;F

urke and +iller, 5666F (apadakis, 566=F ean and Sharfman, 566@F Guinn, 56=>F

+int1berg et al., 567@F #yert and +arch, 56@;'. !hilst, these studies are useful for

providing broad insights into the field of decision2making, very few have investigated

investment decision2making in comple* business environments where there is

substantial risk and uncertainty and each investment decision requires significant

capital e*penditure without the prospect of revenues for many years.

ecision analysis &$aiffa, 56@=F Doward, 56@=F $aiffa and Schlaifer, 56@5' is a label

given to a normative, a*iomatic approach to investment decision2making under

conditions of risk and uncertainty &)oodwin and !right, 5665'. y using any one, or

a combination, of decision analysis techniques, the decision2maker is provided with

an indication of what their investment decision ought to be, based on logical argument

lemen, 5666'. (revious research into the usage of decision analysis by companies

has typically been survey2based and produced evidence of a difference between the

decision analysis techniques described in the literature, and the decision analysis tools

which practitioners choose to use &for e*ample see studies by Arnold and

Dat1opoulous, 5666F #arr and Tomkins, 566=F Schuyler, 5667F uckley et al., 566@

"letcher and romgoole, 566@F Shao and Shao, 566;F 4im et al., 56=


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56=>F Stonehill and /athanson, 56@='. It appears that whilst decision analysts

describe a range of decision analysis techniques, some of which are very

sophisticated, organisational decision2makers are choosing to utilise only the most

simplistic tools and concepts in their investment decision2making &Atrill, 9>>>'.

Dowever, the methodological approaches adopted by the researchers conducting these

studies precluded them from providing any e*planation into the reasons why some

techniques fail to be implemented and others succeed lemen, 5666'. #onsequently,

some writers, typically behavioural decision theorists such as Tocher &567@ and 567=

reprinted in "rench, 56=6', have e*plained the results by arguing that decision2makers

choose not to use decision analysis techniques because their use adds no value to

organisationsB investment decision2making processes since decision analysis does not

aim to predict what decision2makers will do, only to suggest what they ought to do.

#lemen &5666' offers another interpretation. De believes that at least one reason why

decision analysis techniques and concepts are not widely used by organisations is that

no study to date has provided evidence that organisations that use decision analysis

tools perform better than those companies that do not. espite over four decades of

research undertaken developing decision analysis tools, understanding the behavioural

and psychological aspects of investment decision2making and applying decision

analysis to practical e*amples, no research has been able to show conclusively what

works and what does not. #lemen &5666' believes that to rectify this situation, future

studies into investment decision2making should investigate the relationship between

organisational performance and the use of decision analysis techniques. If, as many

decision analysts believe &for e*ample, "rench, 56=6', companies that use decision

analysis in investment decision2making outperform those that do not, such research

would contribute to the theoretical debate between the decision analysts and

behaviouralists. The behavioural decision theorists would no longer be able to claim

that there is no value in a theory that does not aim to predict what decision2makers

will do. Such research would obviously also be valuable to practitioners.

This type of study, however, has been slow to appear in the literature doubtless

because of the threat they represent to the decision analysts lemen, 5666 pp9;29


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individuals J consultants, academics, instructors J with a vested interest indecision analysis could lose standing clients, or even 8obs.K

The current study aims to remedy this situation by researching the use of decision

analysis in investment appraisal decision2making by the ma8or companies in the

upstream oil and gas industry. The oil and gas industry epitomises investment

decision2making under conditions of risk and uncertainty &!atson, 566=F /ewendorp,

566@F $ose, 56=7F Ikoku, 56=


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decision2making literature are the most appropriate for practitioners to use for

investment decision2making. The current study undertakes such research in the

upstream oil and gas industry.

The current study draws on the decision analysis and oil industry literatures to

ascertain which decision analysis tools are the most appropriate for companies to use

for investment decision2making. This involves firstly, identifying the whole range of

techniques that are available and, secondly deciding which of these tools are the most

appropriate for upstream investment decision2making. This demands careful

consideration of factors such as the business environment of the upstream industry

and the level and type of information used for investment decision2making in the

industry. Through this process, the research identifies the decision analysis

techniques that are particularly useful for upstream investment decision2making. This

constitutes current capability. Then, drawing again on the investment appraisal and

industry literatures, and also on insights gained at conferences and seminars, an

approach to investment decision2making in the oil industry is presented that utilises

the full spectrum of tools identified. Some decision analysts advocate using one

decision analysis technique for investment appraisal &for e*ample, Dammond, 56@7'.

Dowever, in reality, each tool has limitations &-efley and +organ, 5666' some that are

inherent, others which are caused by a lack of information or specification in the

literature. As such, the knowledge that the decision2maker can gain from the output

of one tool is limited &/ewendorp, 566@'. Therefore, a combination of decision

analysis techniques and concepts should be used to allow the decision2maker to gain

ma*imum insight which, in turn, encourages more informed investment decision2

making. Some oil industry analysts have recognised this and presented the collection

of decision analysis tools that they believe constitute those that decision2makers ought

to use for investment decision2making in the oil and gas industry &for e*ample,

/ewendorp, 566@'. Dowever new techniques have only recently been applied to the

industry &for e*ample, )alli et al., 5666F i*it and (indyck, 566= and 566


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This question is prompted by the observation highlighted in section 5.9 that very few

previous studies into decision2making have investigated the use of decision analysis in

investment appraisal decision2making by organisations. The current study e*amines

the use of decision analysis in investment appraisal decision2making within the

operating companies in the 3.4. upstream oil and gas industry.

ata are collected by conducting semi2structured interviews in twenty2seven of the

thirty2one companies who were operators in the 3.4.Bs upstream oil and gas industry

in +arch 566=. The data is analysed in two stagesF first against the core themes

contained in the interview schedule &Appendi* 5', which are informed by the

literature analysed in #hapters 9 and ;, and the emergent themes identified in

contemporaneous notes taken during the research process. Second, after this initial

coding, the data is coded again. In this second level coding, the core themes are more

highly developed and closely specified, and other emergent themes are included. This

allows the researcher to develop a model of current practice in investment decision2

making in the upstream oil and gas industry that is grounded in the data. The model

provides insights into the use of decision analysis in investment appraisal decision2

making organisations. In particular it permits identification of the techniques

organisations do use and those that they do not, and, by drawing on the behavioural

decision theory literature and the interview data, it is possible to suggest reasons for

this.

5( Is there a relationship #et2een using decision analysis techni@ues in

investment appraisal decision-making and good organisational per"ormanceB

This question is motivated by the observation by #lemen &5666' discussed in section

5.9 that there is a need for researchers to e*plore the relationship between the use of

decision analysis in investment appraisal decision2making by companies and

organisational performance. The current study investigates whether such a

relationship e*ists in the operating companies in the 3.4. upstream oil and gas

industry.

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0ery few other studies have attempted to value the usefulness to organisations of

using decision analysis lemen, 5666'. Some studies in behavioural decision theory

have evaluated the effectiveness of individual decision analysis techniques &for

e*ample, Aldag and (ower, 56=@F ohn et al., 56=;F Dumphreys and +c"adden,

56=>'. Dowever, such research has been criticised because the studies typically use

hypothetical decision situations and there is evidence in the behavioural decision

theory literature to suggest that people make different decisions under these

circumstances than the decisions they would make if the situation were real &Slovic,

566?F )rether and (lott, 5676F -ichenstein and Slovic, 5675F -indman, 5675'.

#lemen and 4wit &9>>>' investigated the e*istence of a relationship between use of

decision analysis and organisational performance in 4odak. The researchers used

depth interviews and documentary analysis to inform their research. This

methodological approach permitted the researchers to value the HsoftK effects on the

organisationBs performance of utilising decision analysis techniques and concepts.

Dowever, whilst their research provides useful insights, as the authors themselves

acknowledge, the focus on one organisation meant that the results could not be

generalised to a larger sample. The current study differs from this since it attempts to

establish whether there is a relationship in the operating companies in the 3.4. oil

industry between using decision analysis in investment decision2making and business

success. Therefore, by implication, the research involves numerous companies and

this prohibits use of the type of time2consuming qualitative methodology

implemented by #lemen and 4wit &9>>>'.

Instead, the current study uses the indication of current capability and current practice,

gained from answering the first and second research questions, to rank the operating

companies according to the number of decision analysis techniques they use for

investment appraisal. The research then assumes that any value added to the company

from using a decision analysis approach, including any HsoftK benefits, ultimately

affects the bottom2line. This means that it is therefore possible to use publicly

available financial measures and other criteria indicative of performance in the

upstream oil and gas industry, to indicate business success. The e*istence of a

relationship between organisational performance and use of decision analysis in

investment appraisal decision2making in the oil industry is then analysed statistically.

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The remainder of the thesis concentrates on answering these research questions. ach

chapter is outlined in the following section.

3(7 OU+I) OF )0I0

The literature review in #hapter 9 draws on the academic literature on investment

decision2making to highlight the gaps in the e*isting literature that the research

questions presented above are drawn from. It is structured so that attention is

focussed on the source of each of the research questions in turn.

#hapter ; draws on the oil industry literature to provide a brief description of the

conte*t of the current study that highlights the main challenges facing the oil industry

in the 95st century. Since the current study is located in the 3.4., the effects of these

global changes on the 3.4. oil industry are e*amined. This indicates the growing

comple*ity of the industryBs business environment and highlights why it is such a

useful environment in which to study the use of decision analysis in investment

decision2making.

#hapter < outlines the methodology adopted in the research. The current study

utilises qualitative methods for data collection and a combination of mechanisms for

data analysis. The qualitative method of semi2structure interviewing is used for the

investigation of companiesB investment decision2making processes and non2

parametric statistical analysis is employed to investigate the relationship between the

use of decision analysis in investment appraisal decision2making and organisational

performance. ach type of analysis is evaluated in terms of their appropriateness for

the study of investment decision2making.

!hilst #hapter ? primarily draws on secondary data sources, it is presented as a

significant contribution to this thesis, since it first identifies the decision analysis

techniques available for upstream oil and gas industry investment decision2making,

and also presents a new approach to investment decision2making in the industry

which utilises this spectrum of tools.

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#hapter @ presents the first set of findings from the research interviews. It draws on

the interview data to provide a model current practice in investment decision2making

in the upstream oil and gas industry. In particular, the decision analysis techniques

that upstream organisations actually use are presented. !hen this is compared with

the indication of current capability ascertained in #hapter ?, the findings confirm the

trend observed in previous quantitative research studies that there is a gap between

current theory in investment appraisal and current practice. Dowever, unlike these

survey2based studies, where the research methodology used prohibited further

investigation of such issues, the current study uses insights from the semi2structured

interviews, together with behavioural decision theory literature, to suggest why this

might be the case.

#hapter 7 uses the data presented in #hapters ? and @ to produce a ranking of the

companies according to their usage of decision analysis techniques in investment

appraisal decision2making. The assumption that any value added to the company

from using a decision analysis approach will ultimately affect the organisationBs

bottom2line is 8ustified. This assumption is then used to investigate the relationship

between the ranking of organisations by their use of decision analysis in investment

appraisal decision2making and business success statistically by using criteria that are

indicative of organisational performance.

The final chapter, #hapter =, brings together the information gathered for the thesis

and provides the answers to the research questions posed in #hapter 5. It sets out the

conclusions that can be drawn from the research. In particular, the implications of the

results to the theoretical debate between the decision analysts and behavioural

decision theorists are highlighted. The limitations of the research presented in this

thesis are discussed and this leads into the identification of areas for future research

that arise from the current study.

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*hapter %

+iterature Revie2

5>


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%(3 IRODU*IO

This chapter presents the literature review for the current study. It draws on the

e*isting academic literature on investment decision2making to highlight the gaps in

this literature that the research questions presented in #hapter 5 are drawn from. The

literature review is structured so that attention is focussed on the source of each of the

three research questions in turn.

%(% R I0. AD U*)RAIC

The first section of the literature review emphasises the centrality of risk and

uncertainty to investment decision2making by focusing on the following three

questions:

5. Dow does the academic investment decision2making literature conceptualise risk

and uncertainty

9. Dow do investment decision2makers conceptualise risk and uncertainty

;. Dow do these decision2makers cope with risk and uncertainty in investment

decision2making

Investigating the methods of coping with risk and uncertainty adopted by investment

decision2makers highlights the role of quantitative techniques. This leads into

identification of the need for a study that ascertains which of the tools and techniques

that are presented in the decision theory literature are most appropriate for investment

appraisal. This is the first research question that this thesis aims to answer.

#onsider the first question proposed above. $isk and uncertainty are inherent in all

decision2making &ailey et al., in press, Dammond et al ., 5666F Darrison, 566?F

)oodwin and !right, 5665F +organ and Denrion, 566>' and hence receive

considerable attention in the academic investment decision2making literature &for

e*ample, Atrill, 9>>>F uckley, 9>>>F +urtha, 5667F orsch and +ossinF 56@='. This

prominence is well deserved. 3biquitous in realistic settings, risk and uncertainty

constitute a ma8or obstacle to effective capital investment decision2making &Simpson

et al., 9>>> and 5666F -amb et al., 5666F all and Savage, 5666F !atsonF 566=F $ose,

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56=7F +urtha, 5667F /ewendorp, 566@F %ransanu and #onnolly, 566;F +c#askey,

56=@F runsson, 56=?F #orbin, 56=>F Thompson, 56@7'.

AUOR0 )RM *O*)'UA+I0AIO

5. Anderson et al. &56=5'

9. Anderson et al. &56=5'

;. Anderson et al. &56=5'

. Darrison &566?'

55. Spradlin &5667'

59. Dolmes &566='

5;. Dolmes &566='

3ncertainty

3ncertainty

$isk

$isk

3ncertainty

$isk

3ncertainty

3ncertainty

$isk

3ncertainty

$isk

$isk

3ncertainty

A situation in which one has no knowledge aboutwhich of several states of nature has occurred or

will occur

A situation in which one knows only the

probability of which several possible states of

nature has occurred or will occur

Same as &5'

Same as &9'

The inability to assert with certainty one or more

of the following: &a' act2event sequencesF &b'

event2event sequencesF &c' value of consequencesF

&d' appropriate decision processF &e' future

preferences and actionsF &f' oneBs ability to affect

future events

(otential for deleterious consequences

-ack of information available concerning what the

impact of an event might be

*posure to the chance of loss in a choice situation

A common state or condition in decision2making

characterised by the possession of incomplete

information regarding a probabilistic outcome.

An uncommon state of nature characterised by the

absence of any information related to a desired

outcome.

The possibility of an undesirable result

A situation which refers to a state where the

decision2maker has sufficient information to

determine the probability of each outcome

occurring.

A situation where the decision2maker can identify

each possible outcome, but does not have the

information necessary to determine the

probabilities of each of the possibilities.

Table 9.5: Conceptualisations of risk and uncertainty (source: adapted from Lipshitz and Strauss,1997

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Dowever, despite this prominence, there is much confusion in the academic

investment decision2making literature over the definitions of risk and uncertainty.

Table 9.5 presents a sample of the definitions of risk and uncertainty given by some of

the contributors to the capital investment decision2making literature. The table clearly

illustrates conceptual proliferation in the academic investment decision2making

literature. This has led Argote &56=9 p' to assert:

Hthere are almost as many definitions of risk and uncertainty as there aretreatments of the sub8ect.K

A comment echoed by Cates and Stone &56=9 p5':

Hif we were to read 5> different articles or books on risk, we should not besurprised to see it described in 5> different ways.K

To answer the first question proposed above of how the academic investment

decision2making literature conceptualises risk and uncertainty then, it is clear that

whilst it is widely acknowledged in this literature that risk and uncertainty are

inherent in capital investment decision2making, there is no conceptual basis for

agreement of the definitions of risk and uncertainty.

The second question that this section aims to address, how investment decision2

makers conceptualise risk and uncertainty, has received relatively little attention in the

empirical literature on investment decision2making &-ipshit1 and Strauss, 5667'.

Dowever, there is evidence in this literature which suggests that the conceptualisation

of risk and uncertainty adopted by a decision2maker affects the method of coping that

the decision2maker adopts &-ipshit1 and Strauss, 5667'. +illiken &56=7' found thatdecision2makers encountering diverse risks and uncertainties respond differently. The

e*istence of contingent coping is a recurrent theme in the academic decision2making

literature &for e*ample, )ans, 5666'. #yert and +arch &56@; p556' proposed that:

HLorganisationsM achieve a reasonably manageable decision situation byavoiding planning where plans depend on prediction of uncertain future eventsand by emphasising planning where the plans can be made self confirmingthrough some control device.K

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)randori &56=


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making literature is outlined in the section of this literature referred to as decision

theory lemen and 4wit, 9>>>F #lemen, 5666F )oodwin and !right, 5665F "rench,

56=6F $aiffa, 56@=F Doward, 56@=F $aiffa and Schlaifer, 56@5'.

In the decision theory literature, the process decision2makers are advised to adopt for

coping with risk and uncertainty involves three steps known as $.G.(. &-ipshit1 and

Strauss, 5667'. The first stage involves the decision2maker reducin! the risk and

uncertainty by, for e*ample, conducting a thorough information search &4aye, 566?F

awes, 56==F anis and +ann, 5677F )albraith, 567;'. The decision2maker then

"uantifies the residue that cannot be reduced in the second step. "inally, the result is

plu!!ed into a formal scheme that incorporates risk and uncertainty as a factor in the

selection of a preferred course of action &/ewendorp, 566@F Smithson, 56=6F Dogarth,

56=7F #ohen et al., 56=?F $aiffa, 56@='. ach step will now be discussed further.

This will highlight the role of quantitative techniques and introduce the concept of

decision analysis. The section will conclude by identifying the need for a study that

ascertains which of the many decision analysis tools and concepts described in the

decision theory literature are the most appropriate for investment decision2making.

This is the first research question that this thesis aims to address.

Strategies for reducing risk and uncertainty include collecting additional information

before making a decision &4aye, 566?F awes, 56==F )albraith, 567;F anis and

+ann, 5677'F or deferring decisions until additional information becomes available

and it is possible to reduce risk and uncertainty by e*trapolating from the available

evidence &-ipshit1 and Strauss, 5667'. A typical method of e*trapolation is to use

statistical techniques to predict future states from information on present or past

events &utler, 5665F Allaire and "irsirtou, 56=6F ernstein and Silbert, 56=


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developments in script2like fashion &Schoemaker, 566?', is another strategy of

reducing risk and uncertainty that combines prediction and assumption2based

reasoning. "inally, risk and uncertainty can also be reduced by improving

predictability through shortening time hori1ons &preferring short2term to long2term

goals, and short2term feedback to long range planning, #yert and +arch, 56@;', by

selling risks to other parties &Dirst and Schweit1er, 566>', and by selecting one of the

many possible interpretations of equivocal information &!eick, 5676'.

It is important to recognise, however, that reducing risk and uncertainty by collecting

information can be problematic since often the information is ambiguous or

misleading to the point of being worthless &Dammond et al , 5666F +organ and

Denrion, 566>F "eldman and +arch, 56=5F )randori, 56=>>F Dammond et al., 5666F #lemen,

5666F Thomas and Samson, 56=@F 4eeney, 5676F 4aufman and Thomas, 5677F $aiffa,

56@='. ecision analysis &$aiffa, 56@=F Doward, 56@=F $aiffa and Schlaifer, 56@5' is

a normative discipline within decision theory consisting of various techniques and

concepts that provide a comprehensive way to evaluate and compare the degree of

risk and uncertainty associated with investment choices &/ewendorp, 566@'.

Traditional methods of analysing decision options involve only cash flow

considerations, such as computation of an average rate of return &/ewendorp, 566@'.

The new dimension that is added to the decision process with decision analysis is the

quantitative consideration of risk and uncertainty lemen and 4wit, 9>>>F #lemen,

5666F /ewendorp, 566@F )oodwin and !right, 5665F +organ and Denrion, 566>F

"rench, 56=6F $aiffa, 56@=F Doward, 56@=F $aiffa and Schlaifer, 56@5'. In #hapter ?,

all aspects of decision analysis will be discussed in detail and specific techniques will

be reviewed. Dowever, for the purposes of gaining an overview of the approach, the

5@


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standard decision analysis can be summarised as a series of steps &Simpson et al.,

5666F -amb et al., 5666F /ewendorp, 566@F )oodwin and !right, 5665F +organ and

Denrion, 566>F "rench, 56=6F Thomas and Samson, 56=@':

5. efine possible outcomes that could occur for each of the available decision

choices, or alternatives.

9. valuate the profit or loss &or any other measure of value or worth' for each

outcome.

;. etermine or estimate the probability of occurrence of each possible outcome.


27/250

The prospective investor is then provided with a complete risk2return profile of the

pro8ect showing the possible outcomes that could result from the decision to stake

money on this investment &/ewendorp, 566@'.

+ore recently, preference, portfolio and option theories have been attracting some

attention in the decision theory literatures &for e*ample, ailey et al., in pressF

Simpson et al., 9>>>F Simpson et al.O 5666F )alli et al., 5666F Dammond et al., 5666F

Smith and +c#ardle, 5667F $oss, 5667'. ach of these techniques will be discussed

in #hapter ?. The plethora of techniques that are presented in the academic decision

theory literature for the quantification of risk and uncertainty has confused

practitioners &see Section @.; of #hapter @ and studies by Schuyler &5667' and

"letcher and romgoole &566@''. +ost decision2makers report uncertainty about

what each tool aims to do, the differences between techniques and are unclear about

when certain tools should and should not be used &Section @.; of #hapter @'. #learly

then, there is a need to identify which of the decision analysis techniques and concepts

presented in the academic decision theory literature, are the most appropriate for

investment decision2making. The current study aims to do this by answering the first

research question which was posed in #hapter 5.

The focus in this chapter now turns to the motivation for the second research question

proposed in #hapter 5. In e*ploring this question the researcher aims to ascertain

which techniques companies actually use to quantify risk and uncertainty in

investment appraisal and to understand how the results from the techniques are

plugged into the organisational investment appraisal decision2making process. The

following section draws on the academic investment decision2making literature to

analyse the recent studies of current practice in investment decision2making. In doing

so, it identifies the gap in the e*isting literature that by answering the second research

question and producing a description of current practice in investment appraisal in the

operators in the 3.4. upstream oil and gas industry, this study aims to fill.

%(5 *URR) 'RA*I*) I I?)0M) A''RAI0A+ D)*I0IO-MA.IG

The fundamental concepts used in decision analysis were formulated over two

hundred years ago. Cet the application of these concepts in the general business

5=


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sector did not become apparent until the late 56?>s and early 56@>s &for e*ample,

)rayson, 56@>', and it has only been within the last five to ten years that it has

seriously been applied to investment decision2making in practice &for e*ample, see

Section @.; of #hapter @ and studies by Schuyler &5667' and "letcher and romgoole

&566@''. "urthermore, it is widely acknowledged that current practice in the

techniques used for investment appraisal decision2making in practice in all industries

trails some way behind current decision theory &for e*ample, Atrill, 9>>>F Arnold and

Dat1opouous, 5666F Schuyler, 5667'. This has been established via empirical

research which has tended to focus on whether, when and which decision analysis

techniques are used by organisations &for e*ample see studies by Arnold and

Dat1opoulous, 5666F #arr and Tomkins, 566=F Schuyler, 5667F uckley et al., 566@

"letcher and romgoole, 566@F Shao and Shao, 566;F 4im et al., 56=F Stonehill and /athanson, 56@='. These studies have typically used survey

techniques to produce statistical results indicating the percentage of organisations

using decision analysis techniques &for e*ample, Schuyler, 5667'. As will be

discussed in more detail in #hapter


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answering the first research question proposed in #hapter 5' and those which

companies choose to use, it will e*plore this issue. "urthermore, since previous

research has suggested that the relationship between the conceptualisation of risk and

uncertainty in the organisation and the techniques or method of coping with risk and

uncertainty adopted by decision2makers &see section 9.9', this will also be

investigated. The researcher will then be able to offer insights into how the results

from the decision analysis techniques are integrated into the organisational investment

decision2making process.

Attention is now focussed on the source of the third research question which aims to

establish whether there is a relationship between the use of decision analysis

techniques by organisations and organisational performance. The ne*t section

e*amines the evolution of the decision theory literature from classical decision theory

through to the potentially useful technology of decision analysis and the more recent

contributions of behavioural decision theory. The current debates in the decision

theory literature are then reviewed and this indicates the need for a study that

investigates the relationship between use of decision analysis in investment appraisal

decision2making and organisational performance. In section 9.?, a hypothesis is

advanced for empirical testing.

%(7 ) )?O+UIO OF D)*I0IO )ORC

#onsider first the status of systematic reasoning about human action. !ith stylistic

changes the following, written by -aplace in 5=59, could represent an optimistic view

of decision analysis today &Doward, 56== p@76':

Hy this theory, we learn to appreciate precisely what a sound mind feelsthrough a kind of intuition often without realising it. The theory leavesnothing arbitrary in choosing opinions or in making decisions, and we canalways select, with the help of this theory, the most advantageous choice onour own. It is a refreshing supplement to the ignorance and feebleness of thehuman mind.

If we consider the analytic methods brought out by this theory, the truth of its basic principles, the fine and delicate logic called for in solving problems, theestablishments of public utility that rest on this theory, and its e*tension in the

past and future by its application to the most important problems of natural philosophy and moral science, and if we observe that even when dealing with

9>


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things that cannot be sub8ected to this calculus, the theory gives the surestinsight that can guide us in our 8udgement and teaches us to keep ourselvesfrom the illusions that often mislead us, we will then realise that there is noother science that is more worthy of our meditation.K

The possibility of effective, systematic reasoning about human action has been

appreciated for over two hundred years. -aplaceBs predecessor, ayes, showed in

57@; that probability had epistemological power that transcended its aleatory uses

&Doward, 56=='. In the early 57>>s, ernoulli captured attitudes towards risk taking

in mathematical form. In his #rs Con$ectandi &575;', acob ernoulli proposed an

alternative to the ob8ectivist view that probability is a physical concept such as a

limiting frequency or a ratio of physically described possibilities. De suggested that

probability is a Hdegree of confidenceK 2 later writers use degree of belief 2 that an

individual attaches to an uncertain event, and that this degree depends on the

individualBs knowledge and can vary from individual to individual. Similarly, -aplace

himself stated in # %hilosophical &ssay of %ro'a'ilities &5=59', that probability is but

the He*pression of manBs ignoranceK and probability calculus is relevant to Hthe most

important questions of lifeK and not 8ust to repetitive games of chance as previously

thought. In addition, Augustus e +organ in his ormal Lo!ic &5=


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many physicists. Dowever, aynes &56?@' also showed that these ideas pay off

handsomely when applied to inference problems in our macroscopic world &Doward,

56=='. "rank $amsey was the first to e*press an operational theory of action based on

the dual intertwining notions of 8udgmental probability and utility. In his essay, )ruth

and %ro'a'ility &569@' $amsey adopted what is now termed the sub8ective or decision

theoretic point of view. To $amsey, probability is not the e*pression of a logical,

rational, or necessary degree of belief, the view held by 4eynes and effreys, but

rather an e*pression of a sub8ective degree of belief interpreted as operationally

meaningful in terms of willingness to act &$aiffa, 56@='. e "inetti in his essay,

oresi!ht: *ts Lo!ical La+s, *ts Su'$ectie Sources originally published in 56;7, like

$amsey, assessed a personBs degree of belief by e*amining his overt betting

behaviour. y insisting that a series of bets be internally consistent or coherent such

that a shrewd operator cannot make a sure profit or HbookK regardless of which

uncertain event occurs, e "inetti demonstrated that a personBs degrees of belief J his

sub8ective probability assignments J must satisfy the usual laws of probability &$aiffa,

56@='. 0on /eumann and +orgenstern developed the modern probabilistic theory of

utility in their second edition of )heory of ames and &conomic ehaiour published

in 56


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is no scientific way to make this final choice &$aiffa, 56@= p977'. Dowever, they

were in the minority.

In the early 56?>s, there were many proposals suggesting how a decision2maker

should ob8ectively choose a best strategy from the admissible class. /o sooner did

someone suggest a guiding principle of choice, however, than someone else offered a

simple concrete e*ample showing that this principle was counterintuitive in some

circumstances and therefore the proposed principle could not serve as the long sought

key &$aiffa, 56@='. In 56?


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assist in the definition of the decision problem, allow the decision2maker to consider a

larger number of attributes than is possible holistically and encourage the use of

sensitivity analysis. Dolistic evaluations, he believes, are made on a limited number

of attributes, contain considerable random error and, moreover, are e*tremely difficult

when there are fifty or more possible outcomes. 4leinmunt1 &566>' shares this

perspective. De suggests that the consistency of holistic 8udgements will deteriorate

as the number of possible outcomes increases because of the limits on human

information processing capabilities. !hereas he argues, systematic decomposition

rela*es the information processing demands on the decision2maker reducing the

amount of potential error in human 8udgement. "urthermore, since decompositional

methods provide an Haudit trailK it is possible to use them to produce a defensible

rationale for choosing a particular option. #learly this can be important when

decisions have to be 8ustified to senior staff, colleagues, outside agencies, partners, the

general public, or even to oneself &)oodwin and !right, 5665'.

Since its conception the role of decision analysis has changed. /o longer is it seen as

a method for producing optimal solutions to decision problems. As 4eeney &56=9'

points out:

Hecision analysis will not solve problems, nor is it intended to do so. Its purpose is to produce insight and promote creativity to help decision2makersmake better decisions.K &)oodwin and !right, 5665 p


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rational &)oodwin and !right, 5665'. !hen a decision2maker acts rationally it means

that they calculate deliberately, choose consistently, and ma*imise, for e*ample, their

e*pected preferenceNutility. #onsistent choice rules out vacillating and erratic

behaviour. If it is assumed that managerial decision2makers want to ma*imise, for

e*ample, their personal preferences, and that they perceive that this will happen

through ma*imising the organisationBs ob8ectives, then it may also be assumed that

such managers will pursue the ma*imisation of the organisationBs performance in

meeting its ob8ectives &Darrison, 566? p=5'. +ore simply, if managers are rewarded

based on the organisationBs performance and they behave rationally, they will try to

ma*imise the outcome of their decisions for the organisation, to achieve the highest

amount of personal utility.

"or many years it was believed, implicitly or e*plicitly, that such normative theories

of decision2making not only represent the HoughtK but also the HisK: the normative and

descriptive facets were assumed to be one and the same &4eren, 566@'. The

unprecedented advancements in the physical sciences and information theory and the

realisation of the enormous capabilities inherent in computing machines and

information technology, strengthened and encouraged the belief in rational agents who

were considered to be in full control of their thoughts and actions, and capable of

following the normative desiderata. ecision failures were e*clusively attributed to

the perceptual2cognitive machine and could, it was assumed, be avoided by increasing

mental effort and by appropriate training &4eren, 566@'. #onsequently, the

presupposition that normative models &with, conceivably, some minor modifications'

can concurrently serve descriptive accounts was introduced with little contention

&4eren, 566@'. "or e*ample, in a frequently quoted article, (eterson and each &56@7

p96' concluded that:

HIn general, the results indicate that probability theory and statistics can beused as the basis of psychological models that integrate and account for human

performance in a wide range of inferential tasks.K

There was little attempt to e*plain human behaviour &4eren, 566@'. ven the most

transparent cases of discrepancy between human behaviour and normative models &for

e*ample, see the often referred to AllaisB parado* outlined in )oodwin and !right,

9?


35/250


36/250

calibration of group probability 8udgements. +ore recently, Argote, Seabrigh and

yer &56=@' found that groups use certain types of heuristics more than

individuals, presumably leading to more biases lemen, 5666'.

The situation outlined above is aggravated by the observation that whilst most

people find it easiest to e*press probabilities qualitatively, using words and

phrases such as HcredibleK, HlikelyK or He*tremely improbableK, there is evidence

that different people associate markedly different numerical probabilities with

these phrases &for e*ample, udescu and !allsten, 566?'. It also appears that, for

each person, the probabilities associated with each word or phrase varies with the

semantic conte*t in which it is used &+organ and Denrion, 566>' and that verbal,

numerical and different numerical e*pressions of identical uncertainties are

processed differently &)igeren1er, 5665F Pimmer, 56=;'. Dence, in most cases

such words and phrases are unreliable as a response mode for probability

assessment lemen, 5666'. )iven this, many writers have proposed encoding

techniques. Dowever, the results of the considerable number of empirical

comparisons of various encoding techniques do not show great consistency, and

the articles reviewed provide little consensus about which to recommend lemen,

5666'. As +eehl &567= p=;5' succinctly comments:

Hthere are many areas of both practical and theoretical inference in whichnobody knows how to calculate a numerical probability value.K

The most unequivocal result of e*perimental studies of probability encoding has

been that most assessors are poorly calibratedF in most cases they are

overconfident, assigning probabilities that are nearer certainty than is warranted by

their revealed knowledge &+organ and Denrion, 566>'. Such probability

8udgements, -ichenstein, "ischoff and (hillips &56=9' found, are not likely to be

close to the actual long run frequency of outcomes.

Some researchers have investigated whether using specific procedures can improve

probability 8udgements. Stael val Dolstein &5675a and 5675b' and Schafer and

orcherding &567;' provide evidence that short and simple training procedures can

increase the accuracy &calibration' of assessed probability, although their empirical

results do not indicate an overwhelming improvement in performance. "ischoff

97


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&56=9' discusses debiasing techniques intended to improve the quality of sub8ective

performance assessments. )igeren1er and Doffrage &566?' emphasise that framing

8udgements in frequency terms &as opposed to the more traditional sub8ective

Hdegree of beliefK' can reduce assessment bias in a variety of situations. %ther

studies lemen, ones and !inkler, 566@F Dora, odd and Dora, 566;' suggest

that embracing the divide and conquer orientation of decision analysis in

probability assessment can improve assessment performance lemen, 5666'.

• %reference assessment 2 !hile probability assessments can be evaluated readily,

the study of preference and preference assessment techniques, is more problematic

lemen, 5666'. The most popular approach to studying preferences has been to

consider the e*tent to which e*pressed preferences are internally consistent, as

e*emplified by the Allais parado* &Allais and Dagen, 5676F Allais, 56?;' or by

Tversky and 4ahnemanBs &56=5' work on framing lemen, 5666'. ecision

analysis prescribes a number of approaches that are formally equivalent for

assessing preference functions lemen, 5666'. "arquhar &56=


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logic on which decision analysis rests lemen, 5666'. Studies have shown that they

do not. "ollowing such observations, there is a tendency in the decision theory

literature for decision analysts and behavioural decision theorists to become

embroiled in a somewhat circular argument over the use and benefits of decision

analysis &for e*ample, see the e*changes between "rench and Tocher summarised in

"rench, 56=6 pp5;625?;'. ehavioural decision theorists argue that people do not

behave in the manner suggested by decision analysis. ecision analysts reiterate that

it is not their aim to predict what the decision2maker will do, but rather to suggest to

the decision2maker what they ought to do, if the decision2maker wishes to be

consistent. To behavioural theorists this argument is weak. Tocher &567@ reprinted in

"rench, 56=6 p5;6' writes:

Hany theory which is worth using predicts how people will behave, not howthey should, so we can do our mathematics.K

$ecently researchers such as #lemen and 4wit &9>>>' have attempted to circumvent

this discussion by focussing not on whether people naturally follow the a*ioms of

decision analysis, but on whether learning to do so can lead them to better choices and

consequences.

The relationship between performance and the investment decision2making process

has attracted much theoretical attention &for e*ample, ailey et al., in pressF Simpson

et al., 9>>>F !ensley, 5666 and 5667F +c#unn, 566=F %tely, 5667F /utt, 5667'. In

5677 Dambrick and Snow advanced a model of interaction between current and past

performance and the investment decision2making process, but concluded that the

effects of the investment decision2making process on performance were not well

articulated and that the available evidence was insufficient to support specific theories

&(apadakis, 566='. Although many other studies &for e*ample, ean and Sharfman,

566@F Dart, 5669F Guinn, 56=>' have described and e*plained the investment

decision2making process, little consensus has emerged as to the e*pected relationship

between organisational performance and investment decision2making processes &for

e*ample, (riem et al., 566?F $a8agopalan et al., 566;'. Specifically, whilst it is well

established that management science and operations research add value to

organisations when used well lemen and 4wit, 9>>>', the value of decision analysis

96


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remains less well documented. Although many successful applications have been

performed and published &for e*ample, %tis and Schneiderman, 5667F /angea and

Dunt, 5667', the evidence remains largely anecdotal and unsystematic lemen and

4wit, 9>>>'. espite over four decades of research developing decision analysis

techniques, gaining an understanding of the behavioural and psychological aspects of

decision2making, and the application of decision analysis to real organisational

decisions, no research has been able to show conclusively what works and what does

not lemen, 5666'. It is highly likely that being unable to document the value of a

decision analysis approach to investment appraisal decision2making has hampered

some proponents as they have tried to gain acceptance for decision analysis within

their organisations &see Section @.; of #hapter @ and #lemen, 5666'. This could be

seen as contributing directly to the gap between current practice and current capability

in investment appraisal. If decision analysis could be shown to be definitively of

value, and that this value easily overwhelms the typical costs of compiling the

modelling and analysis, decision analysis would become much more attractive to

organisations &Section @.; of #hapter @F #lemen, 5666'. #onsequently, in time, the

current gulf between theory and practice would narrow. "urthermore, such research

would contribute to the theoretical debate between decision analysts and behavioural

decision theorists lemen, 5666'. If, as many decision theorists believe &for

e*ample, "rench, 56=6', companies that use decision analysis outperform those that

do not, such research would contribute to the theoretical debate between the decision

analysts and behaviouralists. The behavioural decision theorists would no longer be

able to claim that there is no value in a theory that does not aim to predict what

decision2makers will do. The third research question that this thesis aims to e*plore

then, is the question of whether success in decision2making depends on the decision2

making process managers use &Ditt and Tyler, 5665' and, specifically, whether

adopting decision analysis techniques in investment appraisal decision2making has a

positive effect on organisational performance.

The literature reviewed in this section has indicated that there is a need for a study to

investigate the e*istence of a relationship between the use of decision analysis

techniques and concepts in investment appraisal decision2making and organisational

performance. This is the third research question that this thesis aims to answer.

Dowever, before such a link can be proved to e*ist, two assumptions must hold. The

;>


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ne*t section begins by stating these assumptions and proving their validity. It

continues to review previous studies that have been undertaken investigating the

relationship between business performance and various aspects of the organisational

investment decision2making process. Specifically, the section focuses on those

studies that have concentrated on the effects of rationality, formality and consensus in

the decision2making process since these are all features inherent in using decision

analysis techniques and concepts. The section concludes by advancing a hypothesis

for empirical testing.

%(8 D)*I0IO AA+C0I0 AD ORGAI0AIOA+ ')RFORMA*)

As ean and Sharfman &566@' observe, the following two assumptions must hold to

prove a link between investment decision process and decision effectiveness. "irstly,

it must be assumed that investment decision processes are related to choicesF or, more

specifically, that the investment decision process followed influences the choices

made. Although this assumption appears intuitively obvious, many academics have

argued that the operating environment shapes organisational and individual choices

&for e*ample, Aldrich, 5676F (feffer and Salancik, 567='. %thers, however, claim that

despite the e*istence of these e*ternal factors, managers retain a substantial degree of

control over choices &for e*ample, +iles, 56=9F #hild, 5679'. %ne argument made in

favour of this position by ean and Sharfman &566@' is that some managers make

very poor choices with devastating consequences for their firms, while others in very

similar circumstances make much better choices &for e*ample, ourgeois, 56=


41/250

The two assumptions then appear plausible &ean and Sharfman, 566@' which

suggests that it is reasonable to e*pect the investment appraisal decision2making

process to influence decision effectiveness. Dowever, as Aldrich rightly observed

&5676', the importance of managerial decisions in determining organisational

outcomes is ultimately an empirical question &ean and Sharfman, 566@'. +any

empirical studies have investigated the e*istence of a relationship between the

investment decision2making process and effectiveness. /one have concentrated on

the use of decision analysis in the investment decision2making processes of

organisations. Dowever, several have e*plored the effects of comprehensiveness,

rationality, formality and consensus in the decision2making process on organisational

performance. In much of the decision theory literature, it is argued that decision

analysis provides:

Hconvincing rationale for choice, improves communication and permitsdirect and separate comparisons of different peopleBs conceptions of thestructure of the problem, and of the assessment of decomposed elementswithin their structures, thereby raising consciousness about the root of anyconflict.K &Dumphreys, 56=> in )oodwin and !right, 5665 p577'

)oodwin and !right &5665' also argue that adopting a decision analysis approach

implies comprehensivenessNrationality and formalisation of the decision2making

process, improved communication amongst the stakeholders and provides the

organisation with access to a common language for discussing the elements of a

decision problem. This, they argue, helps to build consensus in the company, which

in turn e*pedites implementation of the decision. 4eeney and $aiffa &5679 pp5>255'

say of decision analysis:

HAs a process, it is intended to force hard thinking about the problem area:generation of alternatives, anticipation of future contingencies, e*amination of dynamic secondary effects, and so forth. "urthermore, a good analysis shouldilluminate controversy J to find out where basic differences e*ist, in valuesand uncertainties, to facilitate compromise, to increase the level of debate andundercut rhetoric J in short, Hto promote good decision2makingK.K

Since adopting decision analysis clearly involves comprehensiveness, rationality,

increased formality and high levels of organisational consensus, it suffices to e*amine

that empirical literature that has e*amined the relationship between these aspects of

;9


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the investment decision2making process and decision effectiveness. These studies are

now e*amined. Attention is first focussed on the effect of comprehensiveness and

rationality in the decision2making process.

Smith et al. &56==' provided some empirical support for a positive relationship

between performance and comprehensivenessNrationality in the decision2making

process. They found that, for both small and larger firms, comprehensive decision2

making processes out2performed less comprehensive. Similarly, ones et al. &5669'

reported consistently positive relationships between organisational effectiveness and

comprehensiveness in decision2making. In addition, a series of publications on

hospital integration strategies &for e*ample, lair et al., 566>', researchers found that

successful ventures were associated with comprehensive strategy formulation

processes &(apadakis, 566='. anisB &56=6' case studies suggested that public policy

decisions that used rational methods were more successful than those that did not.

(apadakisB &566=' study also provided evidence that the companies that e*hibit the

strongest organisational performance tend to be those with rational decision2making

processes, a participative approach and e*tensive financial reporting. "urthermore,

studies by #apon et al. &566


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Similarly, #yert and +arch &56@;' argued that superior performance lowered the

intensity with which organisations HsearchedK for and analysed information. +ore

specifically, ourgeois &56=5' and +arch and Simon &56?=' proposed that slack

resources permit organisations the Hlu*uryK of HsatisficingK and sub2optimal decision2

making. !hereas in poorly performing organisations the lack of basic funds e*erts

pressure on management during the making of crucial decisions, as a wrong decision

may drive the firm out of business. #onsequently, since management has less scope

for error, they may have strong incentives to follow rationalNcomprehensive processes

&ourgeois and isenhardt, 56==F #yert and +arch, 56@;'. This suggests that

managers of poorly performing firms may hire consultants, seek advice from various

sources and conduct e*tensive financial analyses &(apadakis, 566='. Such

observations led "redrickson &56=?' to conclude that the investment decision2making

process of poor performers is more comprehensive than that of e*cellent performers.

The above arguments, if correct, would indicate that good organisational performance

is negatively related to comprehensivenessNrationality in the investment decision2

making process &(apadakis, 566='.

#learly, then, much of the research to date appears to have produced contradictory

results and no consensus seems to have yet emerged. #ontrary to the arguments of

"redrickson &56=?' and others, it can be argued that good performance enables

companies to rationaliseNmodernise their internal structure and systems and thus be in

a position to apply more rationalNcomprehensive and formalised investment decision2

making processes for two reasons. "irstly, as ean and Sharfman &566@' have

previously argued, effective decisions must be based on organisational goal. $ational

decisions usually require e*tensive data collection and analysis efforts and it is

difficult to do this unless the decision is closely aligned to the organisationsB

ob8ectives &-angley, 56=6'. Ditt and Tyler &5665, p;96' described rational, formalised

decision2making as a series of analytical processes in which a set of ob8ective criteria

is used to evaluate strategic alternatives. This orientation toward organisational goals

makes it more likely that procedurally rational decisions will be effective &ean and

Sharfman, 566@'. Secondly, formalised, rational decisions are also likely to involve

relatively complete information and knowledge of constraints. *ecutives who

collect e*tensive information before making decisions will have more accurate

;


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perceptions of environmental conditions, which has been shown to relate positively to

firm performance &ourgeois, 56=?'.

A second stream of research deals with the impact of consensus on performance.

espite the profound importance given to the performance2consensus relationship in

the normative literature &(apadakis, 566=', there is still much disagreement in the

empirical literature which indicates that more testing is required &kenberg, 9>>>F

(riem, 566>F ess, 56=7F ess and %riger, 56=7'. #onsensus is the agreement of all

parties to a group decision &(apadakis, 566='. #urrent thinking attributes tremendous

significance to the homogenisation of perceptions and to goal consensus, which is

assumed to be fundamental to good economic performance &(apadakis, 566=F

ourgeois, 56=?'. #hild &567


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Dowever, conversely, some researchers have provided evidence that too much internal

consensus may be dysfunctional. "or e*ample, !hitney and Smith &56=;' argued that

an emphasis on organisational or management consensus could reduce individualsB

receptivity to information that contradicts the views of the dominant coalition despite

the fact that such information may be vital for the quality of the final decision. Thus,

the pressure for consensus postulated by normative methods to decision2making may

produce negative results &(apadakis, 566='. Investigating the performance2consensus

relationship, )rinyer and /orburn &567727=' found that the highest performing firms

e*perienced a negative correlation between performance and consensus. Thus they

hypothesised that high levels of cohesiveness may be dysfunctional, and that some

disagreement among members of the top management team may be an internal

strength related to superior performance &(apadakis, 566='. -angley &566?' also

warned that when everyone in power instinctively shares the same opinion on an

issue, the wise manager should be wary. 3nanimity, she writes, is unlikely to lead to

an ob8ective evaluation of options, and normal checks and balances may be short2

circuited. -angley argues that unanimity may mean that a proposal has strong value,

but it may also be symptomatic of a disturbing trend, that is, a uniformity in which

members share values and beliefs and that e*cludes deviation from the decision2

making process. She concludes that whilst obviously a strong culture has many

advantages, when the organisation is faced with discontinuities this same culture

becomes a liability as common beliefs become invalid.

"inally, contrary to both the above streams of results, !ooldridge and "loyd &566>'

found no statistically significant relationship between consensus and organisational

performance.

vidently then, the performance2consensus research has produced some conflicting

results. This may be attributed to differences in units of analyses, in methodologies

and research questions &ess and %riger, 56=7', or, perhaps, even to the nature and

stage of the strategic process under investigation which may impact upon the scope,

content and degree of consensus &!ooldridge and "loyd, 566>F (apadakis, 566='.

+ore interestingly, (apadakis &566=' postulates that a lack of any significant

relationship suggests the co2e*istence of two opposite effects that Hcancel each other

;@


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outK in practice. ean and Sharfman &566@' have argued that effective decisions must

be based on organisational goals. (olitical decision processes are, by their very

nature, organised around the self2interests of individuals or groups &(feffer, 56=5F

(ettigrew, 567;', which are often in conflict with those of the organisation.

Therefore, it can be argued that good performers are less likely to e*hibit less politics

and less problem2solving disagreement in their decision2making process.

This section has 8ustified the assumptions that must hold in order to prove a link

between investment decision process and effectiveness. It has reviewed those

empirical studies that have focussed on the effects of comprehensiveness, rationality,

formality and consensus in the decision2making process on organisational

performance. It has provided evidence that using decision analysis means rationality,

comprehensiveness, formality and increased consensus in investment decision2

making. It therefore suffices to advance only one hypothesis for empirical testing in

this thesis: organisational performance is positively related to use of decision analysis

in investment appraisal decision2making. In answering the third research question,

the researcher aims to investigate this proposition.

The current study will use the indication of current capability and current practice

gained from answering the first and second research questions to rank the companies

according to the number of techniques used in their investment appraisal process. The

research will then assume that any value added to the company from using a decision

analysis approach, including any HsoftK benefits, ultimately affects the bottom2line.

This assumption will be 8ustified in #hapter 7. It means that it is therefore

permissible to use publicly available financial data to indicate business success. The

e*istence of a relationship between organisational performance and use of decision

analysis in investment appraisal will then be analysed statistically.

%(: *O*+U0IO

In seeking to e*plore the investment decision2making processes of companies, the

literature review for the current study has e*amined the academic literature on

investment decision2making. The source of each of the three research questions

proposed in #hapter 5 was e*plored and a hypothesis advanced for empirical testing.

;7


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The ne*t chapter e*amines the conte*t for the current study. It will show how the oil

and gas industry is such an e*treme e*ample of investment appraisal decision2making

under conditions of risk and uncertainty that it provides a useful environment in which

to study investment decision2making.

;=


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*hapter hree

he Oil Industry in the U(.(

;6


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5(3 Introduction

This chapter draws on the oil industry literature to present a brief description of the

industry that highlights the main challenges facing it in the 95 st century. Since the

current study focuses on oil and gas companies that operate in 3.4., the effects of

these global changes on the 3.4. industry are e*amined. This indicates the growing

comple*ity of the business environment of those companies operating in the upstream

oil and gas sector and highlights why decision analysis is beginning to receive

increasing attention in the industry and, consequently, why it provides such a useful

conte*t in which to study investment decision2making.

5(% *urrent challenges in the glo#al oil industry

or oer a century and a half, oil has 'rou!ht out 'oth the 'est and

+orst of our ciilisation. *t has 'een 'oth 'oon and 'urden. &ner!y is

the 'asis of our industrial society. #nd of all ener!y sources / oil has

loomed the lar!est and the most pro'lematic 'ecause of its central role,

its strate!ic character, its !eo!raphic distri'ution, the recurrent pattern

of crisis in its supply / and the ineita'le and irresisti'le temptation to

!rasp for its re+ards. *ts history has 'een a panorama of triumphs and

a litany of tra!ic and costly mistakes. *t has 'een a theatre for the no'le

and the 'ase in the human character. Creatiity, dedication,

entrepreneurship, in!enuity, and technical innoation hae coe0isted

+ith aarice, corruption, 'lind political am'ition, and 'rute force. il

has helped to make possi'le mastery oer the physical +orld. *t has

!ien us our daily life and, literally, throu!h a!ricultural chemicals and

transportation, primacy. *t has also fuelled the !lo'al stru!!les for

political and economic primacy. 2uch 'lood has 'een spilled in its

name. )he fierce and sometimes iolent "uest for oil / and for the

riches and po+er it coneys / +ill surely continue so lon! as oil holds a

central place since eery facet of our ciilisation has 'een transformed

'y the modern and mesmerisin! alchemy of petroleum.


50/250

The above paragraph has been adapted from the closing remarks made by aniel

Cergin in his book, )he %rize &5665', which chronicles the development of the worldBs

oil industry. Three themes are used to structure the book and these clearly illustrate

the global impact of the oil and gas industry. The first of these is that oil is a

commodity intimately intertwined with national strategies, global politics and power

as evidenced by its crucial role in every ma8or war in the last century. The second is

the rise and development of capitalism and modern business. According to Cergin

&5665 p5;':

H%il is the worldBs biggest and most pervasive business, the greatest of thegreat industries that arose in the last decades of the nineteenth century.K

A third theme in the history of oil illuminates how ours has become a Hhydrocarbon

societyK &Cergin, 5665 p5


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• "ield si1e

)lobally many of the oil ma8ors still generate much of their output J and profits J

from giant fields discovered decades ago. "or e*ample, in 566@ it was estimated that=>E of (Bs &ritish (etroleum' oil and gas production was from /orth America and

ritain, mainly from a handful of large fields in Alaska and the /orth Sea &The

conomist, 566@'. (roduction from nearly all these giant fields is either near its peak

or is already declining. /ew fields are rarely as large or as profitable as these earlier

large reservoirs. !orldwide since the mid256=>s, few giant oilfields have been

discovered &figure ;.5' and, although, many smaller fields have been found, they have

not delivered the same economies of scale &The conomist, 566@'.

"igure ;.5: 3orld+ide !iant fields (initial reseres 'y discoery year (source: Camp'ell, 1997 p45

&

8

3&

38

%&

%8

5&

58

7&

78

367& 3678 368& 3688 36:& 36:8 369& 3698 36;& 36;8 366& 3668

1illion 1arrels

!8yr moving

average$


52/250


53/250

"igure ;.;: istri'ution of remainin! (;et-to-%roduce oil (in illions of 'ls 'y country (calculated 'y su'tractin! total production of conentional oil to date from Camp'ells estimate of cumulatie

production of conentional oil and diidin! 'y country (source: Camp'ell, 1997 p 94

"igure ;.


54/250

by using new technology either to e*tend field life or to e*ploit fields that were

previously inaccessible, oil companies have been able to increase their reported

reserves. Secondly, petroleum companies are becoming increasingly reliant on gas

which is harder to transport and less profitable to produce &The conomist, 566@'.

Some, such as -aherrQre &5666', are more cynical and believe that the bulk of the

recent Hreserves growthK can be attributed to faulty reporting practices.

• emand

!orld demand for oil, gas and coal in the 95st century will depend on two contrary

forces. "irstly, there is the possible reduction in demand by the countries in the

%rganisation for conomic #o2operation and evelopment &%#' caused by

structural changes, saturated markets, ageing populations and increasing efficiency.

Such efficiency gains are driven by competition, concerns for energy security and

environmental measures. Action to meet 4yoto targets, set in a summit on global

warming in 4yoto, apan in ecember 5667, will put a cost on carbon emissions J

either by ta*ation or by trading. #oal and oil will face fierce competition in power

generation. As indicated above, oil ma8ors are relying increasingly on gas &The

conomist, 566@'. Skeikh Ahmed Paki Camani believes that new hybrid engines

could cut petrol consumption by almost ;>E, while fuel2cell cars, which he predicts

will be widely used by 9>5>, will cut demand for petrol by 5>>E. In a recent article

in &ner!y ay he said:

HThirty years from now there will be a huge amount of oil J and no buyers.%il will be left in the ground. The Stone Age came to an end not because wehad a lack of stones and the oil age will come to an end not because we have alack of oil.K &nergy ay, ;rd uly 9>>> p7'

Dis claims are substantiated by a study from 3.S. based #llied usiness *ntelli!ence

&AI', which forecasts millions of fuel2cell vehicles by 9>5>. AI business analyst

Atakan %1bek is also quoted in the same &ner!y ay article:

Hy the second decade of this century mass production of automotive fuelcells will result in first a glut in the world oil supply and then in a totalreduction of oil as a vehicle fuel.K &nergy ay, ;rd uly 9>>> p7'


55/250

Secondly, there is the potential demand in developing countries. Dow it is fulfilled

depends on future economic growth. The oil companies, however, are optimistic with

Shell suggesting that energy consumption will be between si*ty and eighty percent

higher by 9>9>, with developing countries consuming over half of the available

energy &+oody2Stuart, 5666'.

• $estructuring

International oil prices are notoriously volatile &figure ;.?'. Dowever, when, in the

winter of 566=25666, oil prices dropped to their lowest levels in real terms for twenty2

five years, the profit margins of even the largest companies were squee1ed and all

companies were forced to reduce costs. This proved difficult and with the need to

improve their return on capital employed, which has historically been lower than the

cost of that capital, the boards of some of the largest companies perceived the only

way to make further savings was through big mergers, followed by ruthless

restructuring &The conomist, 566='.

"igure ;.?: #ctual spot rent oil price oer time (source: % Statistical


56/250

already starting to transform the worldBs oil industry. "irms that were once considered

big, such as #hevron and Te*aco, are rushing to find partners. This is true even in

urope, where national champions have traditionally resisted pressures to merge.

"ranceBs Total announced in 566= that it was buying elgiumBs (etrofina for some

R5; billion &The conomist, 566=' and, more recently, Total "ina have also bought

"ranceBs lf.

!hilst some argue that this is 8ust typical oil industry over2reaction to the bottom of

the price cycle &for e*ample, uan aird of Schlumberger in The conomist, 566=',

others believe that the structure of the oil industry has altered irreversibly:

Hthe changes unleashed by the mergers look unstoppableK &The conomist,566= p7


57/250

production &including /orway' averaged some @.5? million barrels per day in 5666.

This is forecast to increase to an average of some @.>>

&!ood +acken1ie /ewsletter, "ebruary 9>>>'. Since 56@,>>> 8obs offshore and

over ;>>,>>> direct and indirect 8obs onshore &"oreword of The %il and )as Industry

Task "orce $eport published by the epartment of Trade and Industry, 5666'F and in

5666 it was responsible for ;@E of the 3.4.Bs industrial investment &3.4. nergy in

rief published by the epartment of Trade and Industry, 9>>>'.

Dowever, in the early 567>s the average si1e of a 34#S discovery was about one

billion barrels of oil &rown, 5669'. Today, nearly half of all developed fields in the

34#S contain less than fifty million barrels of oil &Shell, 566='. This decline is

shown in figures ;.@ and ;.7.

"igure ;.@: )he aera!e size of =.>. fields 'y discoery year (source: =nited >in!dom ffshoreperators #ssociation, 5a, http:??+++.ukooa.co.uk

&

%&&

7&&

:&&

;&&

3&&&

3%&&

369& 369% 3697 369: 369; 36;& 36;% 36;7 36;: 36;; 366& 366% 3667

Million #arrels

o" oil e@uivalent


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"igure ;.7: iscoeries 'y field-size class i

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