African Journal of Business Management Vol. 4(13), pp.

3013-3025, 18 October, 2010

Available online at http://www.academicjournals.org/AJBM
ISSN 1993-8233 2010 Academic Journals



Full Length Research Paper

Portfolio management as a new approach on
improvement of financial resources allocation: A case
study of the National Iranian Oil Company (NIOC)

Mohammad Reza Moghaddam

Research Institute of Petroleum Industry, Ministry of Petroleum of Tehran, Iran. E-mail: mr_moghaddam@yahoo.com.
Tel: 0098 021 220 90 347.

Accepted 23 September, 2010

The National Iranian Oil Company (NIOC) is one of the largest exploration and production (E and P) oil
companies in the world, which enjoys numerous investment opportunities. The selection and formation
of the projects basket (portfolio) of this industry needs some considerations on decision making tools,
key targets, priorities and constraints of NIOC. Due to NIOCs vision, which is to be one of the excellent
commercial companies of the world in production, refining and export of oil and gas, the necessity of
keeping the production level unchanged and enhancing the abilities of production by fields
developments and improving the recovery factor, are very important. As regards numerousity of
investment opportunities at different stages of exploration, development, exploitation and production,
considering all constraints, are not feasible without applying scientific methods. According to these,
the model of this paper considers the government expectations, strategies, national targets, priorities
and constraints of NIOC and evaluates economic risks of projects, economic evaluation of portfolio,
applying MERAK products (for a few pilot projects) in the oil industry and finally, determines the
optimum basket of the projects. For implementing the system, an organization is required in each
planning departments of NIOC. This system as a decision support system (DSS) is able to use the
current data, the government and ministrys strategies, the policies of CEO and other budgetary and
financial considerations, and determines the investment priorities and optimum portfolio of NIOC.

Key words: Risk management, portfolio management, upstream industries, software, decision support system.


INTRODUCTION

NIOC as one of the largest oil companies in exploration
and production (E and P) has various opportunities, while
it also faces limited financial resources. Selection of
projects (or portfolio) in this industry requires conside-
rations on different aspects of decision making such as
key objectives, priorities and constraints of NIOC.
According to NIOCs perspectives, as an outstanding
commercial oil company, NIOC has to keep the
production level unchanged and also increase the
capacity of oil production through developing fields and
improving the recovery factor. The number of investment
opportunities in some aspects such as exploration,
development, production, exploitation show that the best
portfolio and its dynamics during different periods of time
is impossible under consideration of all constraints and
restrictions, without applying the scientific methods and
related softwares (Schlumberger, 2008). In this direction,
a company would be successful which evaluates the
economic risks and establish its portfolio management
system according to its existing strategies, aims, priorities
and constraints (Alam et al., 2010). The main problem for
NIOC is to have a better financial allocation among
projects and should be equipped by modern tools for
managing its portfolio.
This paper is divided into two sectors; the first,
discusses about the methods of risk management in the
oil and gas industry, while the second, indicates the
desired manner of portfolio management for optimum
allocation of the financial sources to improve the
allocation in the industry. So, a pilot case is used to show
the applicability of the model.


Risk management in upstream oil and gas industries

Risk is defined as an event which leads to negative results.
3014 Afr. J. Bus. Manage.



Table 1. Classification of risks.

Kind of risk Effect on economics project Confronting/how to avoid risk
Political risks Negative Yes / Multinational portfolio
Environmental risks Negative Yes / Many projects
Technical risks (Reserves/costs) Negative / Positive Yes / Many fields
Economical risks (Price of oil and gas) Positive / Negative Yes / Contract conditions
Economical risks (Foreign exchange rate) Positive / Negative Yes / Contract conditions
Economical risks (Inflation) Positive / Negative Yes / Contract conditions
Commercial risks (Financial) Positive / Negative Yes / Differentiation
Commercial risks (Tariffs) Positive / Negative Yes / Hedging




Earth quake metering
Ceology
Modellng
eLrophyslcs
8eserve slmulaLlon
Production data
roducLlon full
Allocation of production
1axes
LxcavaLlon
Individual economic
evaluation of projects
orLfollo
Economic evaluation of
ath project
Production
forecast
Economic evaluation of
nth ath project
uLlllzaLlon
LxporLs
Capital expenses Price level
Operation expenses
Owners share


Figure 1. Oil and gas upstream activities and risky areas.



results. From a scientific view, risk is defined as all
events which could lead to positive or negative results
(Alam et al., 2010). The oil companies try to recognize
the effects of these risks on cash flow investment and
long-term value of the company. From the point of
investment theory, more efficiency takes place with
acceptance of higher risk. Small and independent oil
companies react against inefficiency and high risks, trying
to decrease such risks. Mid-scale oil companies which
are active in the explorations, usually preserve an equal
portfolio between exploration and production (Benoit et
al., 2000). As such, the large-scale oil companies, which
are active in refining, have a weak reaction against the
price, and they do not tend to decrease risks. Due to a
competitive environment, the technical risks could be
recognized and their effects could be restricted. Oil
companies try to internationalize their risks on the
investment value, cash flow and long-term value of the
company (Wheitside, 1999). Table 1 shows the
classification of risks and Figure 1 shows the different
stages liable to the risk for upstream levels of oil and gas
industry.
Figure 2 shows the effects of the risk on the economic
evaluation of oil and gas projects, operational and current
costs and finally on net present value (NPV). Each
parameter which is used in the economics of project is
liable to a probability that converts the NPV to a
stochastic variable. The methods used in measuring the
value and risk are: conventional analysis, decision
making analysis and simulation techniques.


Conventional analysis

By this analysis with a clear procedure, there are many
defined parameters. Managers use the cash flow of the
Moghaddam 3015





6 8 10 12 14













6 8 10 12 14














6 8 10 12 14









6 8 10 12 14
6 8 10 12 14


Figure 2. Economics of oil and gas projects.



company through NPV and rate of return (ROR).
Although a deep analysis can provide a better outlook
from positive and negative results of a potential
investment, but it cannot help the managers to quantify
the probability of these results and do some sensitivity
analysis (Bigdeli et al., 1999). In conventional analysis,
the most probable situation is not clear.


Decision analysis

In most cases, the different sectors of the oil industry use
the decision analysis for the stages of the project (after
exploration). Simpler, decision analysis imputes the
different probabilities of success to the clear events. For
each event, this method determines NPV and its related
probability. By multiplying NPV to each probability and
adding them up for all events, only one result is
measurable (Schlumberger, 2008). There are some
restrictions by this method that forces the researcher to
define some clear events and even limit the number of
analyzing variables.


Probabilistic simulation technique

The probabilistic simulation technique (related to Monte
Carlo analysis) is used to determine the distribution
pattern of reserves, especially in the oil industry. By this
technique, distribution of associated probability is
determined for each key variable and randomized
sampling is done for each variable. This process is
repeated a thousand times which leads to "probable
reserves distribution". However, the average value of
distribution indicates the "expected reserves".
The subject of oil reserve is relatively simple, because
it composes of less than 10 variables and limited
algorithms, whereas for analyzing the cash flow there are
more variables and algorithms. To perform financial and
economical analysis in the oil industry, Monte Carlo
technique is often used. Some large-scale oil companies
have developed their domestic and commercial systems
so that they could be connected to the international fiscal
regime model. These new systems allow the decision
makers to design a model that is more complete for all
technical, commercial and economical variables, and as
such, show a dependency rate between the variables.
Through the probabilistic simulation techniques, it is
possible to recognize a full probable distribution for NPV,
its standard deviation and EMV feasible for a project or
portfolio of projects. Also, this technique could be applied
to determine the rate of correlation between projects and
integration of risks, especially to calculate the overall risk,
value and portfolio cash flow.
Figure 3 shows the sensitivity analysis of upper and
3016 Afr. J. Bus. Manage.





Figure 3. Expected monetary value and net present value.



lower limits of NPV and specifies values according to the
related probability; as such, the asset risks are not
addable. A risk that is measured by the standard
deviation is not independent, in that it depends on the
number of assets and risk of portfolios. There are two
main mechanisms for diversification: Simple and
Markowitzian diversifications.
When the economical efficiency is considered, the
assets are not independent (that is, they are not cor-
related). As such, efficiency of all assets is independent
from the common economic conditions. Under these
circumstances, the simple diversification cannot lead to
zero-risk, but can lead to minimum rate. In stock market,
this risk is known as market or systematic risk. For an
exploration company, the risk of oil price is the main risk.
However, the risk is composed of other factors such as
gas market, inflation risk and so on.
Markowitzian diversification is applied to decrease the
portfolio risk of assets with intense correlation. This
diversification uses the analytical optimization portfolio
techniques to maximize the efficiency according to a
defined level of risk. This method indicates the fact that a
combination of assets with low correlation could be faced
by less risk in the efficiency of total assets.
These two mechanisms provide a better understanding
of risks sources. All risk sources influence the risk of
efficiency for individual asset. However, this effect
depends on the independency and rate of risks toward
the total portfolio risk. Anyway, the oil company,
regardless of whatever strategy it has, only pursues an
objective that maximizes the value of the company
according to the defined risk. Portfolio optimization is a
method used to determine where to invest. It maximizes
the efficiency and the achieved strategy is usable for a
long term. To achieve a higher EMV, investment in
exploration and new projects is required. Difference
between EMV of an asset and its market value, is known
as risk premium. Whenever the asset is bought, the
added value is considered as the risk premium (Alam,
2009a). If the investor pays the market value of an asset,
its value will be increased up to EMV. The added value
can compensate the additional risk arising from keeping a
risky asset toward a non-risky one. Similarly, for every
asset in the portfolio, it is possible to select between the
sale of an asset by market price or keeping the asset until
it reaches a higher EMV with a defined risk (Alam,
2009b). Some facts of the oil and gas industry are:

(i) Lack of a compatible political basket for strategic long-
term planning.
(ii) Higher growth of domestic consumption of energy,
threatening exports.
(iii) Decreasing the production capacity of NIOC.
(iv) Limitation of NIOCs resources for development of the
energy sector.
(v) Try to fulfill Irans share in OPEC.
(vi) Necessity of 70 billion dollars investment in the oil
and gas sector during the 10 to 15 years period of
investment.

More so, the oil minister has declared his priorities:

(i) In the exploration sector
(ii) Priority of common oil and gas fields
(iii) Priority of gas injection
(iv) Recognition of potential capabilities
(v) In the production sector
(vi) Development and exploration of new fields
(vii) Reserves conservation
(viii) Gas and water injection
(ix) Improving the recovery factor
(x) Decreasing the associated gas
(xi) In the refinery and petrochemical sector
(xii) Self-performance
Moghaddam 3017



Merak Capital Planning
Porllo||o 0pl|r|zal|or ard Ara|ys|s
Results Broker
Corporale Resu|ls 3lardard|zal|or
Merak Peep & DTK
Ecoror|c Eva|ual|or, F|sca| Reg|re Vode|s,
urcerla|rly ard R|s|, Producl|or Forecasl|rg
Merak VOLTS
Reserves Varagererl


Figure 4. Relation among the components of MERAK products.



(xiii) Qualitative and quantitative development
(xiv) In the domestic energy consumption sector
(xv) Pipeline management
(xvi) Storage tanks management
(xvii) CNG stations development (Compacted natural
gas)
(xviii) Attention to the environment
(xix) Decreasing the polluting productions
(xx) Oil and gas swap
(xxi) International relations development
(xxii) Preservation of OPECs share
(xxiii) Preservation and improvement of gas exports
share in the world.

The commercial targets of NIOC are:

(i) Planning process management with calculation of
risks, value and uncertainties.
(ii) Quantification of uncertainties in the production
process, to forecast needed investment and project
plans.
(iii) Enjoyment of an optimum commercial and long-term
plan.

Current planning to determine the optimum basket of
projects, confronts the following challenges:

(i) Weakness of criteria (unusual) for economical evaluation
of the projects.
(ii) Using excel-based calculations.
(iii) Lack of concentrated economical database (usually
on personal computers).
(iv) Lack of optimum portfolio management, based on
mental criteria.

Hence, portfolio management could be used to establish
a knowledge-based system for oil and gas industry and
applying software to do better economical analyses,
determining the investment basket on the light of the
minimum risk and maximum value in NIOCs planning
system.

Advantages of portfolio management are:

(i) Board of Directors trust to capital allocation.
(ii) Coordination of the 5-year plans and NIOCs
investment plan.
(iii) Optimization of risk and companies efficiency
in the investment plan.
(iv) Providing the auditing of investment decisions.
(v) Improving the operations through sharing and
optimum capital allocation.


MERAK software

The schema of relations among the component is shown
in Figure 4. According to this figure, individual economic
evaluation of the projects is done by the PEEP module,
while production data are provided through VOLTS
module and calculations of risk are done through DTK
module. All data are transferred to the capital planning
module, and as such, the optimization portfolio will be
done along with a basket of projects. Figure 5 shows the
3018 Afr. J. Bus. Manage.





Figure 5. Role of deciding tools in portfolio management process.



relations of every stage assigned to the optimum
portfolio.
In this package, it is possible to introduce the
strategies of the deciding model in NIOC. The relation of
each project in the candidate basket is introduced to the
software along with its strategies and assigning priority
coefficient. There are 50 pilot projects in this basket and
the process is applied to each one. According to Figures
5, 6 and 7, every project is placed on a pre-determined
strategy and the strategic index of each project is used to
assign the basket of projects. 50 pilots are used to
implement the allocation of financial resources. Tables
2, 3 and 4 show the estimation of revenue of each
project.
Figures 8, 9, 10 and 11 show the income and expected
production rate that resulted from performing the projects
with any constraints. Tables 5 and 6 show the first and
second optimum portfolios arising from optimization of
the model.

Pay attention to the following example.

First stage: Targeting the oil and gas production and
income during the plan.

-Target: Producing 15 bln barrels.
-Limitation: Max. production of 18 bln barrels of oil during
the schedule.
-Expected income rate and production of oil and gas is
determined by the technical sector and the beneficiaries
of the project.

Description of results: The optimum portfolio includes
49 of 50 projects, but 32 projects were not started on
time.

Description of results: The optimum portfolio includes
49 of 50 projects, but 24 projects were not started on
time.


Conclusion

The National Iranian Oil Company (NIOC), one of the
largest exploration and production oil companies in the
world, is faced with numerous investment opportunities.
The selection and formation of projects basket (portfolio)
in this industry needs some considerations on decision
makings, key targets, priorities and constraints of NIOC.
On the one hand, due to NIOCs vision as one of the
excellent commercial companies of the world in produc-
tion, refining and export of oil and gas, the necessity of
keeping the production level unchanged and enhancing
the abilities of production by fields developments and
increasing the recovery factor, is very important, whereas
on the other hand, the numerousity of investment oppor-
tunities at different stages of exploration, development,
exploitation, production, complexity of backward and
forward linkages of projects and correspondent risks, the
Moghaddam 3019





Figure 6. Introducing the strategies to the model.





Figure 7. Qualification of every projects relation with model strategies.
3020 Afr. J. Bus. Manage.



Table 2. List of 50 pilots projects.

Candidate set
Project name Objective Base business
Totals for proposed candidates: 0
Candidates set totals: 0
Base business totals: 0
DS2- Buying Office R2C N/A *
DS3- Buying Residential in Kish- R2C N/A *
DS4- CNG Bus Plant- R2C N/A *
DS6- R2c N/A *
DS9- R2C N/A *
DS13- Refinery- R2C N/A *
M2-Cap-R2C N/A *
MS1-R2C N/A *
MS4-R2C N/A *
MS5-R2C N/A *
MS6-South Pars-R2C N/A *
MS7-NGL Plant-R2C N/A *
MS9-NGL Plant-R2C N/A *
MS10-used to be DS10-R2C N/A *
UDOD7-R2C N/A *
USLGD1-R2C N/A *
USOD2-R2C N/A *
USOD3-R2C N/A *
USOD5-R2C N/A *
USOD6-R2C N/A *
USOD8-R2C N/A *
USOD9-R2C N/A *
USOD10-R2C N/A *
USOD11-R2C N/A *
USOD12-R2C N/A *
USOD13-R2C N/A *
USOD14-R2C N/A *
USOL1-Oil Layer-R2C N/A *
USOL2-R2C N/A *
USOL3-R2C N/A *
USOL4-R2C N/A *
DS5 N/A *



Table 3. Total revenue.

Candidate set
Project name Objective Base business
Totals for proposed candidates: 619222720
Candidates set totals: 619222720
Base business totals: 0
DS2- Buying Office R2C N/A 38
DS3- Buying Residential in Kish- R2C N/A 5974
DS4- CNG Bus Plant- R2C N/A 645000
DS6- R2c N/A 160309
DS9- R2C N/A 13050057
Moghaddam 3021



Table 3. Contd.

DS13- Refinery- R2C N/A 7670056
M2-Cap-R2C N/A 52363
MS1-R2C N/A 5873220
MS4-R2C N/A 17152210
MS5-R2C N/A 228360
MS6-South Pars-R2C N/A 51426460
MS7-NGL Plant-R2C N/A 2254776
MS9-NGL Plant-R2C N/A 14243453
MS10-used to be DS10-R2C N/A 32159620
UDOD7-R2C N/A 6159660
USLGD1-R2C N/A 2329400
USOD2-R2C N/A 5426964
USOD3-R2C N/A 2720066
USOD5-R2C N/A 1103927
USOD6-R2C N/A 1664915
USOD8-R2C N/A 13531612
USOD9-R2C N/A 12749160
USOD10-R2C N/A 3637776
USOD11-R2C N/A 5967630
USOD12-R2C N/A 4693225
USOD13-R2C N/A 14663427
USOD14-R2C N/A 35365534
USOL1-Oil Layer-R2C N/A 722000
USOL2-R2C N/A 4162697
USOL3-R2C N/A 29619650
USOL4-R2C N/A 345678765
DS5 N/A 23456780



Table 4. Expected income of the oil and gas production rates.

Expected income (bln$) Oil production rate (MMB) Gas production rate (MMB)
Date Amount Date Amount Date Amount
2006 2006 2006
2007 2007 2007
2008 2008 2008
2009 522000.000 2009 2009 1100000
2010 575000.000 2010 2010 1550000
2011 619000.000 2011 2200000 2011 1850000
2012 692000.000 2012 2200000 2012 2100000
2013 692000.000 2013 2200000 2013 2100000
2014 696000.000 2014 2200000 2014 2100000
2015 691000.000 2015 2200000 2015 2100000
2016 700000.000 2016 2200000 2016 2100000
2017 701000.000 2017 2200000 2017 2100000
2018 696000.000 2018 2200000 2018 2100000
2019 694000.000 2019 2200000 2019 2000000
2020 696000.000 2020 2100000 2020 2000000
2021 683000.000 2021 2100000 2021 2000000
2022 673000.000 2022 2000000 2022 2000000
2023 666000.000 2023 1460000 2023 1850000
2024 661000.000 2024 1430000 2024 1850000
2025 652000.000 2025 1400000 2025 1600000
2026 621000.000 2026 875000 2026 1500000
3022 Afr. J. Bus. Manage.





Figure 8. Expected income during planning.






Oil Production Profile


Figure 9. Expected oil production rate during the planning (Mean of Oil-Volume).


Moghaddam 3023





Figure 10. Expected gas production rate during planning (Mean of Total-Gas-Production).





Figure 11. Relations of projects with strategies (red=very weak relation, yellow= medium, green=too strong).
3024 Afr. J. Bus. Manage.



Table 5. First optimum portfolio.

Project name Base In Working
Interest
Eval.
Date
Delay Mean of at-ror
(maximized)
Selected By
Gen
Candidate Set Totals: 50 2000.00
Base Business Totals: 0.00
Project grid filter totals: 0 49/49 47.46 49
DS2- Buying Office R2C * 1.00 2006/1 5 37.17
DS3- Buying in Kish- R2C * 1.00 2006/1 0 8.53
DS4- CNG Bus Plant- R2C * 1.00 2011/1 5 36.86
DS6- R2c * 1.00 2006/1 0 17.17
DS9- R2C * 1.00 2011/1 5 39.34
DS13- Refinery- R2C * 1.00 2011/1 5 2000.00
M2-Cap-R2C * 1.00 2006/1 0 12.97
MS1-R2C * 1.00 2006/1 0 17.93
MS4-R2C * 1.00 2006/1 0 24.38
MS5-R2C * 1.00 2006/1 1 32.59
MS6-South Pars-R2C * 1.00 2007/1 0 90.93
MS7-NGL Plant-R2C * 1.00 2006/1 5 2000.00



Table 6. Second optimum portfolio

Project Name Base In Working
Interest
Eval
Date
Delay Mean of at-ror
(maximized)
Selected
By Gen
Candidate Set Totals: 50 2000.00
Base Business Totals: 0.00
Project grid filter totals: 0 29/29 53.49 29
DS5 * 1.00 2006/1 5 37.17
DS1- Buying Office-R2C * 1.00 2006/1 0 8.53
DS2- Buying Office R2C * 1.00 2011/1 5 36.86
DS4- CNG Bus Plant- R2C * 1.00 2006/1 0 17.17
DS7- R2C 1.00 2007/1 32.59
DS8-R2C 1.00 2008/1 15.16
DS13- Refinery- R2C 1.00 2006/1 2000.00
MS1-R2C 1.00 2009/1 34.56
MS4-R2C 1.00 2007/1 62.59
MS5-R2C 1.00 2006/1 38.88
MS6-South Pars-R2C * 1.00 2011/1 5 39.34
MS7-NGL Plant-R2C * 1.00 2011/1 5 2000.00
MS8-R2C * 1.00 2006/1 0 12.97
USGF1-R2C * 1.00 2006/1 0 17.93
USGFD3-R2C * 1.00 2006/1 0 24.38
USGLD1-R2C * 1.00 2006/1 1 32.59
USOD10-R2C * 1.00 2007/1 0 90.93
USOD14-R2C * 1.00 2006/1 5 2000.00



and correspondent risks, the number of portfolios such as
selecting optimum portfolio and its dynamics through time
periods, considering all constraints, are not feasible
without applying scientific methods. According to these, a
model which identifies the expectations, strategies,
targets, priorities and constraints of NIOC, as well as
critical success factors (CSFs) and also economic risks of
projects, economic evaluation and portfolio management,
is presented. However, it applies MERAK products (for a
few pilot projects at the upstream level) in this industry




and determines the optimum basket of the projects.


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