The Cozzolino Criterion as a Tool of Oil and Gas Exploration Projects Evaluation Adjusted for Risk Aversion

Abstract

Oil and gas exploration projects are typically characterized by a combination of high potential gains and extremely low chances of success, so their appraisal requires some risk aversion discounting. Amongst many risk aversion-adjusted methods of project valuation proposed by economists, the Cozzolino criterion appears to be the most appropriate. However, being applied to the problem of determining the optimum working interest in an exploration venture, this criterion yields an anomalous result such that the optimum working interest first increases and then decreases as the potential gain increases. This problem has inspired an intensive discussion in the oil and gas economics literature but, apart from attempts to overcome the problem by adding extraneous constraints that are somewhat palliative in nature, there has not been proposed a clear and acceptable procedure for overcoming all difficulties. In this article, it is shown that the paradoxical result can be explained if one steps outside the narrow limits of the working interest optimization task and view the issue as a part of a broader problem of building an investment portfolio. The authors propose a decomposition of the total impact of the project gain change on the optimum working interest into two components that resemble the substitution effect and the income effect. Both components have intuitively understandable economic sense and unambiguous sign. The resulting sign of the total impact depends upon the relative sizes of the two oppositely directed effects that can be calculated numerically, thus providing a better understanding of the issue.