Personal ruin versus corporate profit: why individual risk attitudes lessen economic outcomes

Abstract

Previous work on utility theory has highlighted value lost as a result of companies’ non-risk-neutral behaviour. Prospect theory, however, extends utility theory to describe how individuals make decisions under uncertainty. Key features include: use of decision weights rather than probabilities, and asymmetry between losses and gains, with losses weighted more heavily. Both effects impact on peoples’ risk tolerance (i.e., how risk averse or risk seeking they are). Given the petroleum industry’s reliance on decisions made under uncertainty, prospect theory can significantly impact on the value of decisions.

This paper presents multiple studies highlighting the impact of prospect theory on decision value and, in particular, the changes in value resulting from differences between individual and company risk tolerances. Results indicate that prospect theory effects cause changes in risk tolerance, resulting in lost value compared to risk-neutral decisions and that this is strongest when probability of success is low—as is often the case in petroleum exploration. Differences between individual and corporate risk tolerances also impact value. The presented studies, however, demonstrate why it can benefit an individual to be risk averse even when their employer would prefer risk-neutrality, as this reduces the chance of personal ruin and increases personal expected value (EV).

Finally, the implications for oil and gas decision makers are discussed. It is argued that corporate risk tolerances are, in fact, aggregated individual risk tolerances, which should be compared to ideal corporate risk tolerances calculated using the chance of ruin for a company with a particular portfolio of investments.