Petroleum Investments on the Norwegian Continental Shelf: Is 10% still the right rate of return?

Abstract

Oil and gas companies on the Norwegian continental shelf are frequently conducting investments. Important part of that process is to set a required rate of return or hurdle rate on the assets, as well as choosing a discount rate to be used in the discounted cash flow analysis. The topic of this thesis was to evaluate the basis and underlying assumptions of determining the required rate of return that should be used when evaluating petroleum investments on the Norwegian continental shelf. 10 percent rate of return has traditionally been considered the standard, but as this thesis show, the 10 percent rate of return is due for an update. The weighted average cost of capital (WACC) has frequently been used as a proxy for the hurdle rate. The findings show that the WACC is not able to fully capture the long-term risk associated with the current volatile and cyclic nature of the oil and gas industry. The main reason for that is capital rationing leading companies to implement an ambitious constraint on break-even oil price to ensure robust investments. Another long-term risk that the WACC is not capturing is the generic term “climate risk”, which covers all aspects of added risk due to climate impact and the energy transition. The WACC on the Norwegian continental shelf is well below 10 percent while the required rate of return is currently in the range of 15-20 percent. The recommended methodology to determine the hurdle rate is to combine the WACC with an additional risk to capture the short term risk and long-term risk associated with an investment. This additional risk needs to be quantified and including climate risk.