600.019 Advanced Petroleum Economics
Lecture Notes
Originaly prepared by Stephan Staber, 2007, Leoben Revised by Stephan Staber, October 2008, Vienna Revised by Stephan Staber, September 2009, Vienna Revised by Stephan Staber, October 2010, Vienna Revised by Stephan Staber, September 2011, Vienna
© Economics and Business Management, University of Leoben, Stephan Staber
Page 1
Preface
■ These lecture notes can be seen as a reasonable supplement for the lecture “Advanced Petroleum Economics”.
■ Because of didactic reasons placeholder can be found instead of most figures in these lecture notes. The figures are presented and discussed in the lessons. Subsequently this is not a complete manuscript and consequently not sufficient for the final examination.
■ For further reading and examination prparation the following books are recommended:
▪ Allen, F.H.; Seba, R. (1993): Economics of Worldwide Petroleum Production, Tulsa: OGCI Publications.
▪ Campbell Jr., J.M.; Campbell Sr., J.M.; Campbell, R.A. (2007): Analysing and Managing Risky Investments, Norman: John M. Campbell.
▪ Newendorp, P.; Schuyler, J. (2000): Decision Analysis for Petroleum Exploration. Vol. 2nd Edition, Aurora: Planning Press.
■ The interested student finds the full list used literature at the end of this document.
© Economics and Business Management, University of Leoben, Stephan Staber
Page 2
Why Advanced Petroleum Economics?
■ The content of teaching is based on your knowledge gained in the lecture „Petroleum Economics“!
■ Required knowledge:
▪ Time Value of Money Concept
_{} consult „Allg. Wirtschafts und Betriebswissenschaften 1“ and „Petroleum Economics“
▪ Measures of Profitability
_{} consult „Allg. Wirtschafts und Betriebswissenschaften 1“ and „Petroleum Economics“
▪ Financial Reporting and Accounting Systems
_{} consult „Allg. Wirtschafts und Betriebswissenschaften 2“ and „Petroleum Economics“
▪ Basic Probability Theory and Statistics
_{} consult „Statistik“ and „Petroleum Economics“
▪ Reserves Estimation
_{} consult „Reservoir Engineering“ and „Petroleum Economics“
© Economics and Business Management, University of Leoben, Stephan Staber
Page 3
Lecture Outline
■ Cash Flow and Costs
■ Profitability and Performance Measures
■ Expected Value Concept
■ Decision Tree Analysis
■ Probability Theory
■ Risk Analysis
■ Sensitivity Analysis
© Economics and Business Management, University of Leoben, Stephan Staber
Page 4
Setting the scene…
■ What are the core processes of an E&P company?
Fig. 0: Core processes in an E&P company
■ What are potential decision criteria/ decision influencing factors regarding e.g. a field development approval decision?
© Economics and Business Management, University of Leoben, Stephan Staber
Page 5
Cash Flow and Costs
Cash Flow and Costs
■ Net Cash Flow= Net Annual Revenue – Net Annual Expenditure (both cash)
■ Costs:
▪ Capital expenditure (CAPEX)
▪ Operating expenditure (OPEX)
▪ Abandonment Costs
▪ Sunk Costs
▪ Opportunity Costs
Fig. 1: Cash Flow Projection
© Economics and Business Management, University of Leoben
Page 7
Cf. Allen and Seba (1993), p. Mian (2002a), p. 86ff.
Capital Expenditure (CAPEX)
■ …onetime costs
■ …occurring at the beginning of projects
■ Classification by purpose:
▪ Exploration costs (capitalized portion)
▪ Appraisal costs
▪ Development costs
▪ Running Business costs
▪ Abandonment costs
▪ Acquisition costs
■ Classification by purchased items:
▪ Facility costs
▪ Wells/ Drilling costs
▪ Pipeline costs
▪ G&G costs (mainly seismic)
▪ Signature bonus
■ Classification and wording differ from company to company
© Economics and Business Management, University of Leoben
Page 8
Operational Expenditure (OPEX)
■ …occur periodically
■ …are necessary for daytoday operations
■ …consist typically of:
▪ Utilities
▪ Maintenance of facilities
▪ Overheads
▪ Production costs, e.g.:
▪ Treatment Costs
▪ Interventions
▪ Secondary recovery costs
▪ Water treatment and disposal costs
▪ (Hydrocarbon)Evacuation costs
▪ Insurance costs
■ Classification and wording differ, but often:
▪ Production cost per unit = OPEX/production volume [USD/bbl]
▪ Lifting cost per unit = (OPEX + royalties + expl. expenses + depreciation)/sales volume [USD/bbl]
© Economics and Business Management, University of Leoben
Page 9
Cf. Mian (2002a), p. 126ff.
Types of Cost Estimates
▪ Linked to the stage of development
▪ Based on the available information
■ Order of Magnitude Estimate
▪
Data: Location, weather conditions, water depth (offshore), terrain conditions (onshore), distances, recoverable reserves estimate, number and type of wells required, reservoir mechanism, hydrocarbon properties
■ Optimization Study Estimate
▪
Also based on scaling rules but with more information and for individual parts
■ Budget Estimate
▪ Engineers create a basis of design (BOD)
▪ Contractors are invited for bidding
▪ Result is a budget estimate
■ Control Estimate
▪ Actual expenditure is monitored versus the budget estimate
▪ If new information is available, then the development plan is updated
© Economics and Business Management, University of Leoben
Page 10
Cf. Mian (2002a), p. 139ff.
Accuracy and Cost Overrun
■ Main reasons for Cost Overrun
▪ Contractor delay
▪ Unforeseen difficulties
▪ New information may change the project
■ Accuracy improves over time
▪ Major improvement occurs when the BOD is frozen
© Economics and Business Management, University of Leoben
From Mian (2002a), p. 139ff.
Contingency and Allowance
■ Contingency
▪ Budget for the unknown unknowns
■ Allowances
▪ Budget for the known unknowns
▪ …are probable extra costs
▪ E.g. for material, identified risks, foreseeable market or weather conditions, new technology, growth…
▪ The value is often taken from the 10% probability budget estimate
© Economics and Business Management, University of Leoben
Cf. Mian (2002a), p. 139ff.
Measures of Profitability and Performance
Popular Criteria
■ Three which ignore timevalue of money:
▪ Net Profit
▪ Payout (PO)
▪ Return on Investment (undiscounted profittoinvestment ratio)
■ Others which recognize timevalue of money:
▪ Net present value profit
▪ Internal rate of return (IRR)
▪ Discounted Return on Investment (DROI)
▪ Appreciation of equity rate of return
■ Some criteria might have alternate names, but these are the common ones in petroleum economics
© Economics and Business Management, University of Leoben, Stephan Staber
Page 14
Cf. Newendorp, Schuyler (2000), p. 9ff.
Prospect Cashflow Example
■
This example helps to understand the measures of profitability (Taxation is excluded from this analysis for simplicity)
Investment: 
$268,600 for completed well; $200,000 for dry hole 
Estimated recoverable reserves: 
234,000 Bbls; 234 MMcf gas 
Estimated average producing rate during first two years: 
150 BOPD 
Future Expenditures: 
Pumping Unit in year 3, $10,000; Workover in year 5, $20,000 
Working interest in proposed well: 
100% 
Average investment opportunity rate: 
10% 
Type of discounting: 
Midprojectyear 
© Economics and Business Management, University of Leoben
From Newendorp, Schuyler (2000), p. 14f.
Net Profit
■ Net Profit=Revenues – Costs = Cash Receipts – Cash Disbursements
■ Prospect Cashflow Example:
▪ $547,500 – $298,600 = $248,900
■ Strengths:
▪ Simple
▪ Project profits can be weighted, e.g., (n x average = total)
■ Weaknesses:
▪ Does not recognize the size of investment
▪ Does not recognize the timing of cash flows
© Economics and Business Management, University of Leoben, Stephan Staber
Cf. Newendorp, Schuyler (2000),p. 9ff.
Page 16
Payout (PO) 1/2
■ The length of time which elapses until the account balance is exactly zero is called payout time.
■ If one tracks the cumulative project account balance as a function of time he gets the socalled cash position curve.
Fig. 5: Cash position curve
■ All other factors equal a decision maker would invest in projects having the shortest possible payout time.
© Economics and Business Management, University of Leoben, Stephan Staber
Page 17
Cf. Newendorp, Schuyler (2000), p. 9ff.
Prospect Cashflow Example
■ Unrecovered portion of the initial investment:
▪ $268,600 – $132,900 = $135,700
■ Unrecovered portion of the investment at the end of year 2:
▪ $135,700 – $132,900 = $2,800
■ Assuming constant cashflow rates the portion of year 3 required to recover this remaining balance:
▪ $2,800 / $97,600 = 0.029
■ Payout time:
▪ 2.029
© Economics and Business Management, University of Leoben, Stephan Staber
Page 18
Cf. Newendorp, Schuyler (2000), p. 9ff.
Payout (PO) 2/2
■ Strengths:
▪ Simple
▪ Measures an impact on liquidity
■ Weaknesses:
1. Payout considers cashflows only up to the point of payback.
2. Especially troublesome with large abandonment costs
3. Project profits cannot be weighted: (n x average ≠ total)
Fig. 9: Variation 1
Fig. 10: Variation 2
© Economics and Business Management, University of Leoben, Stephan Staber
Cf. Newendorp, Schuyler (2000), p. 9ff.
Fig. 6: Weakness 1
Fig. 7: Weakness 2
Fig. 8: Weakness 3
Fig. 11: Variation 3
Page 19
Return on Investment (ROI)
■ Reflects total profitability!
■ Sometimes called:
ROI =
∑ NCF
Investment
▪ (undiscounted) profittoinvestment ratio
■ Strengths:
▪ Recognizes a profit in relation to the size of investment
▪ Simple
■ Weaknesses:
▪ Accounting inconsistencies
▪ Continuing investment is not represented properly
▪ Project ROI cannot be weighted: (n x average ROI ≠ total ROI)
© Economics and Business Management, University of Leoben
Cf. Newendorp, Schuyler (2000), p. 9ff.
Page 20
Return on Investment (ROI)  Variations
1. Using “maximum outofpocket cash” instead of investment
Fig. 12: Maximum outofpocket cash
2. Return on Assets (ROA):
ROA =
AverageNetIncome
Fig. 13: ROA
AverageBookInvestment
■ Prospect Cash Flow Example:
▪ ($517,500 – $268,600) / $268,600 = 0.927
© Economics and Business Management, University of Leoben
Page 21
Cf. Newendorp, Schuyler (2000), p. 9ff.
Net Present Value
■ Money received sooner is more worth than money received later!
■ The money can be reinvest in the meantime! (Opportunity cost of capital)
■ The present value can be found by:
▪ PV = FV (1+i) ^{}^{t}
▪ PV… Present Value of future cashflows
▪ FV… Future Value
▪ i… Interest or discount rate
▪ t… Time in years
▪ (1+i) ^{}^{t} … Discount factor
© Economics and Business Management, University of Leoben, Stephan Staber
Page 22
Cf. Newendorp, Schuyler (2000), p. 9ff.
Discount rate
■ Two philosophies what this rate should be:
1. Opportunity cost of capital (OCC)
▪ The average yield we can expect from funding other projects. This is the rate at which one can reinvest future cash.
2. Weightedaverage cost of capital (WACC)
▪ The marginal cost of funding the next project. This is calculated as an weightedaverage cost of a mixture of equity and debt.
© Economics and Business Management, University of Leoben, Stephan Staber
Page 23
Cf. Newendorp, Schuyler (2000), p. 9ff.
Net Present Value
■ Prospect Cash Flow Example:
Year 
Net 
Discount 
10% discounted 
cashflow 
factor 10% 
cashflow 

0 
$268,600 
1.000 
$268,600 
1 
+$132,900 
0.953 
+$126,700 
2 
+$132,900 
0.867 
+$115,200 
3 
+$97,600 
0.788 
+$76,900 
4 
+$69,200 
0.716 
+$49,500 
5 
+$23,500 
0.651 
+$15,300 
6 
+$28,600 
0.592 
+$16,900 
7 
+$15,900 
0.538 
+$8,600 
8 
+$9,400 
0.489 
+$4,600 
9 
+$5,600 
0.445 
+$2,500 
10 
+$1,900 
0.404 
+$800 
$148,400 

= NPV @ 10% 
© Economics and Business Management, University of Leoben
Cf. Newendorp, Schuyler (2000), p. 9ff.
Fig. 14: e.g. profitable, but neg. NPV
Fig. 15: Major weakness of NPV
Page 24
(Internal) Rate of Return (IRR)
■ Sometimes:
▪ Discounted rate of return
▪ Internal yield
▪ Sometimes: Profitability index (PI)
■ IRR is the discount rate such that the NPV is zero
■ Prospect Cash Flow Example:
(trailanderror procedure)
© Economics and Business Management, University of Leoben
Cf. Newendorp, Schuyler (2000), p. 9ff.
Discounted Return on Investment (DROI)
■ Sometimes:
▪ Discounted profit to investment ratio (DPR, DPI, or DPIR)
▪ Present value index (PVI)
▪ Sometimes: Profatibility Index (PI)
DROI =
NPV
PV of Investment
_
_
■ DROI is the ratio obtained by dividing the NPV by the present value of the investment
■ Prospect Cash Flow Example:
▪ DROI = $148,400 / 268,600 = 0.553
© Economics and Business Management, University of Leoben
Cf. Newendorp, Schuyler (2000), p. 9ff.
Page 26
Discounted Return on Investment (DROI)
■ Strengths:
▪ All advantages of NPV (such as realistic reinvestment rate, not trail and error procedure)
▪ Providing a measure of profitability per dollar invested
▪ Suitable for ranking investment opportunities
▪ Only meaningful if both signs of the ratio are positive
■ Ranking investments with DROI gives a simple and often good enough portfolio
■ But there are a couple of considerations around that might optimize one’s portfolio:
▪ Synergies
▪ Fractional participation
▪ Strategic and option values
▪ Gametheoretical thoughts
© Economics and Business Management, University of Leoben
Page 27
Cf. Newendorp, Schuyler (2000), p. 9ff.
Appreciation of Equity Rate of Return
■ Also: Growth rate of return
■ Idea:
▪ Reflecting the overall net earning power of an investment
▪ Assumes the reinvestment at a lower rate (e.g. 10%) than the true rate of return (e.g. 40%)
▪ As a consequence the overall rate of return is less!
■ Baldwin Method:
1. Calculate a compound interest factor for each year: (1+i) ^{n} , where i is the discount rate for the opportunity cost of capital and n is always the number of years reinvested (midyear)
2. Calculate the appreciated value of the net cash flows. The sum is the total value of the cash flows at the end of the last project year.
3. Solve this equation for i Investment*(1+i _{a}_{e} ) ^{N} =Σ Αppr. value of NCFs
:
ae
© Economics and Business Management, University of Leoben
Page 28
Cf. Newendorp, Schuyler (2000), p. 9ff.
Appreciation of Equity Rate of Return
■ Prospect Cash Flow Example using the Baldwin Method:
Year 
Net 
Number of 
Compound 
Appreciated value of net cashfliws as of end of project 
cashflow 
years 
interest 

reinvested 
factor, 10% 

1 
+$132,900 
9.5 
2.475 
+$328,900 
2 
+$132,900 
8.5 
2.247 
+$298,600 
3 
+$97,600 
7.5 
2.045 
+$199,600 
4 
+$69,200 
6.5 
1.859 
+$128,600 
5 
+$23,500 
5.5 
1.689 
+$39,700 
6 
+$28,600 
4.5 
1.536 
+$43,900 
7 
+$15,900 
3.5 
1.397 
+$22,200 
8 
+$9,400 
2.5 
1.269 
+$11,900 
9 
+$5,600 
1.5 
1.153 
+$6,500 
10 
+$1,900 
0.5 
1.049 
+$2000 
$1,081,900 
■ $268,600 (1+iae)10=$1,081,900
■ Appreciation of equity rate of return = iae = 0.1495
© Economics and Business Management, University of Leoben
Cf. Newendorp, Schuyler (2000), p. 9ff.
Page 29
Net Present Value Profile Curve
Fig. 16: Net Present Value Profile Curve
■ NPV and rate of return not necessarily prefer the same ranking!
© Economics and Business Management, University of Leoben
Cf. Newendorp, Schuyler (2000), p. 9ff.
Page 30
Net Present Value Portfolios
■ Due to limited statements of single measures portfolios are established
■ Common are “x” vs. NPV portfolios
Fig. 17: IRR vs. NPV Portfolio
Fig. 18: DROI vs. NPV Portfolio
Fig. 19: Cash Out vs. NPV Portfolio
© Economics and Business Management, University of Leoben
Page 31
Rate Acceleration Investments
■ Typical for the petroleum industry!
■ Investments which accelerate the cashflow schedule
■ Examples:
▪ Infill drilling
▪ Installing large volume lift equipment
■ Simple calculation example:
Year 
Present 
Accelerate 
Incrementa 
Discount 
Discounted incremental cashflows, 10% 
cashflow 
d cashflow 
l cashflow 
factor, 10% 

0 
0 
$50 
$50 
1.000 
$50.00 
1 
+$300 
+$500 
+$200 
0.953 
+$190.60 
2 
+$200 
+$400 
+$200 
0.867 
+$173.40 
3 
+$200 
0 
$200 
0.788 
$157.60 
4 
+$100 
0 
$100 
0.716 
$71.60 
5 
+$100 
0 
$100 
0.651 
$65.10 
+$19.70 
© Economics and Business Management, University of Leoben
Cf. Newendorp, Schuyler (2000), p. 9ff.
Page 32
Multiple choice review questions
Past costs which have already been incurred and cannot be recovered are called…
O 
CAPEX. 
O 
OPEX. 
O 
Abandonment costs. 
O 
Sunk costs. 
© Economics and Business Management, University of Leoben
Page 33
Multiple choice review questions
The expected return forgone by bypassing of other potential investment projects for a given capital is called…
O 
weighted average cost of capital (WACC). 
O 
opportunity cost of capital. 
O 
profit. 
O 
halflife. 
© Economics and Business Management, University of Leoben
Page 34
Multiple choice review questions
The length of time which elapses until the account is balanced of e.g. a development project is called…
O 
maximumoutofpocketcash. 
O 
net present value. 
O 
return on investment. 
O 
payout. 
© Economics and Business Management, University of Leoben
Page 35
Expected Value Concept
Expected Value Concept (EVC)
■ Previously discussed measures were all “no risk” parameters
■ But petroleum exploration involves a high degree of risk!
■ Two way out:
▪ Doing intuitive risk analysis or
▪ trying to consider risk and uncertainty in a logical, quantitative manner.
■ Expected value concept combines profitability estimates and risk estimates
© Economics and Business Management, University of Leoben
Cf. Newendorp, Schuyler (2000), p. 71ff.
Page 37
Risk and Uncertainty
■ Risk:
▪ Addresses discrete events (e.g. discovery or dry hole)
▪ Can be both: A threat or an opportunity
■ Uncertainty:
▪ Result depends on unknown circumstances (e.g. oil price)
▪ Occurrence probability of an event is not quantifiable
■ Deterministic:
▪ Calculations using exact values for their parameters are called deterministic
■ Stochastic:
▪ Calculations which use probabilities within their model are called stochastic
© Economics and Business Management, University of Leoben
Page 38
Cf. Newendorp, Schuyler (2000), p. 71ff and Laux (2003), p. 105.
Definitions and EVC
■ Expected Value (EV):
▪ The EV is the probabilityweighted value of all possible outcomes.
■ Expected Monetary Value (EMV):
▪ The EMV is the expected value of the present values of the net cashflows
▪ EMV = EV (NPV)
■ “Conditional”
▪ In this context “conditional” means that a value will be received only if a particular outcome occurs.
▪ Often it is omitted!
■ Simple Example:
▪
■ More generally:
EV Cost of Stuck Pipe = P(Stuck Pipe) * (Cost to remedy Stuck Pipe)
EMV
=
∑
all _ i
(
P outcome i
_
)
×
NPV
Outcome _ i
© Economics and Business Management, University of Leoben
Page 39
Cf. Newendorp, Schuyler (2000), p. 71ff.
EMV Example
■ Situation in a drilling prospect evaluation:
▪ Probability of a successful well 0.6
▪ Two decision alternatives:
▪ Farm out: A producer is worth $50,000, a dry hole causes no profit or loss
▪ Drilling the well: A dry hole casts $200,000, a hit brings (after all costs) $600,000
Decision Alternatives 

Drill 
Farm Out 

Outcome 
Probability 
Conditiona 
Expected 
Condition 
Expected 
outcome 
l monetary 
monetary 
al 
monetary 

will occur 
value 
value 
monetary 
value 

value 

Dry hole 
0.4 
$200,000 
$80,000 
0 
0 
Producer 
0.6 
+$600,000 
+$360,000 
+$50,000 
+$30,000 
+$280,000 
+$30,000 
■ EMV Decision Rule:
▪
=EMV (drill)
=EMV (farm out)
Fig. 20: Cumulative result for drill decisions
When choosing among several mutually exclusive decision alternatives, select the alternative having the greatest EMV.
© Economics and Business Management, University of Leoben
Page 40
Cf. Newendorp, Schuyler (2000), p. 79ff.
Characteristics of the EVC
■ Mutually exclusive outcomes
■ Collectively exhaustive outcomes
■ The sum of probabilities for one event must be one
■ Any number of alternatives can be considered
■ Normally values are expressed in monetary profit, therefore “expected monetary value”
■ The EMV does not necessarily have to be a possible outcome
© Economics and Business Management, University of Leoben
Page 41
Cf. Newendorp, Schuyler (2000), p. 71ff.
Risked DROI
Risked DROI =
^{_}
EMV
(
EV PV of Investment
_
_
)
Cf.
DROI =
NPV
PV of Investment
_
_
■ Reasonable under limited capital constraints
© Economics and Business Management, University of Leoben
Cf. Newendorp, Schuyler (2000), p. 71ff.
Page 42
Concerns about the EV Concept
■ Is there a need to quantify risk at all?
■ No benefit seen in using the EV!
■ We don’t have probabilities anyway…
■ Every drilling prospect is unique, therefore we have no repeated trail!
■ Isn’t EV only suitable for large companies?
■ For sure other concerns override EV!
■ “…EMV is not perfect. It is not an oil finding tool, and it is not (…) the ‘ultimate’ decision parameter.”
© Economics and Business Management, University of Leoben
Cf. Newendorp, Schuyler (2000), p. 71ff.
Newendorp, Schuyler (2000), p. 119.
Page 43
Decision Tree Analysis
Simple Decision Tree Example
■ Decision trees are necessary if sequent decision must be made
■ Decision tree analysis is an extension of the EMV concept
Decision Alternatives 

Drill 
Don‘t Drill 

Possible 
Probability 
Outcome 
Expected 
Outcome 
Expected 

Outcome 
outcome 
monetary 
monetary 

will occur 
value 
value 

Dry hole 
0.7 
$50,000 
$35,000 
0 
0 

2 
Bcf 
0.2 
+$100,000 
$20,000 
0 
0 
5 
Bcf 
0.1 
+$250,000 
$25,000 
0 
0 
1.0 
EMV = +$10,000 
EMV = $0 
Fig. 21: Simple decision tree (partially completed)
■ There is no scale to decision trees
© Economics and Business Management, University of Leoben
Page 45
Cf. Newendorp, Schuyler (2000), p. 127ff.
Decision Tree Symbols
■ There exist two different nodes (forks)
▪ Decision node (or activity node)  squares
▪ Chance node (or event node)  circles
▪ Terminal nodes (last chance node of a branch)
Fig. 22: Simple decision tree (partially completed with correct symbols)
© Economics and Business Management, University of Leoben
Cf. Newendorp, Schuyler (2000), p. 127ff.
Page 46
Decision Tree Completion
■ Associate probabilities to all chance nodes
■ Place the outcome value to all branch ends
Fig. 23: Simple decision tree (completed)
■ Three important rules:
▪ Normalization requirement: The sum of all probabilities around a chance node must be 1.0
▪ There are no probabilities around decision nodes
▪ The end nodes are mutually exclusive
© Economics and Business Management, University of Leoben
Page 47
Cf. Newendorp, Schuyler (2000), p. 127ff.
Decision Tree Solution
■ Start at the back of the tree and calculate the EMV for the last chance node.
■ The expected value is written above the node
■ The decision rule for a decision node is to choose the branch with the higher EMV
Fig. 24: Simple decision tree (solved)
© Economics and Business Management, University of Leoben
Page 48
Cf. Newendorp, Schuyler (2000), p. 127ff.
Case Study: Decision Tree Analysis
Fig. 25: Case Study: Decision Tree
© Economics and Business Management, University of Leoben
Cf. Newendorp, Schuyler (2000), p. 127ff.
Page 49
Advantages of Decision Tree Analysis
■ The complexity of a decision is reduced
■ Provides a consistent action plan
■ Decision problems of any size can be analysed
■ Forces us to think ahead
■ If conditions change the situation can be reanalysed
■ Logical, straightforward an easy to use
© Economics and Business Management, University of Leoben
Cf. Newendorp, Schuyler (2000), p. 127ff.
Page 50
Probability Theory
Concept of Probability
▪ Probability Theory enables a person to make an educated guess
■ Objective Probability
1. Classical approach:
▪ Derives Probability measures from undisputed laws of nature
▪ Requires the identification of the total number of possible outcomes (n)
▪ Requires the number of possible outcomes of a wanted event (m)
▪ Probability of occurrence of an event: P(A)=m/n
▪ Three basic condition must be fulfilled: equally likely, collectively exhaustive and mutually exclusive
2. Empirical approach:
▪ Derives Probability measures from the events longrun frequency of occurrence
▪ The observation is random
▪ A large number of observations is necessary
▪ The following mathematical relationship is valid: P(A)=lim _{n} _{} _{∞} (m/n)
■ Subjective Probability
▪ Based on impressions of individuals
© Economics and Business Management, University of Leoben
Page 52
Cf. Mian (2002b), p. 84ff.
Fig. 39: Vann diagram showing two mutually exclusive events
Probability Rules
■ Complementation Rule:
▪ P(A)+P(Ā)=1
■ Addition Rule:
Fig. 40: Vann diagram showing of partly overlapping events
▪ For simultaneous trails
1. Events are mutually exclusive:
▪ P(A∪B)=P(A)+P(B)
▪ P(A∩B)=0
2. Events are partly overlapping:
▪ P(A∪B)=P(A)+P(B)P(A∩B)
▪ P(A∩B)=P(A)+P(B)P(A∪B) (=P(AB))
Fig. 41: Vann diagram showing union two events
■ Multiplication Rule:
▪ For consecutive trails
▪ Independent events:
▪ P(AB)=P(A) x P(B)
▪ Dependent events:
▪ P(AB)=P(A) x P(BA)
© Economics and Business Management, University of Leoben
Page 53
Cf. Mian (2002b), p. 84ff. and http://cnx.org/content/m38378/latest/?collection=col11326/latest
Example “Addition Rules”
■ Assume 50 wells have been drilled in an area with blanket sands. The drilling resulted in (a) 8 productive wells in Zone A, (b) 11 productive wells in Zone B, and (c) 4 productive wells in both Zones. With the help of Venn diagrams and probability rules, calculate the following:
1. Number of wells productive in Zone A only,
2. Number of wells productive in Zone B only,
3. Number of wells discovered, and
4. Number of dry holes.
■ Solution:
▪ n(S)=50; n(A)=8; n(B)=11; n(A∩B)=4
1. n(A∩B)=n(A)  n(A∩B)=8  4=4
2. n(Ā∩B)=n(B)  n(A∩B)=11  4=7
3. n(A∪B)= n(A) + n(B)  n(A∩B)=8+11  4=15
4. n(S)  n(A∪B)=50  15=35
© Economics and Business Management, University of Leoben
Fig. 42: Vann diagram for example “Addition Rules”
Page 54
Cf. Mian (2002b), p. 84ff.
Example “Multiplication Rules”
■ 10 prospective leases have been acquired. Seismic surveys conducted on the leases show that three of the leases are expected to result in commercial discoveries. The leases have equal chances of success. If drilling of one well is planned for each lease, calculate the probability of drilling the first two wells as successful discoveries.
■ Solution:
▪ W _{1} is the first, W _{2} the second well.
▪
▪
▪ P(W _{1} W _{2} )= 3/10 x 2/9=6,67%
P(W
P(W
_{1}
_{2}
)=3/10
W _{1} )=2/9
© Economics and Business Management, University of Leoben
Page 55
Cf. Mian (2002b), p. 84ff.
Bayes’ Rule
■ Beyesian analysis addresses the probability of an earlier event conditioned on the occurrence of a later event
(
P B
A i
)
⋅
(
P A
i
)
(
)
P B A P A
i
⋅
i
(
)
(
)
P A B
i
^{=} k
∑
i = 1
■ Where:
▪ P(A _{i} B)=posterior probabilities and
▪ P(A _{i} )=prior event probabilities
■ Bayes’ theorem is used if additional information results in revised probabilities.
© Economics and Business Management, University of Leoben
Page 56
Cf. Mian (2002b), p. 84ff.
Theoretical Example “Bayes’ Rule”
■ One box contains 3 green and 2 red pencils. A second box contains 1 green and 3 red pencils. A single fair die is rolled and if 1 or 2 comes up, a pencil is drawn from the first box; if 3, 4, 5 or 6 comes up, then a pencil is drawn from the second. If the pencil drawn is green, then what is the probability it has been from the first box?
■ Solution:
Fig. 43: Probability tree for the theoretical example
“Bayes’ Rule”
▪ P(B _{1} )=1/3 and P(B _{2} )=2/3
▪ In box 1: P(G)=3/5 and P(R)=2/5
▪ In box 2: P(G)=1/4 and P(R)=3/4
⎛ 3 ⎞
⎜
⎝
5
⎠
⎛ 1 ⎞
⎟
3
⎠
⎝
⎟⋅ ⎜
(
P G
B
i
)
⋅
(
P B
i
)
(
P G B
i
)
⋅
(
P B
i
)
(
6
11
P B G
i
)
^{=} ∑
k
i = 1
=
=
= 54,55%
⎛ 3 ⎞
⎜
⎝
5
⎠
⎟
⋅
⎛ 1 ⎞
⎜
3
⎠
⎟
⎝
+
⎛ 1 ⎞
⎜
⎝
⎠
⎟
4
⋅
⎛ 2 ⎞
⎜
⎝
3
⎠
⎟
© Economics and Business Management, University of Leoben
Page 57
Page 57
Cf. Mian (2002b), p. 84ff.
Offshore Concession Example “Bayes’ Rule”
■ We have made a geological and engineering analysis of a new offshore concession containing 12 seismic anomalies all about equal size. We are uncertain about how many of the anomalies will contain oil and hypothesize several possible states of nature as follows:
▪ E _{1} : 7 anomalies contain no oil and 5 anomalies contain oil
▪ E _{2} : 9 anomalies contain no oil and 3 anomalies contain oil
■ Based on the very little information we have, we judge that E _{2} is twice as probable as E _{1} .
■ Then we drill a wildcat and it turns out to be a dry hole. The question is: “How can this new information be used to revise our initial judgement of the likelihood of the hypothesized state of nature?”
© Economics and Business Management, University of Leoben
Page 58
Cf. Newendorp, Schuyler (2000), p. 318ff.
Offshore Concession Example “Bayes’ Rule”
Fig. 44: Solution of the offshore concession example
© Economics and Business Management, University of Leoben
Page 59
Probability Distributions
■ Stochastic or random variable:
▪ The pattern of variation is described by a probability distribution
■ Probability distributions:
▪ Discrete (Stochastic variable can take only a finite number of values) Widely used in petroleum economics:
▪ Binomial
▪ Multinomial
▪ Hypergeometric
▪ Poisson
▪ Continuous (Stochastic variable can take infinite values)
▪ Widely used in petroleum economics:
▪ Normal
▪ Lognormal
▪ Uniform
▪ Triangular
© Economics and Business Management, University of Leoben
Cf. Mian (2002b), p. 99ff.
Page 60
Binomial Distributions
■ Applicable if an event has two possible outcomes
■ Equations:
n !
(
P x
)
C
n
x
⋅
p
x
⋅
n x
−
n
C =
x
=
q
!(
x n
⋅
−
x
)!
▪ Where,
▪ P(x)=probability of obtaining exactly x successes in n trails,
▪ p=probability of success,
▪ q=probability of failure,
▪ n=number of trails considered and
▪ x=number of successes
■ Example:
▪
A company is planning six exploratory wells with an estimated chance of success of 15%.What is the probability that (a) the drilling will result in exactly two discoveries and (b) there will be more than three successful wells.
Fig. 45: Solution of the “six exploratory wells” example
© Economics and Business Management, University of Leoben
Page 61
Cf. Mian (2002b), p. 99ff.
Multinomial Distributions
■ Applicable if an event has more than two possible outcomes
■ Equations:
N !
k ! k
1
2
!
k
m
!
P S =
(
)
P P
1
1
2
2
k
k
k
P
m
m
▪ Where,
▪ P(S)=probability of the particular sample,
▪ p=probabilities of drawing types 1, 2, …m from population,
▪ N=k _{1} +k _{2} +…+k _{m} =size of sample,
▪ k _{1} , k _{2} , …,k _{m} =total number of outcomes of type 1, 2, …,m
▪ m=number of different types
© Economics and Business Management, University of Leoben
Page 62
Cf. Mian (2002b), p. 99ff.
Multinomial Distributions  Example 1/2
■ In a certain prospect, the company has grouped the possible outcomes of an exploratory well into three general classes as (a) dry hole (zero reserve), (b) discovery with 12 MMBbls reserves, and (c) discovery with 18 MMBbls reserves. Each of these categories probabilities of 0.5, 0.35, and 0.15 were assigned, respectively. If the company plans to drill three additional wells, what will be the probabilities of discovering various total reserves with these three additional wells?
■ Solution:
▪ m=3; N=3; P _{1} =0.5; P _{2} =0.35; P _{3} =0.15
▪ k _{1} =number of wells giving reserves of zero
▪ k _{2} =number of wells giving reserves of 12 MMBbls
▪ k _{3} =number of wells giving reserves of 18 MMBbls
N !
k k k
1
!
2
!
3
!
3!
2!1!0!
3
⋅
2 1
⋅
(
P S
)
P P P
1
1
2
2
3
3
k
k
k
0.5 0.35 0.15
2
1
0
⋅
0.25 0.35 1
⋅
⋅
0.263
=
=
=
2
⋅
1
⋅
1
⋅
1
=
▪ Corresponding reserves=2x0+1x12+0x18=12MMbbls
▪ Expected reserves=0.263x12MMBbls=3.15MMBbls
© Economics and Business Management, University of Leoben
Page 63
Cf. Mian (2002b), p. 99ff.
© Economics and Business Management, University of Leoben
Cf. Mian (2002b), p. 99ff.
Hypergeometric Distributions
■ Application in statistical sampling, if trails are dependent and selected, is from a finite population without replacement
⎛ C ⎞ ⎛ ⎜ N
n
⎝
⎠
⎜
⎜
C ⎞
⎟
⎟
⎠
Fig. 46: Solution of the “Hypergeometric distribution” example
■ Equation:
⎟
⎟
−
−
⎝ ⎜
(
P x
)
x
x
=
⎛ N ⎞
⎟
⎟
⎠
⎜
⎝
⎜
n
▪ Where,
▪ N=number of items in the population
▪ C=number of total successes in the population
▪ n=number of trails (size of the sample)
▪ x=number of successes observed in the sample
■ Example:
▪ A company has 10 exploration prospects, 4 of which are expected to be productive. What is the probability 1 well will be productive if 3 wells are drilled.
© Economics and Business Management, University of Leoben
Page 65
Cf. Mian (2002b), p. 99ff.
Poisson Distributions
■ Good for representing a particular event over time or space
■ Equation:
x
λ
x !
(
)
P x =
− λ
e
▪ Where,
▪ λ=average number of occurrence per interval of time or space
▪ x=number of occurrences per basic unit of measure
▪ P(x)=probability of exactly x occurrences
■ Examples:
▪ Assume Poisson distribution!
1. If a pipeline averages 3leaks per year, what is the probability of having exactly 4 leaks next year?
2. If a pipeline averages 5 leaks per 1000 miles, what is the probability of having no leaks in the first 100 miles?
Fig. 47: Solutions of the “Poisson distribution” examples
© Economics and Business Management, University of Leoben
Page 66
Cf. Mian (2002b), p. 99ff.
Normal Distributions
■ Linear systems, like NCF, approximate a normal distribution, regardless of the shape of subordinate variables like OPEX, CAPEX, taxes, etc…
■ Probability density function:
2
▪ Where,
▪ μ=mean
▪ σ=standard deviation
Fig. 48: Solutions of the “Normal distribution” example
■ Example:
▪ Porosities calculated from porosity logs of a certain formation show a mean porosity of 12% with standard deviation of 2.5%. What is the probability that the formation’s porosity will be (a) between 12% and 15% and (b) greater than
16%.
■ Solution:
▪ By means of the standard normal derivate (Z) and probability tables
Z = ^{X}
− μ
σ
© Economics and Business Management, University of Leoben
Page 67
Cf. Campbell et al. (2007) p. 218ff and Mian (2002b), p. 99ff.
Lognormal Distributions
■ The occurrence of oil and gas reserves is approximately lognormal distributed (the same as return on investments, insurance claims, core permeability and formation thickness)
■ Y=ln(X) …is normal distributed
Fig. 49: Lognormal distribution
© Economics and Business Management, University of Leoben
Page 68
Cf. Campbell et al. (2007) p. 218ff and Mian (2002b), p. 99ff.
Uniform Distributions
■ Equal probability between a minimum and a maximum
1
x
max
−
x
min
(
)
f x =
Fig. 50: Probability density function and cumulative distribution function of a uniform distribution
© Economics and Business Management, University of Leoben
Page 69
Cf. Campbell et al. (2007) p. 218ff and Mian (2002b), p. 99ff.
Triangular Distributions
■ Used if an upper limit, a lower limit, and a most likely value can be specified
■ Equation:
(
F x
)
=
■ Example:
⎧ ⎪ X
⎪
⎛
⎜
⎜
⎝
⎞ 2 ⎛ ⎜ X
X
⎠
⎞
X
min
⎟
⎟
X
−
−
⎜
⎝
mod
min
⎟ , X
⎟
⎨
⎪
⎪
⎩
1
X
⎛
X
−
mod
X
−
max
min
X
− ⎜
⎜
⎝
X
max
−
X
mod
⎞
⎟
⎟
⎠
2
⋅
max
−
X
min
⎠
⎛ ⎜ X
X
⎝
⎜
mod
⎞
X
−
max
max
−
X
min
⎠
⋅
≥
mod
min
⎟ , X
⎟
X
≥
≥
X
X
≥
mod
X
max
▪ A bit record in a certain area shows the minimum and maximum footage, drilled by the bit to be 100 and 200 feet, respectively. The drilling engineer has estimated, that the most probable value of the footage drilled by a bit will be 130 feet, and the footage which is drilled follows triangular distribution. What is the probability that the bit fails within 110 feet?
■ Solution:
(
F x
)
⎛
= ⎜
⎜
⎝
X _{m}_{i}_{n} =100; X _{m}_{o}_{d} =130; X _{m}_{a}_{x} =200; X=110
X
−
X
min
X
−
mod
X
min
⎞
⎟
⎟
⎠
2
⋅
⎛ ⎜ X
⎜
⎝
X
−
mod
X
min
max
−
X
min
⎞
⎟
⎟
⎠
⎛ 110
= ⎜
−
100 ⎞
⎟
⎠
100
⎝
130
−
2
⋅
⎛ 130
⎜
⎝
200
−
100 ⎞
_{⎟} =
−
100
⎠
0.033
=
3.33%
© Economics and Business Management, University of Leoben
Cf. Campbell et al. (2007) p. 218ff and Mian (2002b), p. 99ff.
Fig. 51: Probability density function and cumulative distribution function of a triangular distribution
Page 70
Tests of Goodness of Fit
■ With these tests one can analyse whether a sample emanates from a certain population or not.
■ ChisquaredTest
For continuous and discrete data Need to define bins
■ KolmogoroffSmirnowTest
For continuous No need to define bins
■ AndersonDarlingTest
For continuous No need to define bins
■ RootMeanSquareError
For continuous and discrete data No need to define bins
■ The probability of a sample data drawn from a certain distribution is measured by Pvalues (called observed significance
level)
© Economics and Business Management, University of Leoben
Page 71
Cf. Mian (2002b), p. 99ff and PalisadeCorporation (2002), p. 148ff.
Risk Analysis
Risk Management in E&P Projects
■ Example for key points of a risk management policy:
Risk management is an integrated part of project management Every project faces risks from the very beginning The ability to influence and manage risk is higher the earlier identified Risk management supports the achievement of the project’s objectives The project manager – and development manager in case of composite projects – is ac countable for managing project’s risks Risk management is a continuous process The selective application of risk management tools supports risk management Proper risk management involves multidiscipline teams Taking calculated risk consciously generates value Risk can be quantified by multiplying the probability that the unfavourable event happens with the severity (financial exposure) of possible consequences Risk auditing is subject to project peer reviewing
■ In risk analysis one can distinguish between:
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