Advanced Petroleum Economics Staber

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.
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
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?
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

Cf. Allen and Seba (1993), p. Mian (2002a), p. 86ff.
Page 7
Capital Expenditure (CAPEX)

one-time 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 Facility costs Wells/ Drilling costs Pipeline costs G&G costs (mainly seismic) Signature bonus
Page 8
Classification by purchased items:

Classification and wording differ from company to company
Operational Expenditure (OPEX)

occur periodically are necessary for day-to-day 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]
Page 9

Cf. Mian (2002a), p. 126ff.
Types of Cost Estimates

Linked to the stage of development Based on the available information Data: Location, weather conditions, water depth (offshore), terrain conditions (onshore), distances, recoverable reserves estimate, number and type of wells required, reservoir mechanism, hydrocarbon properties Also based on scaling rules but with more information and for individual parts Engineers create a basis of design (BOD) Contractors are invited for bidding Result is a budget estimate Actual expenditure is monitored versus the budget estimate If new information is available, then the development plan is updated
Page 10
Order of Magnitude Estimate
Optimization Study Estimate

Budget Estimate
Control Estimate


Cf. Mian (2002a), p. 139ff.
Accuracy and Cost Overrun

Main reasons for Cost Overrun
Contractor delay Unforeseen difficulties New information may change the project Major improvement occurs when the BOD is frozen
Fig. 2: Accuraccy of cost estimates
Accuracy improves over time
Fig. 3: Probability of cost overrun

From Mian (2002a), p. 139ff.
Page 11
Contingency and Allowance

Contingency
Budget for the unknown unknowns 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
Allowances
Fig. 4: One possible statistical view on contingency and allowance

Cf. Mian (2002a), p. 139ff.
Page 12
Measures of Profitability and Performance
Popular Criteria
Three which ignore time-value of money:
Net Profit Payout (PO) Return on Investment (undiscounted profit-to-investment ratio)
Others which recognize time-value 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

Cf. Newendorp, Schuyler (2000), p. 9ff.
Page 14
Prospect Cashflow Example

This example helps to understand the measures of profitability (Taxation is excluded from this analysis for simplicity)
Investment: Estimated recoverable reserves: Estimated average producing rate during first two years: Future Expenditures: Working interest in proposed well: Average investment opportunity rate: Type of discounting: $268,600 for completed well; $200,000 for dry hole 234,000 Bbls; 234 MMcf gas 1 150 BOPD Pumping Unit in year 3, $10,000; Workover in year 5, $20,000 100% 10% Mid-project-year 9 10 3,700 2,200 234,000 5,600 1,900 $547,500 $30,000 5,600 1,900 $517,500 2 3 4 5 6 7 8 Year Estimated oil Production, Bbls 54,750 54,750 44,600 29,200 18,900 12,900 7,800 5,200 Annual Net Revenue* $132,900 132,900 107,600 69,200 43,500 28,600 15,900 9,400 20,000 10,000 Future Expenditures Net Cash Flow $132,900 132,900 97,600 69,200 23,500 28,600 15,900 9,400
*Annual Net Revenue = Annual Gross Revenue Royalties Taxes Operating expenses

From Newendorp, Schuyler (2000), p. 14f.
Page 15
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
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 so-called cash position curve. All other factors equal a decision maker would invest in projects having the shortest possible payout time.
Fig. 5: Cash position curve

Page 17
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

Page 18
Payout (PO) 2/2

Strengths:
Simple Measures an impact on liquidity Payout considers cashflows only up to the point of payback. Especially troublesome with large abandonment costs Project profits cannot be weighted: (n x average total)
Fig. 6: Weakness 1
Weaknesses:
1. 2. 3.
Fig. 7: Weakness 2
Fig. 8: Weakness 3
Fig. 9: Variation 1
Fig. 10: Variation 2
Fig. 11: Variation 3

Page 19
Return on Investment (ROI)

Reflects total profitability! Sometimes called:

ROI =
NCF
Investment
(undiscounted) profit-to-investment ratio Recognizes a profit in relation to the size of investment Simple Accounting inconsistencies Continuing investment is not represented properly Project ROI cannot be weighted: (n x average ROI total ROI)
Page 20
Strengths:
Weaknesses:

Return on Investment (ROI) - Variations

1. Using maximum out-of-pocket cash instead of investment
2. Return on Assets (ROA):

ROA = AverageNetIncome AverageBookInvestment
Fig. 12: Maximum out-of-pocket cash
Prospect Cash Flow Example:

($517,500 $268,600) / $268,600 = 0.927
Fig. 13: ROA

Page 21
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
Page 22

Discount rate
Two philosophies what this rate should be:
The average yield we can expect from funding other projects. This is the rate at which one can reinvest future cash. The marginal cost of funding the next project. This is calculated as an weighted-average cost of a mixture of equity and debt.
1. Opportunity cost of capital (OCC)
2. Weighted-average cost of capital (WACC)

Page 23
Net Present Value

Prospect Cash Flow Example:
Year 0 1 2 3 4 5 6 7 8 9 10 Net cashflow -$268,600 +$132,900 +$132,900 +$97,600 +$69,200 +$23,500 +$28,600 +$15,900 +$9,400 +$5,600 +$1,900 Discount factor 10% 1.000 0.953 0.867 0.788 0.716 0.651 0.592 0.538 0.489 0.445 0.404 10% discounted cashflow -$268,600 +$126,700 +$115,200 +$76,900 +$49,500 +$15,300 +$16,900 +$8,600 +$4,600 +$2,500 +$800 $148,400 = NPV @ 10% 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)
Year 0 1 2 3 4 5 6 7 8 9 10 Net cashflow -$268,600 +$132,900 +$132,900 +$97,600 +$69,200 +$23,500 +$28,600 +$15,900 +$9,400 +$5,600 +$1,900 Discount factor 40% 1.000 0.845 0.604 0.431 0.308 0.220 0.157 0.112 0.080 0.057 0.041 40% discounted cashflow -$268,600 +$112,300 +$80,300 +$42,100 +$21,300 +$5,200 +$4,500 +$1,800 +$700 +$300 +$100 $0
IRR = 40%
IRR is the discount rate such that the NPV is zero Prospect Cash Flow Example: (trail-and-error procedure)

Page 25
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

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 ones portfolio:
Synergies Fractional participation Strategic and option values Game-theoretical thoughts
Page 27

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 iae: Investment*(1+iae)N= ppr. value of NCFs
Page 28
Appreciation of Equity Rate of Return

Prospect Cash Flow Example using the Baldwin Method:
Year Net cashflow +$132,900 +$132,900 +$97,600 +$69,200 +$23,500 +$28,600 +$15,900 +$9,400 +$5,600 +$1,900 Number of years reinvested 9.5 8.5 7.5 6.5 5.5 4.5 3.5 2.5 1.5 0.5 Compound interest factor, 10% 2.475 2.247 2.045 1.859 1.689 1.536 1.397 1.269 1.153 1.049 Appreciated value of net cashfliws as of end of project +$328,900 +$298,600 +$199,600 +$128,600 +$39,700 +$43,900 +$22,200 +$11,900 +$6,500 +$2000 $1,081,900
1 2 3 4 5 6 7 8 9 10
$268,600 (1+iae)10=$1,081,900 Appreciation of equity rate of return = iae = 0.1495

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!
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
Page 31
Rate Acceleration Investments

Typical for the petroleum industry! Investments which accelerate the cashflow schedule Examples:

Year
Infill drilling Installing large volume lift equipment

Present cashflow 0 +$300 +$200 +$200 +$100 +$100 Accelerate d cashflow -$50 +$500 +$400 0 0 0 Incrementa l cashflow -$50 +$200 +$200 -$200 -$100 -$100 Discount factor, 10% 1.000 0.953 0.867 0.788 0.716 0.651 Discounted incremental cashflows, 10% -$50.00 +$190.60 +$173.40 -$157.60 -$71.60 -$65.10 +$19.70
Simple calculation example:
0 1 2 3 4 5

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.
Page 33

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 half-life.
Page 34

The length of time which elapses until the account is balanced of e.g. a development project is called
O maximum-out-of-pocket-cash. O net present value. O return on investment. O payout.
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

Page 37
Risk and Uncertainty

Risk:
Addresses discrete events (e.g. discovery or dry hole) Can be both: A threat or an opportunity Result depends on unknown circumstances (e.g. oil price) Occurrence probability of an event is not quantifiable
Uncertainty:
Deterministic:
Calculations using exact values for their parameters are called deterministic Calculations which use probabilities within their model are called stochastic
Page 38
Stochastic:

Cf. Newendorp, Schuyler (2000), p. 71ff and Laux (2003), p. 105.
Definitions and EVC

Expected Value (EV):
The EV is the probability-weighted value of all possible outcomes. The EMV is the expected value of the present values of the net cashflows EMV = EV (NPV) In this context conditional means that a value will be received only if a particular outcome occurs. Often it is omitted! EV Cost of Stuck Pipe = P(Stuck Pipe) * (Cost to remedy Stuck Pipe)
EMV =
all _ i
Expected Monetary Value (EMV):
Conditional
Simple Example: More generally:

P(outcome _ i) NPV
Outcome _ i
Page 39
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 Outcome Probability outcome will occur 0.4 0.6 Conditiona l monetary value -$200,000 +$600,000 Expected monetary value -$80,000 +$360,000 +$280,000 Farm Out Condition al monetary value 0 +$50,000 Expected monetary value 0 +$30,000 +$30,000
=EMV (farm out) Fig. 20: Cumulative result for drill decisions
Dry hole Producer
EMV Decision Rule:
=EMV (drill)
When choosing among several mutually exclusive decision alternatives, select the alternative having the greatest EMV.
Page 40

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

Page 41
Risked DROI
EMV Risked _ DROI = EV ( PV _ of _ Investment )
DROI = NPV PV _ of _ Investment
Cf.
Reasonable under limited capital constraints

Page 42
Concerns about the EV Concept

Is there a need to quantify risk at all? No benefit seen in using the EV! We dont have probabilities anyway Every drilling prospect is unique, therefore we have no repeated trail! Isnt EV only suitable for large companies? For sure other concerns override EV! EMV is not perfect. It is not an oilfinding tool, and it is not () the ultimate decision parameter.
Newendorp, Schuyler (2000), p. 119. Cf. Newendorp, Schuyler (2000), p. 71ff.
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 Possible Outcome Dry hole 2 Bcf 5 Bcf Probability outcome will occur 0.7 0.2 0.1 1.0 Outcome Expected monetary value -$35,000 -$20,000 -$25,000 Dont Drill Outcome Expected monetary value 0 0 0 0 0 0 EMV = $0
Fig. 21: Simple decision tree (partially completed)
-$50,000 +$100,000 +$250,000
EMV = +$10,000
There is no scale to decision trees

Page 45
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)

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
Page 47

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)

Page 48
Case Study: Decision Tree Analysis
Fig. 25: Case Study: Decision Tree

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 re-analysed Logical, straight-forward an easy to use

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 Derives Probability measures from the events long-run frequency of occurrence The observation is random A large number of observations is necessary The following mathematical relationship is valid: P(A)=limn (m/n)
2. Empirical approach:

Subjective Probability
Based on impressions of individuals
Page 52 Economics and Business Management, University of Leoben
Cf. Mian (2002b), p. 84ff.
Probability Rules
Complementation Rule:
P(A)+P()=1
Fig. 39: Vann diagram showing two mutually exclusive events
Addition Rule:
For simultaneous trails 1. Events are mutually exclusive:
P(AB)=P(A)+P(B) P(AB)=0 P(AB)=P(A)+P(B)-P(AB) P(AB)=P(A)+P(B)-P(AB) (=P(AB))
2. Events are partly overlapping:

Fig. 40: Vann diagram showing of partly overlapping events
Multiplication Rule:
For consecutive trails Independent events:
P(AB)=P(A) x P(B) P(AB)=P(A) x P(B|A)
Fig. 41: Vann diagram showing union two events
Dependent events:
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. 2. 3. 4. Number of wells productive in Zone A only, Number of wells productive in Zone B only, Number of wells discovered, and Number of dry holes. n(S)=50; n(A)=8; n(B)=11; n(AB)=4 n(AB)=n(A) - n(AB)=8 - 4=4 n(B)=n(B) - n(AB)=11 - 4=7 n(AB)= n(A) + n(B) - n(AB)=8+11 - 4=15 n(S) - n(AB)=50 - 15=35
Solution:
1. 2. 3. 4.
Fig. 42: Vann diagram for example Addition Rules

Cf. Mian (2002b), p. 84ff.
Page 54
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:
W1 is the first, W2 the second well. P(W1)=3/10 P(W2|W1)=2/9 P(W1W2)= 3/10 x 2/9=6,67%

Cf. Mian (2002b), p. 84ff.
Page 55
Bayes Rule
Beyesian analysis addresses the probability of an earlier event conditioned on the occurrence of a later event
P( Ai B ) = P (B Ai ) P( Ai )
P(B A ) P( A )
k i =1 i i
Where:

P(Ai|B)=posterior probabilities and P(Ai)=prior event probabilities
Bayes theorem is used if additional information results in revised probabilities.

Cf. Mian (2002b), p. 84ff.
Page 56
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:
P(B1)=1/3 and P(B2)=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
Fig. 43: Probability tree for the theoretical example Bayes Rule
3 1 P(G Bi ) P(Bi ) 6 5 3 P (Bi G ) = k = = 54,55% = 3 1 1 2 11 ( ) ( ) P G B P B + i i 5 3 4 3 i =1

Cf. Mian (2002b), p. 84ff.
Page 57
Page 57
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:
E1: 7 anomalies contain no oil and 5 anomalies contain oil E2: 9 anomalies contain no oil and 3 anomalies contain oil
Based on the very little information we have, we judge that E2 is twice as probable as E1. 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?
Page 58
Offshore Concession Example Bayes Rule
Fig. 44: Solution of the offshore concession example
Page 59
Probability Distributions
Stochastic or random variable:
The pattern of variation is described by a probability distribution Discrete (Stochastic variable can take only a finite number of values) Widely used in petroleum economics:
Binomial Multinomial Hypergeometric Poisson
Probability distributions:
Continuous (Stochastic variable can take infinite values) Widely used in petroleum economics:
Normal Lognormal Uniform Triangular
Page 60

Cf. Mian (2002b), p. 99ff.
Binomial Distributions
Applicable if an event has two possible outcomes n! n Equations: C xn = P(x ) = C x p x q n x

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
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.
Example:
Fig. 45: Solution of the six exploratory wells example

Cf. Mian (2002b), p. 99ff.
Page 61
Multinomial Distributions
Applicable if an event has more than two possible outcomes Equations:
Where,
P (S ) = N! km k1 k 2 P m 1 P 2 ...P k1!k 2 !...k m !
P(S)=probability of the particular sample, p=probabilities of drawing types 1, 2, m from population, N=k1+k2++km=size of sample, k1, k2, ,km=total number of outcomes of type 1, 2, ,m m=number of different types

Cf. Mian (2002b), p. 99ff.
Page 62
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; P1=0.5; P2=0.35; P3=0.15 k1=number of wells giving reserves of zero k2=number of wells giving reserves of 12 MMBbls k3=number of wells giving reserves of 18 MMBbls
P(S ) =

N! 3! 3 2 1 k1 k 2 k3 2 1 0 P P P 0 . 5 0 . 35 0 . 15 0.25 0.35 1 = 0.263 = = 1 2 3 k1!k 2 !k3! 2!1!0! 2 1 1 1

Corresponding reserves=2x0+1x12+0x18=12MMbbls Expected reserves=0.263x12MMBbls=3.15MMBbls
Page 63

Cf. Mian (2002b), p. 99ff.
Multinomial Distributions - Example 2/2

Probability k1 3 2 2 1 1 1 0 0 0 0 k2 0 1 0 2 1 0 3 2 1 0 k3 0 0 1 0 1 2 0 1 2 3 P(S) 0.125 0.263 0.113 0.184 0.158 0.034 0.043 0.055 0.024 0.003 1,000 Reserves [MMBbls] 0 12 18 24 30 36 36 42 48 54 Probability Of Reserves 1.000 0.875 0.613 0.500 0.316 0.159 -----0.082 0.027 0.003 Exp. Reserves [MMBbls] 0.000 3.150 2.025 4.410 4.725 1.215 1.544 2.315 1.134 0.182 20.700

Cf. Mian (2002b), p. 99ff.
Page 64
Hypergeometric Distributions
Application in statistical sampling, if trails are dependent and selected, is from a finite population without replacement Equation:

C N C nx x P(x ) = N n
Example:
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 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.
Fig. 46: Solution of the Hypergeometric distribution example

Cf. Mian (2002b), p. 99ff.
Page 65
Poisson Distributions
Good for representing a particular event over time or space Equation:

Examples:
x! Where, =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
P(x ) =
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

Cf. Mian (2002b), p. 99ff.
Page 66
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:
Where, =mean =standard deviation
f (x ) =
1 e 2
1 x 2
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 formations porosity will be (a) between 12% and 15% and (b) greater than 16%. By means of the standard normal derivate (Z) and probability tables
Solution:
Z=

Cf. Campbell et al. (2007) p. 218ff and Mian (2002b), p. 99ff.
Fig. 48: Solutions of the Normal distribution example
Page 67
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

Page 68
Uniform Distributions
Equal probability between a minimum and a maximum
f (x ) =
1 xmax xmin
Fig. 50: Probability density function and cumulative distribution function of a uniform distribution

Page 69
Triangular Distributions
Used if an upper limit, a lower limit, and a most likely value can be specified Equation: 2
XX X mod X min min , X min X X mod X X X X min min max F ( x ) = mod 2 X max X X max X mod 1 X X , X mod X X max X X max mod max min Example:
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?
Xmin=100; Xmod=130; Xmax=200; X=110
2
Solution:
X X min F (x ) = X X min mod
X mod X min 110 100 130 100 = 0.033 = 3.33% X X = 130 100 200 100 min max
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. Chi-squared-Test
For continuous and discrete data Need to define bins For continuous No need to define bins For continuous No need to define bins
Kolmogoroff-Smirnow-Test Anderson-Darling-Test Root-Mean-Square-Error
For continuous and discrete data No need to define bins
The probability of a sample data drawn from a certain distribution is measured by P-values (called observed significance
level)
Cf. Mian (2002b), p. 99ff and PalisadeCorporation (2002), p. 148ff.
Page 71
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 projects objectives The project manager and development manager in case of composite projects is accountable for managing projects risks Risk management is a continuous process The selective application of risk management tools supports risk management Proper risk management involves multi-discipline 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:

Qualitative risk analysis Quantitative risk analysis
Page 73
Qualitative Risk Analysis

Risk management is understood as
Identifying potential project threats, Reducing the probability that negative events occur (prevention), and Minimizing the impact of the occurrence of negative events (mitigation).
The process:
M on ito rin g
Policy
As
Re Pla spon nn se ing
Standards
se ss m en t
Id ic tif en n io at
Page 74
Bow-Tie Diagram
Fig. 51a: Bow-Tie Diagram
Bow-tie diagrams are used for in depth analysis of major risk issues. Especially when the cause-effect-chain of a risk issue is too complicated to be overlooked due to multiple threats, consequences, and barrier opportunities, bow-ties reduce the complexity and help to understand the coherence of the risk issue.
Economics and Business Management, University of Leoben Page 75
Risk Matrix (for projects)

Probability
Never heard of in Heard of in E&P E&P industry industry Has occured in company Has occured several times in company Occurs frequently in company
B Unlikely
C Seldom
D Probable
E Frequent
Cost
Schedule
> 6 months delay
Scope
Total change in project scope or leading to desastrous quality Major change in project scope or leading to bad project quality Moderate change in project scope or leading to inferior quality Minor change in project scope or leading to inferior quality Marginal change in project scope and quality No consequence
Improbable
>= EUR 10 mn
Catastrophic
>= EUR 2 mn up to < 10 mn
2 - 6 months delay
Major
High
Consequence
>= EUR 100.000 up to < 2 mn
2 week - 2 month delay
Moderate
Medium
>= EUR 10.000 up to < 100.000
2 days - 2 weeks delay
Minor
Low
< EUR 10.000
< 2 days delay
Slight
No consequence
No consequence
Fig. 51b: Bow-Tie Diagram
Page 76
Basic Problems of Risk Analysis

Incomplete understanding Not independent trails Little data or experience Price instability Geology as an art
These factors make the judgement of probabilities in petroleum exploration difficult.

Page 77
Judging Probability of Recovery

What is the wildcat success ratio? Derive from past success rates Calculate the geologic risk factor Considered factors:
Source Migration Timing Thermal Maturity Reservoir (porosity and permeability) Trap Seal
P(wildcat discovery)=P(trap) x P(source) x P(porosity and permeability) x etc.

Page 78
Three Level Estimation of Risk
Is used instead of two discrete levels:

Dry hole Average discovery
The three levels are:

Low Medium High

Page 79
Monte Carlo Simulation

Numerical procedure Random numbers provide computer-aided an artificial sample Pioneers:
Earl George Buffon John von Neumann @Risk Cristal Ball
Software packages in use:
Page 80
Monte Carlo Process Workflow:

Define variables Develop the deterministic projection model Sort the input variables in two groups Define distributions for random numbers Perform the simulation trails Calculate EMV and preparing graphical displays
Input Data
Sampling of Input Data via Probability Distributions
Computing Outputs (e.g.: NPV)
i=n? yes
no
Evaluation of Output Probability Distribution
In Monte Carlo simulations risky events and values are modelled by means of probability distributions and repeating relevant calculations a sufficiently number of times using random numbers in order to end up with calculated probability distributions for output variables.
Cf. Zettl (2000), p. 43 and Newendorp, Schuyler (2000), p. 397ff.
Result Interpretation and Decision
Page 81
Random Numbers
Sources of random numbers:
Mechanical experiment Noise in nature (really random) Table of random number (boring book!) (Pseudo) Random number generator (pseudo random)
Uniformly distributed numbers between 0 and 1 If computers offer to set the seed value, the random numbers are reproducible

Page 82
Sampling
Monte Carlo Sampling
Fig. 52: Monte Carlo Sampling
Latin Hypercube Sampling
Fig. 53: Latin Hypercube Sampling

Page 83
Result Interpretation
The result is a probability distribution of the output value Received statistical measures:

Measures of location: mean, median, mode Measures of dispersion: range, interquantile range, standard deviation, variance Measures of shape: modality, skewness, kurtosis
Fig. 57: Hidden relationship between input and output shape of distribution
Fig. 58: Possible output probability distribution of a Monte-Carlo-Simulation
Page 84
Main Fields of Application

Risked Costs Risked Economics Risked Schedule
Page 85
Selected Measures of Risk

Risk Adjusted Capital (RAC)
Maximum amount of money that can be lost (with a certain confidence)
Value-at-Risk (VaR)
Difference between the mean and the maximum amount of money that can be lost (with a certain confidence) Relation between expected profit (e.g. mean) and the maximum amount of money that can be lost (with a certain confidence)
Return on Risk Adjusted Capital (RORAC)
Fig. 59: Selected Measures of Risk
Different definition in literature!

Cf. Gleiner (2004) and Homberg, Stephan (2004)
Page 86
Risked Schedules
Stochastic Inputs:
Durations of project tasks Start dates of project tasks Predecessor links Calendar Global variables
Fig. 59a: Risked Gantt Chart
Outcome:

Ranges, P10, P50, P90, and expected end dates Probability of meeting a deterministic schedule
Fig. 59b: Important issue in risking schedules
Within probabilistic schedule analyses, a closer look on the project schedule is taken by means of a Monte Carlo simulation.
Economics and Business Management, University of Leoben Page 87
Sensitivity Analyses
Sensitivity Analysis
A way to handle uncertainty Demonstrates the significance of uncertain elements in economic evaluations Typical items for sensitivity analysis:
Investment Operating costs Reserve size Production rates Prices etc.

Cf. Allen, Seba (1993), p. 213.
Page 89
Deterministic Sensitivity Analysis

Where the range of outcome is known but not the probability Input parameters in an economic model are changed over a certain range Y-axis represents an economic yardstick X-axis represents the fractional change of the input parameters Does not depict interrelations between input parameters
Fig. 60: Spider Diagram

Cf. Allen, Seba (1993), p. 213ff.
Page 90
Probabilistic Sensitivity Analysis

The input parameters of an economic valuation model have probability distribution Correlation- or Regression-Coefficients of every input parameter and the output are calculated Visualisation is normally done in a tornado diagram Does depict interrelations between input parameters
Fig. 62: Tornado Diagram
Fig. 61: Correlation diagram
Page 91
Literature
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. Clo, A. (2000): Oil Economics and Policy, Boston/Dordrecht/London: Kluwer Academic Publisher. Dahl, C.A. (2004): International Energy Market - Understanding Pricing, Politics and Profits, Tulsa: Penn Well. Deffeyes, K.S. (2005): Beyond Oil - The view from Hubbert's Peak, New York: Hill and Wang. Dias, M.A.G. (1997): The Timing of Investment in E&P: Uncertainty, Irreversibility, Learning, and Strategic Considerations. In: 1997 SPE Hydrocarbon Economics and Evaluation Symposium. Dallas, TX: SPE. Dixit, A.K.; Nalebuff, B.J. (1997): Spieltheorie fr Einsteiger - Strategisches Know-how fr Gewinner, Stuttgart: Schffer-Poeschel Verlag. Gleiner, W. (2004): Die Aggregation von Risiken im Kontext der Unternehmensplanung. In: Zeitschrift fr Controlling und Management. Vol. 48, Nr. 5: S. 350-359. Homburg, C.; Stephan, J. (2004): Kennzahlenbasiertes Risikocontrolling in Industrie und Handelsunternehmen. In: Zeitschrift fr Controlling und Management. Vol. 48, Nr. 5: S. 313-325. Johnston, D. (2003): International Exploration Economics, Risk, and Contract Analysis, Tulsa: Pann Well. Laux, H. (2003): Entscheidungstheorie. 5. Auflage, Berlin Heidelberg: Springer. Mian, A.M. (2002a): Project Economics and Decision Analysis - Volume I: Deterministic Models, Tulsa: PennWell. Mian, A.M. (2002b): Project Economics and Decision Analysis - Volume II: Probabilistic Models, Tulsa: PennWell. Newendorp, P.; Schuyler, J. (2000): Decision Analysis for Petroleum Exploration. Vol. 2nd Edition, Aurora: Planning Press. PalisadeCorporation (2002): @Risk - Advanced Risk Analysis for Spreadsheets. Vol. Version 4.5, Newfield: Palisade Corporation. Zettl, M. (2000): Application of Option Pricing Theory for the Valuation of Exploration and Production Projects in the Petroleum Industry. Leoben: Montanuniversitt Leoben, Dissertation.
Page 92

Advanced Petroleum Economics Staber

Încărcat de

Informații document

Descriere originală:

Drepturi de autor

Formate disponibile

Partajați acest document

Partajați sau inserați document

Opțiuni de partajare

Vi se pare util acest document?

Este necorespunzător acest conținut?

Drepturi de autor:

Formate disponibile

Advanced Petroleum Economics Staber

Încărcat de

Drepturi de autor:

Formate disponibile

600.

019 Advanced Petroleum Economics

Why Advanced Petroleum Economics?

Economics and Business Management, University of Leoben, Stephan Staber

Economics and Business Management, University of Leoben, Stephan Staber

Setting the scene

Fig. 0: Core processes in an E&P company

Cash Flow and Costs

Cash Flow and Costs

Fig. 1: Cash Flow Projection

Economics and Business Management, University of Leoben

Capital Expenditure (CAPEX)

Classification by purchased items:

Classification and wording differ from company to company

Economics and Business Management, University of Leoben

Operational Expenditure (OPEX)

(Hydrocarbon-)Evacuation costs Insurance costs

Classification and wording differ, but often:

Economics and Business Management, University of Leoben

Types of Cost Estimates

Order of Magnitude Estimate

Optimization Study Estimate

Economics and Business Management, University of Leoben

Accuracy and Cost Overrun

Accuracy improves over time

Fig. 3: Probability of cost overrun

Economics and Business Management, University of Leoben

Contingency and Allowance

Fig. 4: One possible statistical view on contingency and allowance

Economics and Business Management, University of Leoben

Measures of Profitability and Performance

Others which recognize time-value of money:

Economics and Business Management, University of Leoben, Stephan Staber

Prospect Cashflow Example

Economics and Business Management, University of Leoben

Payout (PO) 1/2

Economics and Business Management, University of Leoben, Stephan Staber

Prospect Cashflow Example

Unrecovered portion of the investment at the end of year 2:

Economics and Business Management, University of Leoben, Stephan Staber

Payout (PO) 2/2

Fig. 10: Variation 2

Fig. 11: Variation 3

Economics and Business Management, University of Leoben, Stephan Staber

Return on Investment (ROI)

Economics and Business Management, University of Leoben

Return on Investment (ROI) - Variations

2. Return on Assets (ROA):

Fig. 12: Maximum out-of-pocket cash

Prospect Cash Flow Example:

Economics and Business Management, University of Leoben

Net Present Value

Economics and Business Management, University of Leoben, Stephan Staber

1. Opportunity cost of capital (OCC)

2. Weighted-average cost of capital (WACC)

Economics and Business Management, University of Leoben, Stephan Staber

Net Present Value

Fig. 15: Major weakness of NPV

Economics and Business Management, University of Leoben

(Internal) Rate of Return (IRR)

Economics and Business Management, University of Leoben

Discounted Return on Investment (DROI)

Economics and Business Management, University of Leoben