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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

Stephan Staber, September 2011, Vienna © Economics and Business Management, Univer sity of Leoben, Stephan Staber

Page 1

Preface ■ These lecture notes can be seen as a reasonable supplement for the lecture

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

and „Petroleum Economics“ © Economics and Business Management, Univer sity of Leoben, Stephan Staber Page 3

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

Risk Analysis ■ Sensitivity Analysis © Economics and Business Management, Univer sity of Leoben, Stephan Staber

Page 4

Setting the scene… ■ What are the core processes of an E&P company? Fig. 0:

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

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)

…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

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

and wording differ from company to company © Economics and Business Management , University of Leoben

Page 8

Operational Expenditure (OPEX) ■ …occur periodically ■ …are necessary for day-to-day operations ■ …consist

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]

© 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

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.

Fig. 2: Accuraccy of cost estimates Fig. 3: Probability of cost overrun Page 11
Fig. 2: Accuraccy of cost estimates
Fig. 3: Probability of cost overrun
Page 11

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.

Fig. 4: One possible statistical view on contingency and allowance Page 12
Fig. 4: One possible statistical view on contingency and allowance
Page 12
statistical view on contingency and allowance Page 12 Contingency and Allowance ■ Contingency ▪ Budget for

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 time-value of money: ▪ Net Profit ▪ Payout (PO)

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

© Economics and Business Management, University of Leoben, Stephan Staber

Page 14

Cf. Newendorp, Schuyler (2000), p. 9ff.

Year Estimated oil Annual Net Future Net Cash Production, Revenue* Expenditures Flow Bbls 1 54,750
Year
Estimated oil
Annual Net
Future
Net Cash
Production,
Revenue*
Expenditures
Flow
Bbls
1
54,750
$132,900
$132,900
2
54,750
132,900
132,900
3
44,600
107,600
10,000
97,600
4
29,200
69,200
69,200
5
18,900
43,500
20,000
23,500
6
12,900
28,600
28,600
7
7,800
15,900
15,900
8
5,200
9,400
9,400
9
3,700
5,600
5,600
10
2,200
1,900
1,900
234,000
$547,500
$30,000
$517,500
*Annual Net Revenue =
Annual Gross Revenue – Royalties – Taxes – Operating expenses
Page 15

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:

Mid-project-year

© 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.

© Economics and Business Management, Univer sity 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

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.

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 =

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.

Stephan Staber Cf. Newendorp, Schuyler (2000), p. 9ff. Fig. 6: Weakness 1 Fig. 7: Weakness 2

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) profit-to-investment 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.

total ROI) © Economics and Business Management , University of Leoben Cf. Newendorp, Schuyler (2000), p.

Page 20

Return on Investment (ROI) - Variations 1. Using “maximum out-of-pocket cash” instead of investment Fig.

Return on Investment (ROI) - Variations

1. Using “maximum out-of-pocket cash” instead of investment

Fig. 12: Maximum out-of-pocket 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! ■

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

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. Weighted-average cost of capital (WACC)

The marginal cost of funding the next project. This is calculated as an weighted-average 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.

University of Leoben Cf. Newendorp, Schuyler (2000), p. 9ff. Fig. 14: e.g. profitable, but neg. NPV

Fig. 14: e.g. profitable, but neg. NPV

Fig. 15: Major weakness of NPV

Page 24

Year Net Discount cashflow factor 40% 40% discounted cashflow 0 -$268,600 1.000 -$268,600 1 +$132,900
Year
Net
Discount
cashflow
factor 40%
40% discounted
cashflow
0
-$268,600
1.000
-$268,600
1
+$132,900
0.845
+$112,300
2
+$132,900
0.604
+$80,300
3
+$97,600
0.431
+$42,100
4
+$69,200
0.308
+$21,300
5
+$23,500
0.220
+$5,200
6
+$28,600
0.157
+$4,500
7
+$15,900
0.112
+$1,800
8
+$9,400
0.080
+$700
9
+$5,600
0.057
+$300
10
+$1,900
0.041
+$100
$0
IRR = 40%
Page 25

(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:

(trail-and-error 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.

= 0.553 © Economics and Business Management , University of Leoben Cf. Newendorp, Schuyler (2000), p.

Page 26

Discounted Return on Investment (DROI) ■ Strengths: ▪ All advantages of NPV (such as realis

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

Game-theoretical 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: ▪

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 ae ) 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.

= iae = 0.1495 © Economics and Business Management , University of Leoben Cf. Newendorp, Schuyler

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.

same ranking! © Economics and Business Management , University of Leoben Cf. Newendorp, Schuyler (2000), p.

Page 30

Net Present Value Portfolios ■ Due to limited statements of single measures portfolios are established

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.

  +$19.70 © Economics and Business Management , University of Leoben Cf. Newendorp, Schuyler (2000), p.

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

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

half-life.

© Economics and Business Management, University of Leoben

cost of capital. O profit. O half-life. © 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

maximum-out-of-pocket-cash.

O

net present value.

O

return on investment.

O

payout.

© Economics and Business Management, University of Leoben

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.

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) ▪

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 probability-weighted value of

Definitions and EVC

Expected Value (EV):

The EV is the probability-weighted 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

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

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.

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.

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

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.

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

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

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

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 re-analysed

Logical, straight-forward an easy to use

© Economics and Business Management, University of Leoben

Cf. Newendorp, Schuyler (2000), p. 127ff.

easy to use © Economics and Business Management , University of Leoben Cf. Newendorp, Schuyler (2000),

Page 50

Probability Theory

Concept of Probability ▪ Probability Theory enables a pers on to make an educated guess

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 long-run 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: ▪
Fig. 39: Vann diagram showing two mutually exclusive events

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

Fig. 40: Vann diagram showing of partly overlapping events

For simultaneous trails

1. Events are mutually exclusive:

P(AB)=P(A)+P(B)

P(AB)=0

2. Events are partly overlapping:

P(AB)=P(A)+P(B)-P(AB)

P(AB)=P(A)+P(B)-P(AB) (=P(AB))

Fig. 41: Vann diagram showing union two events

Fig. 41: Vann diagram showing union two events

Multiplication Rule:

diagram showing union two events ■ Multiplication Rule: ▪ For consecutive trails ▪ Independent events: ▪

For consecutive trails

Independent events:

P(AB)=P(A) x P(B)

Dependent events:

P(AB)=P(A) x P(B|A)

© 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

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(AB)=4

1. n(AB)=n(A) - n(AB)=8 - 4=4

2. n(ĀB)=n(B) - n(AB)=11 - 4=7

3. n(AB)= n(A) + n(B) - n(AB)=8+11 - 4=15

4. n(S) - n(AB)=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

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

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

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

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

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.

Uniform ▪ Triangular © Economics and Business Management , University of Leoben Cf. Mian (2002b), p.

Page 60

Binomial Distributions ■ Applicable if an event has two possible outcomes ■ Equations: n !

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 mo re than two possible outcomes ■

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

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.

Multinomial Distributions - Example 2/2 Probability Reserves Probability Exp. Reserves k k k P(S) [MMBbls]
Multinomial Distributions - Example 2/2
Probability
Reserves
Probability
Exp. Reserves
k
k
k
P(S)
[MMBbls]
Of Reserves ≥
[MMBbls]
1
2
3
3
0
0
0.125
0
1.000
0.000
2
1
0
0.263
12
0.875
3.150
2
0
1
0.113
18
0.613
2.025
1
2
0
0.184
24
0.500
4.410
1
1
1
0.158
30
0.316
4.725
1
0
2
0.034
36
0.159
1.215
0
3
0
0.043
36
---“---
1.544
0
2
1
0.055
42
0.082
2.315
0
1
2
0.024
48
0.027
1.134
0
0
3
0.003
54
0.003
0.182
1,000
20.700
Page 64

© 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

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 particul ar event over time or space ■

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

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:

1 ⎛ x − μ ⎞ 1 − ⎜ ⎟ ( ) 2 e ⎝
1 ⎛ x −
μ
1
(
)
2
e
σ
f x
=
σ
2
π

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 rese rves is approximately lognormal distributed

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 −

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 min =100; X mod =130; X max =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.

Campbell et al. (2007) p. 218ff and Mian (2002b), p. 99ff. Fig. 51: Probability density function

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

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 and discrete data Need to define bins

Kolmogoroff-Smirnow-Test

For continuous No need to define bins

For continuous No need to define bins

Anderson-Darling-Test

For continuous No need to define bins

For continuous No need to define bins

Root-Mean-Square-Error

For continuous and discrete data No need to define bins

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)

© Economics and Business Management, University of Leoben

Page 71

Cf. Mian (2002b), p. 99ff and PalisadeCorporation (2002), p. 148ff.

Risk Analysis

Risk Analysis

Risk Management in E&P Projects ■ Example for key points of a risk management policy:

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 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: