PETROLEUM ECONOMICS

Expected Value Concepts

 Lecture Contents
 Expected Value of Random Variables

 Standard Deviation of Random Variables

 Expected Monetary Value (EMV)

 Expected Profitability Index (EPI)

 Expected Opportunity Loss (EOL)

 Sensitivity Analysis
 Lesson Learning Outcome
At the end of the academic session, students should be able to:

 Explain the concepts of expected value and standard deviation

of random variable.

 Differentiate the concepts of EMV, EPI and EOL.

 Choose the best option (alternative) based on EMV, EPI and

EOL concepts.
 Introduction
 Models are constructed and used to predict consequences of
various possible events and decisions.

 Uncertainties can be propagated through the model in order to

discover uncertainty in the predicted consequences.

 This topic presents some basic probabilistic methods used for

selecting a course of action under uncertain environments.

 The methods make use of expected value concepts and decision

trees to aid in the analysis.

 The expected value calculations involve assigning probabilities to

random variables and then calculating the probabilistic weighted
average of these.
 Expected Value Concepts
 The probabilistic weighted average of the variables and their
corresponding probabilities is called expected value of a random
variable.

 Two types of decision elements when dealing with uncertainty:

 Value associated with various alternatives and their outcomes.

The value may be measured in monetary terms or any other
dimensions (e.g: porosity, reserves etc).

 Likelihood of occurrence of this value associated with its

respective outcome. This is the measure in terms of probability.

*the probabilistic rules for these elements are associated with

various alternative actions.
 Expected Value of Random Variable
 In uncertainty, the decision maker is interested in average value
of the occurrence of random variables in many trials.

 The average value is the weighted average of the possible

outcomes, with the probability values used as weights.

 The weighted average of random variable is referred to as the

expected value of the random variable (X)

𝐄𝐗 = 𝐱 𝐢 𝐏(𝐱 𝐢 )
𝐢=𝟏
 Expected Value of Random Variable
 Expected value of X is mathematically denoted as:

𝐄𝐗 = 𝐱 𝐢 𝐏(𝐱 𝐢 )
𝐢=𝟏

where
𝐸 𝑋 = expectation operator, read as “expectation of”
P(𝑥𝑖 ) = denotes P 𝑋 = 𝑥𝑖 , the unconditional probability associated with
variable 𝑋

Unconditional Probability: The probability that an event will occur, not contingent on any
prior or related results. An unconditional probability is the independent chance that a single
outcome results from a sample of possible outcomes
 Standard Deviation of Random Variable
 Since the outcomes of a random variable are probabilistic, it is
useful to measure the dispersion or variability of the outcomes.

 Standard deviation of a discrete random variable given by:

𝐧

𝐬𝟐 𝐗 = (𝐱 𝐢 − 𝐄{𝐗} )𝟐 𝐏(𝐱𝐢)
𝐢=𝟏

where
𝑠 2 𝑋 =Variance of 𝑋

The standard deviation of 𝑿 is then, s X = 𝑠2 X

 Standard Deviation of Random Variable
 The variance is a weighted average of squared deviations.

 The deviations being the outcomes of X around their expected

value and the weights being the respective probabilities of
occurrence.

 The variance measures the extent to which the outcomes of X

depart from their expected value.

 Since it is measured in square units, it has to be converted to a

more meaningful number.

 Its square root is calculated and referred to as standard deviation.

 Example 1
Drilling of a certain prospect is expected to result in an oil producer
with a 30% chance of 20 Mstb reserves, 50% chance of 60 Mstb
reserves, and a 20% chance of 95 Mstb reserves. Calculate the
mean, variance and standard deviation of the expected reserves
encountered by the well.
 Solution
Probability Reserves, 𝑋𝑖 Expectancy Variance
(𝑋𝑖 − 𝐸 𝑋 )2 𝑝𝑖 (𝑋𝑖 − 𝐸 𝑋 )2
𝑝𝑖 Mstb 𝐸 𝑋 = 𝑝𝑖 𝑋𝑖

0.3 20 6 1225 367.5

0.5 60 30 25 12.5
0.2 95 19 1600 320
1.0 55 700

The expected value of reserves is 55MStb and the standard

deviation is 𝑠 = 700 = 26.5 𝑀𝑆𝑡𝑏 . This means that on the
average it is expected to discover 55MStb over a large number
of similar trials and the actual result will lie between 28.5 (55-
26.5) and 81.5 (55+26.5)
 Expected Monetary Value (EMV)
 If the random variable is in monetary terms, then the calculated
expected value is described as the expected monetary value
(EMV).

 The EMV is the weighted average of the possible monetary values

(usually net present value, NPV) weighted by their respective
probabilities.

 The expected value of the discounted net cash flow (NPV) is also
referred to as the expected present value profit.

 The net present value (NPV) for EMV calculations is based on

deterministic models.
 Expected Monetary Value (EMV)
 EMV can also be defined as the mean of the probability
distribution of all possible monetary outcomes.

 The calculation involves generating event probabilities,

multiplying the payoff of each event by probabilities of occurrence
for that event, and summing up the products:
𝑛

𝐸𝑀𝑉 = 𝐸 𝑁𝑃𝑉 = 𝑁𝑃𝑉𝑖 × 𝑃(𝑁𝑃𝑉𝑖 )

𝑖=1

 The expected value of decision alternative can be zero, positive

or negative.
 Expected Monetary Value (EMV)
 To make a choice between mutually exclusive investment
alternatives, the expected monetary value of each alternative is
calculated and the alternative with the largest EMV is selected.

 For screening alternatives, all investments with EMV greater than

zero is acceptable.

 If all the conditional values are expressed as costs, then the

alternative with the lowest expected value of costs is selected.

 In some cases, the values in terms of opportunity losses are used

where the alternative with the lowest expected opportunity loss
would be selected.
 Expected Monetary Value (EMV)
 The decision problems incorporating probabilities have common
structural elements:

 Act or strategies, 𝑨𝒋 – are various available alternatives (drill a

well, don’t drill a well, farmout etc.). The decision problem
involves choosing an alternative out of those available.

 Outcome states, 𝑺𝒊 – the different situations that may prevail

and affect the consequences of 𝐴𝑗 (dry hole, 20 Mstb reserves
etc.).

 Consequences or payoffs, 𝑪𝒊𝒋 – are the gains, rewards, losses

etc. associated with the 𝑗th act that results in the 𝑖th outcome
state.
 Expected Monetary Value (EMV)
 Outcome state probabilities, 𝑷(𝑺𝒊 ) – are the probabilities
assigned to the outcome states.
 Example 2
A drilling prospect is evaluated with an estimate that the probability of
a successful well is 35% and the probability of a dry hole is 65%.
Drilling of a dry hole will result in net loss of $250,000. If the well
successful, then the net present value of the future streams of net
revenue will be $500,000. Instead of drilling the well the prospect can
be farmout (i.e., no exposure to drilling expenditure) and retain an
overriding royalty interest in the well. The net present value of
farmout will be $50,000. Is it economically better to drill the well or
farm it out?
 Solution
Outcome Probability Drill Farmout
State NPV EMV NPV EMV
Dry hole 0.65 -$250,000 -$162,500 $0 $0
Producer 0.35 $500,000 $175,000 $50,000 $17,500
1.00 $12,500 $17,500

The EMV= $17500 for farmout is higher than EMV= $12500 of

drilling ourselves. In order to maximize the expected net present
value, it is prudent to farmout in this situation. The farmout giving
net advantage of $5,000 in expected present value profit over the
drill option.

**However is it still advisable to farm out if the probability of a

producer were increased to 36% versus the 35%?

Sensitivity Analysis
 Example 3
A proposed drilling prospect has been evaluated. A well will be drilled
on 160-acre prospect area. The evaluation is based on the conditions
that the company will be able to lease 60 acres adjacent to the
prospect. Basic data and economic analysis (net present value at 10%
that would be realized from the prospect for each option, net of taxes,
royalties, lease operating expense and costs of the well) of each
option for the prospect are given in Table 3. The company has
identified the following three options for participation in the deal, given
that the company has acquired the remaining 60 acres.
 Example 3
1. Participate in the drilling with 37.5% (60 acres/160 acres x 100 =
37.5%) non-operating WI.
2. Farmout acreage while retaining 1/8th of 7/8th royalty interest 60
net acres.
3. Carry with a back-in privilege (37.5% WI) after 150% of the
investment by participating parties is recovered.

Based on the above options and the data in Table 3, calculate the
following.

1. Should the adjacent lease be acquired? If yes, how much

(maximum) should be paid for it?
2. If the adjacent lease is acquired, which of the three options will be
more valuable?
 Example 3

Gross Well Cost (including Lease Equipment) = $110,000

Gross Dry Hole Cost = $80,000

Net Present Value
Outcomes Probability
Drill with 37.5% WI Farmout Retain ORI 37.5% Back-in
Dry hole 0.25 - $30,000 $0 $0

20 Mstb 0.30 $4,357 $8,733 $750

35 Mstb 0.25 $45,448 $14,646 $34,142

50 Mstb 0.15 $87,411 $29,693 $73,712

65 Mstb 0.05 $125,863 $26,401 $111,141

Table 3
Expected Opportunity Loss (EOL)
 Solution

Outcomes Drill with 37.5% WI Farmout Retain ORI 37.5% Back-in

State Probability
NPV EMV NPV EMV NPV EMV
Dry hole 0.25 -$30,000 -$7,500 $0 $0 $0 $0
20 Mstb 0.30 $4,357 $1,307 $8,733 $2,620 $750 $225
35 Mstb 0.25 $45,448 $11,362 $14,646 $3,662 $34,142 $8,536
50 Mstb 0.15 $87,411 $13,112 $20,693 $3,104 $73,712 $11,057
65 Mstb 0.05 $125,863 $6,293 $26,401 $1,320 $111,141 $5,557
EMV $24,574 $10,705 $25,374
 Solution
 From the expected value calculation, the back-in option with the
highest EMV of $25,375 is economically the most viable option.
Therefore the remaining acreage is worth acquiring.

 How much maximum should be paid for the additional 60 acres?

 Since the expected net present value of the preferred option is

$25,375, the maximum value of this additional acreage should
not be more than $423/acre ($25,375/60acres)
 Sensitivity Analysis
 Generally used to examine the robustness of an alternative to
changes in the variables used in arriving at the value of the
alternative under consideration.

 The approach is to hold all aspects of the model constant and vary
each parameter while observing the influence of the changes upon
the optimal decision.

 Sensitivity analysis on probabilities used to calculate EMV of each

alternative is carried out.

 Recall Example 2 ; Simple case of two acts (drill or farm out) and
two events (dry hole or producer).
 Sensitivity Analysis
 The objective is to determine the dry hole probability when the
decision maker will be indifferent to the alternatives.

 If 𝑝 is the probability of dry hole and (1 – 𝑝) is the probability of

producer, then decision problem becomes:

EV {Drill} = 𝑝(-$250,000)+(1 – 𝑝)($500,000)

= -$250,000𝑝 + $500,000 – $500,000𝑝
= -$750,000𝑝 + $500,000

EV {Farmout} = 𝑝(0)+(1 – 𝑝)($50,000)

= – $50,000𝑝 + $50,000

Solution
 Sensitivity Analysis
 The question is, at what dry hole probability the expected value of
the two alternatives will be equal. The probability is computed as:

EV {Drill} = EV {Farmout}
-$750,000𝑝 + $500,000 = – $50,000𝑝 + $50,000
-$700,000𝑝 = – $450,000
𝑝 = 0.6429 or 64.29%

 This means that at the point of indifference, both expected values

are equal.

 If the probability of a dry hole is higher than 64.29%, then the

optimal act would be to farm out. If the probability of a dry hole is
less than 64.29%, then the optimal act would be to drill.
 Sensitivity Analysis

Figure 1. Sensitivity analysis on the probability of dry hole in Example 2

 Sensitivity Analysis
 The correlation in Figure 1 assists in estimating a general range of
dry hole probability on which a decision can be made.

 If the analyst is not certain of the probability of encountering a

producer but felt it was below 35.71%, then the preferred choice
would be to farmout.

 As long as the probability of a dry hole is higher than 64.29% then

optimal choice would be to farmout.

 The drill option is highly sensitive to change the probability.

 A small improvement in the dry hole probability makes the drill

option dominant over the farmout option.
 Sensitivity Analysis
 Sensitivity analyses become more complex when there are more
than two alternatives.

 Recall Example 3: Three alternatives (drill, farmout, and back-in).

This leads to solving three simultaneous equations, the graphical
method is recommended in such situations.

 The correlation assists the analyst in estimating a general range of

the probabilities of encountering a productive well.

 Figure 2 illustrates if the probability of dry hole is less than 23%, the
drill with 37.5% WI option is the preferred option. If the probability of
dry hole is greater than 23%, then the back-in option is preferred.

 The farmout option is not the preferred choice either case.

 Sensitivity Analysis

Figure 2. EMV versus the probability to encounter producer

 Expected Profitability Index (EPI)
 EMV or E{NPV} was used for choosing the most economically
viable option out of a set of mutually exclusive investment
alternatives.

 When working under limited capital and with non mutually

exclusive investment, it is recommended to use EPI criterion to
arrive at the highest expected net gain per unit of expected
investment.

𝐸{NPV}
 E{PI} is given by: 𝐸𝑃𝐼 = 1 +
𝐸{𝑃𝑉 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡}

 The objective is to maximize the ratio if they do not have enough

funds to invest in all of available economically viable options.
 Expected Profitability Index (EPI)
 E.g: Investment with EPI =1.5
 Generates a net expected profit in present value terms of $0.5 per
every dollar of capital invested in the project.
 Means the project will recover the initial capital investment and it will
generate $0.5 for every dollar initially invested.

 Weakness of EMV is it does not give any idea of magnitude of initial

investment

 One project generates EMV of $1,500 for an investment of $1,000, and

another project generates EMV of $500 for an investment of $200
 Based on EMV decision rule – the option that generates EMV of
$1,500 will be selected.
 However, based on EPI, the option with EMV=$500 is better because
its EPI = 3.5 is much higher that EPI= 2.5 of the other option.
 Expected Profitability Index (EPI)
 For screening investment, all investments with EPI > 1 are
economically viable projects.

 For deciding among:

(a) Mutually exclusive investment:

 - Choose investment that yields the highest EPI.

(b) Non-mutually exclusive investment:

If there is no budget constraint – all investment with EPI > 1
are selected.
Under budget constraint – all EPI > 1 are arranged in
descending order of EPI (starting at the top investments are
selected and their investment accumulated until the
budgeted level of investment funds is achieved).
 Example 4
Three different drilling prospects are under evaluation. Detailed
deterministic economic analysis for each prospect was conducted
and probability assessment for each outcome was made. The
economic analysis for each prospect included taxes, royalties, lease
operating expenses, and costs of the well. A discounted rate of 10%
was used in each case to arrive at their NPV. Calculate:

1. The EMV and EPI for each prospect.

2. Based on the decision rule of maximizing the EMV, which of the
prospect will be economically most viable (assume the prospects
are mutually exclusive).
3. If the decision maker has limited funds of $150,000 and he/she
want to maximize the expected worth per expected investment
costs , which of these prospects would be the preferred choice.
 Example 4
Prospect A Prospect B Prospect C
Completed
$120,000 $225,000 $45,000
Well Cost
Dry Hole
$80,000 $150,000 $30,000
Cost
Outcome
Probability NPV Probability NPV Probability NPV
State
Dry Hole 0.40 -$80,000 0.35 -$150,000 0.25 -$30,000
100 Mstb 0.25 $90,000 0.25 -$85,000 0.30 $25,000
200 Mstb 0.20 $180,000 0.20 $325,000 0.25 $45,000
300 Mstb 0.10 $270,000 0.15 $520,000 0.15 $62,000
400 Mstb 0.05 $360,000 0.05 $715,000 0.05 $90,000
1.00 1.00 1.00
 Solution
Prospect A
Completed Well Cost $120,000
Dry Hole Cost $80,000
Outcome State Probability NPV EMV
Dry Hole 0.40 -$80,000 -$32,000
100 Mstb 0.25 $90,000 $22,500
200 Mstb 0.20 $180,000 $36,000
300 Mstb 0.10 $270,000 $27,000
400 Mstb 0.05 $360,000 $18,000
1.00 $71,500
E{Drilling} $104,000
EPI 1.688

The expected value of capital drilling cost (CAPEX) The EPI for Prospect A:
for Prospect A: 𝐸𝑀𝑉𝐴
𝐸{𝐶𝐴𝑃𝐸𝑋}𝐴 𝐸𝑃𝐼𝐴 = 1 +
𝐸{𝐶𝐴𝑃𝐸𝑋}𝐴
= [𝑃(𝐷𝑟𝑦 𝐻𝑜𝑙𝑒)𝐴 × 𝐶𝐴𝑃𝐸𝑋(𝐷𝑟𝑦 𝐻𝑜𝑙𝑒)𝐴 ]+
[𝑃(𝑃𝑟𝑜𝑑𝑢𝑐𝑒𝑟)𝐴 × 𝐶𝐴𝑃𝐸𝑋(𝑃𝑟𝑜𝑑𝑢𝑐𝑒𝑟)𝐴 ]
 Solution
Prospect B Prospect C
Completed
$225,000 $45,000
Well Cost
Dry Hole
$150,000 $30,000
Cost
Outcome
Probability NPV EMV Probability NPV EMV
State
Dry Hole 0.35 -$150,000 -$52,500 0.25 -$30,000 -$7,500
100 Mstb 0.25 -$85,000 -$21,250 0.30 $25,000 $7,500
200 Mstb 0.20 $325,000 $65,000 0.25 $45,000 $11,250
300 Mstb 0.15 $520,000 $78,000 0.15 $62,000 $9,300
400 Mstb 0.05 $715,000 $35,750 0.05 $90,000 $4,500
1.00 $105,000 1.00 $25,050
E{Drilling} $198,750 $41,250
EPI 1.528 1.607
 Solution
Summary of the expected profitability indicators arranged in
descending order of EPI:
∑E{CAPE
Prospect EMV EPI E{CAPEX}
X}
Prospect A $71,500 1.688 $104,000 $104,000 √
Prospect C $25,050 1.607 $41,250 $145,250 √
Prospect B $105,000 1.528 $198,750 $344,000
If prospects were mutually exclusive, Prospect B (with highest EMV)
would have been chosen to maximize the expected monetary value.

However, under limited capital constrain of $150,000, Prospect B

(with E{CAPEX}=$198,750>$150,000) cannot be selected
 Solution
Prospect A and Prospect C are chosen for a total expected capital cost
of $145,250 (within the budget constraint of $150,000)
 if both prospects are successful, then the budget will be short by
$15,000
 If Prospect A is successful and Prospect C is a dry hole, then the
budget of $150,00 will be matched exactly

If all three prospects are selected:

 the minimum capital requirement will be the total of dry hole costs
of $260,000.
 maximum capital requirement will be the total of the completed
well costs of $390,000.

However, the budget for all three prospects (if all prospects are to be
drilled) will be the sum of the expected investments for each prospect
($344,000).
 Performance Index
 Incorporates the expected returns and the risks.

 Complete measure of the feasibility of an investment subject to risk

constraint (by choosing the less risky investment).

𝐸𝑀𝑉 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑀𝑜𝑛𝑒𝑡𝑎𝑟𝑦 𝑉𝑎𝑙𝑢𝑒

𝑃𝑒𝑟𝑓𝑜𝑟𝑚𝑎𝑛𝑐𝑒 𝐼𝑛𝑑𝑒𝑥, 𝐼 = =
𝑠 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝐷𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛

 The objective of any investment is to maximize the economic

returns at the lowest risk(maximizing the value of the performance
index).

 A minimum performance index value is set as a threshold for

screening investments:
- the project with performance index greater than the minimum
desirable value would be considered as economically feasible.
 Performance Index
 Recall Example 3:
 The performance indexes for the three investment alternatives
are (a) 0.539 for the drill option, (b) 1.371 for the farmout option,
and (c) 0.772 for the back-in option.
 The farmout option carries minimum risk (highest performance
index), followed by the back-in option and the drill option.
Outcomes State Probability Drill with 37.5% WI Farmout Retain ORI 37.5% Back-in
NPV EMV NPV EMV NPV EMV

Dry hole 0.25 -$30,000 -$7,500 $0 $0 $0 $0

20 Mstb 0.30 $4,357 $1,307 $8,733 $2,620 $750 $225

35 Mstb 0.25 $45,448 $11,362 $14,646 $3,662 $34,142 $8,536

50 Mstb 0.15 $87,411 $13,112 $20,693 $3,104 $73,712 $11,057

65 Mstb 0.05 $125,863 $6,293 $26,401 $1,320 $111,141 $5,557

EMV
$24,574 $10,705 $25,374
Standard Deviation
$45,622 $7,809 $32,869
Performance Index, (I) 0.539 1.371 0.772
 Expected Opportunity Loss (EOL)
 Probabilistic value criterion used to arrive at the selection of the
most economically viable option out of several available
alternatives.

 The opportunity loss is the difference between the highest possible

profit for an event and the actual profit for an action taken.

 For example, based on the EMV calculations in Example 3 the drill

option was selected:
 After drilling the well, it turns out to be a dry hole. This would
result in a loss of $30, 000 (dry hole cost).
 If it was known the well would be a dry hole, then the farmout or
back-in options with zero loss would have been selected.
Therefore, the EOL would be $30,000 – $0 = $30,000
 Expected Opportunity Loss (EOL)
 EOL and EMV rules give exactly the same preference rankings of
alternatives; they are essentially the same rule, incorporating a
linear transformation between them.

 The difference between the two is that EMV is a maximization rule

while EOL is a minimization rule.

 EOL rule states that the most economically viable alternative is the
one with the most preferred expected regret (EOL value).

 EOL concept is particularly useful in situations where the value of

obtaining perfect information has to be determined.
 Example 5
Rework the data of Example 3 using the EOL criterion. If a decision
maker wants to run detailed seismic survey on the prospect before
choosing one of the options, how much (maximum) should he pay for
the seismic (the cost of this additional information)?

Net Present Value

Outcomes Probability Farmout Retain
Drill with 37.5% WI
State ORI 37.5% Back-in
Dry hole 0.25 -$30,000 $0 $0
20 Mstb 0.30 $4,357 $8,733 $750
35 Mstb 0.25 $45,448 $14,646 $34,142
50 Mstb 0.15 $87,411 $20,693 $73,712
65 Mstb 0.05 $125,863 $26,401 $111,141
 Solution
Outcomes Drill with 37.5% WI Farmout Retain ORI 37.5% Back-in
Probability
State OL EOL OL EOL OL EOL
Dry hole 0.25 $30,000 $7,500 $0 $0 $0 $0
20 Mstb 0.30 $4,376 $1,313 $0 $0 $7,983 $2,395
35 Mstb 0.25 $0 $0 $30,802 $7,701 $11,306 $2,827
50 Mstb 0.15 $0 $0 $66,718 $10,008 $13,699 $2,055
65 Mstb 0.05 $0 $0 $99,462 $4,973 $14,722 $736
1.00 $8,813 $22,681 $8,012

 From the Table, the minimum EOL is for the back-in option. It is
because it minimizes the expected opportunity loss.

 The selection is consistent with the option selected using the EMV
decision rule (as in Example 3).

 The EOL values also represent the cost of uncertainty for each
alternative.
 Active Learning
Closure Reviews Pairs

Goal: To come up with a set of summaries about the major topics

learned in the class session

Task: Recall what you learnt about each subtopics covered in the
lecture ( 5 minutes ) . In pairs, answer the following questions:

- What is the subtopic and why is it important

- What interests you most about the topic

You would be randomly called and asked to explain.

 Active Learning
Closure Reviews Pairs

Subtopics :
 Expected value and Standard Deviation of random variables
 Expected Monetary Value
 Sensitivity Analysis
 Expected Profitability Index
 Performance Index
 Expected Opportunity Loss
 THANK YOU
© 2013 INSTITUTE OF TECHNOLOGY PETRONAS SDN BHD
All rights reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means (electronic,
mechanical, photocopying, recording or otherwise) without the permission of the copyright owner.
 Q&A
Session