Exploration Economics

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14 Exploration Economics
Petroleum Economics (Universiti Teknologi Malaysia)
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EXPLORATION ECONOMICS
by
Dr. Muhammad A.Manan
Department of Petroleum Engineering
Universiti Teknologi Malaysia
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RISK / UNCERTAINTY
What is the Cause of Risk and Uncertainty?

 At the time of analysis we are not able to measure exact values
of all the factors which affect profitability:
• Hydrocarbon generation
• Hydrocarbon migration
• Finding trap/structure
• Existence of seal
• Existence of reservoir
• Oil/gas reserves
• Net pay thickness, porosity
• Recovery factor, well productivity
• Drilling costs
• Future crude prices, platform costs
• Etc., etc.
 Result is that determining the value of a drilling prospect is a

probabilistic calculation, rather than a deterministic calculation.
 We cannot predict the exact outcome of the prospect because
we can’t measure exact values of all the factors in the net cash
flow tables.
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RISK / UNCERTAINTY
What are the Options for Treating Risk and Uncertainty?
 Use standard financial criteria plus sensitivity analysis.

 Use adjective to communicate information about risk to
management (the prospect is high risk, low risk, a sure thing, a
long shot, etc.).
 Use higher discounting rate in DCF calculations for net cash
flow associated with a discovery.
 Use “risk analysis” where we are quantifying risk with
probabilities. Procedure then would be to calculate “weighted-
average profitability” or the Expected Monetary Value (EMV) of
the prospect.
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PROBABILITY
Background
 Probability theory deals with the events of a special kind called

random events. There are events for which the outcome is
determined by chance.
 The most important use of probabilities for our purpose is in
terms of factor that governs rational behavior when money is
involved in chance situations. Probabilities are used in
determining the odds of success or failure.
 There two fundamental rules of probability which are important
and useful for our present purposes: The Addition Rule and
The Multiplication Rule.
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PROBABILITY
Background
 The Addition Rule: this rule states that probability that one or
another of two or more mutually exclusive events will occur is
the sum of their separate probabilities. The sum of the
probabilities of all events equal to unity, and that probabilities
must lie between zero and unity.
P(1)  P(2)  P(3)  1, 0  P(X)  1
 Another rule
฀ states that, face with two possible (non-mutually
exclusive) events, the probabilities that one or the other or both
(at least one) of them will happen is equal to the sum of the
probabilities that each will happen diminished by the
probability that both will happen.
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PROBABILITY
Background
 The Multiplication Rule: this rule states that if, of two events,
the one has no conceivable relationship with or influence on
the other, then the two events are considered to be
independent events and the probability of them both occurring
together is the product of their respective probabilities.
 Example:
P(discovery)  P(source) x P(structure) x P(seal) x P(reservoir)
฀
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PROBABILITY
Obtaining Probabilities
 Industry statistics: to examine past experience (data, statistics
date, etc.) with similar or analogous events.
 Personal probabilities: geologist to incorporate all information
about past success rations, direct evidence of the particular
prospect, his experience and his judgment when he makes the
probability assignments. They are only statements of degrees
or belief in a particular venture, but not statements of relative
frequencies of what could happen.
 Binomial expansion: this expansion is useful for generating in
situations where only one of two possible events can occur for
each trial, such as success or failure in drilling an exploratory
well. Equation of binomial probability distribution:
Binomial probability of x "successes" in n trials
 
 Cnx P 1 P
x nx
where C 
n n!
, 0! 1, and n! 1x2x3x...xn
x!n  x!
x
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PROBABILITY
Obtaining Probabilities
 For example, the binomial expansion could be used to
calculate the probabilities for various outcomes associated
with drilling five wildcat wells in an area where the success
ratio is estimated to be one in four.
1 in 4 success ratio
Possible Outcomes of Probability
Drilling 5 Wildcats
5 Dry holes 0.23730
4 Dry, 1 Producer 0.39550
3 Dry, 2 Producers 0.26367
5 Producers 0.00098
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DECESION TREE
ANALYSIS
by
Dr. Muhammad A.Manan
Department of Petroleum Engineering
Universiti Teknologi Malaysia
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Background
 Normally decision is made or occurred at time zero.

 However there are some complicated decision strategies
in which later, contingent or sequential decision points
after initial time-zero decision.
 The initial decision is just a link in a chain of future
decision options and contingencies.
 These more complex decisions require an approach of
“Decision Tree Analysis” for computing expected value.
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Definition
 A decision tree is a pictorial representation of a sequence of events and
possible outcomes.
 No scale of the length line and no meaning of the angle between lines.
 The tree normally reads from left to right.
 Point from which two or more branches emanate is called a node. The node
could be a decision note or a chance node. A decision tree can have two or
more decision nodes in sequence, and it can have two or more chance
nodes in sequence.
 Assign probabilities to all branches radiating from chance node and
specify conditional value received (usually monetary profits or losses) at
endpoints of tree. The endpoints are called terminal points.
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Solving a Decision Tree
① We start at terminal points and work backward towards the time-

zero decision.
② When we reach a chance node we make an EMV calculation at that

point and place the EMV number above the chance node.
③ When we reach a decision node we select the decision which

maximizes EMV, cross off all the other choices, and place the EMV
corresponding to the selection made above the decision node.
④ Process is continued, moving backwards step-by-step, until initial

decision node is reached.
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Advantages of Decision Tree Analysis

 All contingencies, sequential management choices are
defined and considered.
 The entire set of options has been analyzed and planned

before the initial decision is made.
 Entire sequential course of action is set out before the initial

decision.
 For every complex decisions the exercise of just drawing the

tree will force us to think about the prospect in more detail
than earlier, less formal method of analyses.
 It’s the only way we can compute expected values if there are
management options beyond time-zero.
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Example
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EXPECTED VALUE
CRITERIA
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Explorationist Has to Supply

These Information
 The possible outcomes of their activities – could be in the form

of the possible field sizes, possible levels of ultimate
profitability, dry hole or a discovery, different levels of reserves
each with two or three assumptions about future economic
condition, etc.
 Their relative likelihoods of occurrence – likelihood of
occurrence are probability numbers between zero to 1.0.
 The financial profit or loss associated with each outcome –
normally be an after-tax NPV, discounted at corporation’s time-
value of money.
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EMV Calculated Using a Four-

Column Table
 Numbers in Column 4 are called the expected value of the

outcomes.
 Algebraic sum of Column 4 product terms is called the expected
value of the decision alternative. If column 3 values are in units of
money than sum of Column 4 will be the expected monetary value
of the decision strategy, or the EMV of the prospect. 18
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Decision-Making Rule of EMV
 If EMV greater than or equal to zero, accept the project.
 If EMV less than zero, reject the project.
 When selecting investments from among mutually exclusive

alternatives select the alternative(s) which maximizes
positive EMV.
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What Does EMV Mean?
 EMV represents the average gain per decision that the

corporation would realize over a series of repeated trials.
 If positive EMV is always maximized, and if the corporation

participates in many corporate decisions (prospects) it can
be shown that the firm will have, as a result, more money in
the long term than any other strategy for selecting and
screening decision under uncertainty.
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Applying EMV to Prospect Analyses
 Any number of outcomes can be considered. Only proviso is

that sum of probabilities of occurrence must add to 1.0.
 Any number of decision alternative can be evaluated and

compared.
 Option in expressing conditional values received.:

• Monetary profits and losses (after-tax basis)
• Undiscounted or discounted NPV at io.
• Costs / Expenditures
• Opportunity losses, preference vales
• Conditional expected values
• Quantity of reserves
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Applying EMV to Prospect Analyses

 If operating under a limited capital constraint use this ratio:
Expected Monetary Value Profits (EMV)
Expected Investment
 Decision rule is to take the alternative which has highest EMV

฀ Investment ratio.
/ Expected
 Prepare the sensitivity graph of EMV versus Probability of
hydrocarbons present in prospect.
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Advantages of EMV
 Take explicit account of geological and economic risk.
 Considers all possible outcomes, even up to the limiting case
of the continuum of possible field sizes.
 Uses a decision theory concept which has been proven
correct by other industries.
 Is part of a decision-making strategy which, if followed
consistently, will guarantee that the corporation’s long term
wealth will be maximized.
 Input is still geologic / geophysical / engineering / economic
studies.
 Can evaluate extremely complex decision strategies using
decision tree analysis and EMV concepts.
 Probability numbers are a clear, unambiguous way of
communicating information about risk.
 Allow a consistent management policy for decision making
when authority is delegated to various levels in the
corporation.
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Application’s Problem of EMV

 The EMV number itself is a difficult thing to grasp for some
people.
 We can’t try it a few times to see if it works.
 It is difficult to quantify exploration and long-term economic
risks.
 The concept demands repeated trial to work.
 It is difficult for explorationists to treat their prospect as just
“one of many”.
 It is sometimes hard to quantify one’s feeling about a
prospect – the “feel for the deal”, the instincts some have for
finding oil.
 Effective use of the expected value concept requires that the
entire management chain-of-command accept EMV.
 There may be other issues which will override the indicated
EMV choice, such as asset position. Risk preferences of the
corporation, and goals.
 Can EMV be used as basis for decision making for larger,
“one-in-a-lifetime” investment opportunities?
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lOMoARcPSD|3729105

Petroleum Economics (Universiti Teknologi Malaysia)

Studocu is not sponsored or endorsed by any college or university

What is the Cause of Risk and Uncertainty?

 Result is that determining the value of a drilling prospect is a

What are the Options for Treating Risk and Uncertainty?

 Use standard financial criteria plus sensitivity analysis.

 Probability theory deals with the events of a special kind called

P(1)  P(2)  P(3)  1, 0  P(X)  1

P(discovery)  P(source) x P(structure) x P(seal) x P(reservoir)

 Normally decision is made or occurred at time zero.

Solving a Decision Tree

① We start at terminal points and work backward towards the time-

② When we reach a chance node we make an EMV calculation at that

③ When we reach a decision node we select the decision which

④ Process is continued, moving backwards step-by-step, until initial

Advantages of Decision Tree Analysis

 The entire set of options has been analyzed and planned

 Entire sequential course of action is set out before the initial

 For every complex decisions the exercise of just drawing the

Explorationist Has to Supply

 The possible outcomes of their activities – could be in the form

EMV Calculated Using a Four-

 Numbers in Column 4 are called the expected value of the

Decision-Making Rule of EMV

 If EMV greater than or equal to zero, accept the project.

 If EMV less than zero, reject the project.

 When selecting investments from among mutually exclusive

What Does EMV Mean?

 EMV represents the average gain per decision that the

 If positive EMV is always maximized, and if the corporation

Applying EMV to Prospect Analyses

 Any number of outcomes can be considered. Only proviso is

 Any number of decision alternative can be evaluated and

 Option in expressing conditional values received.:

Applying EMV to Prospect Analyses

 Decision rule is to take the alternative which has highest EMV

Application’s Problem of EMV

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