600 019 Advanced Petroleum Economics 600.019 Advanced Petroleum Economics

600.
019
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
Staber, September 2011
2011, Vienna
Revised by Stephan Staber, September 2012, Vienna
Leoben, October 2012
WBW, Stephan Staber WS 2012/2013 Page 1
Preface
Th
These llecture
t notes
t can beb seen as a reasonablebl supplement
l t for
f the
th
lecture Advanced Petroleum Economics.
Because of didactic reasons placeholder can be found instead of most
fi
figures in
i these
th lecture
l t notes.
t TheTh figures
fi are presented
t d and
d discussed
di d
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,
N d P.;
P Schuyler,
S h l JJ. (2000):
(2000) Decision
D i i A Analysis
l i ffor P
Petroleum
l
Exploration. Vol. 2nd Edition, Aurora: Planning Press.
The interested student finds the full list used literature at the end of
thi document.
this d t

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
Financial Reporting and Accounting Systems
Basic Probability Theory and Statistics
consult Statistik and Petroleum Economics
Reserves Estimation
consult Reservoir Engineering and Petroleum Economics
Lecture Outline
Cash Flow and Costs

Profitability and Performance Measures
Expected Value Concept
Decision Tree Analysis
Probability Theory
Risk Analysis
Sensitivity Analysis

Setting the scene
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?
What do we mean when talking about E&P projects

projects

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

Cf. Allen and Seba (1993), p. Mian (2002a), p. 86ff.

Capital Expenditure (CAPEX)
one-time
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
Operational Expenditure (OPEX)
occur
occur periodically
are necessary for day-to-day operations
consist typically of:
Utilities
Utiliti
Maintenance of facilities
Overheads
Production costs,
costs e.g.:
eg:
Treatment Costs
Interventions
Secondary recovery costs
p
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.
expl expenses + depreciation)/sales volume [USD/bbl]
Cf. Mian (2002a), p. 126ff.

Types of Cost Estimates
Linked
Li k d tto the
th stage
t off development
d l t
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
R
Result
lt iis a budget
b dg t estimate
ti t
Control Estimate
Actual expenditure is monitored versus the budget estimate
If new information is available, then the development plan is updated
Cf. Mian (2002a), p. 139ff.
Accuracy and Cost Overrun
M i reasons for
Main f Cost
C Overrun
O
Contractor delay
Unforeseen difficulties
New information may change the
project
Fig.
g 2: Accuraccyy of cost estimates
Accuracy improves over time
Major improvement occurs when
the BOD is frozen
Fig. 3: Probability of cost overrun

From Mian (2002a), p. 139ff.

Contingency and Allowance
C ti
Contingency
Budget for the unknown unknowns
Allowances
Budget for the known unknowns
are probable extra costs
E.g.
E g for material,
material identified risks,
risks
foreseeable market or weather
conditions, new technology,
growth
The value is often taken from the
10% probability budget estimate
Fig. 4: One possible statistical view on contingency and allowance
Cf. Mian (2002a), p. 139ff.
Measures of Profitability and Performance

Popular Criteria
Three
Th which
hi h ignore
ig time-value
ti l off money:
Net Profit
Payout
ayout (PO)
( O)
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.
Prospect Cashflow Example

This example helps to understand the measures of profitability (Taxation
is excluded from this analysis for simplicity)
Investment: $268,600 ffor completed

$ l d well;
ll Year EEstimated
i d oil
il Annuall Net FFuture Net Cash
C h
$200,000 for dry hole Production, Revenue* Expenditures Flow
Bbls
Estimated recoverable 234,000 Bbls; 234 MMcf gas
reserves: 1 54,750 $132,900 $132,900
Estimated average 150 BOPD 2 54 750
54,750 132 900
132,900 132 900
132,900
producing rate during first
two years: 3 44,600 107,600 10,000 97,600
Future Expenditures: Pumping Unit in year 3, 4 29,200 69,200 69,200

$10,000; Workover in year 5, 5 18,900 43,500 20,000 23,500
$20 000
$20,000
6 12,900 28,600 28,600
Working interest in 100%
proposed well: 7 7,800 15,900 15,900
Average investment 10% 8 5,200 9,400 9,400

opportunity rate: 9 3,700 5,600 5,600
Type of discounting: Mid-project-year 10 2,200 1,900 1,900
234,000 $547,500 $30,000 $517,500
*Annual Net Revenue =

From Newendorp, Schuyler (2000), p. 14f. Annual Gross Revenue Royalties Taxes Operating expenses

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.
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
p
payout time.
Fig. 5: Cash position curve

Prospect Cashflow Example
Unrecovered
U d portion
i off the
h initial
i i i l investment:
i
$268,600 $132,900 = $135,700
Unrecovered portion of the investment at the end of year 2:
$135,700 $132,900 = $2,800
Assuming g constant cashflow rates the p
portion of year
y 3 required
q to
recover this remaining balance:
$2,800 / $97,600 = 0.029
Payout time:
2.029
Payout (PO) 2/2

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

Return on Investment (ROI)
Reflects total profitability!

ROI
NCF
Sometimes called: Investment
( di
(undiscounted)
d) profit-to-investment
fi i ratio
i
Strengths:
Recognizes a profit in relation to the size of investment
Simple
Weaknesses:
W k
Accounting inconsistencies
Contin ing in
Continuing investment
estment is not represented properl
properly
Project ROI cannot be weighted: (n x average ROI total ROI)
Return on Investment (ROI) - Variations

1. Using maximum
maximum out-of-
out of
pocket cash instead of
investment
2 Return
2. R on Assets
A (ROA):
(ROA) Fig 12:
Fig. 12 M
Maximum
i out-of-pocket
t f k t cash
h
AverageNetIncome
ROA
AverageBookInvestment
Prospect Cash Flow Example:

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

Net Present Value
M
Money received
i d sooner is
i more worthth than
th money received
i d
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

PV
FV Future Value
i Interest or discount rate
t Time in years
(1+i)-t Discount factor
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
2. W i ht d costt off capital
it l (WACC)
The marginal cost of funding the next project. This is calculated as
an weighted-average
weighted average cost of a mixture of equity and debt.
debt

Net Present Value
Ye Net cashflow Discount 10% discounted

ar 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
Fig. 14: e.g. profitable, but neg. NPV
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%
Fig. 15: Major weakness of NPV

(Internal) Rate of Return (IRR)
Sometimes: Year Net Di

Discount 40% discounted
di d
cashflow factor 40% cashflow
Discounted rate of return 0 -$268,600 1.000 -$268,600
1 +$132,90
, 0.845 +$112,300
,
Internal yield 0
Sometimes: Profitability index 2 +$132,90 0.604 +$80,300

0
((PI)) 3 +$97 600
+$97,600 0 431
0.431 +$42 100
+$42,100
IRR is the discount rate 4 +$69,200 0.308 +$21,300

5 +$23,500 0.220 +$5,200
such that the NPV is zero 6 +$28,600 0.157 +$4,500
7 +$15,900 0.112 +$1,800
Prospect Cash Flow 8 +$9,400 0.080 +$700
p (trail-and-error
Example: ( 9 +$5,600 0.057 +$300
10 +$1,900 0.041 +$100
procedure) $0
IRR = 40%

Sometimes:
Discounted profit to investment ratio (DPR, DPI, or
DPIR)
Present value index (PVI)
Sometimes: Profatibility Index (PI)
NPV
DROI is the ratio obtained by dividing the DROI
PV _ of _ Investment
NPV by the present value of the investment
DROI = $148,400 / 268,600 = 0.553
Strengths:
S h
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
B t there
th r are
r a couple
l off considerations
id r ti around
r d that
th t might
ight optimize
ti i
ones portfolio:
Synergies
Fractional participation
Strategic and option values
Game-theoretical thoughts
g

Appreciation of Equity Rate of Return
Also: Growth
Al G th rate
t off return
t
Idea:
Reflectingg the overall net earningg p
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
Appreciation of Equity Rate of Return

Prospect Cash Flow Example using the Baldwin Method:
Year Net cashflow Number of years Compound interest Appreciated value of net
reinvested factor, 10% cashfliws as of end of project
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
$23 500 55
5.5 1 689
1.689 +$39,700
$39 700
6 +$28,600 4.5 1.536 +$43,900
7 +$15,900 3.5 1.397 +$22,200
8 +$9 400
+$9,400 25
2.5 1 269
1.269 +$11 900
+$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
0 1495

Net Present Value Profile Curve
NPV and rate of return not necessarily prefer the

same ranking!
Fig. 16: Net Present Value Profile Curve

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

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 Accelerated Incremental Discount factor, Discounted incremental
cashflow cashflow cashflow 10% cashflows, 10%
0 0 -$50
$ 0 -$50
$ 0 1.000
000 -$50.00
$ 0 00
1 +$300 +$500 +$200 0.953 +$190.60
2 +$200 +$400 +$200 0.867 +$173.40
3 +$200 0 -$200
$200 0 788
0.788 -$157.60
$157 60
4 +$100 0 -$100 0.716 -$71.60
5 +$100 0 -$100 0.651 -$65.10
+$19 70
+$19.70
Multiple choice review questions
Past costs which

P hi h have
h already
l d been
b incurred
i d and
d cannot be
b recovered
d are
called
O CAPEX.
O OPEX.
O Abandonment
Ab d t costs.
t
O Sunk costs.

Th expected
The d return fforgone by
b bypassing
b i off other
h potential
i l investment
i
projects for a given capital is called
O weighted average cost of capital (WACC).
O opportunity cost of capital.
O profit.
fit
O half-life.
Th llength
The h off time
i which
hi h elapses
l untilil the
h account is
i balanced
b l d off e.g. a
development project is called
O maximum-out-of-pocket-cash.
O net present value.
O return
t on investment.
i t t
O payout.
p y

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

Risk and Uncertainty
Risk:
Ri k
Addresses discrete events (e.g. discovery or dry hole)
Can be bot
Ca both: A tthreat
eat or
o an
a opportunity
oppo tu ty
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
Cf. Newendorp, Schuyler (2000), p. 71ff and Laux (2003), p. 105.
Definitions and EVC

Expected
p 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
Conditional
In this context conditional means that a value will be received
only if a particular outcome occurs.
Often it is omitted!
Simple Example:
EV Cost of Stuck Pipe = P(Stuck Pipe) * (Cost to remedy Stuck
Pipe)
More generally: EMV P(outcome _ i) NPV
all _ i
Outcome _ i

EMV Example
Situation in a drilling prospect evaluation:
Probability of a successful well 0.6
06
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
O t
Outcome Probability
P b bilit Conditional
C diti l EExpected
t d Conditiona
C diti EExpected
t d
outcome monetary monetary l monetary monetary
will occur value value value value
Dry hole 0.4 -$200,000 -$80,000 0 0
Producer 0.6 +$600,000 +$360,00 +$50,000 +$30,000
0
+$280,00 +$30,000 Fig. 20: Cumulative result for drill decisions
0
=EMV (drill) =EMV (farm out)
EMV Decision Rule:
When choosing among several mutually exclusive decision alternatives,
select
l t the
th alternative
lt ti having
h i g th
the greatest
g t t EMV.
EMV
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,
p
therefore expected monetaryy value
The EMV does not necessarily have to be a possible
outcome

Risked DROI
EMV
Risked _ DROI
EV ( PV _ of _ Investment )
NPV
Cf. DROI
PV _ of _ Investment
Reasonable under limited capital constraints
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 Dont Drill
Possible Probabilit Outcome Expected Outcome Expecte
Outcome y outcome monetar d
will occur y value monetar
y value
Dry hole 0.7 -$50,000 -$35,000 0 0
2 Bcf 0.2 +$100,0 -$20,000 0 0
00
Fig. 21: Simple decision tree (partially completed)
5 Bcf 0.1 +$250,0 -$25,000
$25,000 0 0
00
1.0 EMV = +$10,000 EMV = $0
There is no scale to decision trees

Decision Tree Symbols
There exist two different nodes (forks)

Decision node (or activity node) - squares
C
Chance node (or event node) - circles
Terminal nodes (last chance node of a branch)
Fig. 22: Simple decision tree (partially completed with correct symbols)

Decision Tree Completion
Associate probabilities to all chance nodes

Place the outcome value to all branch ends
Fi 23
Fig. 23: Si
Simple
l ddecision
i i ttree ((completed)
l t d)
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
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)

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

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
straight-forward
forward an easy to use

Probability Theory
Concept of Probability
Probabilit Theory
Probability Theor enables a person to make an educated
ed cated guess
g ess
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)
P b bilit off occurrence off an event:
Probability t P(A)=m/n
P(A) /
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)=limn (m/n)
Subjective Probability
Based on impressions
p of individuals
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
2
2. E t are partly
Events tl overlapping:
l i
P(AB)=P(A)+P(B)-P(AB)
P(AB)=P(A)+P(B)-P(AB) (=P(AB)) Fig. 40: Vann diagram showing of partly overlapping
events
Multiplication Rule:
For consecutive trails
Independent events:
P(AB)=P(A)
( ) ( ) x P(B)
( )
Dependent events:
P(AB)=P(A) x P(B|A)
Cf. Mian (2002b), p. 84ff. and

http://cnx.org/content/m38378/latest/?collection=col11326/latest
Fig. 41: Vann diagram showing union two events
Example Addition
Addition Rules
Rules
Assume 50 wells
A ll have
h been
b drilled
d ill d in
i an area with
i h blanket
bl k sands.d The
Th
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 p
productive in Zone B only,
y,
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(B)=n(B) - n(AB)=11 - 4=7
3. n(AB)= n(A) + n(B) - n(AB)=8+11 - 4=15 Fig. 42: Vann diagram for example Addition Rules
4. n(S) - n(AB)=50 - 15=35
Cf. Mian (2002b), p. 84ff.

Example Multiplication
Multiplication Rules
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.
discoveries
The leases have equal chances of success. If drilling of
one well is p
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
) 3/10
P(W2|W1)=2/9
P(W1W2))= 3/10 x 2/92/9=66,67%
67%
Cf. Mian (2002b), p. 84ff.
Bayes Rule
Bayes
Bayesian analysis addresses the probability of an earlier
event conditioned on the occurrence of a later event
PB Ai P Ai
P Ai B
PB A P A
k
i i
i 1
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.

Theoretical Example Bayes
Bayes Rule
Rule
One box contains 3 ggreen and 2 red ppencils. 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,
up then a pencil is drawn from the second.
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
3 1 Fig. 43: Probability tree for the theoretical example

PG Bi PBi
B
Bayes RRule
l
6
PBi G k 5 3 54,55%
3 1 1 2 11
PG Bi PBi
i 1 5 3 4 3
Cf. Mian (2002b), p. 84ff.
Offshore Concession Example Bayes

Bayes Rule
Rule
W
We h have made
d a geological
g l gi l and d engineering
gi i g analysis
l i off a
new offshore concession containing 12 seismic anomalies
q
all about equal size. We are uncertain about how manyy 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 veryy little information we have,, we judge
j g
that E2 is twice as probable as E1.
Then we drill a wildcat and it turns out to be a dry hole.
Th question
The i is:
i How
H can thishi new iinformation
f i beb used d to
revise our initial judgement of the likelihood of the
ypot es ed state o
hypothesized of nature?
atu e

Offshore Concession Example Bayes
Bayes Rule
Rule
Fig. 44: Solution of the offshore concession example
Probability Distributions
St h ti or random
Stochastic d variable:
i bl
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
Cf. Mian (2002b), p. 99ff.

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

Multinomial Distributions
Applicable if an event has more than two possible
outcomes
N!
Equations: P S P1k1 P2k 2 ...Pmk m
k1!k 2 !...
! km!
Where,
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.

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),
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
b off wells
ll giving
i i reserves off zero
k2=number of wells giving reserves of 12 MMBbls
k3=number of wells giving reserves of 18 MMBbls
N! 3! 3 2 1
P S P1k1 P2k 2 P3k3 0.52 0.351 0.150 0.25 0.35 1 0.263
k1!k 2 !k3! 2!1!0! 2 1 1 1
Corresponding reserves=2x0+1x12+0x18=12MMbbls
Expected reserves=0.263x12MMBbls=3.15MMBbls
Cf. Mian (2002b), p. 99ff.
Multinomial Distributions - Example 2/2
Probabilit
Probability Reser es
Reserves Probabilit
Probability E p Reserves
Exp. Reser es
K1 k2 k3 P(S) [MMBbls] Of Reserves [MMBbls]
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
0.184 24 0 00
0.500 4 410
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
Cf. Mian (2002b), p. 99ff.

Hypergeometric Distributions
Application in statistical sampling, if trails are
dependent and selected
selected, is from a finite
population without replacement
C N C
Equation:
x n x
P x
N

n
Where,
Where
N=number of items in the population
C=number of total successes in the population
n=number
n number of trails (size of the sample)
x=number of successes observed in the sample
Example:
A company
p y has 10 exploration
p p
prospects,
p , 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
Hypergeometric distribution
distribution
example
Cf. Mian (2002b), p. 99ff.
Poisson Distributions
Good for representing a particular event over time or space
x
Equation:
Px e
Where, x !

=average numberb off occurrence per iinterval
t l off time
ti 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 p
pipeline
p averages
g 5 leaks pper 1000 miles,, what is the pprobabilityy of havingg no leaks
in the first 100 miles?
Fig. 47: Solutions of the Poisson distribution examples
Cf. Mian (2002b), p. 99ff.

Normal Distributions
Linear systems, like NCF, approximate a normal distribution, regardless of the
shape of subordinate variables like OPEX, CAPEX, taxes, etc
2
1 x
1
Probability density function: f x e 2
Where, 2
=mean
=standard deviation
E
Example:
l
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%.
Solution:
By means of the standard normal derivate
(Z) and probability tables
X
Z Fig. 48: Solutions of the Normal distribution example

Cf. Campbell et al. (2007) p. 218ff and Mian (2002b), p. 99ff.
Lognormal Distributions
The occurrence off oilil and

Th d gas reserves is
i approximately
i l
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


Uniform Distributions
Equal probability between a minimum and a maximum
1
f x
xmax xmin
1
f x
xmax xmin
Fig 50: Probability density function and cumulative distribution function of a uniform distribution
Fig.
Triangular Distributions
Used if an upper limit, a lower limit, and a
most likely value can be specified
Equation:
XX 2
X mod X min
min
, X min X X mod
X X min X max X min
F x mod 2
X max X X max X mod
1 X X X X , X mod X X max
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 b
by a bit will
ill be 130 feet,
feet and the
footage which is drilled follows triangular distribution.
What is the probability that the bit fails within 110
feet?
Solution: Fig. 51: Probability density function and
Xmin=100; Xmod=130; Xmax=200; X=110 cumulative distribution function of a triangular
distribution
2 2
X X min X X min 110 100 130 100
F x mod 0.033 3.33%
X mod X min X max X min 130 100 200 100
Tests of Goodness of Fit
With these
th ttests
t one can analyse
l whether
h th a sample
l emanates
t ffrom
a certain population or not.
Chi-squared-Test
For continuous and discrete data
Need to define bins
Kolmogoroff-Smirnow-Test
For continuous
No need to define bins
Anderson-Darling-Test
For continuous
Root-Mean-Square-Error
For continuous and discrete data
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.
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
Th ability
The bilit to
t influence
i fl andd manageg risk
i k is
i higher
high th
the earlier
li ididentified
tifi d
Risk management supports the achievement of the projects objectives
The project manager 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
Qualitative Risk Analysis
Risk management is understood as

Identifying potential project threats,
Reducing the probability that negative events occur (prevention), and
Mi i i i g th
Minimizing the iimpactt off th
the occurrence off negative
g ti events
t ((mitigation).
itig ti )
The process:
Id
en
g
Policy
rin
t if
ic
it o
at
on
io
n
M
Standards
Re
t
en
Pla spon
m
nn se
ss
ing
se
As

Bow-Tie Diagram
Fig. 51a: Bow

Bow-Tie
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.
Risk Matrix (for projects)

Probability
y
Has occured Occurs

Never heard of in Heard of in E&P Has occured in
several times in frequently in
E&P industry industry company
company company
A B C D E
Cost Schedule Scope Improbable Unlikely Seldom Probable Frequent
Total change in project

> 6 months
>= EUR 10 mn
delay
scope or leading to 1 Catastrophic
desastrous quality
Major change in
>= EUR 2 mn 2 - 6 months project scope or
up to < 10 mn delay leading to bad project
2 Major High
quality
ce
Moderate change in
Consequenc
>= EUR 100.000 2 week - 2 month project scope or

up to < 2 mn delay leading to inferior
3 Moderate Medium
quality
Minor change in
>= EUR 10.000 2 days - 2 weeks project scope or
up to < 100.000 delay leading to inferior
4 Minor Low
quality
Marginal change in
< 2 days
< EUR 10.000
delay
project scope and 5 Slight
quality
No consequence No consequence No consequence
Fig. 51b: Bow-Tie Diagram

Judging Probability of Recovery
What iis the

Wh h wildcat
ild success ratio?
i ?
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.
Three Level Estimation of Risk
Is used instead of two discrete levels:

levels
Dry hole
Average discovery
The three levels are:

LLow
Medium
High

Monte Carlo Simulation
Numerical procedure
Random numbers provide computer-aided an artificial
sample
l
Pioneers:
Earl George Buffon
John von Neumann
Software p
packages
g in use:
@Risk
Cristal Ball
Monte Carlo Process Input Data
Workflow:
Workflow Sampling of Input
Data via Probability
Distributions
Define variables
Develop the deterministic projection model Computing
Outputs
(e.g.: NPV)
Sort the input variables in two groups
Define distributions for random numbers no
i=n?
Perform the simulation trails
yyes
Calculate EMV and preparing graphical Evaluation of
displays 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 Result Interpretation
probability distributions for output variables. and Decision
Cf. Zettl (2000), p. 43 and Newendorp, Schuyler (2000), p. 397ff.

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
Sampling
Monte Carlo Sampling
Fig. 52: Monte Carlo Sampling
Latin Hypercube Sampling
Fig. 53: Latin Hypercube Sampling
WBW, Stephan Staber Cf. Newendorp, Schuyler (2000), p. 397ff.WS 2012/2013 Page 82
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
Main Fields of Application
Risked Costs
Risked Economics
Risked Schedule

Selected Measures of Risk
Risk Adjusted
j Capital
p (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
i confidence)
fid )
Return on Risk Adjusted Capital (RORAC)
Relation between expected profit (e.g. mean) and the maximum amount of money that can be
lost (with a certain confidence)
Fig. 59: Selected Measures of Risk
Different definition in literature!

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

Sensitivity Analyses
Sensitivity Analysis
A way to handle uncertainty

Demonstrates the significance of uncertain elements
in economic evaluations
Typical
yp items for sensitivityy analysis:
y
Investment
Operating costs
Reserve size
Production rates
Prices
etc.
Cf. Allen, Seba (1993), p. 213.

Deterministic Sensitivity Analysis
Where the
Wh th range off outcome
t iis
known but not the probability
p parameters
Input p in an
economic model are changed
over a certain range
Y-axis
Y axis represents an economic
yardstick
X-axis represents the fractional
change of the input parameters
Does not depict interrelations
between
bet ee input
put pa
parameters
a ete s
Fig. 60: Spider Diagram
Cf. Allen, Seba (1993), p. 213ff.
Probabilistic Sensitivity Analysis
The iinput parameters off

Th
an economic valuation
model have probability
distribution
Correlation- or Regression-
Coefficients of every input Fig 61
Fig. 61: C
Correlation
l ti didiagram
g
parameter and the output

are calculated
Visualisation is normally
done in a tornado diagram
Does depict interrelations
between input parameters
Fig. 62: Tornado Diagram

Literature
Allen F.H.;
Allen, F H ; Seba,
Seba R R. (1993): Economics of Worldwide Petroleum Production
Production, Tulsa: OGCI Publications.
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. g
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.
Johnston, D (2003): International Exploration Economics,
Economics Risk
Risk, and Contract Analysis
Analysis, Tulsa: Pann Well.
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. y Leoben: Montanuniversitt Leoben,, Dissertation.

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Originaly prepared by Stephan Staber, 2007, Leoben

Leoben, October 2012

WBW, Stephan Staber WS 2012/2013 Page 1

WBW, Stephan Staber WS 2012/2013 Page 2

The content of teaching is based on your knowledge gained

WBW, Stephan Staber WS 2012/2013 Page 3

Cash Flow and Costs

WBW, Stephan Staber WS 2012/2013 Page 4

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

What are potential decision criteria/ decision influencing factors

What do we mean when talking about E&P projects

WBW, Stephan Staber WS 2012/2013 Page 6

WBW, Stephan Staber WS 2012/2013 Page 7

Cash Flow and Costs

Net Cash Flow=

Fig. 1: Cash Flow Projection

WBW, Stephan Staber WS 2012/2013 Page 8

Operational Expenditure (OPEX)

WBW, Stephan Staber WS 2012/2013 Page 10

Accuracy and Cost Overrun

Fig. 3: Probability of cost overrun

WBW, Stephan Staber WS 2012/2013 Page 12

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

Cf. Mian (2002a), p. 139ff.

WBW, Stephan Staber WS 2012/2013 Page 13

Measures of Profitability and Performance

WBW, Stephan Staber WS 2012/2013 Page 14

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

WBW, Stephan Staber WS 2012/2013 Page 15

Prospect Cashflow Example

Investment: $268,600 ffor completed

Future Expenditures: Pumping Unit in year 3, 4 29,200 69,200 69,200

Average investment 10% 8 5,200 9,400 9,400

*Annual Net Revenue =

WBW, Stephan Staber WS 2012/2013 Page 16

Net Profit=Revenues Costs = Cash Receipts Cash

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

WBW, Stephan Staber WS 2012/2013 Page 17

Payout (PO) 1/2

The length of time which elapses until the account balance

All other factors equal a

WBW, Stephan Staber WS 2012/2013 Page 18

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

WBW, Stephan Staber WS 2012/2013 Page 19

Payout (PO) 2/2

Fig. 9: Variation 1 Fig. 10: Variation 2 Fig. 11: Variation 3

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

Reflects total profitability!

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

WBW, Stephan Staber WS 2012/2013 Page 21

Return on Investment (ROI) - Variations

Prospect Cash Flow Example:

WBW, Stephan Staber WS 2012/2013 Page 22

PV Present Value of future cashflows

WBW, Stephan Staber WS 2012/2013 Page 23

Two philosophies what this rate should be:

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

WBW, Stephan Staber WS 2012/2013 Page 24

Prospect Cash Flow Example:

Ye Net cashflow Discount 10% discounted

Fig. 15: Major weakness of NPV

WBW, Stephan Staber WS 2012/2013 Page 25