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• Sensitivity Analysis

• Expected Monetary Value


• Decision Tree
• Monte Carlo Simulation
Expected Monetary Value
• EMV is defined as the mean of the probability
distribution of all possible monetary outcomes
• EMV is a weighted average of the possible
monetary values (usually NPV), weighted by
their respective probabilities
• 𝐸𝑀𝑉 = 𝐸 𝑁𝑃𝑉 = σ𝑛𝑖=1 𝑁𝑃𝑉𝑖 × 𝑃(𝑁𝑃𝑉𝑖 )
EMV Structural Element
• Acts or strategies, Aj. These are the various available alternatives (drill, don’t
drill, farm out, etc.)
• Outcome states, Si. The different situation that may prevail and affect the
consequences of Aj. Drilling a well is our control, but whether it will be a
producer od dry hole is an uncontrollable variable/outcomes
• Consequences or payoffs, Cij. These are the gains, rewards, losses, etc.,
associated with j-th act that results in i-th outcomes state
• Outcome state probabilities, P(Si). These are the probabilities assigned to
the outcome states
• Criterion. This is the basis used by decision maker to choose the appropriate
course of action that is best action
Outcome Probability Act A1 Act A2
State Value of A1 E{A1} Value of A2 E{A2}
S1 P(S1) C11 P(S1) C11 C12 P(S1) C12
S2 P(S2) C21 P(S2) C21 C22 P(S2) C22
: : : : : :
Sx P(Sx) Cx1 P(Sx) Cx1 Cx2 P(Sx) Cx2
EV1=∑E{A1} EV2=∑E{A2}
Example-1
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 a dry hole with result in a net loss of
$250,000. If the well is successful, then the NPV of the future
streams of net cash flow (NCF) will be $500,000. Instead of
drilling the well, the prospect can be farmed out (i.e., no
exposure to any costs) and retain an overriding royalty interest in
the well. The NPV of farmout is estimated at $50,000, the
amount received in the form of royalty. Is it economically better
to drill the or farm it out?
Decision Tree
• Decision trees can be used to assist in
reaching a decision to maximize the EMV by
tracking alternative outcomes of any decision
and comparing the likely returns of those
alternatives while minimizing the risk
involved
Example-2
A company has to decide whether to drill a certain prospect. If it
drills the prospect, geologist and engineers expect the following:
– Probability of dry hole (zero reserves) is 60%
– Probability of 60,000 bbls is 30%
– Probability of 90,000 bbls is 10%
The NPV for each option are -$65,000, $120,000, and $180,000,
respectively. Determined the optimum course of action the
company should take in order to maximizing the EMV
Example-3
A company is planning to drill a well. Geologist and engineers
estimate that there is a 65% chance that the well will be a
producer and a 35% chance that it will be a dry hole. If the well is
successful, it is estimated that there is a 60% chance that it will
have reserves of 30,000 bbls, a 30% chance of 60,000 bbls, and a
10% chance of 90,000 bbls. The dry hole cost is $65,000 and the
NPV corresponding to each reserves value is $60,000, $120,000,
or $180,000, respectively. Using a decision tree, calculate the
expected monetary value (EMV) for this proposal
A
0.60 x $ 60,000 = $36,000
0.30 x $120,000 = $36,000
0.10 x $180,000 = $18,000 NPV’s
$90,000
0.65 x $90,000 = $58,500 30 MStb
$60,000
0.60

EMV = $58,500 + -$22,750 Producer 60 MStb


= $35,750 C1 C2 $120,000
0.65 0.30

Drill
90 MStb
$180,000
0.10
D 0.35 x -$65,000
= -$22,750
Dry hole
-$65,000
0.35

Don’t Drill
$0

Note that the probability of the chance node C2 are


conditional probabilities, conditional upon countering
a producer with a probability of 65%
B
0.65 x 0.60 x $ 60,000 = $23,400
0.65 x 0.30 x $120,000 = $23,400
0.65 x 0.10 x $180,000 = $11,700 NPV’s
$58,500
30 MStb
$60,000
0.60

EMV = $58,500 + -$22,750 Producer 60 MStb


= $35,750 C1 C2 $120,000
0.65 0.30

Drill
90 MStb
$180,000
0.10
D 0.35 x -$65,000
= -$22,750
Dry hole
-$65,000
0.35

Don’t Drill
$0

• Joint Probabilities C2: Multiplying the simple probability of


chance node C1 by the conditional probabilities of each
branch of the chance node
• Combining the chance nodes can collapse the node
C

NPV’s EMV’s
30 MStb
0.39 x $60,000 = $23,400
0.60

60 MStb
C1 0.195 x $120,000 = $23,400
0.30

Drill
90 MStb
0.065 x $180,000 = $11,700
0.10
D EMV = $35,750
0 MStb 0.35 x -$65,000 = -$22,750
0.35
X $35,750

Don’t Drill
$0

Significant collapsing of the trees is not recommended


Example-4
A drilling company is considering bidding on a
$150 million turnkey drilling contract for
offshore oil wells. The company estimates that it
Probability NPV
has a 65% chance of winning the contract at this
(MM$)
bid price. If the company is awarded the
contract, it has three options: Using existing rig
- High profit 0.35 60
• Use the existing rig to drill the wells - Medium profit 0.45 30
• Buy a new rig - Low profit 0.20 -20
• Subcontract the drilling to another drilling Buying new rig
company - High profit 0.55 35
- Medium profit 0.35 25
The contract allows for subcontracting part or - Low profit 0.10 -10
all of the drilling functions. The probability and
payoffs for each option are given in the table Subcontract
- Medium profit 1.00 20
below.
The cost of preparing the contract proposal is
$1.5 million. If the company does not bid on this
tender, it has an opportunity to make a
guaranteed profit of $10 million elsewhere.
Construct a decision tree for this situation and
advise the contractor if he/she should bid.
35%
High profit
$60
$30.5

Existing 45%
Rig C Medium profit
$30

20%
Low profit
-$20
65%
Contract
Won D Decision:
$30.5
55%
High profit
$35

$27

35%
New Rig C Medium profit
$25

Bid C $19.3 10%


Low profit
-$10

Subcontract
$20
Decision:
D $19.3 Contract 35%
Loss -$1.5

Don’t Bid
$10
Example-5
Exploration drilling on one of the offshore prospects has resulted in a commercial oil
discovery. To develop this field, facilities need to be designed. The studies have
indicated reserves in the range of 5 – 25 MMSbt. The geologists and engineers have
estimated that there is 30% probability of a large field with 25 MMStb reserves, 45%
probability of a medium field with 15 MMStb reserves, and 25% probability of a small
field with 5 MMStb reserves.
There are two options: (a) to design the facility based on the information available, or
(b) drill delineation wells to further improve the probability and reservoir size.
Based on the possibility of three different field sizes, three different sizes of facilities
can be installed. The economics of the different combinations of facilities are shown
below:
Field Size Probability NPV of each field size and facility, MM$
Size A Size B Size C
Large 0.30 290 350 450
Medium 0.45 90 210 160
Small 0.25 60 35 50
Cont’d...
Using the information in table above, perform the following
calculation:
1. Using the EMV criterion, select the most economical facility
size without obtaining any additional information
2. Calculate the expected value of imperfect information (EVII)
if it is decided to drill delineation well at a costs of 15 MM$
before deciding on the size of facilities. The geologists
consider that:
– There is a 90% probability that the delineation well will show a large
reservoir
– 60% probability that will show a medium reservoir
– 30% probability that will show a small reservoir
The expected value of imperfect information (EVII) is the
expected payoff with imperfect information (EPII) minus
EMV
1. The size C facility with EMV of 219.5 MM$ is the best
economic option because it is the highest of the three EMV’s
Field Size Probability NPV of each field size and facility,
MM$
Size A Size B Size C
Large 0.30 290 350 450
Medium 0.45 90 210 160
Small 0.25 60 35 50
EMV 142.5 208.3 219.5

2. To calculate EVII, consider two alternatives:


a. Install a platform without acquiring additional information
b. Drill delineation wells and based on their result decide on the
platform size
Prior probabilities of various field size
Large field Medium field Small field Total
Prior Probability 0.30 0.45 0.25 1.00
Results from delineation well
Favorable 0.90 0.60 0.30
Unfavorable 0.10 0.40 0.70
Pre-posterior probabilities
Favorable 0.27 0.27 0.075 0.615
Unfavorable 0.03 0.18 0.175 0.385
Posterior probabilities
Favorable 0.439 0.439 0.12 1.00
Bayesian
Theory
Unfavorable 0.078 0.467 0.454 1.00
Delineation drilling favorable
Field Size Probability NPV – Size A NPV – Size B NPV – Size C
Large 0.439 290 350 450
Medium 0.439 90 210 160
Small 0.120 60 35 50
EMV 174.1 250.1 273.9
Delineation drilling unfavorable
Large 0.078 290 350 450
Medium 0.467 90 210 160
Small 0.454 60 35 50
EMV 91.9 141.4 132.6
• From the table above, the facility of size C will be
selected if the results of the delineation wells are
favorable, and facility of size B will be selected if the
results is unfavorable.
• The expected payoff with imperfect information is:
EPII = EMV (Favorable) x Probability (Favorable) + EMV
(Unfavorable) x Probability (Unfavorable)
= ($273.9 x 0.615) + ($141.4 x 0.385)
= $222.88
• The EVII is: EPII – EMV = $222.88 - $219.5 = $3.38 MM
• Thus, it would not be worth paying more than 3.38
MM$ to drill delineation wells.
Large 43.9% 290
43.9%
Size A Medium 90
12.2%
Small 60
to be continued... Large
43.9% 350

Favorable Size B Medium


43.9% 210
12.2% 35
Small
43.9%
Large 350
43.9%
Size C Medium 210
12.2% 35
Small
Drilling
delineation Large
wells
Size A Medium

Small

Large

Unfavorable Size B Medium

Small

Large
Large
Size C Medium
Size A Medium
Small
Small

Large
No
delineation Size B Medium
wells
Small

Large

Size C Medium

Small
Bayes Theory
• Teori dengan dua penafsiran berbeda
• Teori ini menyatakan seberapa jauh derajat
kepercayaan subjektif harus berubah secara rasional
ketika ada petunjuk baru

• P(E|B) berarti peluang kejadian E bila B terjadi


dan P(B|E) peluang kejadian B bila E terjadi