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ALFRED
P.
Risk Analysis:
From Prospect
Portfolio
To Exploration
and Back
by
Gordon M. Kaufman
MIT
Risk Analysis:
From
Portfolio
Prospect
To Exploration
and Back
by Gordon M. Kaufman
MIT
RISK ANALYSIS:
FROM PROSPECT
MIT
Stavanger,
Norway
December
6-8,
1993
Jr. for
valuable discussions,
Brant Liddle
assistance.
for
programming
INTRODUCTION
In a 1962 visit to the offices of General Petroleum in Los Angeles, the corporate exploration
company's
next aimual exploration budget allocation meeting, a geologist must assign a "dry hole"
probability to each prospect that he promotes. This was the company's
first
venture into
We
statistical
to oil
in
in
geophysical, geochemical
more
infor-
precise
now
routine for
oil
to
employ
geological, geochemical
bases,
management
it
in de-
how much
to spend
it
and where
should be spent.
profit
at this meeting illustrate the broad ramge of systems that can be constructed
mon
core of ideas and they give us a view of techniques for exploration and development
My
comments hinge on
the
first
theme
is
the importance of
of aggregation-
accounting correctly
for covariation of
uncertain quantities at
all levels
among
uncertain
quantities can lead to seriously distorted estimates. Covariability plays different roles as
analysis steps
up the ladder
for covariation of
uncertain quantities in
much
the
geological
for
is
first:
among
basins,
among
plays and
among
Mean-
its
When
is
one or more technical experts, post mortems aimed at measuring the ex post quality of
such assessments
is
much
In addition,
direct eUcitation of
is
almost
always
difficult
and often
field size.
The
final
theme
Ls
flexibility.
The most
frequently used
method
is
it
computed
method
is
is
alter its
as
the future unfolds then unfortunately, the method does not correctly account for project
value.
it
if oil
or gas
is
found
commercial quantities
is
just such
an option. In
fact,
it is
an option
(to develop
or not depending
drilling) within
an option to explore
Modern
methods
that correctly account for fiexibihty in the timing of exploration and development.
An
illustrative
example
is
given in section
4.
oil
It
sets the
The
appearing in Table
is
[Table
here].
The
and non-
systematic risk
is
fundamental:
Oil
risks are
tide,
oil
and gas
prices.
We
show
later
how
the aggregate risk of an exploration prospect portfoUo can be spUt into systematic
parts.
and non-systematic
tools with
which to reduce
[Table
2 here].
The
is
ence.
They range
widely:
to
Grant.
Milton and Thompson develop the concept of play uncertainty maps and play risk maps.
art
menu
Kaxlsen
and Backer-Owe
and Bjorlykke predict reservoir quality on a regional and Sylta show us a method
hydrocarbons.
and Krokstad
nities.
Duff and Hall suggest a distinctive approach to play defanition and modelling that
style.
emphasizes closure
ation of
They
mortem
evalu-
to
new information
data
that supports assignment of a geologic event to an interval. Morbey's examination of historical play efficiency
rift
system
is,
in effect a post
mortem
of play successes
and
an aggregated basinal
level.
Ex
made by
explo-
rationists
is
Without a vigourous
effort to
judgement
is
AAPG
paper,
Rose
tells
us
how
Edwards underground
river,
Rose
says:
of uncertainty-they cannot differentiate between 98 percent confidence and 30 percent confidence\ Moreover, the prevaihng pattern is one of
at, say,
90%
confidence,
they characteristically set predictive ranges that actually reflect about 35-40% accuracy. As Capen says, "people tend to be a lot prouder of
their answers
[i.e.,
This bias
empt!)
is
nearly universal (scientists and engineers are not exitself specifically in forecasts
and expresses
by subsequent events
(or not
met
at
all).
That
is,
in their quantitative
predictions, experts usually set their predictive ranges far too narrow.
In qualitative forecasts
rely
this bias
is
Put simply, most scientists and engineer are overconfident-they think they know more than they do! So they frequently find themover the past 10 years I selves surprised by Nature's outcomes have tested more than 100 technical audiences, totaUing well over 5,000 professional scientists and engineers. The results are always the samethey are significantly overconfident, actually estimating at about 40%
confidence while believing they are estimating at
80%
confidence.
...
We
have found that, with training and practice, scientists and engineers can improve significantly, but even after considerable eS'ort, they have a hard time consistently setting ranges that really do correspond to demonstrable uncertainty."
Now
let's
turn to covariability.
2.
IT
oil
and gas
ex-
is
Some
variables covary at
all levels
spatially
as well.
precision
Many
statistical analysis
aimed
at splitting a covaxiance
structure into orthogonal components. Several presenters call attention to the importance
of proper modeling of probabiUstic dependencies:
Thompson highUght
tic
dependencies in play analysis, and Snow, Dore and Dorn-Lopez model risks generated
by a portfolio of prospects.
The
that do not vanish even after drilling has confirmed the play's existence.
case for discovery process models based on the idea that discovery
This
is
the
is
akin to sampling
finite
size.
Damsleth's
model
number
made
in
dependence
in the
a cluster of prospects that share the same marginal probabilities and pairwise
probabilities of success. Sinding-Laxsen
It is
is
sensitive to dependencies
among
geo-
logical events
rock and
seal.
field size
underfield
stood that even mild correlations among the primary physical variables that determine
size-area of closure, average feet of pay and yield per acre foot, for example-can induce
large differences in properties of a field size distribution relative to a field size distribution
The Lloydminster
play
is
an excellent example.
The Lloydminster
ways. First,
play
is
unusual
in
two
all
down
1 is
to single well deposits using a uniform protocol. Second, there are 2509 deposits.
Figure
oil in
Normal probability
is
scale [Figure
here].
The
horizontal scale
is
in
constructed so that
if
fractiles of the
logarithm
Normal
will
appear
clearly
as a straight line.
The assumption
that
oil in
place
is
approximately Lognormal
is
reasonable (See
statistics
Kaufman
in
Lloydminster play
appear
The
large
number
down with
precision the
covariance structure of deposit area, net pay and yield per acre-foot.
Table 4b displays
[Table 4b
covariance and correlation matrices for the logarithms of area, pay and yield.
here].
None
Since
oil in
place in a deposit
is
if
we adopt
easily
all
we can
compute properties
Table 5
oflFers
pay and
yield.
oil
independence of log area, log pay and log yield with the distribution that arises
account for empirically derived correlations (those of Table 4b).
correlations are small, ignoring
we
them
mode
oil in
mean
deposit size
is
underestimated
47% and
the
mode
is
overestimated bv
about 30%.
A 21%
underestimate of
oil in place!
mean
skewed
that,
on
When
is
nents of deposit
that
size,
assumption
absolutely convincing.
When
the
assumption of indeif
pendence
3.
aggregate economic
risk
of a
cor-
may be
risks
variabilities
of geological,
engineering
and cost
and
is
is
always
influenced
by
price risk.
The
allocated
among
basins,
among
plays
within
basin
As stated
earlier,
is
fundamental:
set,
(ROR)
uncertainties. Farmouts,
in this fashion.
oil
diversifying
away from
oil
(e.g.,
oil eind
interest
here centers on those risks associated with exploration and development management.
It is
and non-systematic
10
aim
of this theory
is
ROR
ROR. Table
6 outlines inputs
ROR
is
minimum
variance portfoho.
The graph
describing
ROR
By
ration
known
ROR
for
any explo-
into a
sum
and
is
seen to be the
sum
ROR
condi-
tionaJ
and the variance with respect to future prices of the expectation of ROR conditional on future prices the non-diversifiable
on future
prices
the
diversifiable
component
component.
RORs
of individual
is
generally
The formula
in
diversifica-
tion of geological
and engineering
Consider a portfoho of
A'^
prospects with a fraction 1/iV of the exploration budget (scaled to equal one) allocated to
each.
risk characteristics of
that, given
known
11
by
V{ROR\P) and
let
E{ROR\P)
be the expected
V equal
the
V{ROR\P). Because
ROR variance
V/N and
the systematic
component
larger,
is
E{ROR\P)
with respect to P. As
V/N
remains unchanged.
To
mean-variance tradeoffs
for
an exploration opportunity
4.
set
shown
in Figures 3
and
The set
consists of sixty U. S.
is
an
illustrative
measured
tional
MCF
and
on success, production
less
interest in a prospect
is
constrained to be
denominated
in
terms of a single uncertain price that scales a future price vector. At the
time that these prospects were in contention, the relevant unregulated price was about
$6.15/MCF because
1978.
of
an
ROR
an
ROR given
this
teirget.
is
etllocation of the
on a
fixed price of
12
efficient frontiers
volatility of
70%
(standard devia-
tion of percent change in price from one period to the next). Price volatiUty introduces a
risky shift of efficient frontiers. Systematic risk as a percent of total risk varies with target
ROR
and budget
size as
shown
in Figiu-e 5.
$10/MCF appeared
is
RORS
of
Thus with
and a 50 miUion
dollar
budget, here
is
how
ROR.
TARGET ROR
20%
30%
.343
40%
If
.440
target
ROR
is
amount invested
set, increases,
risk.
As the
target
ROR
An
the decrease in systematic risk divided by total risk for a fixed budget as target
ROR
in-
creases, rests
for this
example.
the expected
NPV
of each prospect.
to the variance of price even in the presence of substsLntied volatifity of .707 leads to
13
.5
and Expectation{PriceSquared)/[CurrentPrice]^
of portfolio variance
is
The non-systematic
risk
component
.5.
weighted by
1.5
and
Third,
if
the budget
is
ROR
is
increased, effort
is
As
this
happens,
risk
1.5)
than systematic
.5).
Some managers
treats upside
minimum
it
in
ROR
symmetrically.
They
prefer to minimize
ROR. A
risk of
downside
and non-systematic
risk
components
possible.
How
this
can be done
is
a story
for
another day!
14
4.
AND DEVELOPMENT
We
are
all
MIT
professors (Black,
Merton and
at extending
Scholes) of a
valuation. Recent
work aimed
the theory to provide correct valuation of exploration and development projects should be
of particular interest to exploration managers.
It
has long been recognized that possessing the right to explore a tract
is
for
a specific
period of time
stock.
is
The analogy
sketched in Table
8.
the option value of pre-emption-get into a highly prospective frontier area before the
flexibility
and to pick
off the
most promising
If
a discovery
is
arises:
is
at
some point
manager
faces a
compound
method
this
option.
Only
sound and
easily explainable
for valuing
Just what
is
method?
Trigeoris
stock market option theory to embrace valuation of project flexibihty axe a special, market
adjusted version of decision tree analysis that expUcitly prices out the value of operating
flexibihty.
Why
is
this
important?
Because, acccording to
all
15
of approaches to project
management that
rest
on choice
(NPV):
ability
NPV methods do not properly capture the value of a manager's modify a project as uncertainty is resolved.
risk increases or decreases, so
The
adapt the operation of a project to future contingencies introduces asymmetries in future project value resulting in an overall increase in value, relability to
ative to static
NPV
analysis.
"DCF
added
make operating
decisions
during the
life
of the project
flexibility
have advantages:
There
is
prices.
The appropriate
i.e.
there
intrinsic
and the
as-
oil
is
in equilibrium.
Paddock, Siegel and Smith (1988) document the practical importeince of option valuation:
"The government uses valuations to establish presale reservation prices and to study the effect of policy changes on revenues it expects to receive from lease sales. Because the bidding process involves billions of dollars,
16
[As of 1988]
Government valuations have tended same geological and cost data as the
The
analysis of stock option value done by Merton, Black and Scholes requires an
(Ito's stochastic calculus
and parabolic
Siegel
traditional
NPV
made
discussion of
how
oil field.
Pickles
oil
latter
the time span between periods of price change approaches zero, converges to the same
aJ.
In addition, the
is
is
by
They provide
a prototypical valuation
of a North Sea
oil field.
A friendly
of real
toy example of a development option will help set the stage for a discussion
options.
compoimd
17
develop.
will
immediately
in the
sell
the
field.
ground
and
is
fall
now
is
[Figure 6
here].
tell
will
What
is
the
value of being able to postpone choice until the clairvoyant has spoken? (She will speak
in
time
for
The
is
postponed
This tree
is
shown
at the
bottom of Figure
is
5.
The
revealed
is
of the best (static with respect to price) choice in the top tree.
If price
is
if
choice
is
to be
made without
Any
operating option, no
compound option
remains to be done.
Paddock
et al.
assiune that
if
exploration
is
is
made
at the
same time
This ignores the value of development delay. Pickles and Smith assume that the decision
to explore
is
taJcen immediately,
This
compound option
via Pickles
and
18
sheets,
one
for
each binomial
presents key
lattice of
field size.
The appendix
compound option
value of a four
is
The parameters
7]
it is
assumed
Figiire
a discovery
is
will
be discovered.
Figures
9,
10,
and
development timing
Table 10 and
flexibiUty built in, eax;h at different choice of exploration cost per barrel.
Figure 12 summaxizes
how
values at
and developing a
tract
is
may be
positive.
At an
i
exploration cost of $.2 per barrel hi our example, the expected value of exploring at
negative, but the
is
of exploration rights
is
positive.
The
reader
is
in the
appendix.
is
con-
is
19
induction.
The
value at
of "Wait
is
of
"Explore
Now" (EXERCISE)
lattice
and by accounting
for uncertainty
about discovery
20
5.
CONCLUSION
Our
in oil
and gas
from prospect
up the
ladder of aggregation to prospect portfolio risk via mean-variance portfolio analysis and
level.
The
risk
management messages
effort
is
large.
If present, neglect at
your
peril!
Import
statistical analogies.
and
its
generalizations
mean path
of future-prices
21
REFERENCES
Bjerksund,
P.,
and
S.
Ekern (1990).
Uncertainty:
19(3): 65-83.
Cox, John
C, Stephen
A. Ross, and
1979).
"Option Pricing:
229-264.
Practical Asset
Kaufman. Gordon, M. (1993). "Statistical Issues in the Assessment of Undiscovered Oil and Gas Resources". The Energy Journal 14(1), 183-215.
Paddock, James L., Daniel R. Siegel, and James L. Smith (1988). "Option Valuation of Claims on Real Assets: The Case of OfTshore Petroleum Leases." The Quarterly Journal of Economics, 479-508
Pickles, Eric
Smith (1993). "Petroleum Property Valuation: Lattice Implementation of Option Pricing Theory." The Energy Journal
and James
L.
A
,
Binomial
14(2), 1-26.
How Can
We
1-16.
Trigeoris
Midland Corporate
Finance Journal.
22
APPENDIX
and Development
Vcduation Schematic for Exploration as a Compound Option
23
ACTS AVAILABLE
=
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TABLE 9
ASSUMPTIONS
Have
to
delay.]
develop by the fourth period and have to explore by the end of the
third period.
Upward
1.38%
Downward
= 10.22%
Probability of
Probability of
downward change
(1-p)
= .6160
d = .9954
Present value of after tax cost of development Present value of price $3,293
Probability of discovery q
If discovery, field size is
D = $2,528
= Current
Price
.2
lOOM
barrels
AVAILABLE ACTS
Initial
TABLE
10
EXPLORATION OPTIONS
Value of Exploration Rig hts
.0532
Exp cost^bl *
10
Flexibility
Gains
.0135
.15
.0323
.0323
.20
.0161
.0161
FLEXIBILITY GAINS
EXPL COST/BBL
*With LOW exploration cost^bl, the inflexible option "E now, D one period later" has positive E. V. With HIGH
exploration cost/bbl the inflexible option has negative E.V.
HGURE
LJJ
_l
Q UJ
O LU
a.
h-
LU
LOGOIP
nGURE2
LLOYDMINSTER
Var=3,221
OIP:
CL
0.2
HGURES
MV ANALYSIS FIXED
PRICE
70
o
Z O H < > Q Q < Q Z < H
1-^
c:/5
60
1
50
1
40
1
30
1
20
1
10 1
nGURE4
o
100
-
o < >
l-H
60
<
CO
nGURE5
SYSTEMATIC RISK/TOTAL RISK HIGH VOLATILITY
0.31
O
H
O O
IQ
o
> Q O
CO
<N
>
on
H O u
a:
o a
<
HGURE?
Figure
5.
Introduction of
T
lyrt
I
Ltr>gT^ of Oina
pnod
Votatilny lannualutdl
RmI
Pnca
PlVOid rata
it
oma
laro.par
bM
Marginal
rata
PV
(SI
PV
fX)
OV
HGURES
VALUE OF THE DEVELOPMENT OPTION GIVEN DISCOVERY
Initial
1^1
T=2
T=3
T=4
nGURE9
Exploration Option with q = Exploration Cost = 0.1
.2
Initial
T=1
T=2
T=3
FIGURE
10
.2
Initial
T=1
T=2
HOLD
Exercise value Hold value
0.0323 0.0323
HOLD
0.0092 0.0092
HOLD
0.384
FIGURE
11
.2
Initial
T=1
T=2
T=3
0.384
fs
D O E
o
0)
MIT tIRRARIES
=1080
OOflSbbbT
Date Due
2005