Evaluation of Exploration  Prospects

- Investment analysis

Exploration prospect evaluations differ from many other investment analyses, because they are entirely dependent on an uncertain event- a hydrocarbon discovery that meets the threshold of being commercial.     Prior to drilling, due to this uncertain event, any  analysis is inherently speculative. Sometimes seismic data can suggest the presence of hydrocarbons, however true discovery occurs only by drilling wells and running tests .

The common benchmarks for evaluation of any project are net present value (NPV),  discounted cash flow rate of return (DCF-ROI),  present value index (PVI), and payout.    Payout can be based on discounted or undiscounted cash flows.

In theory,  investments should be made in accordance to the “cost-benefit”  ratio to maximize asset returns.   Thus  acquisitions should be made with the projects with the highest present value index (NPV/Investments).  This simple concept is difficult to apply when a project proceeds in a series of stages, and each stage is contingent on success of the previous stage.  

The means of investing  in exploration areas are numerous.   They include acquisitions,  farm-ins and competitive bidding for exploration acreage.   In all cases,  there are large upfront costs and uncertainty. Companies can limit their exposure to the large initial exploration costs by forming operator groups composed of a number of partners.

- New Drivers for Change

Investment analysis of oil/gas ventures exists in a microcosm of an industry experiencing an incredible transformation.     It was recognized in the 1990’s  that new drivers would play an increasing role in the future exploration efforts.   The “Drivers of Change”  enumerated  in reference  1 (1994) have all come to fruition:

· Volatility of Oil Prices

· Deintegration  of upstream resources and downstream sources

· New technology – principally 3-D seismic, horizontal drilling, and tension leg platforms (deep sea exploration)

· Communication revolution

· Political transformation and breakdown of national frontiers

· Growing  global environment awareness

· Ownership and governance –Expanded  state sponsored NOC investments

· Deregulation

The most powerful drivers for the 21^st Century are growing global environment awareness and new technology.    This awareness that companies needed to examine every opportunity in the world and the new technology for deep water exploration translated into a future of need for  large well funded and international oil companies.   This lead to nearly a decade of mega-mergers.    A partial list of mergers is provided below.

 BP/ Amoco  1998                Conoco/ Philips 2002

Exxon/  Mobil    1999          Devon/ Ocean Energy 2003

Chevron/ Texaco 2001

Consolidation of the seismic processing, drilling and other oil service companies has been equally rapid, with a partial list provided below:

Santa Fe/ Global Marine 2003                     National Oilwell/ Varco  2005

Baker Hughes/ Western Atlas                    Baker Hughes/ B.J. Services –Announced Aug 2009  in progress

Santa Fe/ Global Marine 2003   

Western Geco/ Schlumberger 2006

The impacts on this structural transformation meant :  a) More competition for the high value exploration blocks around the globe with NOC  b)  Major oil companies interested in operating the block, rather than being participant,  and c) A few mega-service companies  partnering with the oil companies  at every phase of exploration and production in every location where E&P exists.

- Evaluation of Exploratory Prospects (Classic  Approach)

Exploratory prospect  evaluation requires risk evaluation.   There is no single method for analysis.  

The probability of  the existence of hydrocarbons in a play depends on:

1)  Confinement or closure of the deposit

 2) Adequate deposition of organic material to form oil

3) Right conditions (time, pressure and temperature) to become oil or gas

If each factor  is assigned a probability, then

Often this is referred to as the “geological risk.” This does not describe the chance of a commercial discovery.   For a commercial discovery,  the discovered accumulation must meet certain threshold criteria:

1)  Sufficient quantity of recoverable hydrocarbons (HC)

2)  Reservoir  productivity is sufficient to produce hydrocarbons at commercial (economic ) rates
3)  Hydrocarbon discovered is commercially marketable- this may rule out a large gas, condensate, or volatile oil discovery as commercial.  Also, heavy oils discovered offshore may be considered non-commercial.

Some economic analyses will lump these factors into a “commerciality risk factor”  however if possible, it is worthwhile to identify each one separately. 

Now, consider that the chance of success of each of these six factors is 95% or a 1 in 20 chance of being absent.   The chance of hydrocarbons being present is 86%, but the chance of a commercial discovery is 74%.   If all factors are 50%,  the chance of hydrocarbons drops to 12.5% or 1:8, and the chance of a commercial discovery is 1.5%.   If in this example, we can eliminate the chance that the  hydrocarbon is marketable, the chance of a commercial discovery now is 3% or 1:33.

Now,  an exploration program of a block will typically involve more than one well, so the chances of one or more successes  will in theory,  increase as exploration program continues.   The probability of having one success after “n” wells are drilled, each with a success probability, ,  can be calculated using the binomial distribution.   This is covered in Reference 2.

- Monte-Carlo Simulation to determine recoverable oil

The expected recoverable oil in an accumulation hydrocarbons as risked  is:

Classical risk analysis  assigns probability distributions to the variables including .  Typically, the triangular distributions are used.    Triangular distribution are simple to understand and provide a limited domain for the random variable. Other distributions such as the uniform and normal can be used. From Monte-Carlo simulation,   a distribution of  can be generated.

Given  and recoverable oil, the expected reserves for the discovered hypothetical field within the block can be calculated.

- Economic Evaluation

At this point,  it is necessary to construct  various scenarios to identify  an expected return on the prospect.      If the contract establishes a  mandatory exploratory program,  then this is given in our model as a 100% certainty cost, along with signature bonus.   If no oil is found, then this establishes our “unsuccessful scenario” or maximum loss.

The “success case” may involve numerous evaluations, considering various drilling costs and facility costs.  Ultimately, each of these scenarios must be assigned a probability.

Under a Production Sharing Contract,  cost recovery provisions allow an Operator to achieve a more rapid payout of the investment, however as the project becomes more profitable, the PSC mandates that a greater share of revenues go to the government.

The economic evaluations of the various scenarios are very important as they identify the full range of economic gain and loss.   The private oil company, may after examining the potential for disaster, not proceed unless it can reduce its working interest.

- Weaknesses

The risk factor approach has a number of weaknesses,  including:  a) estimation of probabilities and distributions  are highly subjective and  b) each risk factor is considered to be independent and stationary (time invariant) contrary to the nature of the factors.    To improve the quality of estimation, companies often rely on outside geologic and seismic consultants, to provide additional  opinions.  

The assumption of independence of variables is done to simplify analysis.  The short comings of this form of analysis should be recognized early on.   As a real world example,  an exploratory block in Brazil had shown to have an extensive structure based on seismic.   As there was no prior wells, the seismic structural map was in time units.   As the drilling progressed,  the sands became increasingly more compacted with  no signs of hydrocarbons.  The top of target  was continually  prognosticated to be considerably deeper due to the higher velocities.   Drilling costs rose due to compaction.   The well’s chance of success was quickly diminishing due to the interaction between risk factors.

At times, the interdependence of risk factors is responsible for positive results.   A high porosity will impact the quantity of oil found and improves the productivity of the well.

Monte-Carlo simulation can be performed using correlated variables (Crystal Ball software, Reference 5).    This may be helpful in the economic simulation of prospects.   A higher oil price forecast is correlated with higher drilling costs, and facility costs.

- Time invariance

The binomial distribution works when the success probability is a fixed value.    There is a philosophical argument of whether, with  more exploratory drilling,  we will: a) become more successful,  because every dry hole shows us our errors or b) become less successful, because we progressively explore the less prospective  structures.   

Both perspectives have merit. However, with improved seismic techniques, the latter argument of progressively less prospective structures, I believe, holds more support.

- Other approaches

Decision tree diagrams can be used either as an alternative or to complement Monte-Carlo studies.  It is a  very effective tool in showing risks.  Reference 3  shows many ways to  construct diagrams to describe economic analyses.

Sensitivity analyses, including best/ worse case scenarios and impact of variables, provides added insight to the analyses.  

An approach of calculating “thresholds” in modeling economics also adds insight.    If a project is uneconomic,   under what conditions might we consider it to be economic.   What possible changes can be made to the Production Sharing Contract (PSC) terms to make exploration (or production related projects) economical.  I call this “reversing the question.”

Exploration decisions  do not rely on a few simple metrics.    To maximize assets, one  should choose investments in accordance to the NPV/ investment or PVI.   In comparing two prospects, one with an expected PVI  of 2  and a second one with a PVI of 1.6,  an Operator opts for the lower PVI.  Why?   The investment of the higher PVI and the potential  loss is much higher.   The Operator is risk averse.  The role of “risk acceptance/ aversion”  is part of utility theory.

This concept is very important   The expected economic returns do not tell the full story.   An investment without sufficient back away provisions can cause the company severe economic hardship.  This is explained at length as part of utility theory in Reference 3, on page 159.

 The Operator has perhaps looked beyond the prospect area, and considered exogenous variables- how have other Operators in similar prospects fared?

If the economic analysis has considered fields sizes with upside reserves of > 1 billion barrel, the analyses is suspect.   An alternative analysis is to examine the chance of success and the size of fields discovered in “analogous” areas.  I put the term analogous in quotes, because I know how difficult it is to consider an different geological area as being analogous.

-  PSC Considerations/ Creativity at the bargaining table

Signature bonuses and royalties  can be demanded by the host country .   The host country is, in effect, ensuring itself against failure, but this can reduce competition for bids.

Certain provisions of a PSC may be modified through negotiations.   The host country has multiple objectives.      The PSC typically has extension/ renewal provisions, however if the Operator is particularly successful,  the NOC is highly motivated to take over operations.   A PSC should contain provisions to train nationals in the eventual transfer to operate the fields.   A lengthy transition of several years may be  very beneficial to both the Operator and NOC.

The Operator is generally in the best position to continue exploration at the end of a contract.   It is incumbent for the Operator to prove to the host country that it will make the NOC a full partner in this effort.   

Restoration and abandonment considerations are very important.  The problems of Texaco in Ecuador and Occidental in Colombia are excellent examples of why the PSC needs to address environmental concerns associated with R+A.

Gas discoveries  for offshore fields is an area that I believe will become an increasingly “hot area” for PSC’s.   The provisions of a PCS must be very carefully written to prevent the national  government  to demand   certain sales  price that will deny the Operator’s right to a return on their  investment. 

Competitive Bidding

If there are numerous bidder and all are looking at the same information, then the highest bidder is the most optimistic of the group and therefore is the  “greater fool”  more likely than not to lose money.     There is an extensive literature involved in the psychology of competitive bidding, which is outside of the scope of this summary.

References

1. Treat, John Elting, Editor,  Creating the HIgh Performance International Petroleum Company: Dinosaurs can Fly, Pennwell Publishing,  1994.

2.  Harrett, R. and Cronquist, C., Estimation of Primary Reserves of Crude Oil, Natural Gas and Condensate, Reservoir Engineering and Petrophysics, Volume V(B), page V-1479.

3.  Newendorp, Paul and Schuyler, John, Decision Analysis for Petroleum Exploration, Planning Press, 2000.

4.  Greater Fool Theory, Wikipedia Summary