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Abstract

During the 1990s, many international petroleum companies improved their exploration performance significantly by using principles of risk analysis and portfolio management, in combination with new geotechnolo-gies. While exploration risk cannot be eliminated, it can certainly be reduced substantially, on a portfolio scale. And the widespread adoption of standardized risk analysis methods during the 1990s brought badly needed discipline to petroleum exploration.

By the mid-1980s, most well-informed major international petroleum firms that were engaged in exploration recognized that, globally, the average size of new discoveries was diminishing (Figure 1). Not coin-cidentally, the class of exploratory prospects categorized as “high-risk/high-potential” was showing marked signs of underperformance. For major companies such as Shell, Mobil, and Amoco, when all such ventures—which averaged around a 10% perceived probability of success—were considered, less than 1% actually discovered profitable oil and gas reserves, and the sizes of these discoveries were generally far smaller than predicted. All in all, such exploration for new giant fields destroyed value, rather than creating it, in the 1980s and early 1990s.

Consequently, exploration, as a corporate function, lost credibility. It badly needed to begin delivering on its corporate promises. It needed to become more efficient, and thereby more profitable. At the same time, as superior new technologies were introduced, and exploration came to be a global effort under more centralized coordination, corporations realized that they needed to adopt systematic procedures to better manage the exploration function. To optimize the allocation of exploration capital, concepts of portfolio management began to be considered.

During the 1990s, many international petroleum companies improved their exploration performance significantly by using principles of risk analysis and portfolio management, in combination with new geotechnolo-gies. While exploration risk cannot be eliminated, it can certainly be reduced substantially, on a portfolio scale. And the widespread adoption of standardized risk analysis methods during the 1990s brought badly needed discipline to petroleum exploration.

By the mid-1980s, most well-informed major international petroleum firms that were engaged in exploration recognized that, globally, the average size of new discoveries was diminishing (Figure 1). Not coin-cidentally, the class of exploratory prospects categorized as “high-risk/high-potential” was showing marked signs of underperformance. For major companies such as Shell, Mobil, and Amoco, when all such ventures—which averaged around a 10% perceived probability of success—were considered, less than 1% actually discovered profitable oil and gas reserves, and the sizes of these discoveries were generally far smaller than predicted. All in all, such exploration for new giant fields destroyed value, rather than creating it, in the 1980s and early 1990s.

Consequently, exploration, as a corporate function, lost credibility. It badly needed to begin delivering on its corporate promises. It needed to become more efficient, and thereby more profitable. At the same time, as superior new technologies were introduced, and exploration came to be a global effort under more centralized coordination, corporations realized that they needed to adopt systematic procedures to better manage the exploration function. To optimize the allocation of exploration capital, concepts of portfolio management began to be considered.

Casino Analog for Exploration Portfolio

Consider the operator of a casino containing a certain number of gaming devices and tables: the odds on each game are well known to the owner, and they are set to be slightly in his favor. He is playing a repeated-trials game in which the expected value (EV) of each trial, for him, is positive. Please note here the definition of expected value: The chance of success times the value of success, minus the chance of failure times the cost of failure (Equation 1). When EV is positive, you're investing; when it's negative, you're gambling. If the casino operator knows the number of tables, the number of players in an evening, and the house rules, he can predict with considerable precision what his profit will be. He is not a gambler, any more than a life insurance company is. He is an investor. And he knows what the odds are. 

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The casino analogy may be distasteful to petroleum geoscientists and corporate managers, but it is actually a pretty fair analog to the centralized drilling portfolio:

  • The diversity of investment opportunities, such as new-field wildcats, step-outs, development wells, enhanced-recovery projects, and property acquisitions, could be likened to the various types of games in the casino, such as roulette, blackjack, craps, and keno.

  • Repeated trials at the roulette wheel (which is set to favor the house) are analogous to the prospects in the annual exploration portfolio: all represent positive expected value and are selected to maximize value and be consistent with acceptable risk.

  • The casino operator cannot predict which spin of the wheel will produce a “win” for the house (any more than the Exploration vice president can scan the annual portfolio and predict which prospect will be a discovery), but he knows that at the end of the evening the house will be ahead.

Figure 1

Global large field discoveries, 1960-1999. While the rate of global scale (>1 BBOE, or billion barrels of oil equivalent) discoveries has decreased since 1980, opportunities for smaller, but significant, fields have remained high. MMBOE = million barrels of oil equivalent. Source: Petroconsultants; reprinted with permission.

Figure 1

Global large field discoveries, 1960-1999. While the rate of global scale (>1 BBOE, or billion barrels of oil equivalent) discoveries has decreased since 1980, opportunities for smaller, but significant, fields have remained high. MMBOE = million barrels of oil equivalent. Source: Petroconsultants; reprinted with permission.

However, there are some significant differences between operating a casino and an annual exploration portfolio:

  • The actual odds on every drilling venture can't be certainly known; they can only be estimated. However, the ability of the firm's geoscientists to estimate chance correctly can be measured and calibrated by reviewing the performance of past portfolios, and can be thus improved. The basic problem is that different geoscientists, in different geologic areas, are estimating prospect reserves, profitability, and chance of success; this calls for the adoption of consistent methods throughout the company. Also, all prospectors are competing for advancement, which promotes optimistic bias.

  • Greater uncertainty attends prospect reserves, and thus profitability, than attends the payoff for each spin of the roulette wheel. The magnitude of exploration uncertainty, and geoscience's limited ability to reduce it, are widely unappreciated by managers and directors.

  • Usually, there are fewer wells in the drilling portfolio than there are spins of the roulette wheel in any evening. Most exploration portfolios contain only about 10 to 100 exploration wells.

  • The payoff at the gaming table is immediate; the payoff at the wellhead is long-term and subject to fluctuations in price and politics.

Exploration Tasks and Risk Analysis

Beginning in the late 1980s and early 1990s, most exploration organizations began to (1) adopt various methods of risk analysis, (2) bring objectivity and consistency to the valuation of the ventures in their prospect inventories, and (3) adopt more discriminating economic yardsticks and risk/reward definitions in selecting their annual exploration portfolios. By 1999, most prospectors had begun to accept three main professional responsibilities:

  • To identify geologic anomalies that have an enhanced likelihood of containing commercial hydrocarbons;

  • To measure them, by estimating chance of success and reserves (translated into profitability), if successful;

  • To be professionally objective—to recognize that if the estimates are biased, portfolio value is not optimized, and the firm (as well as the stockholder), is damaged.

Background of Risk Analysis

Modern risk analysis, as it is now applied in international petroleum exploration, utilizes principles of statistics, probability theory, and utility theory, which began to be recognized as significant subdisciplines of mathematics and philosophy during the 16th, 17th, and 18th centuries (Bernstein, 1996) through published and unpublished works by Cardono (1545), Pascal and Fermat (1654, unpub., cited by Bernstein, 1996), Graunt and Petty (1662), Halley (1693), Jacob Bernoulli (1713, posthumously), De Moivre (1733), Daniel Bernoulli (1738), and Bayes (1764, posthumously). The impetus and applications for the early studies concerned games and gambling; subsequent applications had to do with actuarial and insurance matters.

Petroleum exploration—like many serial business ventures—is clearly a process of repeated trials under conditions of uncertainty, each trial requiring a substantial commitment of investment capital. As such, the casino analog is apt, but because we do not know certainly what the odds are, or the size of the prize, we have learned to employ modern science and technology to refine our “bets.” For example:

  • Stratigraphy may help us predict the presence and quality of reservoir rocks;

  • Geochemistry may give us a better idea whether or not oil or natural gas has migrated into the area of our prospect, thus allowing better estimates of the chance of hydrocarbon presence;

  • Geophysics may help refine our estimates as to how large an accumulation may be contained in the trap, thus the “size of the prize,” as well as the likelihood that the trap indeed contains reser-voired oil or gas;

  • Drilling technology may let us reduce our investment by testing the prospect at lower cost; and

  • Reservoir technology may allow us to develop and produce the successful prospect (= discovery) more efficiently, thus increasing our profit.

The success of exploration science and technology during the 1945-1995 period helped advance the myth that petroleum exploration was “driven by science” and obscure its analogy to the casino example, which was distasteful to many businessmen and scientists. Pioneering publications by Grayson (1960) on decision analysis in petroleum exploration, and by Kaufman (1962) on lognormality, provided the basis for practical applications in valuing exploration ventures. However, the systematic employment of statistics and probability theory in exploration did not begin until the mid-1960s, led by Exxon, Shell, Arco, and Cities Service (Newendorp, 1975). By the late 1970s, companies like Chevron, BP, and ELF, as well as some governmental agencies (G.S.C., I.F.P., and U.S.G.S.) were also beginning to employ risk analysis routinely in their exploration evaluations and ventures. But in the late 1980s and early 1990s, a technological explosion in risk analysis took place because most modern oil and gas companies saw the need for systematic management of their exploration portfolios on a worldwide basis.

Today, the concepts and methodologies of exploration risk analysis used by most large oil companies and state petroleum agencies have converged to the status of “a generally accepted technology” (MacKay, 1996), and many smaller firms are now adopting this technology.

Risk Analysis and Petroleum Exploration

The most critical decision in petroleum exploration is not which prospect to drill—it is which basin or trend (“play”) to explore (Rose, 1996a, 1996b; Brown and Rose, 2000). A play is a family of geologically similar fields, discoveries, prospects, and leads (McCrossan, 1973; Roy, 1975; Baker et al., 1986; Miller, 1986; White, 1992). Because of the similarity of reservoir type and trap geometry, commonality of hydrocarbon charge, and consistent exploration and development methods, it is possible to carry out economic evaluations of plays as full-cycle economic ventures. Such evaluations utilize regional geologic, geochemical, and geophysical studies (see Appendix E and Appendix G), and they are conducted by applying basic principles of prospect risk analysis, as outlined in the first part of this volume. However, in order to understand the principles of play analysis, we must first understand the risk analysis of prospects, simply because plays are aggregates of geologically similar prospects.

Accordingly, we begin with the assumption that the company has already committed to explore in several different basins and trends (i.e., the process of play selection has already occurred), and drilling prospects are now being searched for, identified, and evaluated. Later, in Chapter 5, we return to play analysis.

Step one in petroleum exploration, once the exploration trend has been selected, is identification of the drilling prospect by geoscientists. This is the basic value-creating act. It requires geotechnical skill and creative imagination.

After the exploration prospect has been identified, there are key tasks involved throughout the life cycle of petroleum exploration and development. The first three tasks deal with measuring the prospect's value.

Step two in petroleum exploration is measuring value:

  • Estimating how large the producible reserves are likely to be (assuming that a hydrocarbon accumulation is indeed present);

  • Estimating the chance that a producible hydrocarbon accumulation is present; and

  • Estimating the profitability of the entire project, given that producible hydrocarbons are present.

Step three consists of implementation and management of exploration projects as business ventures, and includes three additional tasks:

  • Acquisition strategies—determining the terms under which the company would commit to explore and develop the prospect, whether acquisition is by sealed bonus-bidding, oral auction, performance contract, serial contract negotiations, private treaty, contract renegotiations, or the like. Note: acquisition strategies often apply to properties much larger than individual prospects, such as plays and contract areas.

  • Inventory and portfolio management—choosing which prospects should be included in the annual drilling program to maximize economic return, consistent with the company's risk tolerance. This topic may also include considerations of risk aversion or utility theory.

  • Operations—carrying out the various business operations that result in leasing, data acquisition, drilling, completion, and delineation of new dis-coveries. The cost-effectiveness of data acquisition for emerging prospects may be addressed operationally, using principles of Valuation of Information.

Tasks (1) through (5) are ordinarily included in the overall subject of exploration risk analysis, which may also include considerations such as the value of information.

Purposes and Organization of this Volume

The purposes of this book are to review the main principles and procedures of exploration risk analysis, and to discuss industry patterns of implementation, experience, and general results. The book follows the general sequence outlined above. Following this introduction, Chapter 2 addresses theory, procedures, and problems in making geotechnical estimates under uncertainty, and techniques for improving staff performance in estimating.

Chapter 3 reviews the key aspects of risk analysis of the prospect as the economic unit of exploration. The key aspects include (1) estimation of the range of potential recoverable reserves, (2) chances of geologic and commercial success, and (3) combination of reserves and chance leading to expected monetary value (EMV). Chapter 4 covers the topic of project profitability, given success, and reviews considerations of both reserves as well as chance of success.

With the principles of prospect risk analysis set out, we proceed to Chapter 5, which covers the key aspects of analysis of the exploration play, which is the operational unit of exploration. This distinction acknowledges that companies usually explore on the basis of regional trends and seismic programs, hoping to make multiple discoveries—given successful explo-ration—even though individual prospects constitute the economic “building blocks” in the overall evaluations of the trend.

Chapter 6 concerns effective practices by which successful companies make and implement sound business decisions based on proper risk analysis of prospects as well as plays. It deals with topics such as risk-reduction techniques, acquisition strategies, inventory and portfolio management, and management of exploration plays. Chapter 7 reviews current organizational practices commonly used by industry in carrying out exploration risk analysis.

Seven appendices cover various aspects of risk analysis concepts and procedures, which are too detailed to be included in the text.

Differing Definitions of Reserves

Much confusion attends the use of the term “reserves.” The term is commonly used in both formal and casual ways. It is important to understand that there are two primary definitions of reserves in petroleum exploration and production.

The term “reserves” has measured, fiduciary implications to the engineer, chief financial officer, banker, or financial analyst. Terms such as “proved,” “probable,” “possible,” “developed,” and “undeveloped” connote varying levels of confidence in the existence of the dif-ferent categories. A fundamental problem with such terms is that no consistent definition for such categories can exist, beyond nebulous guidelines like “reasonable certainty.” The engineering profession appears to be evolving toward the more preferable probabilistic expression of such confidence (Cronquist, 1997).

The term “reserves” used by the explorationist usually means the projected ultimate recovery of hydrocarbons from a given field or drilling prospect; general synonyms are “geologic reserves,” “volumetric reserves,” “potential reserves,” or “estimated ultimate recovery” (EUR). Thus, “field size,” as used in a field-size distribution, represents the projected final cumulative production from a given field—cumulative production, plus proved reserves, plus projected future reserves additions (i.e., anticipated reserves appreciation). This same concept is used when explorationists talk about “prospect reserves” or “potential reserves.” This usage naturally lends itself to the probabilistic expression of confidence in the existence (and eventual recovery) of such hydrocarbons under the economic and technologic conditions currently prevailing.

In most places in this book, the intended meaning should be clear. Where any doubt may exist, I have attempted to specify the meaning intended.

Figures & Tables

Figure 1

Global large field discoveries, 1960-1999. While the rate of global scale (>1 BBOE, or billion barrels of oil equivalent) discoveries has decreased since 1980, opportunities for smaller, but significant, fields have remained high. MMBOE = million barrels of oil equivalent. Source: Petroconsultants; reprinted with permission.

Figure 1

Global large field discoveries, 1960-1999. While the rate of global scale (>1 BBOE, or billion barrels of oil equivalent) discoveries has decreased since 1980, opportunities for smaller, but significant, fields have remained high. MMBOE = million barrels of oil equivalent. Source: Petroconsultants; reprinted with permission.

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