Decision Analysis for

Petroleum Exploration

Lecture notes for PET 472

Spring 2013

Prepared by: Thomas W. Engler, Ph.D., P.E.

Expected Value

• Decision Analysis

– A comprehensive approach to evaluate and compare multiple

options considering both elements of risk and uncertainty

• Risk

– The probability of different outcomes from an event

• Uncertainty

– Statistical variations of a variable; e.g., oil price, oil-in-place, aka

“stochastic”

Definitions

Discovery

Test well

Dry hole

Expected Value

• Expected Value Strategy

– A method of combining profitability estimates with quantitative

estimates of risk to yield a risk-adjusted decision.

• Expected Value

– Probability weighted value of all possible outcomes

Definitions

n

1ii

)outcome(NPV*i

)outcome(PEV

Expected Value

Evaluate a drilling prospect in which the estimated probability of success is 0.6

and the probability of a dry hole is 0.4.

Two options are available:

1. drill the well

2. farm out the prospect retaining an overriding royalty.

Possible outcomes are:

1. If a dry hole the net loss is $200,000.

2. If it hits the net profit will be $600,000.

3. If we farm out the income from a producer is $50,000.

What is your decision?

Example 1

Expected Value Example 1

Decision Options

Drill Farmout

outcome P(outcome) Conditional

value($)

Expected

value of

outcome($)

Conditional

value($)

Expected

value of

outcome($)

Dry hole 0.4 -200,000 - 80,000 0 0

producer 0.6 +600,000 +360,000 +50,000 +30,000

EV = +280,000 +30,000

Expected Value

• EV Decision Rule

– When choosing among several mutually exclusive decision

alternatives, select the alternative with the greatest expected

value.

• Repeated trial clause

– From the example, if you drill one well can you have an outcome

of $280,000?

– What about if you drill 100 wells?

Definitions

If the decision maker consistently selects the alternative having the

highest expected value, then his expected value total of a portfolio of

decisions will be higher than from any alternative strategy. This

statement is true even though each specific decision is a different

drilling prospect with different probabilities and outcome values.

Expected Value

The exploration staff of Devon

Energy has been evaluating a

prospect in the Anadarko Basin of

western Oklahoma. The well

requires a 640-acre gas unitin

Section 29; of which currently 256

acres is not leased. Devon’s

participation in the unit is

predicated on purchasing the

leasehold rights of the 256 acres.

Example 2

29

Unleased

Acreage

(256 ac)

Expected Value

Gross well costs: $100,000

Gross dryhole costs: $ 70,000

Possible outcomes and probabilites

Outcome P(outcome)

Dry hole 0.35

2 Bcf reserves 0.25

3 Bcf reserves 0.25

4 Bcf reserves 0.10

5 Bcf reserves 0.05

1.00

Alternatives:

1. Participate in drilling the well

with a non-operating 40% WI

2. Farm out the acreage and

retain a 1/8 of 7/8 ORRI on

256 net acres.

3. Be carried under a penalty

clause of the proposed

operating agreement with a

backin privilege (40% WI)

after recovery of 150% of the

investment by the

participating parties.

Example 2

Expected Value

Management questions 1. What is the maximum Devon should pay for the

leasehold rights?

2. If Devon obtains the 256 net acres, which of the three

strategies maximizes the expected value?

Example 2

Expected Value Example 2

Decision Options

Possible

outcomes

Drill with 40% WI

($)

Farm out – retain

ORRI on 256 net

acres ($)

Penalty clause

with 40% backin

option ($)

Dry hole -28,000 0 0

2 Bcf +21,000 + 5,000 + 5,000

3 Bcf +42,000 + 8,000 +20,000

4 Bcf +64,000 +11,000 +37,000

5 Bcf +86,000 +13,000 +56,000

Conditional NPV profits or losses

Expected Value Example 2

Drill w/40% W.I. Farm out w/ORRI Penalty w/backin

Possible

outcomes

P(O) NPV ($) EV ($) NPV ($) EV ($) NPV ($) EV ($)

Dry hole 0.35 -28,000 - 9,800 0 0 0 0

2 Bcf 0.25 +21,000 + 5,250 + 5,000 +1,250 + 5,000 + 1,250

3 Bcf 0.25 +42,000 +10,500 + 8,000 +2,000 +20,000 + 5,000

4 Bcf 0.10 +64,000 + 6,400 +11,000 +1,100 +37,000 + 3,700

5 Bcf 0.05 +86,000 + 4,300 +13,000 + 650 +56,000 + 2,800

1.00 EV = +16,650 +5,000 +12,750

Expected value calculations

Expected Value

What is the maximum Devon should pay for the leasehold

rights?

The expected value of a decision represents the average NPV gain that would

be realized over a series of repeated trials in excess of a rate of return equal to

the discount rate.

That is, the maximum economic amount we could offer for the leases (and still

have earnings of the discount rate) is equal to the expected value.

Example 2

acre/65$acres256

650,16$

Expected Value Example 2

-30000

-20000

-10000

0

10000

20000

30000

0 0.2 0.4 0.6 0.8 1

Probability well will

Encounter HCs EV

($),

exclu

siv

e o

f le

ase c

osts

drill

farmout

Penalty &

Back in

Expected value vs chance of success

Expected Value

Compare the merits of three different drilling prospects

• Which of the prospects is preferred?

• If the company is capital constrained and thus must

maximize EV per expected investment costs, which is

the preferred prospect?

Example 3

Expected Value Example 3

Possible outcome Probability of occurrence Discounted cashflow ($)

Dry hole 0.30 - 80,000

100 Mstb 0.30 + 25,000

200 Mstb 0.20 +150,000

300 Mstb 0.10 +250,000

400 Mstb 0.10 +350,000

1.00

Dry hole costs = $80,000 Completed well costs = $100,000

Prospect A

Expected Value Example 3

Possible outcome Probability of occurrence Discounted cashflow ($)

Dry hole 0.50 - 200,000

100 Mstb 0.10 - 100,000

400 Mstb 0.20 + 350,000

700 Mstb 0.10 + 600,000

1000 Mstb 0.10 +1,000,000

1.00

Dry hole costs = $200,000 Completed well costs = $250,000

Prospect B

Expected Value Example 3

Possible outcome Probability of occurrence Discounted cashflow ($)

Dry hole 0.35 - 28,000

2 Bcf 0.25 + 25,000

3 Bcf 0.25 + 50,000

4 Bcf 0.10 + 80,000

5 Bcf 0.05 +100,000

1.00

Dry hole costs = $70,000

Completed well costs = $100,000

Prospect C

Dry hole costs = $28,000

Completed well costs = $40,000 At 40% WI

Expected Value Example 3

Outcomes Prospect A

EV, $

Prospect B

EV, $

Prospect C

EV, $

Dry hole -24,000 -100,000 - 9,800

1 + 7,500 - 10,000 + 6,250

2 +30,000 + 70,000 +12,500

3 +25,000 + 60,000 + 8,000

4 +35,000 +100,000 + 5,000

EV = +73,500 +120,000 +21,950

Expected value calculations