KEY CONCEPTS ON

ECONOMIC EVALUATION
AND
DECISION ANALYSIS
OF
EXPLORATION - PRODUCTION
PROJECTS

Centro Superior de Formacin Repsol

Exploration & Production

ACKNOWLEDGEMENTS
Special thanks to:
Marco Antonio Guimares Dias, professor of Industrial Engineering Departament of
Pontifcia Universidade Catlica do Rio de Janeiro, because his opinion has been key in
the bibliography selection.
Amparo Cervera, professor of Market Research and Techniques of the Business
Administration Department of the Valencia University, because she gave me the access to
the Library of Harvard Business School, in Boston.
Clara Cardone, Director of the Master of Business Administration Program at the Carlos III
University of Madrid, for her advice and guidance.

CONTENTS
Introduction.
Exploration economics.
Exploration success chance.
Exploration considerations.
Economic factors influencing evaluations.
Energy and the Economy.
Oil and Economy. A Relationship of Diminishing Importance. The US example.
Measures of profitability: Those, which do not consider the time-value of money.
Payout.
Profit - to - investment ratio (ROI).
Time - value considerations.
Measures of profitability: Those, which consider the time-value of money
Internal rate of return.
Net present value.
Net present value gives better decisions.
Discounted profit - to - investment ratio (DPR).
Risk analysis and oil exploration.
Basic principles of statistics: sample space, event, relative frequence probability,
objective probability, subjective probability, conditional probability, etc
Probability theory.
Operation rules: addition, multiplication and Bayes theorems.
Analysis based on the condition of dependent events (sampling with
replacement)
Analysis based on the condition of independent events (sampling without
replacement)
Risk, uncertainty and estimating.
Decision analysis.
The expected value concept.
Meaning and interpretation of expected values.
Decision tree analysis.
Solving a decision tree.

Probability distributions.
Discrete, continous and cumulative frequency distributions
Measures of central tendency: mean, median and mode
Measures of variability: standard deviation
Distributions of interest in exploration risk analysis: normal and lognormal
distributions
Preference theory concepts.
The mathematical basis for preference theory.
Glosary of economic evaluation nomenclature

INTRODUCTION
Exploring for new reserves of oil and gas natural is a long-term economic priority for
mankind. New reserves must be located to provide economically viable and politically
secure petroleum sources essential to an expanding global economy in the future. Millions
and millions are spent every year in this search.
Oil and gas exploration is, however, a complex and risky business. Most exploration wells
are dry holes and are abandoned when drilling is completed, with only a fraction of them
leading to commercial developments of new oil and gas reserves.
The volatility of oil prices has raised major questions regarding the economic sense of
exploration program. The financial and regulatory environments for petroleum exploration
have become increasingly complex in recent years. Political risk may also be an important
consideration in many foreign countries.
Concerted evaluation of new exploration opportunities will not remove many of the difficult
to predict risks and uncertainties, but it can improve the economic efficiency of exploration
investments, resulting in annual savings of billions of dollars for the industry as a whole.
This course has been designed to provide a practical approach to assessing the economic
merit of investments made in exploring for new reserves of oil and gas in environments of
technical uncertainty. It strives to embrace the spectrum of business disciplines and
technological and financial considerations involved and weave them into cohesive format,
which facilitates simple yet comprehensive analysis.
The course has been organized in the general sequence in which business, operational
and financial factors are considered in the normal evolution of petroleum exploration. It is a
practitioners treatment, concentrating on the assembly and analysis of the best available
information and showing how to communicate to senior management the information used,
the way in which the analysis was done, the results which were obtained and the
implications these results may have for decisions a corporation may take.
While economics is one of the vital tools in decision making, economic analysis is not the
only criterion used; unquantifiable factors sometimes underlie major strategic moves.

EXPLORATION ECONOMICS
Is defined as quantifying our expectations, in financial terms, with respect to exploring for
and developing new oil and gas prospects.
Includes consideration of numerous technical and financial factors: exploration costs,
success chance, reserve size, well productivities, well spacing, facilities design,
development costs, transportation systems, oil/gas prices, contract terms, discount factors,
capital cost, etc.
According to official exploration drilling statistics, such as those reported by national
petroleum agencies, the conventional definition of success means simply that a well was
completed and did produce some hydrocarbons. But, geological success is not necessarily
the same as commercial success or even economic success. It is well-known the phrase
geological success but economic failure. The standard definitions of successs contain
some possible outcomes:
Geological success, meaning that a reservoired accumulation was found that was at
least large enough to support a flowing test. In onshore any well that flows is likely to be
completed, but many such small reservoirs encountered offshore are often reported as
shows.
Commercial success or completion success. The exploratory well was completed
because anticipated future production revenues will return a profit on the cost of
completing and operating it, but not on the costs of exploratory drilling, leasing, and
seismic, which are thus viewed as sunk cost and not recoverable. This is an economic
success on half-cycle basis, defined as the incremental economics of developing an
oil/gas prospect once a discovery has been made.
Economic success. The well was completed as the discovery well for a field in which
average wells generate sufficient production revenues to recover the cost to drill,
complete, and operate them, as well as the sunk cost to find the field, plus a reasonable
profit. Some authors said this is an economic success on full-cycle basis, defined as the
economics of discovering and developing an oil/gas prospect including the risk cost of dry
holes.
The motive for being in the petroleum exploration business is to make a financial profit. It
is clear the necessity of to find ideas, methods or criteria to measure the ventures
attractiveness.
The decision maker needs tools to distinguish those investment proposals that are not just
a geological success, but large enough to produce the necessary revenues to recover all
the expenditure, plus a certain level of profit to attract investors and, at the same time,
generate sufficient economic resources to continuing exploring.

EXPLORATION SUCCES CHANCE.

Petroleum geologist generally agree that for a subsurface accumulation of hydrocarbons to
exist, there must be porous and permeable reservoir rock, hydrocarbons that have moved
from a petroleum source rock to the reservoir rock, and a sealed closure or trap capable of
containing hydrocarbons.
All three of these requirements must be met for a hydrocarbons accumulation will be
present. This paradigm becomes the fundamental basis for employing geologic chance
factors in estimating probability of geologic success.
Serial multiplication of all factors produces a decimal serial fraction equivalent to the
probability that a hydrocarbons accumulation is present, which is the probability of
geological success.
The chance factors should be thought of as a links chain: if any link breaks, the chain fails.
If any one of the geologic factors is zero, the prospect will be dry.
Chance of hydrocarbon source
Chance of prospect structure
Chance of permeable reservoir
Chance of trapping seal
Composite chance of hydrocarbon discovery

=
=
=
=
=

0.72
0.60
0.50
0.40
0.0864

Chance that hydrocarbons will be oil

Chance of oil discovery

= 0.75
= 0.0648 or 6,48%

This link chain determine the shape of the probability distribution. The Central Limit
Theorem provides that distributions resulting from natural multiplication of independent
random variables will be lognormal. The lognormal distribution in petroleum science has
gained wide acceptance recently (see pag 42).
Dry hole risk broken in two major categories. Primary risk is defined as the perceived level
of exploration risk before the initial discovery is made in an exploration play or area, i.e.:
rank wildcat risk before a play has been demonstrated to be productive.
Secondary risk. Is defined as the perceived level of exploration risk after the initial
discovery has been made in an exploration play or area. Secondary risk is dependent
upon success at the primary risk stage and relates only to whether or not an individual
prospect will be a discovery within an already successful exploration play.
Independent prospects are defined as secondary risk exploration targets where a
discovery in any prospect does not materially change expectations regarding the chance
of making a discovery in exploring follow-up prospects.
Dependent prospects are defined as primary risk in any one of the prospects significantly
enhances the perceived chances for making follow-up discoveries. In some cases, failure
to make a discovery in a proximity risk prospect can result in a downgrading of discovery
expectations for follow-up prospects.

EXPLORATION CONSIDERATIONS
Exploration lands provide the necessary physical base for natural resource companies to
develop and undertake exploration programs to find new reserves of crude oil and natural
gas. Consequently, oil companies place a heavy emphasis on accumulating large
inventories of petroleum lands in attractive geological areas, which are considered to have
a good potential for yielding new petroleum discoveries. Attempts are usually made to
distribute the land holdings over a number of areas having differing types of petroleum
prospects and sometimes contained in a variety of political and administrative settings.
Exploration lands are usually made available by host governments to oil companies
through different ways. There are a number of key considerations linking land holdings
with economic viability of exploration programs including:
Acquisition. Oil and gas lands are made available to exploration companies by host
governments through a variety of means and systems. In most countries they are granted
by government discretion through negotiations and are based on the programs the
companies commit to carry out in exploring them.
Often the up-front costs to acquire such land are relatively low, and the companies are
required to carry out extensive work programs in order to maintain control of a significant
portion of the granted lands for an extended period of time. In other countries oil
companies must bid considerable funds up-front and in competition with one another to
obtain land rights for oil and gas exploration, absorbing considerable funds, which could
otherwise be utilized in undertaking exploration, work.
Oil companies also sell and/or trade interests in lands to other oil companies for
considerations of cash or for work which one company commits to undertake on another
companys behalf. Farmins and farmouts are particularly important land allocation
mechanism because of large land holdings and work commitments of some companies
and the benefits often gained in broadening the number of participants to bring fresh
exploration ideas to an area to share the burden and opportunity of the extensive and
costly work programs.
The cost of acquiring land interest, whether by direct purchase or by farmin, plays an
important role in the economic viability of many exploration opportunities. In some cases
the acquisition costs can be quite high in relation to the potential economic returns from
the land acquired, and because these costs represent expenditures at very outset of a
long program, they can weigh heavily against the ultimate program value when the time
value of those expenditures is considered.
Areal extent. Petroleum exploration companies generally seek large tracts of land on
which to carry out explorations activities. On average, only small fractions of initially sough
exploration land remain attractive after early exploration surveys are completed. Because
land selection often has to be made before the general geological potential of an area is
known, oil companies seek large tracts to increase the probability that at least a portion of
their lands will ultimately turn out to be geologically attractive and worth drilling.

Large land holdings in an active exploration area also mean that if a discovery is made in
the general area, the company will have a reasonable good chance of having a ground
floor interest in some of the follow-up exploration potential stemming from the initial
discovery. A large land spread is an oil companys insurance that it will have its fair share
of exploration and production activity in the future.
Permit term. The term of an exploration permit or license relates to the amount of time an
oil company has to explore a concession or contract area before it either converts its
exploration rights to a production permit or relinquishes them to the host government.
Terms for exploration concessions normally range from 3 to 7 years, but in some cases
are considerably longer.
During the exploration permit stage, an oil company normally conducts a series of jobs in
order to evaluate the lands and determine whether they are to be dropped or retained in
the form of a production lease. These front-end exploration costs have an extremely
important impact on economic viability of a project.
Work obligations. A company, which is awarded an exploration concession or contract
area normally, is required to undertake a pre-specified amount of exploration work in order
to retain longer term rights to at least part of the territory awarded. This requirements
usually takes the form of a work commitment which may be specified in terms of total
investment (budget) or total exploration effort, including geophysical surveys and drilling
number of wells (work program), which a company must achieve on a specified exploration
block in a specified period of time.
These work commitments are the host governments return for awarding the blocks for
exploration, and play a very important economic role in the overall outcome of investments
made on these lands. Predetermining an appropriate work program for a relatively
unexplored block is difficult to do effectively, and frequently the commitments turn out to be
either insufficient to test the true potential of a block or to be too onerous (too much work
too fast) to be justified based on a blocks true economic potential.
The important difference between discretionary work programs and mandatory work
programs has a fundamental impact on exploration economics, and is often not given
sufficient attention in assessing exploration program economics.
Relinquishments. Exploration permit lands awarded to oil companies usually have timespecified requirements to relinquish certain percentages of each awarded block at prespecified time points. This forces a company to assess the value of the lands, from a
regional perspective, as early as possible in order to retain the most promising portions for
future exploration work.
From a host government viewpoint, this encourages early exploration activity and keeps a
large portion of lands in circulation allowing other companies with different exploration
ideas to lease and explore them.
Working and carried interests. Working interests refers to the percentage participation a
company has in a petroleum concession or contract area. Normally, a company pays its
full working interest portion of the costs of exploration, development and production and
receives a pro-rata working interest share of revenues, which relates directly to its working
interests in the lands.

In certain cases where a company, the farmee, is farming in on the interest of another
company, the farmor, the farmee may spend all of certain exploration expenditure
obligations of the farmor in order to earn a portion of the farmors interest in certain lands.
In such cases the farmor is carried through the exploration expense by the farmee. Once
the farmee has earned its interest by fully meeting its expenditure obligations, it will be a
working interest partner alongside the farmor, and both companies will share future
expenditure on the lands in accordance with their respective working interests.
Operating environment considerations. The physical environment and surroundings, in
which oil exploration, development and production activities take place, play an important
role in the economic outcome or results of those activities.
If an exploration prospect is located onshore, it may be important to know whether or not it
is in a remote area, if the terrain is inhospitable, such a mountainous or desert, and
whether or not these activities will be exceptionally costly and take a long time to
complete.
If an exploration prospect is located offshore, it is necessary to know what depth of water it
is in, and what range of weather and oceanographic conditions can be expected over time
on the proposed location. These factors will bear heavily on the type and cost of facilities
required to drill the exploration well and particularly to develop a discovery, and will
significantly affect time requirements, capital and ultimately the potential economic
attractiveness of the prospect.
In both cases, onshore and offshore, when costs or investments are high, sometimes
resulting in fields reaching their economic limit at relatively high rates of production. In
such cases, fields may either have to be fairly large or to be developed in groups in order
to reduce the unit operating and transportation costs.
Finally, discovery of natural gas instead of oil can result in more difficult logistical problem
in gathering and transporting the production. Consequently, it is imperative that the nature
of the operating environment is fully appreciated and considered in the evaluation of
petroleum exploration prospect.

ECONOMIC FACTORS INFLUENCING EVALUATIONS

Following are some of the factors that influence an evaluation:
General Economics. Affect supply and demand.
Marketing Factors. Local factors, for example: avaibility of pipeline, refining facilities, etc.
Role of the Project in the Companys overall organization. What is the relationship of
the project to the overall company, facilities available, nature of company, expertise, etc.
Availability of capital. There are occasions that projects have to be postponed because it
is not possible to find funds, at reasonable price, or there is no room in the companys
budget.
Drilling, Development and Production Costs. Should be obtained from experience.
Look at costs in neighbouring areas, similar circumstances.
Value of Money. Varies with:
Time necessary for return.
Cost of obtaining it.
Opportunity cost of capital.
Availibility, equity/loan financing.
Reserves. Requires largest geological and engineering effort. Magnitude of reserves is a
serious area of disagreement because of interpretation.
Rate of Production. Governs flow of profit. Depends on reservoir characteristics.
Historical Trends. Give an idea of values to use. In the case of oil and gas we have to
consider the following:
Oil and gas prices.
Inflation.
Historical finding rates for oil and gas.
Capital trends of similar projects and past projects.
Opex or operating expenses. Linked to the production as: transport, fuel consumption,
salaries, maintenance, ancillary services, etc.
Capex or capital expenses. They are necessary but not related with the production:
acreage, buildings, facilities, machinery, etc.
Oil and gas prices. The economic reward for oil and gas exploration must finally come
from the sale of oil and gas production from the discoveries made and developed.
Consequently, expectations for the prices to be realized for the products over their
production life is an extremely important factor affecting the potential viability of exploration
programs.

The oil price is notoriously difficult to forecast. Oil supply and demand curves are not
typical of most comodities and the supply of oil is influenced by OPEC policy, who
currently produce about 40% of the worlds oil supply.
Economists would say that oil demand is inelastic, meaning that demand is not very
sensitive to price changes. This is because there are very few immediate substitutes for oil
in the short term.
On the other hand, oil price fluctuations are beyond the control of oil companies, and most
companies no longer use past oil trends for forecasting.
Gas prices differ from oil prices in that they are often contractually agreed with the buyer at
the outset of a project. The price per unit may have a fixed and variable componet, with
the variable componet being linked to the oil price, thus partly indexing the gas sales price
to the crude oil price.
Energy and the Economy
At least since the time of the first oil shock in October 1973, economists have struggled to
understand the ways that disturbances to the supply and demand balance in energy
markets influence economic growth and inflation.
At the most basic level, oil and natural gas are just primary commodities, like tin, rubber, or
iron ore. Yet energy commodities are special, in part because they are critical inputs to a
very wide variety of production processes of modern economies. They provide the fuel that
drives our transportation system, heats our homes and offices, and powers our factories.
Moreover, energy has an influence that is disproportionate to its share in real gross
domestic product (GDP) largely because of our limited ability to adjust the amount of
energy we use per unit of output over short periods of time.
Over longer periods, energy consumption can be altered more easily by, for example,
adjusting the types of vehicles that we drive, the kind of homes that we build, and the
variety of machines that we buy. Those decisions, in turn, influence the growth and
composition of the stock of capital and the productive capacity of the economy.
Beginning around 2003, futures prices began moving up roughly in line with the rise in spot
prices. Thus, unlike in earlier episodes, the significantly higher relative price of energy that
we are now experiencing is expected to be relatively long lasting and thus will likely prompt
more-significant adjustments by households and businesses over time.
In the long run, higher energy prices are likely to reduce somewhat the productive capacity
of the economy. That outcome would occur, for example, if high energy costs make
businesses less willing to invest in new capital or cause some existing capital to become
economically obsolete. All else being equal, these effects tend to restrain the growth of
labor productivity, which in turn implies that real wages and profits will be lower than they
otherwise would have been.
Under the assumption that energy prices do not move sharply higher from their already
high levels, these long-run effects, though clearly negative, appear to be manageable. The
developed countries economy is flexible, and it seems to have absorbed the cost shocks
of the past few years with only a few dislocations.

In the short run, sharply higher energy prices create a rather different and, in some ways,
a more difficult set of economic challenges. Indeed, a significant increase in energy prices
can simultaneously slow economic growth while raising inflation.
An increase in oil prices slows economic growth in the short run primarily through its
effects on consumer spending.
At the same time that higher oil prices slow economic growth, they also create inflationary
pressures. Higher prices for crude oil are passed through to increased prices for the
refined products used by consumers, such as gasoline and heating oil. When oil prices
rise, people may try to substitute other forms of energy, such as natural gas, leading to
price increases in those alternatives as well.
The rise in prices paid by households for energy--for example for gasoline, heating oil, and
natural gas--represent, of course, an increase in the cost of living and in price inflation. A
jump in energy costs could also increase the public's longer-term inflation expectations, a
factor that would put additional upward pressure on inflation.
Since about 1980 most Central Banks have worked hard to bring inflation and
expectations of inflation down. They attempted to contain the inflationary effects of the oilprice shocks by engineering sharp increases in interest rates, actions which had the
consequence of sharply slowing growth and raising unemployment, as in the recessions
that began in 1973 and 1981.
To the extent that households and business owners expect that the Central Banks will
keep inflation low, firms have both less incentive and less ability to pass on increased
energy costs in the form of higher prices, and likewise workers have less incentive to
demand compensating increases in their nominal wages.
Oil and Economy. A Relationship of Diminishing Importance. The US example.
In the long run, the higher relative prices of energy will create incentives for businesses to
create new, energy-saving technologies and for energy consumers to adopt them. The
market for alternative fuels is growing rapidly and will help to shift consumption away from
petroleum-based fuels. Governments can contribute to these conservation efforts by
working to create a regulatory environment that encourages the growth in energy supplies
in a manner that is consistent with our nation's environmental and other objectives.
It has become increasingly apparent that high energy prices have had far less of an impact
on the U.S. and global economy that previously believed. The reason is that the petroleum
consumption to gross domestic product and energy to gross domestic product ratios have
fallen sufficiently in the past few years to make the economy far less sensitive to price
increases than anytime in history. To say it another way, energy prices could go much
higher before having a significant impact. Or, energy could cost consumers more,
potentially a lot more, and not affect the overall economy
In U.S. Economy, the petroleum consumptionGDP ratio in the United States will fall to
nearly half the current level by 2025 in the base case. This implies that by 2025, the
economy will be even less sensitive to energy prices than it is today. Probably in the future
U.S. and global economy will continue to be less energy intensive over time.

MEASURES OF PROFITABILITY
This chapter considers the meaning and uses of measures of profitability, the parameters
used by decision maker to order, accept, reject, or compare investments proposals. These
parameters are also frequently called profit indicators, decision criteria or measures of
investment worth.
There is probably no single measure of profitability that considers all the factors or
dimensions of investment projects that are pertinent to the decision maker.
A good measure of profitability must be suitable for comparing and ranking investment
opportunities. And it should provide means of telling whether profitability exceeds some
minimum, such as the cost of capital or the firms average earnings rate.
The measures of profitability could be classified in two main groups:
Those, which do not consider the time-value of money. They judge the cash flows as they
were received at the same period of time. These indicators are not accurate but, often, are
very useful.
And those which consider the time-value of money and use the compound and discount
factors to homogenize the current of cash flows, which are received at different periods of
time.
Cash flows are defined as movements of money into or out the treasury. A good
understanding of cash flows in and out of the treasury is essential to the proper use and
interpretation of profitability measures. Expenditures for drilling costs, lease equipment,
and revenues from the sale of oil are examples of cash flows.
PAYOUT. It is defined as the length of time required to receive accumulated net revenues
equal to the investment or the length of time it takes to get the invested capital back.
Payout time is an approximate measure of the rate at which cash flows are generated
early in the project and can be expressed in terms of before tax or after tax.
All the factors equal, the decision maker would like to invest in projects having the shortest
payout.
One weakness of payout is it tells the decision maker nothing about of earnings after
payout time and does not consider the total profitability of the investment opportunity.
Consequently, it is not a sufficient criterion in itself to judge the worth of an investment.
Payout time has been in wide use for many years as an integral part of the economic
analysis of exploration opportunities. It is a useful parameter to compare the relative rates
of receipt of revenues early in the projects, but it is not a parameter that reflects or
measures all the dimensions of profitability, which are relevant in capital expenditure
decisions.
When cash flows are constant, the payout period will be equal to the quotient between the
initial investment C and the cash flow S; P = C/S.

PROFIT-TO-INVESTMENT RATIO. It is a measure that does reflect total profitability. It is

defined as the ratio of total undiscounted net profit to investment. It is a dimensionless
number relating the amount of new money generated from a project per monetary unit
invested. It is sometimes called the return-on-investment, or ROI.
Total sales Costs Investment (Capex) = Net Cash flow

Profit-to-investment ratio ( ROI ) =

Net Cash flow

Investment

The denominator of the ratio is usually the drilling cost of a well for a single well prospect.
If expenditures extend over a period of time before any revenues are received, the ratio is
sometimes computed using the maximum amount of cash invested in, but not yet
recovered from the project as the term in the denominator. This investment term is called
the maximum out of pocket cash and represents the lowest negative value on a cumulative
cash position curve.
The major weakness of these ratios is that they do not reflect the time rate patterns of
income from the project.
Example, consider Prospects A and B. Each has the same profit-to-investment and payout
ratios.
Prospect A
Producing rate at early projects life
Costs: $/month
Investment
Payout: months
Recoverable Reserves
Producing Life
Total Revenues
(2,92 $/Bbl, 12,5 % royalty and 5% tax)
Total Costs
Revenues - Costs
Net Profit
Profit-to-Investment Ratio

150 Bbl/d
575 $
150.000 $
14,3
200.000 Bbls
15 years
2,4 M$
103.500 $
382.000 $
212.000 $
1,41

Prospect B

Same

Same

150 Bbl/d
575 $
150.000 $
14,3
243.000 Bbls
30 years
2,9 M$
207.000 $
382.000 $
212.000 $
1,41

Most decision makers, if given a choice would prefer A over B because prospect A returns
total income in one-half time. Thus it should obvious that a missing dimension in these
parameters is the time-rate patterns of cash flows.
To stress this point in a different way, suppose you invest 1$ today to receive 3$ in three
years or 4$ in 10 years. Which would you prefer?

TIME VALUE OF MONEY CONSIDERATIONS

The usual method of relating the time-rate patterns of future cash flows to some measure
of profit is by use of time-value of money concepts: compounding and discounting.
C = Value of a principal sum, as of a specified time, time zero.
S = Value of the principal sum plus interest at a future point in time, n years away.
i = Effective annual interest rate.
n = Number of years separating C and S
The time-value of money considerations are based on the following relation:
C ( 1 + i )n = S

(1)

This equation is called the compound interest equation and relates the future value, S, to a
principal amount of money today, C. The term (1 + i)n is called a compound interest factor.
By dividing both sides of the equation by (1 + i)n we get a modified form of the equation,
called the present value equation:
C = S/( 1 + i )n

(2)

The term, 1/(1 + i)n , is usually called the discount rate factor, when used in the context of
above equation.
It is very important to recognize that C and S are equivalent in value, even though
separated in time by n years.
Thus, 100$ invested at 10% compound interest will appreciate in 146.4$ at the end of 4
years. If 10% represents the inflation rate, receiving 100$ today has no greater, or lesser,
value than receiving 146.4$ in 4 years. To say that 100$ today will become 146.4$ in 4
years is the same as saying that receiving 146.4$ in 4 years has a present value of 100$.
In most petroleum evaluations the common point time for comparing values of monetary
sums is the present time, or time zero. Consequently, equation (2) will be used more
frequently.
We normally speak of compound or discount rates in terms of the nominal interest rate per
year. If the investment earns interest once a year the nominal and effective interest are the
same. If interest is credited to the investment at periods less than a year, such a quarterly,
the effective interest rate is slightly greater than the nominal
It is necessary to avoid the common weakness of the first two indicators and introduce
those that measure or reflect the time-rate patterns of cash flows and the time-value of
money, providing a better quality analysis.

RATE OF RETURN. One of the more widely used profit indicators in recent years. It has
been given many different names, including discounted rate of return, internal rate of
return (IRR), marginal efficiency of capital.
It is the interest rate, which equates the value of all cash inflows to the cash out- lays when
these cash flows are discounted or compounded to a common point in time. Stated
differently, it is the interest rate, which makes the present value of net receipts equal to the
present value of investments.
The rate of return calculation is made after the series of anticipate future cash flows to be
received from the investment has been defined.
Mathematically is equivalent to solving the following rate of return equation:
- C + S1/( 1 + i )1 + S2/( 1+ i )2 + + Sn/( 1 + i )n = 0

(3)

C = initial investment at time zero (wildcat well)

S1 = net cash flow at year 1.
S2 = net cash flow at year 2.
.
.
.

n = number of years ( projects life ).

Sn = net cash flow at year n.
i = rate of return.
If cash flows are equal: S1 = S2 = ... = Sn = S the equation would be:
- C + S(( 1+i )n- 1/ i( 1 + i )n) = 0

S(( 1+i )n- 1/ i( 1 + i )n) = C

In addition, if the length of investment life is unlimited, the internal rate of return will be
defined by the equation:
- C + S/i = 0

i = S/C

If we compare the last equation with we specified in the payout, in case all cash flows are
equal, P = C/S, we can infer that the internal rate of return is equal to the reciprocal of
payout.
IRR i = S/C = 1/P

P = C/S = 1/r = Payout

Specific characteristics of the rate of return concept include:

Computation of rate of return requires a series of trial-and-error computations.

Introduces the time-value of money into the criterion.

It is a profit indicator that is independent of the magnitude of the cash flows.

There are certain types of cash flows in which there is more than one discount rate,
which satisfies the definition of rate of return. In cash flows having multiple rates of
return there is no way to establish which (if any) it is the correct. In situations like this
the analysis should be made using other criteria such as net present value.

Cash flows received early in the project are weighted more heavily than later.

It is a convenient measure of profitability to compare with a minimum.

It includes the implicit assumption that all cash flows will be reinvested at the computed
rate of return when received. This is extremely important characteristic, which is often
misunderstood or ignored by those who assume the criterion. To illustrate this point
consider the following investment project:
C = initial investment = 8.000
S1 = net cash flow at year 1 = 1.000
S2 = net cash flow at year 2 = 3.000
S3 = net cash flow at year 2 = 5.000
- 8.000 +

1.000
(1+r)

3.000
2

(1+r)

5.000

r = 4.54% = IRR

(1+r)3

If we suppose that the first cash flow is reinvested at 20% and the second at 10% the
IRR would be
- 8.000 +

1.000 (1.2)2 + 3.000 (1.1) + 5.000

(1+r)3

=0

r = 6.75% = IRR

But if cash flow were reinvested at 3%, the IRR would be

1.000 (1.03)2 + 3.000 (1.03) + 5.000
- 8.000 +

=0

(1+r)3

r = 4.5% = IRR

If cash flows remain in the security box of the company, the IRR would be

- 8.000 +

1.000 + 3.000 + 5.000

(1+r)3

=0

r = 4.0% = IRR

Rate of return is not a completely realistic parameter to rank competing investments.

Suppose we had two investment opportunities available with internal rates of return
10% and 30% respectively. The discount factor in a common period of time will be
higher for the investment opportunity with lower internal rate of return, and apparently a
monetary unit received from the project with lower internal rate of return has more
value than a monetary unit received from the other. But, in reality, the value of a
monetary unit in certain future period will have a certain value regardless of its source.

Rate of return is very sensitive to errors in estimating initial investment and early cash
revenues.

A rate of return cannot be calculated for the following situations:

Cash flows are all negative.

Cash flows are all positive.
Total undiscounted revenues are less than investment.

In summary, rate of return is certainly a more realistic measure of value than payout and
profit to investment ratio, primarily because it includes the time value of money concept. It
is a useful measure of the relative profitability of investments having approximately the
same total life and cash flow patterns. Its primary weaknesses as a measure of true
profitability are the frequent problems of not satisfying the reinvestment assumption.

NET PRESENT VALUE (NPV). It is similar to rate of return except that a single, previously
specified discount rate is used for all economic analysis. It is usually called the average
opportunity rate, and presumably represents the average earnings rate at which future
revenues can be reinvested. One of the advantages of net present value over rate of
return is that is computed using a more realistic appraisal of future investment
opportunities.
- C + S1/( 1 + i0 )1 + S2/( 1+ i0 )2 + + Sn/( 1 + i0 )n = A (npv)

(4)

A is, by definition, the net present value discounted at the average opportunity rate. One of
the advantages of npv over rate of return is that it is computed using a more realistic
appraisal of future investment opportunities.
If it is positive it means that the investment will earn a rate of return equal to i0 plus an
additional amount of cash money equal to the npv. If the average opportunity rate used is
realistic of the firms ability to invest capital, then it follows those investment opportunities,
which have a negative npv, should be rejected.
Characteristics of npv as a measure of profitability include the following:

Computation is no longer a trial-and-error solution. There is only a solution.

It has all the features of rate of return regarding time-value of money, plus the added
fact that the reinvestment assumption is satisfied because the discount rate
presumably reflects future investment opportunities.

If npv=0, then the investment is yielding an internal rate of return (IRR) equal to
discount rate used i0. If it is negative it means that the investment will yield a rate of
return less than i0. If positive, the sum represents present value cash worth in excess
of making a rate of return equal to i0.

The npv is independent of size of cash flows.

The npv concept can be used to evaluate investment alternatives in which all of the
cash flow terms are negative. In this instance the preferred decision option will have
the least negative present value.

Specifying the rate to use for npv computations is sometimes not an easy procedure.
The usual first reaction is to check the overall corporate annual earning rate in past
years. But, it may not be realistic because the desired rate is what future invested
capital will earn. Predictions of the rate at which future revenues can be reinvested
involve an element of uncertainty. The discount rate for npv calculations is usually set
by top management after consideration of at least some of the following factors:

If the firm is operating on borrowed capital the rate should at least exceed the
interest rate being paid on the loan.

If the capital comes from several sources (internally generated funds, debt and
equity), the average cost of capital is sometimes used as minimum value of i0.

Corporate growth objectives.

The risk of oil exploration as compared to less risky investments such as refining,
marketing, etc.

Future investment opportunities. Are they limited or unlimited?

Npv became very popular and widely used, because the reinvestment assumption is
completely satisfied and based on time-value money system. It is meaningful for all types
of cash flows (including those having all negative terms) and compatible with risk factors.
NET PRESENT VALUE GIVE BETTER DECISIONS.
Consider the following investment projects and that the opportunity cost is 10%
Project
A
B

C0
-2.000
-2.000

C1
+2.000
+1.000

C2

C3

+1.000

+5.000

Payout
1 year
2 years

NPV @ 10%
- 182
3.492

Project A needs 1 year to recover 2.000 and project B, 2 years. If the company use 1
year payout as the criteria to choose investments alternatives, it will choose only project A.
If company uses 2 years payout as criteria, it will accept both projects. As we can see, the
payout criteria give different answer than npv. The reason is because payout gives same
weight to all cash flows generated before to the recovery period.
In the next example all projects have same payout. But project B has a bigger npv than
project A for any discount rate (1.000 in years 1 and 2 have more value than 2.000 in
year 2). And project C has a bigger npv than projects A and B.
Project
A
B
C

C0
-2.000
-2.000
-2.000

C1
+1.000
+1.000

C2
+1.000
+2.000
+2.000

C3
+5.000
+5.000
+5.000

Payout
2 years
2 years
2 years

NPV @ 10%
3.492
3.409
74.867

When a company uses the payout criteria has to establish a time limit. If use a limit without
considers the length of the projects, it will tend to approve too many short projects. If the
average length of the projects is too long the company will accept some projects with npv
negative. On the contrary, if projects are short the company will reject some of them with
positive npv.

As an example, it will be considered a project with the following cash flows:

Co= - 4.000; C1= 2.000; C2= 4.000
NPV
+ 200

+ 100
IIR = 28%
10%

20%

40%

50%

Discount rate

- 100

- 200

If opportunity cost of the capital is less than IRR, 28%, the npv will be positive. If it is equal
to IRR the npv will be zero and if is bigger than IRR the projects npv will be negative. IRR
criteria will give same answer than npv if the npv of a project is a decreasing function of
discount rate.
But not all cash flows have the quality that npv decrease while discount rate increase.
Example:
Project

A
B

C0

-1.000
1.000

C1

1.500
-1.500

IRR

50%
50%

NPV @ 10%

364
-364

If we choose based on IRR criteria both projects are equally attractive. But it is clear that
they are not. In project A we pay a certain amount of money, or we lend money at 50%
interest rate. In project B we receive money, or we borrow at 50% interest rate. When
people lend money wish the highest interest rate as possible. On the contrary, when
people borrow always tried to pay the lowest interest rate. It is what banks do. The interest
rates of active are higher than interest rates of passive.
If we drawing the discounted cash flows of project B we will see that npv increase while
discount rate rise. It is clear that in these circumstances the IRR does not work.
Other problem that it is possible to find with IRR criteria is when certain types of cash flows
have more than one discount rate, which satisfies the definition of rate or return. Examples
of cash flows, which lead to multiple rates of return, are those projects requiring a large
expenditure at a later point in the life of the project. A necessary condition to have multiple
rates of return is a second sign reversal in the cumulative cash position. But a second sign
reversal is not a sufficient condition. It also depends on when the second reversal occurs
and the magnitude of negative cash flows causing the reversal.

NPV
+ 1.000

IRR = 15,2%

-25%

-1.000

0%

25%

50%

Discount rate

IRR = -50%

As we can see in the drawing the cash flow of the following example, there are two
solutions that make npv equal to zero: -50% y 15,2%.
Co = -1.000, C1 = 800, C3 = 150, C4 = 150, C5 = 150, C6 = -150
In cash flows having multiple rates of return there is no way to establish which, if any, of
the rates is the correct, or true IRR. And we must aware that in exploration and production
these circumstances can occur when it is considered the abandon cost of a project.
Moreover, it is possible to find cases where do not exist any IRR, such as the following
example shows.
Project D C0 = 1.000 C1 = -3.000 C2 = 2.500 IRR = no NPV (10%) = 339
Other problem that can arise is, when decision maker is choosing among different
alternatives to make the same project, or simply, when he is analysing mutually exclusive
projects.
Project E

C0 = - 10.000

C1 = 20.000

IRR = 100

NPV (10%) = 8.182

Project F

C0 = - 20.000

C1 = 35.000

IRR = 75

NPV (10%) = 11.818

Project E can be, for instance, an industrial process manually controlled and project F,
same process but automatically controlled. Both projects are good, but results are
opposite depended on the criteria used.
In cases like this, the way to solve the dilemma is analyse the IRR of incremental cash
flow. First, it will be necessary to study the IRR of cash flow of the smaller project. Then, it
will analyse if is worthy to go ahead with the additional investment of 10.000. The
incremental cash flow will be:

Incremental cash flow C0 = -10.000 C1 =15.000 IRR = 50 NPV (10%) = 3.636

All these examples have helped to show how to solve some of the discrepancies that
appear when are compared the results obtained with npv or IRR criteria. At same time
they make clear that, sometimes, the IRR is not a useful measure of profitability to
classified projects of different size.
DISCOUNTED PROFIT-TO-INVESTMENT RATIO (DPR). To sidestep the weakness of
npv being independent of the absolute size of cash flows, it is advantageous to use the
criterion called Discounted Profit-to-Investment Ratio, which is the dimensionless ratio
obtained by dividing npv by the present value of the investment.
Projects net present value
Discounted profit to investment =

= DPR
Investment

The ratio is interpreted as the amount of discounted net profit generated in excess of the
average opportunity rate per monetary unit.
Characteristics of dpr ratio include:

It has all of advantages of npv plus providing a measure of profitability per monetary
unit invested.

It is a suitable measure of value for ranking and comparing investment opportunities.

Some authors conclude that the dpr is the most representative measure of true earning
potential of an investment.

The dpr ratio will always be positive or zero, but never negative.

It should be reasonably obvious that use of a single discount rate gives a more realistic
measure of true profitability than does a rate of return. This implies the superiority of npv.
And since rarely companies have unlimited supply of money, and on the other hand they
work on budget restrictions, we must consider the importance of trying to choose
investments that will give the maximum gain per unit of money invested. This leads to the
investment strategy of maximizing the discounted profit-to-investment ratio.
If we consider the following example with three projects, and the opportunity cost is 10%.
Project
A
B
C

C0
-10
-5
-5

C1
30
5
5

C2
5
20
15

NPV 10%
21
16
12

Based on npv criteria all three projects must be approved. But, if it is established that the
maximum budget expenditure is 10, it is not possible to carry out all the projects together.
Projects B and C have lower npv than project A, but the addition of npv of projects B and C
is bigger than the npv of A.

The discounted profit-to-investment ratio is useful to select investment opportunities under

the constraint of limited capital, when it is essential to gain the most profit per monetary
unit invested.
Project
A
B
C

Investment
-10
-5
-5

NPV @ 10%
21
20
15

Index
2,1
3,2
2,4

Project B has the highest index, the next higher is project C. If budget establish a limit of
10, both projects must be selected.
Unfortunately the application of these criteria can have some problems. One of the most
important is when the constraint affects to more than one variable. We will see it in the
next example. The budget limit of 10 is extended to the years 0 and 1 and it is enlarge the
number of projects with a new one D.
Project
A
B
C
D

C0
-10
-5
-5
0

C1
30
5
5
-40

C2
5
20
15
60

NPV @ 10%
21
16
12
13

Index
2,1
3,2
3,4
0,4

One solution can be to accept projects B and C, but in that case it is not possible to
approve project D because go beyond the budget constrain in year 1. If it is accepted
project A, that provide a cash flow of 30 in year 1, t will be possible go ahead with project
D, obtaining a profitability index lower than projects B and C but with a higher total npv.
This fault is produced because there are more than one limit. It is not possible to anlysed
with this criteria a mutually exclusive projects or a project which is dependent of another.
This simplicity of this method can compensate their limitation, which can be solved using
the lineal programmation.

RISK ANALYSIS AND OIL EXPLORATION

The measures of investment worth considered previously were all non-risk parameters.
The criteria did not include explicit statements about the degree of risk or uncertainty
associated with a given investment. We are all aware, however, that oil exploration
involves a great deal of risk and uncertainty.
Modern risk, 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.
The applications for early studies concerned games and gambling, then interested to
actuarial and insurance companies.
Petroleum exploration is a process of repeated trials under conditions of uncertainty, each
trial requiring a substantial commitment of investment capital. As such, the casino analogy
is apt, but because it is not certainly what the odds are, or the size of the prize, it is
necessary to employ modern science and technology to refine the bets as: Stratigraphy,
Geochemistry, Geophysics, Drilling technology and Reservoir technology.
The systematic employment of statistics and probability theory in exploration did not begin
until mid-1960s, led by Exxon, Shell, and Arco. By the late 1970s, companies like
Chevron, BP, and Elf, as well as some governmental agencies, IFP, USGS, were also
beginning to employ risk analysis in their explorations evaluations.
In 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 methodologies of exploration risk analysis used
by most oil companies have converged to the status of a generally accepted technology.
BASIC PRINCIPLES OF STATISTICS. Risk is somewhat of a catchall term, in that we
may have the need to quantify or asses many types of risks: risk of an exploratory or
development dry hole; political risk, risk to future oil/gas prices, risk that a discovery will
not be a large enough to recover initial exploration costs, environmental risk, etc.
The problems relating to making exploration decisions under conditions of risk and
uncertainty have been with this industry since the oil business began. Early attempts to
define risk were pretty informal and usually involved adjectives rather than probabilities.
Later the new discipline of statistical decision theory began to emerge, and exploration
decision makers began to take note of the potential benefits of decision analysis.
The problem involved in using decision analysis is where do we get all the probabilities
required to solve a decision tree or compute an EMV. Risk analysis is, probably, the
weakest link of the overall decision process. But what is our alternative? Even though risk
analysis is tough, the alternative of ignoring it is untenable. This requires that we attempt
to improve our expertise at evaluating risk and communicating our findings in a clear,
concise manner to the decision maker.
Depending on the grade of information that the decision maker has about all parameters,
which defined an event, in our case, an investment, it is possible to distinguish three
situations:

When all variables can have just one state. That is, the probability of occurrence is 1.

When the variables are aleatories. The values are known in terms of probability.

Total uncertainty. The decision maker does not know the probability of occurrence of
the different parameters of the event.

Until now, the word probability has mentioned many times, the assessment of the
probabilities of occurrence for each possible outcome, without being very specific about its
definition. Now is the time to remind some basic principles of statistics.
Deterministic or causal phenomenons are those that keeping constant all factors the
results always will be equal. On the contrary, aleatory or stochastic phenomenons are
those that although all factors are kept constant the results have variations
It is knew that when aleatory phenomenons are repeated a large number of times it is
possible to find certain rules in their behaviour, proving that there are certain laws, the law
of large numbers, giving stability to these phenomenons. Statistics is the science that
studies these types of phenomenon. If Statistics analysed events that are repeated many
times, trying to find its regularity it is clear that any study should based on watching
experiments or samples.
Sample space is a set or list of all the possible things that can occur from an experiment,
chance phenomenon, or a decision under uncertainty. It is also called a population.
Event is defined as a part of the sample space whose occurrence is of special interest. An
event may be defined in any way we please, and it may contain one, two or more of the
elements of sample space. The size of the sample space is the number of events that
form the population and it can be finite or infinite.
It is obvious that it is not possible to study all the events in infinite or almost infinite
samples. That is the reason why it is necessary to use a small sample and then to extend
the conclusions to the whole sample. The Statistics try to find regularity that appear in
certain phenomena and also, to forecast their behaviour.
As an example suppose we have a standard Spanish deck, which consist in 40 cards, and
we are considering a wager involving the withdrawal of a card at random from the deck. In
this case there are 40 elements in the sample space.
In petroleum exploration is possible to define a sample spaces like: the number of
structures which have oil in a basin, the number of producing wells in a field, or all the
possible values of recoverable reserves in a structure.
Now, it is necessary to define what mean a probability number, or a probability of
occurrence. There are three main definitions which can be given to express probability:
relative frequency, or statistical; a classical, or objective definition; and a subjective
definition.

Relative frequency definition of profitability: It is the long run ratio of the number of
times the event has occurred divided by the total number of times the experiment has
been repeated. An alternative definition is that probability is the ratio of the number of

elements defined as the event divided by the total number of elements in the sample
space.
Examples of this might be: the probability of withdraw a queen is 4/40 in the Spanish
deck, or a wildcat success ratio in hydrocarbons exploration.
There are some chance phenomena of interest where a probability cannot be computed in
this manner. What is the probability of an earthquake occurring certain future date in a
concrete place? How would we determine its value? This phenomenon is not a repetitive
process that could be experiment with a study. It is necessary to consider an alternative
definition of probability. called the classical or objective definition.

Classical or Objective Definition of Probability. It is defined as a measure of the

degree to which available evidence supports a given hypothesis. This measure is
determined by purely objective logic.

The usual way we think about risk in oil exploration is an example of this meaning of
profitability. The explorationists hypothesize that a structure has oil, or a given level of
reserves, and they look at all the evidence which supports the hypothesis: the nearby
structure has oil, rock strata appear correlative, etc. Then, by purely objective logic, the
probability is determined as the degree to which this evidence supports the hypothesis
Structure has oil.
From a practical viewpoint this definition may be difficult to use because explorationists
are usually not free of human emotion about their hypothesis. This leads to a third
definition of profitability.

Subjective Definition of Probability. It is a personal opinion of the likelihood that an

event will occur. A subjective probability estimate represents the extent to which an
individual thinks an event is likely to occur. It is a degree of belief.

Subjective probability estimates are sometimes used where past statistical data are not
available and/or the information is of an indirect nature. These estimations are influenced
by a persons biases, emotions or past experiences, etc.
It is also known as a priori probability and correspond an honour place in its use to the
economist John Maynar Keynes. And because the decision maker never is a situation of
total uncertainty, this idea of profitability has been restored to use in the analysis of
economic decisions.
From mathematics viewpoint subjective probability does not exist, but in the real world of
hydrocarbons exploration, often, it is the only way to consider the probability because
technical people do not have enough information.
In oil and gas exploration risk analysis the tree definitions of profitability are used and
people will not have to concern about which of tree is the most appropriate to use.
There are other important statistical terms that it is necessary to remind as:

Equally likely events. Two or more events are said to be equally likely if they have the
same probability of occurrence. When we are playing with a die, the probability of

obtains 1, 2 ... or 6 is the same and equal to 1/6. The probability distribution of this
event is uniform

Mutually exclusive events. Events are mutually exclusive if the occurrence of any
given event excludes the occurrence of all other events. Mutually exclusive events
have no points of the sample space in common. When it is drilled a wildcat well and it
is unsuccessful implies that it is impossible to find 100 M of oil.

Independent events. Two or more events are independent if the occurrence one
event in no way affects, or are affected by the occurrence of the other events. An
example is flipping a coin, which has no memory and each flip is a new experiment.
Whatever has happened previously has no effect on the probability of a head or tail on
the next flip.

Conditional probability. When two or more events are not independent they are said
to be dependent. Conditional probability is the probability of an event given that some
other has already occurred.

The last two definitions are very important from oil exploration viewpoint, and it is
necessary to be very precise about the distinction between independent or dependent
event in risk analysis.
PROBABILITY THEORY.
The probability is a measure of the grade of certainty that someone has about the chance
of occurrence for a possible outcome.
The probability theory has a set of rules of operation in the same sense that the number
system has a set of rules of operation: addition, multiplication, etc, that now is useful to
remind briefly.
Total probability or addition theorem.
For a number of events, which are mutually exclusive, the probability of any one of the
events occurring is the sum of the individual probabilities.
P(S1 + S2 + S3) = P(S1) + P(S2) + P(S3)
The probability of event S1 and/or event S2 is equal to the probability of S1 occurring plus
the probability of occurrence of S2 minus the probability of both S1 and S2 occurring.
P(S1 + S2) = P(S1) + P(S2) - P(S1 S2)
Compound probability or multiplication theorem.
This theorem is used to find the probability of two events occurring in sequence, or
simultaneously. The theorem is interpreted as: the probability of S1 and S2 occurring is
equal to the probability of S2, given that event S1 has occurred, multiplied by the probability
S1 occurring in the first place.
P(S1 S2) = P(S2/S1) P(S1)

The term P(S2/S1) is called a conditional probability. This theorem applies, for both,
independent and dependent events.
Define event S1 as drawing a king in the Spanish deck on the first draw, and event S 2 a
queen on the second draw. Assume for the moment that the first card is not replaced in
de deck prior to the second draw. What is the probability of both events occurring? What
is P(S2/S1)?
The likelihood of drawing a king on the first draw is 4/40. Since the card is not replaced in
the deck there are only 39 remaining cards on the second draw, and the likelihood of
drawing a queen on the second draw is 4/39. Hence, it is possible compute the
probability of events S1 and S2, (4/40) (4/39). The sequence in this example is said to be
dependent. But, if the first card is placed back in the deck the probability of draw a queen
on the second draw is 4/40. So, using the multiplication theorem we obtain now that the
probability of events S1 and S2, is (4/40) (4/40).
If a series of events are independent the probability that all the events will occur
simultaneously is the product of the individual probabilities of occurrence.
As an example of exploration involving conditional probabilities, we can think in an
explorationist who is analysing a drilling prospect in a field. There has been 20
successful gas completions drilled in the field having reserves ranging from 3-6 Bcf per
well. The field appears to have some rather complex stratigraphic variations and it is
difficult to predict the reserves. As an attempt to determine probabilities he tabulated the
reserves as follows:
Reserves volume
3 Bcf

N of wells
7

Percent
35%

4 Bcf

35%

5 Bcf

20%

6 Bcf

10%
20

100%

After detailed study and comparisons with nearby correlative areas he concluded that the
probability of finding gas is about 25%. The probability of finds gas and that the level of
reserves would be 3 Bcf is:
P(S1 S2) = P(S2/S1) P(S1); Probab gas and 3Bcf reserves = 0.25 x 0.35
Bayes Theorem
Often, at the time of making the decision there may have been little or no information
available upon which to base the probability estimates. Because of this it may be important
to revise, or reassess these initial probability estimates as new information becomes
available. The Statistical method to revise probability estimates from new information is
calls Bayesian Analysis.

The theorem is easily derived from the addition and multiplication theorems already
discussed.
S1

S1 H

S2

Sn

Sn H

An explorationist defines a mutually exclusive events series, S1, S2,... , Sn, which initial
probabilities of occurrence are P(S1), P(S2),... , P(Sn). These estimates are called a priori
probabilities.
H is an event, occurrence of something, which gives new information allowing to revise the
initial values of the probabilities. And now the explorationist must reassess the initial
estimates obtaining new values called a posteriori" probabilities, which can be computed
from the following equation:
P(Si/H) = P(Si) P(H/Si) / P(Si) P(H/Si)
Lets consider a numerical example. Suppose the exploration department has made a
geological analysis of 12 seismic anomalies of about equal size. Because the information
the company have is poor, there is uncertainty about how many of the anomalies will
contain oil, and establish several possible states of nature
S1: 7 anomalies contain no oil and 5 anomalies contain oil; P(S1) = 0,33
S2: 9 anomalies contain no oil and 3 anomalies contain oil; P(S2) = 0,67
The company decide to drill a wildcat on one of the twelve anomalies and it turns out to be
a dry hole. How can this new information be used to revise our original estimates of the
likelihood of each of hypothesized states of nature?
We will use Bayes Theorem to gain an insight and restimate the a priori probabilities and
computing the conditional probabilities.
What is the probability that the first anomaly drilled will be dry? P(S 1) = 7/12 = 0.58. And,
what is the probability that the second anomaly drilled will be dry? P(S2) = 9/12 = 0.75.
What is the revised probability that S1 is the true state of nature given the evidence of one
dry hole? That is, P(S1/H)?
P(S1/H) = P(H/S1) P(S1) / P(H/S1) P(S1) + P(H/S2) P(S2)

P(S1/H) = (0,58)(0,33) / (0,58)(0,33) + (0,75)(0,67) = 0,28

What is the revised probability that S2 is the true state of nature given the evidence of one
dry hole? That is, P(S2/H)?
P(S2/H) = P(H/S2) P(S2) / P(H/S1) P(S1) + P(H/S2) P(S2)
P(S2/H) = (0,75)(0,67) / (0,58)(0,33) + (0,75)(0,67) = 0,72
S1: 7 anomalies no contain oil and 5 yes; P(S1) = 0.33; P(S1/H) = 0.28
S2: 9 anomalies no contain oil and 3 yes; P(S2) = 0.67; P(S2/H) = 0.72
1.00
1.00
ANALYSIS BASED ON THE CONDITION OF DEPENDENT EVENTS (Sampling with
replacement)
It is very important to distinguish the analysis based on dependent or independent events.
But, how can it is possible to tell if a real world series of wells are independent or
dependent events?
To answer this question lets consider an experiment in which the 40 cards of a Spanish
deck are thoroughly shuffled and then laid face down on a table. For this analogy well
assume that each card represents a geologic prospect in a basin.
Lets suppose further that all the gold represent oil productive prospects and all the rest:
spades, cups, etc correspond to prospects having no oil or gas. To complete the analogy
supposes that selecting a card (which is face down initially) and turning it face up is
equivalent to drilling a prospect. Before any wells are drilled what is the likelihood of
finding oil? As we know, the answer is 10/40.
Suppose the card turned up was a gold. Now what is the likelihood of the second card
turn up also being a gold? As long as there are 39 faces down left, the answer is 9/39.
This probability is a conditional probability. The sequence of turning up the two cards in the
manner just described is said to be a series of dependent events. Nature has distributed n
prospects in a basin, some of which have oil and some are dry. As we drill each prospect
we are, in essence, turning one of the cards face-up to see if it is oil or dry. But this card is
then left face up and there is one less in the sample space of outcomes on the next trial. In
the real world once a prospect has been drilled it is removed from the total of those
remaining to be drilled. Each system is one of sampling without replacement.
What would be equivalent analog be if the card experiment represented a series of
independent events? The experiment would be the same, and on the first card selected
the odds of a gold would be 10/40. Then, the card is faced down before selecting another
card and the odds of the second card being a gold would be exactly the same 10/40.

This last analog, clearly, does not apply to the real world because of the fact that once a
prospect is drilled, and observe weather it has oil, it is not possible to un-drill. As result of
this, it is obvious that a sequence of drilling several exploration wells is a sampling without
replacement process. The probabilities of what is left to find at any point are dependent
upon what has been found thus far.
As an example, suppose that exploration department has identified 10 prospects of which
30% were estimated to have oil. What is the probability of finding two discoveries in a 5
well exploration program?
Suppose the first two anomalies tested were oil productive and the next three were dry.
Using symbols P = productive and D = dry, the sequence would be P, P, D, D, D. What is
the probability of this sequence occuring? The likelihood of the first anomaly selected
being oil productive, all other factors equal, is 3/10. The conditional probability of the
second anomaly being oil, given the first was oil is 2/9.
The conditional probability of the third being dry is 7/8. The conditional probability of the
fourth anomaly being dry is 7/8, given that two oil anomalies had been found plus one of
the dry anomalies is 6/7. Finally, the conditional probability of the fifth anomaly being dry,
given that two of the four already tested had been found to be dry is 5/6. The likelihood
that this entire sequence of P, P, D, D, D. could occur is the product of these five
probability terms: 3/10 x 2/9 x 7/8 x 6/7 x 5/6 = 3/72.
Is this the answer to our original question? Definitely not. This is the probability of one
particular way to obtain 2 discoveries in 5 wells, but there are other sequences which also
could occur: P, D, P, D, D, or P, D, D, P, D, etc. There are 10 mutually exclusive ways of
achieving two discoveries in five trials. The probability of each sequence, based on the
condition of sampling without replacement, dependent events, 3/72.
Applying the addition theorem we will sum 10 times the probability of each sequence ant it
will result 30/72.
ANALYSIS BASED ON THE CONDITION OF INDEPENDENT EVENTS (Sampling
without replacement)
While we have just tried to demonstrate that the realities of the drilling of a sequence of
exploration wells is one of dependent events, there are several special instances where
the parallel system of independent events applies.
When each exploration well in the n well program is in a different basin, and the case
where geology varies so rapidly that each well drilled is nearly a separate reservoir.

RISK, UNCERTAINTY AND ESTIMATING.

Risk and uncertainty are inherent aspects of investing in petroleum exploration ventures.
The tasks in serial exploration decision making are to be consistent in dealing with risk and
uncertainty, and to perceive uncertainty realistically, reducing it where possible.
Mineral exploration can be defined as a series of investment decisions, whether to acquire
additional technical data, geological, geophysical, engineering or drilling, and/or additional
mineral interests.
The most critical decision in petroleum exploration is not which prospect to drill; it is which
basin or trend to explore. A play is a family of geologically similar fields, discoveries,
prospects and leads. In order to understand the principles of play analysis it is necessary
first, understand the risks analysis of prospects, simply because plays are aggregates of
geologically similar prospects.
Once the exploration trend has been selected, the first step is the identification of drilling
prospect by geoscientists. 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 second step is measuring value of producible reserves, estimating the chance of
hydrocarbon accumulation and estimating the profitability of the project.
Finally, the third step consists of implementation and management of exploration projects
as business ventures, and includes additional tasks: acquisition strategies, determining the
terms under which the company would commit to explore, and portfolio management,
choosing which prospects should include in the annual drilling program to maximize
economic return.
Each decision should produce a progressively clearer determination of risk versus reward,
and support timely management action concerning the inferred mineral deposit o
accumulation. An idealistic definition of exploration might be a series of investment
decisions made with decreasing uncertainty.
Some authors used risk and uncertainty as synonymous, others considered them to be
separate and distinct factors. Risk connotes the threat of loss. Risk decisions weigh the
level of investment against four considerations: net financial assets, chance of
success/failure, potential gain and potential loss. The last three considerations must rely
on estimates of probabilities that some conditions may occur. In other words, uncertainty
refers to the range of probabilities that some conditions may exist or occur.
Every exploration decision involves considerations of both risk and uncertainty. Risk
comes into play in deciding how much we are willing to pay for additional data or mineral
interests, considering the high impact of front-end costs on project profitability. Uncertainty
is intrinsically involved in all geotechnical predictions about the range of magnitude of the
inferred mineral deposit, the chance of discovery, and the cost of finding and developing it.
Once prospects have been identified, the problem in serial exploration decision is twofold:

to be consistent in the way we deal with risk and uncertainty, and

to perceive uncertainty accurately and reduce it where possible.

One of the problems is how to express the technical uncertainties realistically, and in a
form by which they can be utilized in economic equations and subjected to evaluation. The
most common convention in use today by modern petroleum corporations involves the
formulation of a range of anticipated values for a given parameter with probabilities,
ordinarily 90%, 50% and 10%.
For example, the geologists may believe there is a 90% chance that the anticipated payzone will be more than 10 feet thick, and she may be 50% confident that it will be more
than 20 feet thick, but she is only 10% sure that it could be more than 40 feet thick. The
same procedure may be applied to any parameter: productive area, initial production rate,
decline rate or drilling costs. Such estimates must rely on objective considerations of all
relevant data: maps, cross sections, geophysical data, borehole log interpretations, etc.
The concept of expected value, that we will see immediately, offers an effective way to
evaluate risk ventures.

DECISION ANALYSIS
Consider the operator of a casino containing a certain number of gaiming devices and
table: 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 repeted-trial game in which the expected value of each trial, for
him, is positive. When expected value is positive, it is an investment when expected value
is negative, it is a game.
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.
The casino analogy may be distasteful to petroleum managers, but it is actually a pretty
fair analog to centralized drilling portfolio.
The diversity of investments opportunities, such as drilling wells, enhanced recovery
projects or property acquisitions, could be likened to the various types of games such as
roulette, blackjack, etc.
Repeated trials at the roulete are analologous to the prospects in the annual exploration
portfolio. And, finally, the casino operator cannot predict which spin of the wheel will
produce a win, as exploration manager cannot predict which prospect will be a discovery.
However, there are some significant differences between operating a casino and annual
exploration portfolio.
The actual odds on every drilling venture cannot certainly known; they can only be
estimated. But the ability of the firms explorers to estimate chance correctly can be
measured and improved. The basic problem is that different explorers, in different geologic
areas, are estimating prospect reserves, profitability and chance of success. This calls for
the adoption of consistent methods throughout the company.

There are fewer wells in the drilling portfolio than there are spins of the roulette wheel.
Most exploration portfolio contains only about 10 to 100 exploration wells.
The payoff at the gaming table is inmediate and the payoff at the wellhead is long-term
and subject to fluctuations in price and politics.
THE EXPECTED VALUE CONCEPT. The oil exploration has frequently been given the
dubious distinction of being the classic example of decision making under uncertainty.
Each time he decides to drill a well the decision maker is playing a game of chance in
which he has no assurance that he will win.
Decision analysis considers the element of risk and uncertainty in a quantitative manner
and provides a means to incorporate the dimension of risk into a logical and consistent
decision strategy under conditions of uncertainty.
The cornerstone of Decision Analysis is the expected value concept, a method for
combining profitability estimates with quantitative estimates of risk to yield a risk-adjusted
decision criterion. This method of analysis whereby the various consequences of each
decision can be evaluated and compared. All formal strategies for decision making under
uncertainty rest on the expected value concept.
A decision to drill could result in a dry hole, or a marginal discovery, or a giant discovery.
Decision making under uncertainty always involves at least two possible outcomes for
each decision alternative. Each outcome has some likelihood of occurrence, but none is
certain to occur.
If we knew exact values for all parameters, which affect overall profitability, we would be
able to compute an exact value of project profitability. Such calculation would be called
deterministic value of profitability. If we do not exact values for each of the parameters
the computation is said to be stochastic.
If the consequences of all possible decision alternatives could be computed exactly the
process of decision would be much simpler. It is the unknown resulting from our inability to
measure or predict values of the profit before the events happen that makes the decision
making process complicated.
Quantitative statements about risk and uncertainty are given as numerical probabilities, or
likelihoods of occurrence. Probabilities are decimal fractions in the interval zero to one. An
event, which is certain to occur, has a probability of occurrence of 1, and an event that
cannot occur has a probability of 0.
A decision alternative is an option or choice available to the decision maker. Each decision
alternative will have at least two outcomes.
Two definitions are important to the understanding of the expected value concept.
Expected value of an outcome is the product obtained by multiplying the probability of
occurrence of the outcome and the conditional value that is received if the outcome
occurs. This product can be expressed in various ways, when it is expressed as monetary
profit and losses, usually it is called expected monetary value EMV.

The word conditional means that the value will receive only if that particular outcome
occurs. That is, the value received is conditional upon the occurrence of the outcome.
Expected value of a decision alternative is the algebraic sum of the expected values of
each possible outcome that could occur if the decision alternative is accepted.
The expected value of a decision alternative can be positive, zero, or negative. And it is
the numerical criterion used to compare competing decision choices available to the
decision maker.
The decision rule for expected monetary value choices is: when choosing among several
mutually exclusive decision alternatives select the alternative having the highest positive
expected monetary value (EMV).
If the decision maker consistently selects the alternative having the highest positive
expected monetary value his total net gain from all decisions will be higher than his gain
realized from any alternative strategy for selecting decisions under uncertainty.
Examples:

Outcome
Dry Hole
Producer

Outcome
Dry Hole
2 Bcf
5 Bcf

Probability
Outcome
0.4
0.6
1.0

Probability
Outcome
0.7
0.2
0.1
1.0

Conditional
Monetary Value

Expected
Monetary Value

- 200.000 $
+ 600.000 $

- 80.000 $
+360.000 $
+280.000 $

Conditional
Monetary Value

Expected
Monetary Value

- 50. 000 $
+100. 000 $
+250. 000 $

- 35. 000 $
+ 20. 000 $
+ 25. 000 $
+10. 000 $

Expected
Value
of decision
alternative

E MV

MEANING AND INTERPRETATION OF EXPECTED VALUES. The decision rule means

that, all other factors equal, the decision maker should accept the alternative, which
maximises expected value. The expected value of a decision alternative is interpreted to
mean the average monetary over a series of repeated trials. The key words in this
interpretation are per decision and repeated trials
If the decision maker were presented with a repeated series of prospects having the same
risk and profit values as those of first previous example his overall profit from the series of
repeated trials would average 280.000 $ per decision if, in each instance, he had accept
the drill option.

Suppose he had presented 100 prospects, and suppose further that he elected to drill
each of them. The most probable results of the 100 well drilling series would be 40 dry
holes and 60 producers. His net revenues from producer wells would be 60 x 60.000 =
36.000.000. His losses in 40 dry holes would be 40 x 200.000 = 8.000.000. His net profit,
would be 36.000.000 8.000.000 = 28.000.000. His average profit per decision would be
28.000.000/100= 280.000, the expected monetary value of the decision alternative drill.
If this meaning of the expected value of a decision alternative is accepted it should be
obvious why the decision rule is to accept the alternative having the highest EMV. The
average profit received per decision is not as much if any alternative with a lower EMV is
accepted. The expected value of a decision alternative is really just a weighted arithmetic
average profit that he would expect if the decision was repeated over a series of trials. The
weighting factors in the actual computation of EMV are the probability numbers.
But the usual case in oil business, and in general in economy, is that there is only one
prospect and in this case the EMV represents a profit per decision. Why does this mean, if
anything? Does the repeated trial clause rule out its use in business decisions where
nearly every decision choice has different risk and profit levels? We just proved that
expected value concepts might be useful for repeated events as flipping coins, but not
when we are in economical events, as drilling decisions, where every trial has different
probabilities and profitabilities.
The answer to the above questions is that it is possibly to apply this concept to business
decisions if it is recognized that the repeated trial can be satisfied by continued investment
decisions. If the decision maker consistently selects the alternative having the highest
positive expected monetary value his total net gain from all decisions will be higher than
his gain realized from any alternative strategy for selecting decisions under uncertainty.
This statement is the absolutely essential for any justification of the use of expected value
in business decisions. So we see that this concept is more nearly a strategy for consistent
decision making than an absolute measure of profitability.

DECISION TREE ANALYSIS

In many occasions exploration opportunities involve only a single decision that is made at
time zero. This decision would be, for example, drill. Once the decision is made there
are no decision options with which the decision maker becomes involved.
There are, however, certain decision alternatives of a more complex nature that cant be
analysed in a simple EMV computation. Consider the basic, initial decision of whether to
bid on a lease. The immediate decision choices are bid or not bid. But if the decision
maker bids, and wins the tract, he then has a decision regarding whether to drill
immediately or run more seismic.
It becomes obvious that the initial decision is but a link in a chain of future decision options
and contingencies. And all of these future options must be considered when evaluating the
feasibility of bidding. The simple decision whether to bid has suddenly become quite
complex with future decisions options and what ifs at every step of the anticipated
exploitation of the lease.

These types of decisions require a slight modification in our thinking with respect to the
expected value concept. The mechanical steps to determine expected values for the initial
choices are slightly different. The analysis involves constructing a diagram showing all the
subsequent chance events and decision options that are anticipated. These diagrams look
very much a drawing of a tree, and now are given the name decision tree analysis. A
decision tree is merely a pictorial representation of a sequence of events and possible
outcomes. The decision tree illustrates the decision alternatives.

Dry
hole

2 Bcf
Drill

Dont drill

5 Bcf

The trees normally read from left to right and are drawn in the same order as the actual
sequence in which the decision choices and chance events occur in the real world.
The point from which two or more branches emanate is called a node. A node surrounded
by a square denotes a decision node, a point at which the decision maker dictates which is
followed. An encircled node is called a chance node, a point where chance determines
the outcome. Any number of decision alternatives or outcomes can emanate from a given
decision or chance node.
The next step in constructing a decision tree is that we must associate probabilities of
occurrence to all the branches radiating from chance nodes and we must specify
conditional values received at the endpoints of the tree. When indicating probabilities on a
decision tree we must adhere to two important rules. First, the sum of the probabilities
around a given chance node must add to 1.0. Ad second, no probabilities are shown on
the branches emanating from a decision node.the probabilities around a chance node
indicate the relative likelihoods as to which specific outcome will occur.
The specific path that occurs from a decision node, however, is not a function of chance,
but rather the result of an explicit choice by the decision maker.

SOLVING A DECISION TREE

Decision tree analysis is one the few things we solve by starting at the end and working
backward. We start by making an expected value computation using the terminal around
the last chance node in the tree.

Dry hole
-50 000 $
0.7

2 Bcf
-100 000 $

0.2

Drill

0.1
5 Bcf
+250 000 $

Dont drill

0$

For our example we first make an EMV calculation at point A

EMVA= (0.7)(-50 000 $)+(0.2)(+100 000 $)+(0.1)(+250 000 $)= +10 000 $
Next we proceed backward (to the left) in the tree to the next node B. Now we make a
decision as if the decision maker were actually standing in B. That is, his choices at
decision node B could be represented schematically with the next tree.
+ 10 000 $
Drill

B
Dont drill

0$

Note that the EMV + 10 000 $ at chance node A is used to represent, or replace all the
tree beyond that point.
The decision rule at any decision node is to select the alternative (branch) which has the
highest EMV. In this case it would be to drill.
Each time we come to a chance node we make an EMV calculation, and each time we
come to a decision node we make a hypothetical decision. This process is continued until
the initial, time-zero decision node is reached, at which time the tree has been solved. In
our example there was nothing to the left of decision node B, so the tree was solved at
that point.

Decision tree is pretty simple and logical. As far as the definitions and mechanics of
solution are concerned it is simple. The difficulties usually arise in being able to correctly
organize and draw the trees for decisions of a more complex nature.
The advantages of this form of analysis include the following points:
All contingencies and possible decision alternatives are defined and analysed in a
consistent manner. The complex decision is broken into a series of small parts, then the
parts are reassembled to provide a rational basis for the initial decision.
Such an analysis provides a better chance for consistent action in achieving a goal over a
series of decisions. That is, each step in the sequence has been analysed ahead of time.
Any decision, no matter how complicated, can be analysed by the method.
The decision tree can be used to follow the course of events. At any decision node, if
conditions have changed, the remaining alternatives can be re-analysed to develop a new
strategy for that point forward.

PROBABILITY DISTRIBUTIONS.
A part of petroleum exploration risk analysis is the concept of profitability distributions.
Distributions are useful to describe in a very concise graph the range of possible values a
variable can have as well as the probabilities of these values occurring.
First it is necessary to give some definitions.
Random variable: A parameter or variable, which can have more than one possible
value, is called a random variable. Random variables may be thought of as those variables
whose values cannot be predicted with certainty at the time of decision making. For each
possible value of the random variable there is associated a likelihood, or probability of
occurrence.
Random variables are sometimes called stochastic variables to denote the fact that the
likelihoods of the values occurring are stochastic, or probabilistic in nature. If the value of a
variable is known or can be predicted with certainty at the time of decision making the
variable is called a deterministic variable.
The values of a random variable can be positive or negative. Each value will have a
certain probability of occurrence and different values can have same probability. The
adjective random implies that the values of a variable have specific probabilities of
occurrence, and it does not mean that the variable itself is random, or randomly
distributed.
Examples of random variables in petroleum exploration include the possible values of net
pay thickness, ultimate reserves or net profit from a drilling prospect.
Probability distribution: Is a graphical representation of the range and likelihoods of
occurrence of possible of possible values that a random variable can have. Probability
distributions can be discrete or continuous, depending on the nature of the random
variable. The horizontal axis of a probability distribution is the random variable and its

appropriate units and range of values. The height of probability distributions above the
horizontal axis is proportional to the probability of occurrence of the values of the random
variable.
An example of a continuous probability distribution is given in the next figure. It is
continuous in the sense that any value of recoverable reserves within the range of Xmin
and Xmax is possible. The parameter on the vertical axis, f(x), is called a probability density
function, and the area under all probability distributions is by definition 1. Another
characteristic of all probability distributions is that the probabilities are always zero or
positive. This means that the probability function never goes below the horizontal axis.
Continous distribution

Discrete distribution
P(x). Probability of occurrence.

f(X)

Xmin
Random variable: reserves in X field

Xmax

10

12

14

16

18

20

22

Random variable: n of oil estructures in the Y basin

The continuous distribution that describes a random variable can have infinite numerical
values within a giving range. Their theoretical limits of the probability density function are
+/- . For a random variable having limits such as drawed before the probability density
function is simply defined zero from - to Xmin and zero from Xmax to + . Another
technical point with continuous probability functions distributions is that it is only
meaningful to talk in terms of the probability of a range of values of X and not specific
value of an X. For a continuous random variable the probability of occurrence of a specific
value is, theoretically, zero.
On the contrary, there are some random variables, which can have only specific numerical
values. The probabilities distributions, which describe random variables of this type, are
called discrete distributions. Any random variable whose values result from counting is
an example of a variable that would be described as a discrete probability distribution:
number of producing wells in a field, etc. With discrete distributions the sum of the p(x)
terms for each possible value of the random variable must be exactly one: 0n p(x) = 1.

CUMULATIVE FREQUENCY DISTRIBUTIONS.

Every probability distribution can be expressed in an equivalent graphical form called a
cumulative frequency distribution. There are two principal reasons for expressing
distributions in their cumulative frequency form:

If we have a cumulative frequency distribution we can read any areas under the
probability distribution.

In the mechanics of the risk analysis method called simulation it will be necessary
convert distributions of possible values for each random variable into their equivalent
cumulative frequency form.

For example, we tabulated net pay thickness data from 20 wells in a basin Y.

Range of
Thickness
50-80
81-110
111-140
141-170
171-200

Frecuency
4
7
5
3
1
20

Relative
Frecuency
0.20
0.35
0.25
0.15
0.05
1.00

Cum. relative
frecuency
0.20
0.55
0.80
0.95
1.00

Cum. percent

20%
55%
80%
95%
100%

To represent the data as a cumulative frequency distribution it is necessary to plot the

cumulative frequencies of column 4 versus the upper limit of each range. The cumulative
frequency less than or equal to the minimum possible value of the random variable will
always be 0, and the cumulative frequency less than or equal to the maximum value of the
random variable will always be 1.

50

80

100

110

140

170

200

SINGLE VALUE PARAMETERS OF DISTRIBUTIONS

Although a random variable can normally assume many possible numerical values there
are certain specific values, which can tell us important information about the entire
probability distribution. At this moment it is only necessary to consider two of the single
value parameters of distributions: a) a parameter which describes central tendency o
average values of the random variable, and b) a parameter which describes the variability,
or range within which the random variable is distributed.

Measures of central tendency.

Parameters, which describe central tendency, can provide information about average
values of random variable. The measures most commonly used are: the mean, median
and mode.
Mean: The weighted average value of the random variable where the weighting factors are
the probabilities of occurrence. It is synonymous to the expected value of a distribution and
to the arithmetic average of a set of statistical data. If we are dealing with a distribution of
net monetary value profit the mean value of this profit distribution is exactly equal to EMV.
All probability distributions, discrete or continuous, have a mean value. The units of the
mean are the same as the units of the random variable. The symbols used for the mean
value are: or x.
From a statistical point of view the mean value is, by far, the most important single value
measure of central tendency, and it is very important in decision analysis because it is, by
definition, equivalent to expected value, the basis for decision making under uncertainty
Median: The value of a random variable, which divides the area under the probability
distribution into two equal parts. The probability of the random variable being less or equal
to the median is 0.5. The probability of the random variable being greater than to the
median is also 0.5.
The median value is not as representative a measure of central tendency, average, as the
mean, because is not affected by the magnitudes of the values of the random variable. It
only tells us the value of the variable such that half of the possible values will be smaller
and half of the values will be larger.
Mode: The mode is the value of the random variable, which is most likely to occur. It is the
value of the random variable located under the highest, peak value of the probability
distribution curve. Distributions can have more than one mode.
From risk analysis point of view the mode does not have much value. However, the mode
value is referenced frequently in the decision making process when it is referred to the
most likely or most probable value of the random variable.
In general, the mean, median and mode are all different values for a given distribution.
One exception to this is continuous distributions that are symmetrical in shape. In these
cases the mean, median and mode values will be coincident. Examples of these cases
include the normal and uniform distributions.

Measures of variability.

The mean value of a distribution tells us important information about the average or
expected value of the random variable, but it does not tell us anything about the spread, or
variability of other possible values of the variable on either side of the mean. Will the
range of possible values of the variable be very small with all the values located at or near
the mean, or will the range be very large with possible values much larger or smaller than
the mean? The most important of the single value measures of variability is standard
deviation.

Standard deviation: Each possible value of a random variable is located a given distance
from the mean, as measured along the horizontal axis. These distances are called
deviations about the mean. The mean value of the squared deviations about the mean is
called variance, and standard deviation is defined as the nonnegative square root of the
variance.
All distributions have a standard deviation and its units are identical to the units of the
random variable. The symbols for standard deviation and variance are and 2
respectively. The physical significance of the standard deviation is that it tells us the
degree of spread, or dispersion of distribution on either side of the mean value.

f(X)

In this figure the standard deviation of the narrow distribution A is less than standard
deviation of distribution B.
From statistical point of view standard deviation is by far the most important measure of
dispersion, or variability. In fact, certain distributions such as the normal and lognormal can
be completely and uniquely defined by simply specifying the mean value and the standard
deviation. Other measures of variability such as the range, mean deviation, percentiles,
etc, are much less useful in petroleum exploration risk analysis.

DISTRIBUTIONS
ANALYSIS

OF

INTEREST

IN

EXPLORATION

RISK

There are several specific distributions which appear rather frequently in exploration
analysis and it is necessary describe briefly their characteristics.
Normal distribution. It is probably one of the most common and widely used distributions
in statistics and probability. It is a continuous probability distribution having a symmetrical
shape similar to a bell. Statistics is routinely taught to students by employing the normal
distributions.

The Central Limit Theorem states that distributions resulting from the natural addition of
independent random variables will be normal, a frequency distribution will tend to take the
form of the familiar bell-shaped curve, in which the vertical axis is ordinarily expressed as
a percentage of the total, and the horizontal axis is an arithmetic scale expressing some
variable.
Specific characteristics of the normal distribution include:

The distribution is completely and uniquely defined by the two single value parameters
and .

The mode (most likely value), median (value of the random variable which divides the
distribution into two equal parts), and the mean are all equal.

The distribution curve is symmetrical and the inflection points of the curve occur at
values of the random variable corresponding to + and - . All normal distributions
have 0.6826 of total area under the curve within the limits +- . The area under the
curve between the limits +- 2 is 0.9544 for all normal distributions, and the area
within the limits of +- 3 is 0.9974.
Cumulative frecuency

f(X)

The theoretical limits of all normal distributions are - and + . In practice the
distribution is truncate at values of the random variable corresponding to 4 or 5
standard deviations on the basis of the random variable outside 4 or 5 standard
deviations become infinitesimally small.

The cumulative frequency graph of a normal distribution, when plotted on coordinate

graph paper, has the shape of a symmetrical s as shown in the figure.

Lognormal distribution. Even though students of mathematical statistics have long know
the significance of the Central Limit Theorem, the lognormal distribution in petroleum
science has only gained wide acceptance during the past decade. This theorem provides
that distributions resulting from natural multiplication of independent random variables will
be lognormal (see page 6).
The lognormal distribution is a continuous probability distribution that tends to form a
symmetrical bell-shaped curve, similar to a normal except that is skewed to one side. The
distribution can be skewed in either direction.

Frecuency

Mode
Median
f(X)

Mean

The lognormal distribution can be skewed as shown in the figure describes a random
variable which has a small chance of large numerical values and a large chance of smaller
numerical values of the variable. Some examples of random variables that can sometimes
be represented by lognormal distributions include thickness of sedimentary beds, oil
recovery in a given formation and reserves per well in a sedimentary basin.

Cumulative frecuency

Another convention for presenting the same data is the cumulative probability
distribution, in which the vertical axis is 0-100% and horizontal axis displays a dimensional
variable. The power of cumulative probability distribution is that, conceptually at least, it
represents the full universe of all possible outcomes, 100%, and probability is expressed
as a cumulative percent of some outcome equal to or less than or equal to or more than
a particular value. Thus the cumulative probability distribution is especially useful as a
predictive tool.
Specific characteristics of the lognormal distribution include:

The distribution is completely and uniquely defined by the two single value parameters
and .

If a random variable, x, is lognormally distributed, the logarithms of the numerical

values of x are normally distributed. That is, if it is make the transformation y = ln x,
where x is a lognormally distributed random variable, the distribution of the transformed
variable, y, will be normally distributed.

The theoretical limits of all normal distributions are - and + . In practice the
distribution is usually truncated at values of the random variable where the distribution
curve is nearly asymptotic with the abscissa.

The cumulative frequency graph of a lognormal distribution, when plotted on a special

graph paper called lognormal probability paper, will plot as a straight line.

The meaning of standard deviation of a lognormal distribution is the same as with any
other distribution, the larger the value of the greater the range of the variable.

The most common application of lognormal distributions in exploration risk analysis will be
to describe reserve data, recovery data and formation thickness data.

PREFERENCE THEORY CONCEPTS

The theory relates to an extension of the expected value concept in which the decision
makers attitudes and feelings about money are incorporated into a quantitative decision
parameter, looking for a more realistic measure of value than the EMV.
The real-world application of preference theory is still very controversial and its value in the
decision making context is questioned by some scholars and many businessmen.
When we studied EMV criterion for decision making we pointed out this criteria implied that
the decision maker was totally impartial to money. And therein lies the central issue,
people are not impartial to money. Rather, they have specific attitudes and feelings about
money, which depend on the amounts of money, their personal risk preferences and
immediate or longer term personal objectives.
The result of all this is that the simple, easy to use concept of EMV and its decision rule of
maximizing EMV may not provide the most representative decision criterion, because it is
not included any consideration of the particular attitudes and feelings the decision maker
associates with money.
It is easy to mention a number of situations in which EMV does not provide a clear-cut
decision strategy:

Imagine that the EMV for a drilling venture is positive but the potential loss from a
dry hole is greater than the decision maker can afford. Should he follow and drill,
with the hopes of not getting dry hole?

With same data and probably same decision, using EMV criterion, some decision
makers are conservative in their preferences for taking risk, but others may be
gamblers.

On the flip of a fair coin would receive 2$ if a head occurs and lose 1$ if a tail
occurs. Would you accept this gamble? Would you accept the game in case your
fortune is 10 million $ and you will receive 20 million $ more if a head occurs and
lose 10 million $ if a head occurs?

Which are the answers? Most people will answer yes in case of a 1$ game but no, in case
of 10 million $. In terms of EMV would have both been to accept both games.
Now consider two different gambling situations. As before assume that your personal
funds are being used.

You have saved 5$ to spend for an evening of entertainment. You are then offered
the chance to participate in a coin-flip gamble in which you receive an additional 5$
if a head occurs and lose the 5$ you have saved if a tail occurs. Would you accept
this gamble?

You are desperate to see the NBA final. You have 5$, but the tickets costs 7,5$.
You are offered the chance to participate in a coin-flip gamble in which you receive
an additional 5$ if a head occurs, and lose your 5$ if a tail occurs. Would you
accept this gamble?

What are the answers to these two gambles? The usual reactions are that some would
take the first gamble, but nearly everyone would accept the second. On the basis of EMV
both gambles have same value, which presumably means the decision maker is neutral or
indifferent to each gamble. This suggests that immediate or long term represent another
non-monetary consideration in the decision process.
All of this is positive evidence that people simply are not impartial to money. The
desirability and preferences we associate with various amounts of money are not
proportional to the quantities of money.
This observation is not recent. In the XVII century was famous the Saint Petersburg
Paradox. This Paradox involves the following gamble: Player A pays 1$ to player B for the
privilege of playing the game. The game continues until the first tail appears on flip of a fair
coin. Player A receives 1$ for each head that occurs prior to occurrence of the first tail.
Player A can repeat playing the game as long as he desires, but each time he must pay
the 1$ stake.
Question: Should A play the game? How much does he stand to gain if he does?
Solution:
Probably
Outcome
1/2
1/4
1/8

Outcome
T
HT
HHT

Reward to
Player A
0
1
2

EMVA = (1/2 * 0) + (1/4 * 1) + (1/8 * 2) + + (- 1)

EMVA = (1/4) + (2/8) + (3/16) + + (- 1) = 1 + (-1) = 0
Player As expected winnings are zero. Over a series of games he will neither win nor lose
any money. In the terminology of mathematical game theory this is called a fair game.
Now we will change slightly the game. Player A receives 1$ for one head, 2$ for two
heads, etc., each time doubling the previous payoff. With this exception, the game is
played as before, and player A should be required to pay a higher stake since his winnings
are higher.
Question: How much can player A afford to pay to play this revised game and still expect
to at least break even?
Solution:
Outcome
T
HT
HHT
HHHT

Probably
Outcome
1/2
1/4
1/8
1/16

Reward to
Player A
0
1
2
4

EMVA = (1/2 * 0) + (1/4 * 1) + (1/8 * 2) + (1/16 *4) + + (- stake)

EMVA = (1/4) + (1/4) + (1/4) + + (- stake) = + (- stake)

If player A offered an infinitely large stake each time he plays his overall expectation would
be zero. For any stake less than infinite player As EMV would be positive. And player As
gain is player Bs loss.
Do you believe that? How much would you offer to player B to play the game? If you were
player B would you have played if player A offered you 100$ each time? 1000$?
1.000.000$? The Paradox implied that player A could offer any amount of money and still
win in the long run and player B should never accept the gamble, because his EMV will
always be negative.
For most people the reverse situation would apply: the more money player A offered the
more probable it was that A would lose in the long term, and the more player A offered the
more likely it would be player B would accept the money and offer to play the game.
The Swiss Mathematician, Daniel Bernoulli, studied this Paradox and about 1738
concluded that an individuals preference for money is inversely proportional to the amount
he already has. The mathematical implication is that the correlation between the amounts
of money and the corresponding preferences for money follows the shape of a logarithmic
function. To solve the paradox he computed an expected value in which the rewards to
player A were expressed as the logarithm of 2$, 4$, etc. With this modification the series
become convergent and has a finite sum and one could compute the monetary value of
the stake player A should offer which would reflect his value system of diminishing
preference with increasing wealth.
Thus do not imply that EMV is invalid as a decision parameter. Rather, we have suggested
that all of us have certain attitudes and feelings about money, which EMV does not
consider.

EMV is a completely valid decision parameter if the decision maker is totally

impartial to money. But very few, if any, are completely impartial to money. Most
have specific feelings about it caused by factors as asset position, risk preferences,
goals, etc.

The decision maker has two choices with regard to applying quantitative criteria to
petroleum exploration investments. Use EMV and include attitudes and feelings in
an informal, non-quantitative manner. Or incorporate his beliefs into a quantitative
decision parameter having all the characteristics of the expected value concept and
use the resulting numerical parameter as a basis for decision making.

THE MATHEMATICAL BASIS FOR PREFERENCE THEORY

This theory was developed by two Princeton University mathematicians, von Neumann
and Morgenstern. Their theory is about of strategies against an opponent or adversary, or
game theory as is called in mathematical circles. They concluded that persons value
system regarding money included various emotional attitudes and feelings and developed
the mathematical basis for what we here call preference theory.

A mathematical theory has as its basis one or more axioms. An axiom is simply a
statement, or starting point from which the theory is developed. Von Neumann and
Morgenstern started with eight axioms. We wont go into details of this, other than to
mention two or three of them to illustrate their general nature:

If an individual has two choices, A or B he either prefers A to B, or he prefers B to

A, or he is indifferent between A and B.

If an individual has three choices, A, B, and C and if he prefers A to B and prefers

B to C, then he prefers A to C.

Given three choices, A, B, and C such that A is preferred over B, and B is preferred
over C, there is some combination of A and C where A occurs with probability p
and C occurs with probability (1-p) such that the combination with A and C as
possible outcomes will be preferred over the non-risk alternative of B. Similarly,
there is some value of p such that the non-risk alternative B, will be preferred over
the combination of A and C.

The authors of this theory proved that if a decision maker accepts the eight axioms as the
basis of rational decision it is possible to describe his attitudes about money in a simply
function o curve.

Increasing preference

Increasing amounts of money

This function is mathematically unique up to a linear transformation. This means that the
scales of the preference curve are arbitrary until numerical values of two points have been
specified. There are several important properties of the preference curve:

The vertical preference scale is dimensionless and reflects only the relative
desirability of an amount of money. The zero point on the vertical scale is generally
interpreted as a point of indifference about of money. Positive values on the vertical
denote desirability and negative ones denotes dislike for the corresponding
amounts of money.

The horizontal scale can be in units of money such NPV, etc.

The curve is a monotonically increasing function. This means that the vertical
parameter increases in numerical value as the amounts of money increase.

The preference curve is based on an individuals preferences and does not imply a
comparison among individuals.

The shape of the preference curve reflects preferences of the decision maker. If
he were totally impartial to money his preference curve would be a straight line
passing through the origin.

Same as EMV concept, preference theory has the property of expectation. We can
multiply probabilities of occurrence by the relative preference and compute an
expected preference value for a decision alternative.

The expected preference value of a decision alternative is the decision parameter

used by the decision maker to accept or reject the alternative. The decision rule is
to select the decision alternative, which has the highest positive expected
preference value.

The expected preference value, EMV, of a decision choice represented a weighted

average profit. In preference theory the expected value of a decision alternative
represents a measure of weighted average preference. The decision rule suggests that
the manager select projects, which maximize this weighted average desirability.
Decision Analysis
Using EMV

Decision Analysis
Using Preference Theory

Define decisions alternatives and

outcomes.

Define decisions alternatives and possible

possible outcomes.

Determine numerical probabilities

of occurrence for each outcome.

Determine numerical probabilities

of occurrence for each outcome.

Compute a conditional monetary

profit or loss for each outcome.

Compute a conditional monetary

profit or loss for each outcome.

Multiply probabilities of occurrence

of each outcome by conditional
monetary values.

Read preference values

corresponding to each conditional
monetary profit or loss from
preference values.
Multiply probabilities of occurrence
of each outcome by corresponding

Compute algebraic sum of the

expected monetary values of all

possible outcomes to yield the

decision parameter EMV of
decision alternative.

preference values.

Select alternative which maximizes

EMV.

Compute algebraic sum of the

expected preference values of
all possible outcomes to yield the
decision parameter expected
preference value of decision
alternative.
Select alternative which maximizes
expected preference value.

The only difference between the two concepts is that in EMV we multiply probabilities by
the monetary values to be received whereas in preference theory we multiply probabilities
by the preference values which correspond to the monetary values to be received.
We can probably all agree that people are not impartial to money and the question is how
these attitudes could be incorporated into the quantitative decision process. The
preference curve and resulting decision analysis techniques are just descriptive. The curve
is merely a description of the decision makers attitudes, it does not prescribe what his
preferences should be, nor does it mean that he is wrong for having his particular
preferences.

PETROLEUM EXPLORATION RISK ANALYSIS METHODS.

As we already mentioned risk implies the need to quantify many types of risks: risk of an
exploratory or development dry hole; political risk, risk to future oil/gas prices, risk that a
discovery will not be a large enough to recover initial exploration costs, environmental risk,
etc.
The purpose will be to discuss the strengths and weaknesses of each method, so that you
will be in a better position to judge the conditions for which each method can be used. We
should remind that there are very few absolutes in petroleum exploration risk analysis.
Answers to what if questions are very important and may provide the basis for a rational
decision, even though some of the specific probabilities are not known to three decimal
place accuracy.
The problem in risk analysis can be stated quite simply. For the drilling prospect being
considered what are the probabilities of occurrence of all possible levels of profitability?
What are the chances of a dry hole? What are the probabilities that estimated future oil
prices will occur?
Since an acceptable investment must have a reasonably good chance of making a profit
the various outcomes of interest are expressed in levels of profitability, rather than just
such as 100 MMB, 500 MMB, etc. But the uncertainties relating to possible reserves levels
are, in many cases, a major unknown in the decision.
As we consider solutions to the problem we must bear in mind certain characteristics
which are unique to the petroleum exploration decision process.

With regard to reserve level probabilities we cannot explicitly describe the process
which originally generated the distribution of petroleum accumulations. This is a
handicap to us because it means that we will probably never be able to develop an
exact probabilistic model to serve as an analog to the exploration process.

The drilling of a sequence of wells is a series of dependent events based on a

sampling without replacement process.

Probability estimates must often be made on the basis of very little or no statistical
data or experience. Additional data in petroleum exploration are usually from
additional wells or seismic, and we normally can not afford to delay decisions until
there is a sufficient amount of data upon which to base our probability estimates.

With regard to the economic factors and the prediction of probabilities we have an
equally complex situation to deal with. The volatility of the world crude prices, for
example, can be very difficult to predict. The effects of inflation, shortages of steel
for plataforms, casing for wells, etc must be considered when determining ultimate
value of a discovery.

Geologyis a very abstract science. An explorationist must try to recreate in his mind
how ancient river deltas existed, how the seas regressed, erosion occurred, etc. But
at the end of his analysis he is now being to quantify his feelings about the prospect
in terms of probabilities. Not an easy task.

These considerations certainly make the task of estimating probabilities in exploration

uniquely complex and difficult.

GLOSARY OF ECONOMIC EVALUATION NOMENCLATURE

Acquisition of unproved properties. Costs incurred to purchase, lease or otherwise
acquire a property, including costs of lease bonuses and options to purchase or lease
properties, the portion of cost applicable to minerals when land, including mineral rights, is
purchased in fees, brokers fees, recording fees, legal costs and other costs incurred in
acquiring properties.
Acquisition of proved properties. Costs incurred to purchase or otherwise acquire
proved oil and gas reserves in place, including production payments payable in-kind.
Costs include cash and other forms of consideration, brokers fees, legal costs, etc.
Exploration costs. Costs incurred in identifying areas that may warrant examination and
in examining specific areas that are considered to have prospects containing oil and gas
reserves, including costs of drilling exploratory wells and exploratory-type stratigraphic test
wells. Exploration costs may be incurred both before acquiring the related property
(sometimes referred to in part as prospecting costs) and after acquiring the property.
Principal types of exploration and applicable operating costs of support equipment and
facilities and other costs of exploration activities are:

Costs of topographical, geographical and geophysical studies, rights of access to

properties to conduct those studies and salaries and other expenses of geologists,
geophysical crews and others conducting those studies. Collectively, these are
frequently referred to as geological and geophysical or G&G costs.

Costs of drilling exploratory-type stratigraphic test wells.

Costs of carrying and retaining undeveloped properties, such as delay rentals, ad

valorem taxes on properties, legal costs for title defense and the maintenance of land
and lease records.

Dry hole contributions and bottom hole contributions.

Costs of drilling and equipping exploratory wells. An exploratory well is a well drilled to
find and produce oil or gas in an unproved area, to find a new reservoir in a field
previously found to be productive of oil or gas in another reservoir, or to extend a
known reservoir. Generally, an exploratory well is any well that is not a development
well, service well or a stratigraphic test well.

Costs of drilling exploratory-type stratigraphic test wells.

Development costs. Costs incurred to obtain access to proved reserves and to provide
facilities for extracting, treating, gathering and storing the oil and gas. More specifically,
development costs, including depreciation and applicable operating costs of support
equipment and facilities and other costs of development activities, are costs incurred to:

Gain access to and prepare well locations for development drilling, including surveying
well locations for the purpose of determining specific development drilling sites,
clearing ground, draining, road building and relocating public roads, gas lines and
power lines, to the extent necessary in developing the proved reserves.

Drill and equip development wells, development-type stratigraphic test wells and
service wells, including the costs of platforms and of well equipment such as casing,
tubing, pumping equipment and the wellhead assembly. A development well is a well
drilled within the proved area of an oil and gas reservoir to the depth of a stratigraphic
horizon known to be productive.

Acquire, construct and install production facilities such as lease flow lines, separators,
treaters, heaters, manifolds, measuring devices and production storage tanks, natural
gas cycling and processing plants and central utility and waste disposal systems.

Provide improved recovery systems.

Production costs. Costs incurred to operate and maintain wells and related equipment
and facilities, including depreciation and applicable operating costs of support equipment
and facilities and other costs of operating and maintaining those wells and related
equipment and facilities. They become part of the cost of oil and gas produced. Examples
of production costs (sometimes called lifting costs) are:

Costs of labor to operate the wells and related equipment and facilities.

Repairs and maintenance.

Materials, supplies and fuel consumed and supplies utilized in operating the wells and
related equipment and facilities.

Property taxes and insurance applicable to proved properties and wells and related
equipment and facilities.

Severance taxes.

Proved oil and gas reserves. Proved oil and gas reserves are the estimated quantities of
crude oil, natural gas and natural gas liquids (including natural gas liquids attributable to
plant ownership interests) which geological and engineering data demonstrate with
reasonable certainty to be recoverable in future years from known reservoirs, under
existing economic and operating conditions, i.e., prices and costs as of the date the
estimate is made. Prices include consideration of changes in existing prices provided by
fixed contractual arrangements, but not escalations based upon future conditions (e.g.,
inflation).

Reservoirs are considered proved if economic producibility is supported by either

actual production or a conclusive formation test. The area of a reservoir considered
proved includes (i) that portion delineated by drilling and defined by gas-oil and/or oilwater contacts, if any, and (ii) the immediately adjoining portions not yet drilled but
which can be reasonably judged as economically productive on the basis of available
geological and engineering data. In the absence of information on fluid contacts, the
lowest known structural occurrence of hydrocarbons controls the lower proved limit of a
reservoir.

Reserves which can be produced economically through application of improved

recovery techniques (such as fluid injection) are included in the proved classification
when successful testing by a pilot project, or the operation of an installed program in
the reservoir, provides support for the engineering analysis on which the project or
program was based.

Estimates of proved reserves do not include the following: (i) oil that may become
available from known reservoirs but which is classified separately as indicated
additional reserve; (ii) crude oil, natural gas and natural gas liquids, the recovery of
which is subject to reasonable doubt because of uncertainty as to geology, reservoir
characteristics or economic factors; (iii) crude oil, natural gas and natural gas liquids
that may occur in undrilled prospects; and (iv) crude oil, natural gas and natural gas
liquids that may be recovered from oil shales, coal, gilsonite and other sources.

Changes in proved reserves include the following:

Extensions and discoveries. Additions to proved reserves that result from extension
of the proved acreage of previously discovered (old) reservoirs through additional
drilling periods subsequent to discovery and discovery of new fields with proved
reserves or of new reservoirs of proved reserves in old fields.

Improved recovery. Changes in reserve estimates resulting from application of

improved recovery techniques.

Revisions of previous estimates.

Revisions represent changes in previous
estimates of proved reserves, either upward or downward, resulting from new
information (except for an increase in proved acreage) normally obtained from
development drilling and production history or resulting from a change in economic
factors.

Production.

Purchase of minerals in place.

Sales of minerals in place.

Proved developed oil and gas reserves. Proved developed oil and gas reserves are
reserves that can be expected to be recovered through existing wells with existing
equipment and operating methods. Additional oil and gas expected to be obtained through
the application of fluid injection or other improved recovery techniques for supplementing
the natural forces and mechanisms of primary recovery should be included as proved
developed reserves only after testing by a pilot project or after the operation of an
installed program has confirmed through production response that increased recovery will
be achieved.
Proved undeveloped reserves. Proved undeveloped oil and gas reserves are reserves
that are expected to be recovered from new wells on undrilled acreage or from existing
wells where a relatively major expenditure is required for recompletion. Reserves on
undrilled acreage shall be limited to those drilling units offsetting productive units that are
reasonably certain of production when drilling. Proved reserves for other undrilled units

can be claimed only where it can be demonstrated with certainty that there is continuity of
production from the existing productive formation. Under no circumstances should
estimates for proved undeveloped reserves be attributable to any acreage for which an
application of fluid injection or other improved recovery technique is contemplated, unless
such techniques have been proved effective by actual tests in the area and in the same
reservoir.
Tangible assets; they are assets which may be appraised by inspection. These include
buildings, machinery and equipment of all types, which depreciate in value with age and
usage. Costs that ordinarily have some a salvage value.
Intangible assets; Intangible assets are those that include all types of minerals. No value
may be established by direct inspection and the asset not necessarily depreciate with time.
It loses value only when produced and furthermore cannot be replaced. Or costs that
ordinarily do not have a salvage value.
The exact differentiation between a tangible (capital) asset and an intangible asset is
somewhat arbitrary.
Depletion; It describes the production of a wasting asset, which, in turn, reduces in value
as the remaining supply decreases.
Lease bonuses; A lease bonus is a cash payment to the potential lessor by a potential
lessee as an inducement to give a lease on a property. They may be of several types:
Signature bonus. Payable upon signing the contract with the Government.
Production bonus. Payable as an agreed upon the achievement of a stated level of
production.
Royalty; It is the interest of a party owning minerals in the ground where another party
(the working interest) has gained the right to capture such minerals under a lease
agreement.
Farm-out Agreement; This is the name applied to a specific form of assignment wherein
the lessee grants a conditional interest to a third party in consideration for the development
of a prospect within a specified length of time on given acreage.
Carried Interest; A carried interest is an agreement between two more partners whereby
one party (carried party) does not share in the working interest revenue until a certain
amount of money has been recovered by the other party (carrying party).
Working Interest; It is an interest that is liable for the cost of developing and operating a
property. It is a companys portion of total revenue and also represents the companys
toward investment and operating costs.
Operating Interest; The operating interest is the interest charged with operational
responsibility of the lease. This interest handles all accounting, charging or remitting to
each interest its pro-rata share of expenses and profits.

Incremental Economics; As used in investment evaluation, this term usually refers to the
algebraic difference between two cash flow streams.
Depreciation; It is an annual reduction of income reflecting the loss in useful value of
capitalized investments by reason of wear and tear.
Depletion; It is a reduction in income reflecting the exhaustion of a mineral deposit. It is
allowable to prevent the taxation of a capital asset as ordinary income.
Allowable Depletion; The amount of depletion that may be claimed as an expense in a
given year. It can be shown as:

remaining investment x

Annual production
Remaining reserves

Expended Expenditures; Those which are deducted from income in the year of
expenditure.
Capital; Expenditures that may not be completely deducted from income in the year in
which they are made (office equipment, cars, machinery, etc).
Capitalized Expenditures; Those which are deducted from income over the years of
useful life.
The unit-of-production method; This method is used to depreciate lease, well equipment
and facilities that has a life largely controlled by th physical depletion of reserves. The
amount to be deducted each year may be expressed as:
(C D) x

R
P

C = the cost of equipment

D = accumulated depreciation
P = barrels or millions of cubic feet produced during the year
R = recoverable barrels, or millions of cubic feet, remaining in the reservoir at yearend.

OIL INDUSTRY ACRONYMS

API: American Petroleum Institute
API gravity: Scale expressing the gravity or density of liquid petroleum products. Crude
oil is often described in terms of "lightness" or "heaviness" by an index called the API
gravity. A high number denotes a "light" crude, and vice versa. Degrees API Gravity =
(141.5/Specific Gravity at 60 Deg. F) - 131.5)
AAPG: American Association of Petroleum Geologists
BBLs: barrels of oil
Bcf: Billion cubic feet (109)
Bcfd: billion cubic feet per day
BOE: Barrels of oil equivalent
BTU: British thermal unit
CAPEX: Capital expenditure (Investment)
Cf: Cubic feet
CPI: Consumer price index
CT: Corporation tax
DD&A: Depreciation, Depletion and Amortization
DoE: US Department of Energy
EIA: Energy Information Administration, division of US Department of Energy
EMV: Expected monery value
EOR: Enhanced oil recovery
E&P: Exploration and production
EU: European Union
FPS: Floating production, storage
FPSO: Floating production storage and offloading system
Ft: Foot (feet)
GAAP: = Generally Accepted Accounting Principles

Gal: Gallon
GHG: Greenhouse gases
GOM: Gulf of Mexico
GOR: Gas oil ratio
GTL: Gas-to-liquids conversin
HP: Horsepower
IADC: International Association of Drilling Contractors
In: Inch
IEA: International Energy Agency
IOC: International oil company
IOR: Improved oil recovery
IPE: International Petroleum Exchange (London)
IRR: Internal rate of return
JOA: Joint operating agreement
JV: Joint venture
kW: Kilowatt
kWH: Kilowatt-Hour
LNG: Liquified natural gas, refrigerated for shipping
LPG: Liquified petroleum gas (propane and butane)
MB: Millions of barrels
MBD or MBPD: Millions of barrels per day
MD: Measured Depth
MOU: Memorandum of Understanding
MWD: Measurement while drilling
Natural Gasoline: Condensate (mostly C5+)
NGL: Natural gas liquids (ethane, propane, butane, isobutene) (C3-C4 and some C5+)

NG: Natural gas (mainly methane)

NOC: National oil company (e.g., Saudi Aramco)
NPV: Net present value
NYMEX: New York Merchantile Exchange
OECD: Organization of Economic Cooperation and Development
OOIP: Original oil in place
OPEX: Operating expenditure (Cost)
OWC: Oil water contact
POOH: Pull out of hole
PPM: Parts per million
PRT: Petroleum revenue tax
PSI: Pounds per square inch (pressure unit)
QA: Quality assurance
R&D: Research and development
ROE: Return of equity
ROI: Return on investment
RP: Reserves/production ratio
Scf: Standard cubic foot of natural gas
SEMI: Semisubmersible
Tcf: Trillion cubic feet (dry natural gas 1012)
TD: Total depth
TVD: True vertical depth
USGS: United States Geological Survey
UTC: Universal time
WI: Working Interests
WT: Withholding tax
WTI: West Texas Intermediate (crude oil)