Distributed by permission of Hart's E & P and James Murtha

Risk Analysis: Table of Contents

Biography

im Murtha, a registered petroleum engineer, presents seminars and training courses and advises clients in building probabilistic models in risk analysis and decision making. He was elected to Distinguished Membership in SPE in 1999, received the 1998 SPE Award in Economics and Evaluation, and was 1996-97 SPE Distinguished Lecturer in Risk and Decision Analysis. Since 1992, more than 2,500 professionals have taken his classes. He has published Decisions

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Involving Uncertainty - An @RISK Tutorial for the Petroleum Industry. In 25 years of academic experience, he chaired a math department, taught petroleum engineering, served as academic dean, and co-authored two texts in mathematics and statistics. Jim has a Ph.D. in mathematics from the University of Wisconsin, an MS in petroleum and natural gas engineering from Penn State and a BS in mathematics from Marietta College. x

Acknowledgements

hen I was a struggling assistant professor of mathematics, I yearned for more ideas, for we were expected to write technical papers and suggest wonderful projects to graduate students. Now I have no students and no one is counting my publications. But, the ideas have been coming. Indeed, I find myself, like anyone who teaches classes to professionals, constantly stumbling on notions worth exploring. The articles herein were generated during a few years and written mostly in about 6 months. A couple of related papers found their way into SPE meetings this year. I thank the hundreds of people who listened and challenged and suggested during classes.

I owe a lot to Susan Peterson, John Trahan and Red White, friends with whom I argue and bounce ideas around from time to time. Most of all, these articles benefited by the careful reading of one person,Wilton Adams, who has often assisted Susan and me in risk analysis classes. During the past year, he has been especially helpful in reviewing every word of the papers I wrote for SPE and for this publication.Among his talents are a well tuned ear and high standards for clarity. I wish to thank him for his generosity. He also plays a mean keyboard, sings a good song and is a collaborator in a certain periodic culinary activity. You should be so lucky. x

Table of Contents

A Guide To Risk Analysis . . . . . . . . . . . . . . . . . . . . . . . . . 3 Central Limit Theorem Polls and Holes . . . . . . . . . . . 5 Estimating Pay Thickness From Seismic Data . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Bayes Theorem Pitfalls . . . . . . . . . . . . . . . . . . . . . . . . 12 Decision Trees vs. Monte Carlo Simulation . . . . . . . . 14 When Does Correlation Matter? . . . . . . . . . . . . . . . . . 20 Beware of Risked Reserves . . . . . . . . . . . . . . . . . . . . 24 Decisioneering Company Profile . . . . . . . . . . . . . . . . 26 Landmark Company Profile . . . . . . . . . . . . . . . . . . . 28 Palisade Company Profile . . . . . . . . . . . . . . . . . . . . . . 30
Risk Analysis

Risk Analysis: Risked Reserves

Beware of

Risked Reserves
Risked reserves is a phrase we hear a lot these days.
It can have at least three meanings: 1. risked reserves might be the product of the probability of success, P(S), and the mean value of reserves in case of a discovery. In this case, risked reserves is a single value; 2. risked reserves might be the probability distribution obtained by scaling down all the values by a factor of P(S); or 3. risked reserves might be a distribution with a spike at 0 having probability P(S) and a reduced probability distribution of the success case. Take as an example Exploration Prospect A. It has a 30% chance of success. If successful, then its reserves can be characterized as in Figure 1, a lognormal distribution with a mean of 200,000 STB (stock tank barrels) and a standard deviation of 40,000 STB. Then: definition 1 yields the single number 0.3*200,000 = 60,000 STB; definition 2 yields a lognormal definition with a mean of 60,000 and a standard deviation of 12,000 (See Figure 2); and definition 3 is the hybrid distribution shown in Figure 3. By contrast, suppose another prospect, B, has a 15% chance of success and a reserves distribution with a mean of 400,000 STB and a standard deviation of 200,000 STB.Then under definition 1,B would yield the same risk reserves as A, 0.15*400,000 = 60,000 STB. However, consider Figure 2, which shows how B would be scaled compared with A,with the same mean but larger standard deviation.And Figure 4 shows how the original distributions compare. Assigning these two prospects the same number for the purpose of any sort of ranking could be misleading. Prospect B is much riskier, both in the sense that it has only half the probability of success than does A, and also because even if it is a success, the range of possible outcomes is much broader. In fact, the P10, where P=Percentile, of Prospect B equals the P50 of Prospect A.Thus, if you drilled several Prospect A types,for fully half of your successes (on average),the reserves would be less than the 10th percentile of one prospect B. The only thing equal about Prospects A and B is that, in the long run, several prospects similar to Prospect A would yield the same average reserves as several other prospects like B. Even this is deceptive, because the range of possible outcomes for several prospects like A is much different from the range of
Risk Analysis

Figure 1.Lognormal distribution for Prospect A reserves

Figure 2.Comparing the original distributions for A and B

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Risk Analysis: Risked Reserves

possible outcomes of B-types. For instance, if we consider a program of five wells similar to A, there is a 51% chance of at least one success, and a 9% chance of success on two or more. However, with five prospects like B, the corresponding chances are 26% and 2% assuming they are geologically independent.

Running economics
What kind of economics these two prospects would generate is another story. Prospects like A would provide smaller discoveries more consistent in size. They would require different development plans and have different economies of scale than would prospects like B. So, does that mean we should run economics? Well, yes, of course, but the question is with what values of reserves do we run economics? Certainly not with risked reserves according to definition 1,which is not reality at all.We would never have a discovery with 60,000 STB. Our discoveries for A would range from about 120,000 STB to 310,000 STB and for B from about 180,000 STB to 780,000 STB (we are using the P5 and P95 values of the distributions). So, surely, we must run economics for very different cases.We could take a few typical discovery sizes for A (or B), figure a production schedule, assign some capital for wells and facilities, sprinkle in some operating expenses and calculate net present value (NPV) at 10% and IRR (internal rate of return). My preference is not to run a few typical economics cases and then average them. Even if you have the percentiles correct for reserves, why should you think those carry over to the same percentiles for NPV or IRR? Rather, I prefer to run probabilistic economics. That is, build a cashflow model containing the reserves component as well as appropriate development plans. On each iteration, the field size and perhaps the sampled area might determine a suitable development plan, which would generate capital (facilities and drilling schedule), operating expense and production schedule the ingredients, along with prices, for cashflow. The outputs would include distributions for NPV and IRR. Comparing the outputs for A and B would allow us to answer questions like: what is the chance of making money with A or B? What is the probability that NPV>0? and what is the chance of exceeding our hurdle rate for IRR? The answers to these questions together with the comparison of the reserves distributions would give us much more information for decision-making or
Risk Analysis

Figure 3.Hybrid distribution for A showing spike at 0 for failure case

Figure 4. Original distributions for A and B

ranking prospects. Moreover, the process would indicate the drivers of NPV and of reserves, leading to questions of management of risks.

Summary
The phrase risked reserves is ambiguous. Clarifying its meaning will help avoid miscommunication. Especially when comparing two prospects, one must recognize the range of possibilities inherent in any multiple-prospect program. Development plans must be designed for real cases not for field sizes scaled down by chance of success. Full-scale probabilistic economics requires the various components of the model be connected properly to avoid creating inappropriate realizations.The benefits of probabilistic cashflow models, however, are significant, allowing us to make informed decisions about the likelihood of attaining specific goals. x

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