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Module 11 Risk and Economics

FEL-DSO Course Objectives

Know the basic economic equation for a petroleum production system


Know the basic concepts around risk measurement
Know the basic concepts around Optimization and Uncertainty

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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Pre-test Review
1. What is an uncertainty?
2. Name 3 classic uncertainties in the upstream
3. What is risk?
4. Name 3 classic risks in the upstream
5. What is a decision?
6. Name 3 classic decisions in the upstream
7. What is optimization?
8. What do we usually try to optimize?
9. What are constraints?
10. Name 3 classic constraints in the upstream
11. What is optimization under uncertainty?
12. What can we do about uncertainties?
13. What can we do about risk?
14. What can we do about decisions?

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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Economics
Economics Overview
Hard Factors Affecting Project Economics
Field Operating Expenses Capital Expenditure Operating Income
Well intervention Well Cost Oil Price
Energy to run operation Pipelines Volume
Injected and produced water Surface Facilities Crude & Gas Quality
Supervisory & Maintenance Time to market
Petroleum Treatment and Transport

Soft Factors are important too.


Information Technology

Corporate Overhead
Research & Development
Marketing, Legal, Finance
Discounted Material Procurement
Cash Flow

Outcome
Activation Index: US$/STB/D
Production Cost: $/STB
Time Rate of Return: IRR
Payback Time: [years]

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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Economic Evaluation
Cash Flow Model
Net Cash Flow = Profit
Tax Model
Includes taxes
Tangibles/Intangibles
Financial Model
Capitalization of costs

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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Time Value of Money

F
Time Value of Money P=
(1 + i )n

F - Amount received n periods in the future


P - Present value
i - Interest rate

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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Net Present Value

L NCF j
Net Present Value NPV =
j =0 (1 + i ) j

Present worth of a project


L - project life
NCFj - net cash flow for period j

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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Rate of return

L INV j L NOI j
Rate of Return =
j =0 (1 + i ) j
j =1 (1 + i ) j
INVj = investment during period j
NOIj - net operating income during period j
i - interest rate
ROR = i when summations are equal

Payout - time for investment to be paid back

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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Discounted Cash Flow Example

F
P=
(1 + i )n
Present Value using discount factor i

Year Net Revenue i=0.1 i=0.20 i=0.157


0 -60000 -60000 -60000 -60000
1 37100 33727 30917 32053
2 16800 13844 11667 12540
3 12200 9166 7060 7868
4 8640 5901 4167 4814
5 5440 3378 2186 2618
6 250 141 84 104

S 20430 6198 -3920 0 <= Net Present Value

Rate of Return = 0.157

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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Example Problem

Find the Rate of Return of the following cash flows

Year Net Revenue


0 -30000
1 15000
2 10500
3 7500
4 5000
5 3200
6 1600

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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Net Present Value for a Petroleum Production System

N ( qok Po + qgk Pg qwp


k
C q wi wi )
k
C T I k
C F (
k
1 r k
)
NPV = wp k T
k Tk
k =1
(1 + i ) 365

qok = daily production of oil [STB/D], at time k


q k
g
= daily production of water [STB/D], at time k
q k
wp
= daily production of gas [SCF/D], at time k Without loss of generality, the
q k
= daily injection of water [STB/D], at time k
wi objective function, for a
Po = net selling revenues of oil [$/STB], calculated as
selling price minus the associated production hydrocarbon production
costs: operational budget (payroll, supplies,
maintenance, treatment and transport) and minus
system may be expressed as
the production royalties. the finite sum of discounted
Pg = net selling revenues of gas [$/MSCF]. Idem
C wp = cost of treatment and disposal of produced water
cash flows during the project
per unit barrel, [$/STB]; horizon
Cwi = cost of treatment and compression of injected
water per unit barrel, [$/STB];
ITk = the total capital investment [$] on field assets
(wells, surface facilities) at time interval k
CFk = fixed costs (overhead, leases, capital cost) at time
interval k
rk = tax rate at time interval k
Tk = size in days of the time interval
i = annual discount factor
k = time interval number
N = number of time intervals

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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Risk Measurement
Risk Measurement
Given risk, the uncertainty of a future outcome, the realized (or actual) return on
an asset may be different from what was expected (or anticipated).
Being able to measure and determine the past volatility of a security provides
some insight into the riskiness of that security as an investment.
Increased volatility, or price fluctuations, can be associated with increased risk.
To deal with uncertainty of returns, investors need to think explicitly about a
securitys distribution of probable total returns.
With the possibility of two or more possible outcomes, which is not unusual,
investors must consider each possible likely outcome and assess the probability
of its occurrence.

Source: The Tools and Techniques of Investment Planning


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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Probability Distributions
Probability distributions provides a range of the likelihood of certain outcomes or
returns from an investment, as opposed to a point estimate. The sum of all
probabilities must equal 1.
Probability distributions involve subjective estimates determined by incorporating
anticipated future changes to past outcomes.
Probability distributions can either be discreet or continuous:
with a discreet probability, a probability is assigned to each possible outcome.
with a continuous probability, an infinite number of possible outcomes exist.
The most familiar continuous probability is the normal distribution depicted by a bell-
shaped curve.
It is a two-parameter distribution because it only requires the mean and the variance
to fully describe it.
To describe the mean (or most likely outcome), it is necessary to calculate the
expected value or return.
That is, the average of all possible return outcomes, where each outcome is
weighted by its respective probability of occurrence.
The variance or standard deviation is used, at least as a first approximation, to
calculate the total risk associated with the expected return.

Source: The Tools and Techniques of Investment Planning


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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Variance and Standard Deviation

The variance is the expected value of the average squared differences from the
mean of the distribution.
Simply put, it is a measure of how much, on average, any particular observation
of a randomly distributed variable will differ from the average or mean value of
the distribution.
The standard deviation is the square root of the variance and is also a measure
of dispersion of outcomes around an average.
The larger the standard deviation, the more uncertain the outcome.
The standard deviation is a measure of the goodness or confidence placed in
the mean value of the outcome of a random variable.
A related concept, is the mean absolute deviation, which is the usual or average
amount by which the values observed differ from the mean of the distribution.
The standard deviation alone is only a partial or incomplete, and sometimes,
misleading measure of the riskiness of an investment relative to another one.
Risk assessment should include differences in expected values and the
downside or loss potentials of the alternative investments.
To take on any real meaning when comparing alternative investments,
investors should use standard deviations relative to the investments
expected returns to measure each investments return per unit of risk.

Source: The Tools and Techniques of Investment Planning


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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Variance and Standard Deviation

For example, the standard deviation of equity returns is greater than the
standard deviation of fixed-income investment returns for all investment
horizons. However, at longer investment horizons, equities dominate fixed
income investments and despite greater standard deviations, equities can be
viewed as less risky investments than bonds.

If returns are normally distributed, investors can predict that actual realized
returns will fall within one standard deviation above or below the mean about
68% of the time; and within 2 standard deviations, about 95% of the time.

To compute the standard deviation:


Determine the arithmetic mean of all observations.
Subtract each individual observation from the average return (arithmetic
mean) of all observations.
Square each difference.
Divide the sum of the squared differences by the number of observations
less 1.
Take the square root.

Source: The Tools and Techniques of Investment Planning


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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Variance and Standard Deviation
To calculate the standard deviation of a portfolio, one needs to know:
a) the proportion each asset represents of the total amount invested in the
portfolio, b) the standard deviation or variance of each asset, c)the
covariance of returns of assets in each portfolio.
p= (w12 x 12) + (w22 x 22) + (2 x w1x w2x 12)

where p is the standard deviation of the portfolio, 12 is the variance of


asset 1 (or of asset 2 when using subscript 2), 12 the covariance between
the assets, and w represents the weight of each asset in the portfolio;
stands for the square root.
The variance and standard deviation are a measure of total risk, including both,
systematic and unsystematic, whatever the sources of variability of returns.
Over the short run, and for certain investments (i.e., options, other derivatives,
hedge funds, etc.) the standard deviation may only provide an incomplete and
misleading measure of risk, even when used with expected returns, given that
the distributions may not be normally distributed.

Source: The Tools and Techniques of Investment Planning


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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Coefficient of Variation
While standard deviation is an absolute measure, to make a comparison between two
assets of different means and standard deviations, a relative measure of dispersion is
needed: the coefficient of variation.
The coefficient of variation is found by dividing the standard deviation by the mean or
expected return.

Source: The Tools and Techniques of Investment Planning


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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Semi-Variance
The semi-variance is a measure of downside risk: the risk of realizing an outcome
below the expected returns.
Some investors prefer it because they think that only deviations below the expected
return or below a benchmark or target return really matter.
The semi-volatility, or downside volatility, is computed in exactly the same way as the
semi-variance,except that all returns above target or benchmark, rather than the
expected return, are ignored.
The square root of the semi-variance is sometimes called the semi-deviation.
Semi-deviation is to semi-variance as standard deviation is to variance.
The downside deviation is sometimes used to refer to the square root of the semi-
variance, but more frequently to the square root of the downside volatility, which is
computed with respect to a minimal acceptable rate of return different from the
expected return.
Although the semi-variance may be conceptually superior, in practice, the standard
deviation is the measure of choice due to some difficult math problems.
Over the long run, stock returns have generally been reasonably symmetrical, so the
downside deviation and standard deviation result in exactly the same answer.

Source: The Tools and Techniques of Investment Planning


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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Covariance and Correlation
Covariance is a measure of the degree to which two variables move in a systematic
or predictable way, either positively or negatively.
If they move in opposite directions, they exhibit negative covariance, while moving in
the same direction reflects positive covariance.
If they are completely independent, showing no systematic relationship, their
covariance is zero.
If two variables move in perfect lockstep, up or down, they exhibit perfect positive
covariance. If they move in perfect lockstep, but in opposite directions, they exhibit
perfect negative covariance.
Correlation is a standardized version of covariance where values range from -1
(perfect negative covariance) to +1(perfect positive covariance).
Covariance is equal to the correlation times the standard deviation of the two
variables:
Letting 12 = represent the covariance between 2 variables, 1 the standard deviation of
variable 1, 2 the standard deviation of variable 2, and 12 the correlation of the two variables,
the relation between correlation and covariance is as follows:
12 = 1 x 2 x 12 or 12 = 12 / (1 x 2)
According to Markowitz, by adding stocks that do not exhibit perfect covariance to
their portfolio, the total risk of the portfolio as measured by the variance or standard
deviation, would decline.
In other words, as long as there are any classes of assets whose returns are not
perfectly correlated with the current portfolio, investors can further reduce the risk of
their portfolios by adding securities from those asset classes.
p2 = (w1 2 x 12) + (w22 x 22)+(2 x w1x w2 x 1 x 2 x 12)

Source: The Tools and Techniques of Investment Planning


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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Covariance and Correlation
For each additional independent stock (covariance and correlation are equal to
0) added to the portfolio, the variance attributable to the uncorrelated risk
declines in proportion to the number of stocks and approaches zero as the
number of securities increases.
the standard deviation declines by the square root of the number of
independently distributed securities in the portfolio, assuming, for simplicity,
equal standard deviations and weights:
p = 12/n and p = 1/ n.
2

In the case of two perfectly negatively correlated, splitting ones investment


equally between the two securities completely eliminates all variability and the
variance and standard deviation are equal to 0.
There is no risk reduction advantage in adding perfectly positively correlated
assets to ones portfolio and the variance remains the same.

Source: The Tools and Techniques of Investment Planning


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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Beta
Beta determines the volatility, or risk, of a security or fund in relation to that of its
index or benchmark (whereas standard deviation determines the volatility of a
security or fund according to the disparity of the returns over a period of time).
In the CAPM single factor asset model, the index or benchmark is the market
portfolio, often measured by the S&P500.
When comparing funds in a category or to measure performance, the benchmark is
generally the average of the fund in the category.
A fund with a Beta close to 1 means the funds performance closely matches the
index or benchmark; if greater than one, it means greater volatility than the index or
benchmark; and if less than 1, it indicates less volatility than the index or benchmark.
Choose funds exhibiting Betas less than 1 in bearish markets because they decline
less than the market, and vice-versa.
However, Beta by itself is limited and can be skewed due to factors other than market
risk affecting the funds volatility.
To compute Betas, multiply the standard deviation of returns on a stock by the
correlation coefficient of returns on the security and the returns on the market, divided
by the standard deviation of returns on the market.
1 = 1m 1 / m
The weighted beta coefficients measures the risk of a given portfolio compared to the
overall market.
Beta coefficients are determined using historical price data of individual stocks and
the market as a whole. Regression analysis is used to compute the Betas.
Given that the past is not always an accurate predictor of the future, the beta of an
individual security has shown to be pretty unstable over time. On the other hand,
betas of individual portfolios have proved to be fairly stable over time.
Source: The Tools and Techniques of Investment Planning
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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
R-Squared (Coefficient of Determination)

Measures the proportion of a securitys or portfolios total variability explained by its


relationship to a benchmark/index (i.e. day-to-day fluctuations experienced by the
overall market) and how much is its independent risk unrelated to the
benchmark/index.
When used in conjunction with ratings of mutual funds or the performance of
professional managers, it indicates if the beta of the mutual fund is measured against
an appropriate benchmark.
Values range between 0 and 100, where 0 represents the least correlation and 100,
full correlation. The closer to 100, the more the Beta should be trusted and vice-versa.
An inappropriate Beta would skew more than just beta. Alpha is calculated using beta,
so if the R-squared is low, it is also wise not to trust the figure given for alpha.

Source: The Tools and Techniques of Investment Planning


24
Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
SKEWNESS
Skewness measures the coefficient of asymmetry of a distribution.
While in the normal distribution both tails mirror each other, skewed distributions have
one tail that is longer than the other.
A risk averse investor does not like negative skewness, given the greater
downside tail exposing the investor to low or negative returns below the worst
potential returns on an investment with positive skewness. In addition,
investments with positive skewness offer investors the potential for upside returns
far above any they could expect from the negatively skewed ones.
In symmetric distributions, such as the normal distribution, the mean and median are
equal, but not in skewed distributions.
In positively skewed distributions, the median or point where there is a 50% chance
that returns will fall below that value, is below the mean, which results in less than
50% chance of earning the mean; while in negatively skewed distributions, the median
is above the mean (more than 50% chance of earning the mean).
While a risk-averse investor will prefer a positively skewed over a negative skewed
investment when their means and standard deviations are identical, it does not mean
they will always prefer a positively skewed investment to a symmetrically distributed
one.

Source: The Tools and Techniques of Investment Planning


25
Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Kurtosis
Degree of fatness in tails of the distribution.
Risk averse investors will prefer a distribution with low kurtosis (where tails are more
likely to fall closer to the mean), since they will always weigh the potential downside
returns heavier than the potential upside returns.
Small cap stocks exhibit greater excess kurtosis and negative skewness than larger
stocks, which is not captured under CAPM and hence its failure to account for
anomalies regarding small caps excess returns.

Source: The Tools and Techniques of Investment Planning


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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Skewness and Kurtosis Combined
Some distributions can exhibit both, skewness and excess kurtosis.
As soon as skewness begins to be negative the impact of a high excess kurtosis is
significant for a risk-averse investor.
At a skewness of -1 and a kurtosis higher than 1, the probability of having a huge
negative return increases dramatically.
For optimization, simulation, and investment selection, the investors selection should
account for volatility, skewness and kurtosis when the return distribution over the
relevant period is likely to be significantly different than the normal distribution.

Source: The Tools and Techniques of Investment Planning


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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Field Development optimization example
Example of optimization

Consider a simple decision

Investment to drill out Area A and/or Area B, which have different profit
expectations and constraints.

Area A Area A Area B


Export
Price, $/kscf 7 7
Lifting cost, $kscf 2 3
Area B Overhead, $kscf 2 2
Operators hrs./Mscf 2 1
Engineers hrs./Mscf 1 1
Export Pipeline capacity/Mscfd 40 100
Profit/$kscf 3 2
Operators limit (100 hrs/d)
Engineers limit (80 hrs/d)

What is the development plan?

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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Example of optimization

Intuitive engineering answer

Area A has higher profit margin, thus should produce up to pipeline capacity
and use any left over resources for Area B.

Profit from A = $3/kscf X 40 Mscf/d = $120,000/day

Area A uses 80 operators hrs/day and 40 engineers hrs/day, leaving


resources for Area B to produce 20 Mscf/d.

Profit from B = $2/kscf X 20 Mscf/d = $40,000/day

TOTAL PROFIT = $160,000 / DAY

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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Example of optimization

Intuitive engineering answer

TOTAL PROFIT
= $160,000 / DAY

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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Example of optimization

Establish the optimization problem


Decisions
Pipeline A Flow Rate = A

Pipeline B Flow Rate = B

Objetive Function Total Profit = Profit A + Profit B


Profit A = (Price - Lifting Cost A - Overhead A) Pipeline A Flow Rate = 3A

Profit B = (Price - Lifting Cost B - Overhead B) Pipeline B Flow Rate = 2B

Constraints
Pipeline A Flow Rate = A < 40
Pipeline B Flow Rate = B < 100

hr hr
Operator Hours = 2 Pipeline A Flow Rate + 1 Pipeline B Flow Rate = 2A + B < 100
MSCF MSCF
hr hr
Engineer Hours = 1 Pipeline A Flow Rate + 1 Pipeline B Flow Rate = A + B < 80
MSCF MSCF

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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Example of optimization

sequential thinking
Total Total Total Total Total Total Total
Profit = Profit = Profit = Profit = Profit = Profit = Profit =
A 50 100 150 200 250 300 350
0 25 50 75 100 125 150 175
5 18 43 68 93 118 143 168
10 10 35 60 85 110 135 160
15 3 28 53 78 103 128 153
20 -5 20 45 70 95 120 145
25 -13 13 38 63 88 113 138
30 -20 5 30 55 80 105 130
35 -28 -3 23 48 73 98 123
40 -35 -10 15 40 65 90 115
45 -43 -18 8 33 58 83 108
50 -50 -25 0 25 50 75 100
55 -58 -33 -8 18 43 68 93
60 -65 -40 -15 10 35 60 85
65 -73 -48 -23 3 28 53 78
70 -80 -55 -30 -5 20 45 70
75 -88 -63 -38 -13 13 38 63
80 -95 -70 -45 -20 5 30 55
85 -103 -78 -53 -28 -3 23 48
90 -110 -85 -60 -35 -10 15 40
95 -118 -93 -68 -43 -18 8 33
100 -125 -100 -75 -50 -25 0 25

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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Solve optimization by graphical solution (LP)
1. Plot Objective Function:
100
100 Total Profit = 3A + 2B
B = (Total Profit - 3A) / 2

2. Plot Constraints
B=

0<A<40
10

80

35
80
0-2

0<B<100
Pipeline Flow rate from B (MSCF/D)

0
A

Operator's Limit

3A
2A+B<100 B<100-2A

30
+

0
2B
Engineer's Limit
60
60 A+B<80 B<80-A

=
25
0
3. Find Maximum in the region of
feasible constraints;
20

LP Solution The solution is


0

40
40
always in one of its vertices
15
0
10

20 B<
0

20 80
-A
50

But, what happens if there


00
00 20 40 60
60 80
80
are more than 2 variables or
Pipeline Flow rate from A (MSCF/D) if objective function and
constraints are non linear?
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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Solve Optimization by Using Any Solver

Then, the optimal solution is given by maximizing the objective function:

S.T.R. = Subjectmax [ ( )]
f x =
to restrictions max[Total Profit ]S .T . R.

Objective
Decision
Profit model Function
Making
Evaluation

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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Solve Optimization by Using Excel Solver

1. Set Target Cell Objective Function


2. Set Max, min or Value of Objective
3. Set By Changing Cells Decision Variables
4. Set Subject to Constraints Constraints
5. Click Solve
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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Example of optimization

Total profit is $180,000/day


The Optimal
Answer A produces 20 Mscf/d B produces 60 Mscf/d

80
Ope Optimal

Area B Production, Mscf/d


rato
70 r Co Answer
nst
rai nt $180K
60 /day
50 En
gi
ne
40 er Intuitive
C on
st Answer
30 ra
in
t $160K
20 /day
10
0
0 10 20 30 40
Area A Production, Mscf/d

37
Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
So, What is Optimization?
Optimization is a process that finds a best, or optimal, solution for a model.
Optimization is the selection of the best alternative, or maximizing/minimizing a goal,
subject to a particular model, satisfying (or not) all requirements and constraints
For example, maximize IRR given that the maximum capital exposure does not
exceed $100,000
A constraint restricts the decision variables to specific combinations of values.
For example, if you can only invest $50,000 in a group of portfolio assets (your
decision variables), a constraint will ensure that the investment sum from all of
the assets will never exceed $50,000.
A requirement is a restriction on a forecast statistic such as the mean or standard
deviation. Optimization will ignore any solution that does not comply with your
requirement
For example, you could set a requirement to ensure that in any acceptable
solution, you will be 90% certain of having a final portfolio value of $1 million or
more.
Optimization is very important when you have model variables that you can control
(e.g., spending) and you want a maximum or minimum goal that relies on those
variables.

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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
What do we optimize in Oil & Gas Industry?
(things we can control)

Typically, the objective function (what we optimize) is


to maximize profit and minimize variance

Typically, what we control (decision variables)


Capital allocation into separate investments

Combination of possible projects with budget constraints

number of oil wells to drill given a certain reservoir size and specified production
rates.

Facility size, pipeline dimensions, plateau rate, artificial lift method, gas-lift quantity,
production/injection rates

Shots per foot, slots per foot, mud weight, weight-on-bit, pump strokes

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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Optimization and Uncertainty
Example of uncertainty assessment

What if there is uncertainty?


For a given decision set (A=20, B=60) there is only one Total Profit
value under certain assumptions of input parameters and resource
constraints, but
Assumes that there exists uncertainty in
Reservoir delivery
Lifting costs
Operation efficiencies
Events are uncertain if we do not have control over them in the decision
making process, but they are relevant in at least one of the objectives
Sometimes, uncertainties may be minimized before we take decisions
Sometimes, it is unpractical to eliminate uncertainties but we can
evaluate the impact on our decisions

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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
We model uncertainty using Random Variables with certain
Probability Distribution

Random Variable: variables that cannot be predicted with certainty and,


thus, can take on more than one possible value.

A probability is associated with each possible value of the random


variable. (e.g., ultimate reserves, net pay, drilling costs, commodity
price etc.)

Probability Distribution: description of the range of values that


a random variable can take, together with the associated
probabilities of occurrence of those values.

Discrete Distribution: can only take on specific values.


e.g., Coin toss - Heads or Tails, each has a probability of 0.5

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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Example of optimization under uncertainty

Assume uncertainty in the input parameters

6.8 7.0 7.2 1.8 2.0 2.2 1.8 2.0 2.2


Gas Price ($/kscf) Lift Cost A ($/kscf) Overhead ($/kscf)

Profit A = (Price - Lift Cost A - Overhead A) Pipeline A Flow Rate


?
Profit B = (Price - Lift Cost B - Overhead B) Pipeline B Flow Rate

6.8 7.0 7.2 2.7 3.0 3.3 1.8 2.0 2.2


Gas Price ($/kscf) Lift Cost B ($/kscf) Overhead ($/kscf)

43
Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Example of a Probabilistic distribution

Well Net Pay Range Count Relative Frecuency


1 111 From 50 to 80 ft 4 4/20 = 20%
2 81 From 81 to 110 ft 7 7/20 = 35%
3 142
4 59
From 111 to 140 ft 5 5/20 = 25%
5 109 From 141 to 170 ft 3 3/20 = 15%
6 96 From 171 to 200 ft 1 1/20 = 5%
7 124
8 139
9 89 40% 7
10 129
Frequency

11 104 30% 5
12 186 4
13 65 20% 3
14 95
15 54
10% 1
16 72
17 167
18 135
0%
19 84 From 50 From 81 From 111 From 141 From 171
20 154
to 80 ft to 110 ft to 140 ft to 170 ft to 200 ft

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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Uncertainty Analysis

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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Uncertainties vs. Risk
There is no real consensus between risk and uncertainty
It is usually considered in the Oil and Gas Industry as:
Uncertainty
The parameter variation affecting one evaluation
without uncertainty There is no risk
Uncertainty generates risk and opportunity
Risk
It is related to the probability of failure and the cost associated
It is usually defined with a probability of an adverse scenario
Without risk there is no probability of winning

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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Sources of Model Variations

Uncertainty
Assumptions that are uncertain because of insufficient information about a true,
but unknown, value.
Examples of uncertainty include the reserve size of an oil field or the prime
interest rate in 12 months.
Can be described as an assumption with a probability distribution.
Theoretically, uncertainty can be eliminated by gathering more information.
Practically, information can be missing because you havent gathered it or
because it is too costly to gather.

Variability
Assumptions that change because they describe a population with different
values.
Examples of variability include the individual body weights in a population or the
daily number of products sold over a year.
Variability can be described as assumption with a discrete distribution (or
approximate one with a continuous distribution).
Variability is inherent in the system, and it cannot be eliminated it by gathering
more information.

From: CB7 User Manual - Table 8.7 Sources of model variation


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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Optimization under uncertainty

Assume uncertainty in the input parameters

6.8 7.0 7.2 1.8 2.0 2.2 2.7 3.0 3.3


Gas Price ($/kscf) Lift Cost A ($/kscf) Lift Cost B ($/kscf)

1.8 2.0 2.2 1.5 2.0 2.5 0.7 1.0 1.3


Overhead ($/kscf) Operators Hours ($/kscf) Engineers Hours ($/kscf)

Then, the optimal solution is given by maximizing expected value of the objective
function:

max[E [ f ( x )]] = max[E [Total Profit ]] = max[ ]S .T . R.


where is the mean value of f(x) for a given number of stochastic simulations;
S.T.R. = Subject to restrictions

48
Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Optimization Under Uncertainty

Then, the optimal solution is given by maximizing expected value of the objective
function:
max[E [ f ( x )]] = max[E [Total Profit ]] = max[ ]S .T . R.
where is the mean value of f(x) for a given number of stochastic simulations;
S.T.R. = Subject to restrictions

Probabilistic
Perturbation

Decision
Objective
Profit model Function
Making
Evaluation

Probabilistic
response

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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Example of optimization under uncertainty

One external loop Probabilistic


solves for optimal Perturbation
decision making Decision
Objective
Profit model Function
One internal loop solves Making
Evaluation
for uncertainty Probabilistic
propagation response

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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
Example of optimization under uncertainty

Every point in the plot


represent the solution :[k$/d]
(one scenario) of one
external loop
For every expected
value of Total Profit in
the Upper envelope
there is an optimal
acceptable risk
The slope of the Upper
envelope gives an idea
of the project risk and
they have constant /

= 0.55 = 0.67

:[k$/d]

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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009
What Is an Efficient Frontier?

If examining all combinations of decision variables (e.g. investment strategies for a


given assets), each potential set (e.g. portfolio) has its own specific mean return and
standard deviation of return.
Plot the means on one axis and the standard deviations on another axis
Return -- E(NPV) (MM$)

30
Efficient
28

26

24 Inefficient
22

20
4 5 6 7 8 9
Risk SSD (MM$)

Points above the curve are unobtainable combinations for a particular asset.
Curve represents portfolios where we cannot obtain higher mean returns without
generating higher standard deviations

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Halliburton-Sonatrach On-Boarding Program Reservoir Engineering Introductory Course January 2009