Decision Analysis for

Petroleum Exploration

Lecture notes for PET 472

Spring 2011
Prepared by: Thomas W. Engler,
Ph.D., P.E.
Expected Value Definitions

• Decision Analysis
– A comprehensive approach to evaluate and compare multiple
options considering both elements of risk and uncertainty
• Risk
– The probability of different outcomes from an event

Discovery
Test well
Dry hole

• Uncertainty
– Statistical variations of a variable; e.g., oil price, oil-in-place, aka
“stochastic”
Expected Value Definitions

• Expected Value Strategy

– A method of combining profitability estimates with quantitative
estimates of risk to yield a risk-adjusted decision.

• Expected Value
– Probability weighted value of all possible outcomes
n
EV   P(outcome )i * NPV (outcome )i
i 1
Expected Value Example 1

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

and the probability of a dry hole is 0.4.

Two options are available:

1. drill the well
2. farm out the prospect retaining an overriding royalty.

Possible outcomes are:

1. If a dry hole the net loss is $200,000.
2. If it hits the net profit will be $600,000.
3. If we farm out the income from a producer is $50,000.

What is your decision?

Expected Value Example 1

Decision Options
Drill Farmout
outcome P(outcome) Conditional Expected Conditional Expected
value($) value of value($) value of
outcome($) outcome($)
Dry hole 0.4 -200,000 - 80,000 0 0

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

EV = +280,000 +30,000
Expected Value Definitions

• EV Decision Rule
– When choosing among several mutually exclusive decision
alternatives, select the alternative with the greatest expected
value.
• Repeated trial clause
– From the example, if you drill one well can you have an outcome
of $280,000?
– What about if you drill 100 wells?

If the decision maker consistently selects the alternative having the

highest expected value, then his expected value total of a portfolio of
decisions will be higher than from any alternative strategy. This
statement is true even though each specific decision is a different
drilling prospect with different probabilities and outcome values.
Expected Value Example 2

The exploration staff of Devon

Energy has been evaluating a
prospect in the Anadarko Basin of
western Oklahoma. The well
requires a 640-acre gas unitin
Section 29; of which currently 256 29
acres is not leased. Devon’s Unleased
Acreage
participation in the unit is
(256 ac)
predicated on purchasing the
leasehold rights of the 256 acres.
 Expected Value Example 2

Gross well costs: $100,000 Alternatives:

Gross dryhole costs: $ 70,000 1. Participate in drilling the well
with a non-operating 40% WI
Possible outcomes and probabilites 2. Farm out the acreage and
retain a 1/8 of 7/8 ORRI on
256 net acres.
Outcome P(outcome)
3. Be carried under a penalty
Dry hole 0.35 clause of the proposed
2 Bcf reserves 0.25 operating agreement with a
3 Bcf reserves 0.25 backin privilege (40% WI)
4 Bcf reserves 0.10 after recovery of 150% of the
5 Bcf reserves 0.05 investment by the
participating parties.
1.00
Expected Value Example 2

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

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

strategies maximizes the expected value?
Expected Value Example 2
Conditional NPV profits or losses

Decision Options
Possible Drill with 40% WI Farm out – retain Penalty clause
outcomes ($) ORRI on 256 net with 40% backin
acres ($) option ($)
Dry hole -28,000 0 0

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

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

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

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

Expected Value Example 2
Expected value calculations

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

Possible P(O) NPV ($) EV ($) NPV ($) EV ($) NPV ($) EV ($)
outcomes
Dry hole 0.35 -28,000 - 9,800 0 0 0 0

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

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

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

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

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

Expected Value Example 2

What is the maximum Devon should pay for the leasehold

rights?

The expected value of a decision represents the average NPV gain that would
be realized over a series of repeated trials in excess of a rate of return equal to
the discount rate.

That is, the maximum economic amount we could offer for the leases (and still
have earnings of the discount rate) is equal to the expected value.

$16,650
 $65 / acre
256 acres
Expected Value Example 2

Expected value vs chance of success

drill
30000
EV ($), exclusive of lease costs

20000 Penalty &

Back in
10000
farmout
0
0 0.2 0.4 0.6 0.8 1
-10000

-20000 Probability well will

Encounter HCs
-30000
Expected Value Example 3

Compare the merits of three different drilling prospects

• Which of the prospects is preferred?

• If the company is capital constrained and thus must

maximize EV per expected investment costs, which is
the preferred prospect?
Expected Value Example 3
Prospect A
Possible outcome Probability of occurrence Discounted cashflow ($)

Dry hole 0.30 - 80,000

100 Mstb 0.30 + 25,000

200 Mstb 0.20 +150,000

300 Mstb 0.10 +250,000

400 Mstb 0.10 +350,000

1.00

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

Expected Value Example 3
Prospect B
Possible outcome Probability of occurrence Discounted cashflow ($)

Dry hole 0.50 - 200,000

100 Mstb 0.10 - 100,000

400 Mstb 0.20 + 350,000

700 Mstb 0.10 + 600,000

1000 Mstb 0.10 +1,000,000

1.00

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

 Expected Value Example 3
Prospect C
Possible outcome Probability of occurrence Discounted cashflow ($)

Dry hole 0.35 - 28,000

2 Bcf 0.25 + 25,000

3 Bcf 0.25 + 50,000

4 Bcf 0.10 + 80,000

5 Bcf 0.05 +100,000

1.00
Dry hole costs = $70,000 Dry hole costs = $28,000
Completed well costs = $100,000 Completed well costs = $40,000
At 40% WI