Decision Analysis for

Petroleum Exploration
Lecture notes for PET 472
Spring 2013
Prepared by: Thomas W. Engler,
Ph.D., P.E.
http://infohost.nmt.edu/~petro/faculty/Engler472/PET472-5-DecisionAnalysis.pdf
Expected Value
Decision Analysis
A comprehensive approach to evaluate and compare multiple
options considering both elements of risk and uncertainty
Risk
The probability of different outcomes from an event




Uncertainty
Statistical variations of a variable; e.g., oil price, oil-in-place, aka
stochastic
Definitions
Discovery
Test well
Dry hole
Expected Value
Expected Value Strategy
A method of combining profitability estimates with quantitative
estimates of risk to yield a risk-adjusted decision.

Expected Value
Probability weighted value of all possible outcomes
Definitions

n
1 i
i
) outcome ( NPV *
i
) outcome ( P EV
Expected Value
Evaluate a drilling prospect in which the estimated probability of success is 0.6
and the probability of a dry hole is 0.4.

Two options are available:
1. drill the well
2. farm out the prospect retaining an overriding royalty.

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

What is your decision?
Example 1
Expected Value
Example 1
Decision Options
Drill Farmout
outcome P(outcome) Conditional
value($)
Expected
value of
outcome($)
Conditional
value($)
Expected
value of
outcome($)
Dry hole 0.4 -200,000 - 80,000 0 0
producer 0.6 +600,000 +360,000 +50,000 +30,000
EV = +280,000 +30,000
Expected Value
EV Decision Rule
When choosing among several mutually exclusive decision
alternatives, select the alternative with the greatest expected
value.
Repeated trial clause
From the example, if you drill one well can you have an outcome
of $280,000?
What about if you drill 100 wells?
Definitions
If the decision maker consistently selects the alternative having the
highest expected value, then his expected value total of a portfolio of
decisions will be higher than from any alternative strategy. This
statement is true even though each specific decision is a different
drilling prospect with different probabilities and outcome values.
Expected Value
The exploration staff of Devon
Energy has been evaluating a
prospect in the Anadarko Basin of
western Oklahoma. The well
requires a 640-acre gas unitin
Section 29; of which currently 256
acres is not leased. Devons
participation in the unit is
predicated on purchasing the
leasehold rights of the 256 acres.
Example 2
29
Unleased
Acreage
(256 ac)
Expected Value
Gross well costs: $100,000
Gross dryhole costs: $ 70,000

Possible outcomes and probabilites

Outcome P(outcome)
Dry hole 0.35
2 Bcf reserves 0.25
3 Bcf reserves 0.25
4 Bcf reserves 0.10
5 Bcf reserves 0.05
1.00
Alternatives:
1. Participate in drilling the well
with a non-operating 40% WI
2. Farm out the acreage and
retain a 1/8 of 7/8 ORRI on
256 net acres.
3. Be carried under a penalty
clause of the proposed
operating agreement with a
backin privilege (40% WI)
after recovery of 150% of the
investment by the
participating parties.
Example 2
Expected Value
Management questions
1. What is the maximum Devon should pay for the
leasehold rights?

2. If Devon obtains the 256 net acres, which of the three
strategies maximizes the expected value?

Example 2
Expected Value
Example 2
Decision Options
Possible
outcomes
Drill with 40% WI
($)
Farm out retain
ORRI on 256 net
acres ($)
Penalty clause
with 40% backin
option ($)
Dry hole -28,000 0 0
2 Bcf +21,000 + 5,000 + 5,000
3 Bcf +42,000 + 8,000 +20,000
4 Bcf +64,000 +11,000 +37,000
5 Bcf +86,000 +13,000 +56,000
Conditional NPV profits or losses
Expected Value
Example 2
Drill w/40% W.I. Farm out w/ORRI Penalty w/backin
Possible
outcomes
P(O) NPV ($) EV ($) NPV ($) EV ($) NPV ($) EV ($)
Dry hole 0.35 -28,000 - 9,800 0 0 0 0
2 Bcf 0.25 +21,000 + 5,250 + 5,000 +1,250 + 5,000 + 1,250
3 Bcf 0.25 +42,000 +10,500 + 8,000 +2,000 +20,000 + 5,000
4 Bcf 0.10 +64,000 + 6,400 +11,000 +1,100 +37,000 + 3,700
5 Bcf 0.05 +86,000 + 4,300 +13,000 + 650 +56,000 + 2,800
1.00 EV = +16,650 +5,000 +12,750
Expected value calculations
Expected Value
What is the maximum Devon should pay for the leasehold
rights?

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

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



Example 2
acre / 65 $
acres 256
650 , 16 $

Expected Value
Example 2
-30000
-20000
-10000
0
10000
20000
30000
0 0.2 0.4 0.6 0.8 1
Probability well will
Encounter HCs
E
V

(
$
)
,

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e

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f

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a
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e

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o
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drill
farmout
Penalty &
Back in
Expected value vs chance of success
Expected Value
Compare the merits of three different drilling prospects


Which of the prospects is preferred?

If the company is capital constrained and thus must
maximize EV per expected investment costs, which is
the preferred prospect?
Example 3
Expected Value
Example 3
Possible outcome Probability of occurrence Discounted cashflow ($)
Dry hole 0.30 - 80,000
100 Mstb 0.30 + 25,000
200 Mstb 0.20 +150,000
300 Mstb 0.10 +250,000
400 Mstb 0.10 +350,000
1.00
Dry hole costs = $80,000 Completed well costs = $100,000
Prospect A
Expected Value
Example 3
Possible outcome Probability of occurrence Discounted cashflow ($)
Dry hole 0.50 - 200,000
100 Mstb 0.10 - 100,000
400 Mstb 0.20 + 350,000
700 Mstb 0.10 + 600,000
1000 Mstb 0.10 +1,000,000
1.00
Dry hole costs = $200,000 Completed well costs = $250,000
Prospect B
Expected Value
Example 3
Possible outcome Probability of occurrence Discounted cashflow ($)
Dry hole 0.35 - 28,000
2 Bcf 0.25 + 25,000
3 Bcf 0.25 + 50,000
4 Bcf 0.10 + 80,000
5 Bcf 0.05 +100,000
1.00
Dry hole costs = $70,000
Completed well costs = $100,000
Prospect C
Dry hole costs = $28,000
Completed well costs = $40,000
At 40% WI
Expected Value
Example 3
Outcomes Prospect A
EV, $
Prospect B
EV, $
Prospect C
EV, $
Dry hole -24,000 -100,000 - 9,800
1 + 7,500 - 10,000 + 6,250
2 +30,000 + 70,000 +12,500
3 +25,000 + 60,000 + 8,000
4 +35,000 +100,000 + 5,000
EV = +73,500 +120,000 +21,950
Expected value calculations