1.3. Estimation of volume reserves

One of most important aspects of the risk analysis in oil branch is uncertainty of limiting recovery. Unfortunately, it is usual more attention is given to volumes of industrial reserves while the question on volumes of real recovery can be much more important. Because of money cost changes of resources in time the oil reserves in 50 years, from the financial point of view, have cost much smaller, than produced earlier.

Process of the decision-making connected with accommodation of money resources in area of drilling can base both on instinct and experience, and on the most complicated analytical techniques. Irrespective of a level of problem complexity a value of experience and instinctive perception is not belittled at all. Essentially process of decision-making always the same: at an instinctive level the investor meaningly or subconsciously tries to weigh risk and benefit.

Use of expected monetary value theory (EMV) became standard starting 1980th years. This theory has taken a place in arsenal of the persons responsible for decision-making. Before many managers made decision on the basis of informal estimation of risk and benefits interfaced to plan drilling. The decision about drilling is a magnificent illustration of a described method. Within the limits of this theory a risk capital and probability of its loss compare to possible benefit and probability of its recovery. Estimation is made under the following formula:

EMV = (benefit x probability of success) - [risk capital х (1 - probability of success)],

where,

Benefit - discounted cost of possible productive drilling;

Risk capital - expenses for dry well and other forthcoming expenses;

This formula is based in the analysis of risk. If at the decision of the equation the expected monetary value is positive the weighed risk of compensation surpasses the weighed risk of losses.

Benefit

Benefit is the discounted resulted cost of successful results of drilling in the drilling project. The discounting rate of prospective cash flow should be equaled to comprehensible rate of return. Sometimes with the purpose of discounting corporate financial management establishes the threshold rate required for approval of the project. Its concrete value is based on corporate expenses for capital investment and-or market interest rate for similar investment. Thus, the decision about project development can be accepted at any positive value of the expected cost.

Risk capital

Risk capital, as a rule, is expenses connected with drilling of exploration well, gathering and processing of seismic data, preparation of a platform, drilling of dry well and other processes. It is impossible to overestimate role of risk capital. Its interrelation with discounted cost of the successful enterprise is function of success probability. In that area where probability of success makes not less than 20 %, risk dollars should be compensated according to a parity, at least, 5:1.

Probability of success

Estimation of oil- pool discovery probability at drilling a well is one of the most difficult stages of estimation process. Many managers feel not so comfortably at the task to make such estimation perhaps because extremely developed intuition is necessary. Some analysts are capable to define the future financial results to within three signs after a comma, but panic at idea on necessity of probability of success calculation.

Sometimes it is useful to count up simply factor of break-even success and then to compare it to estimation of probability of success. If the probability of break-even success makes about 20 % for area with average factor of success approximately 25 % the problem would become simpler. Let’s consider example with parity of the basic variable parameters of the expected monetary value theory for a case of expenses $3 MM of dry well drilling. If this well would be dry, investment will be gone, and in case of a productive well the resulted cost of the project are $11MM. If the management is assured of high probability of success, it would have interest in investment. A method of the expected monetary value is formal method of weighing of probability of possible outcomes. We shall admit the management considers the probability of success about 30 %. In that case, apparently from the table 1.1., the expected monetary value would be equal $1,2MM. Drilling would end by loss of all invested money or success but on the average the project would bring about $1,2 MM to company if expenses, the minimal volume of reserves and probability of success are correctly estimated.

Table 1.1. Calculation of EMV

Probable result	PV, (млн.дол.)	Probability (%)	EMV ($ MM)
Benefit	11	30	3,3
Dry well	-3	70	-2,1
Total:			1,2

Considering available monetary risks and potential benefit management would not approve the project if estimated probability of productive well doesn`t exceed 21 %. This is the factor of break-even success defined both by means of the schedule and under corresponding formula at value of the expected monetary value equal to zero:

0 = (benefit x probability of success) - [risk capital х (1 - probability of success)],

where

EMV = 0;

Benefit = $11MM;

Risk capital = $3 MM.

Equation is accept following kind:

SPbreak-even = risk capital : (benefit + risk capital),

Where,

SPbreak-even = 21,4 % - probability of break-even success.

The factor of break-even success is interconnected with the concept of capacity potential that is number of the dry wells falling one productive well, or is equal to inverse value of break-even success factor minus 1:

Potential of capacity - = (1 / Factor of break-even success) - 1.

In our example the potential of capacity [(1/0,214) - 1] exceeds 3,7.

The analysis of decision-making at the expected monetary value

1. To define possible outcomes, or events, and variants

2. To estimate probability of each outcome or event approach.

3. To calculate monetary cost of each possible outcome (analysis of the discounted cash flow. 4. To multiply probability of each possible outcome approach on its monetary cost.

5. Algebraically summarize the received values of monetary value of all possible outcomes.

6. To choose a variant interfaced to the maximal expected monetary value.

Principle of information cost

One of decisions tree branches is a principle of information cost. Let’s consider example with two outcomes. Expected results in view of and without taking into account data of three-dimensional seismic investigation are tabulated. We shall agree to consider that data of three-dimensional seismic investigation raise factor of success.

Table 1.2 Principle of information cost

1. Model with two outcomes without data of seismic
Probable outcome		PV (млн.дол.)	Probablity (%)		EMV (млн.дол.)
Benefit		12	20		2,4
Dry well		-2,5	80		-2
Total:					0,4
2. Model with two outcomes with data of seismic
Probable outcome	PV (млн.дол.)			Probablity (%)		EMV (млн.дол.)
Benefit	12			25		3,00
Dry well	-2,5			75		-1,875
Total:						1,125

In our example probability of success makes 20 % without results of seismic but if places of drilling are chosen in view of these data, the factor of success increases on 5 %. The expected cost increases to $0,725 MM. However, it is necessary to note that expenses for seismic investigation are not considered. Thus, it is easy to understand: these expenses should not exceed $0,725MM, otherwise, decision on drilling is better for accepting without charges on additional data.

Risk diversification

Simultaneously with decision on participation in drilling and almost with each decision on investment there is a question on what risk the company can stand. The investment philosophy does not approve those who "puts all eggs in one basket ". Distinction from decision-making by a player and by a professional strategist investing in some projects on drilling is in accepted comprehensible degrees of risk.

Account of probability

The most important things in all ways of expected cost estimation are resulted cost of projected cash flows and probability of success. The estimation of success probability or failure is based partially on scientific methods, partially on assumptions. Sometimes, outside of dependence on degree of project complexity the analysis is made with intuitive guesses. The approach, undoubtedly, is good if, certainly, such intuition is based on understanding of the expected monetary value theory and long-term experience. However conception of success probabilities and its application is not such simple business as it seems.

Success probabilities should be based on experience and accessible information at analysis of the decision about investment estimation. The person who is making a decision should know chances of oil field. This would help to understand some factors influencing probability of success and to take the first step to comprehension of a difference between success technical and commercial.

Technical and commercial success

When a well gives essential volume of oil we have can speak about it as about successful from the technical point of view. However, whether the well pays for invested means it is already a question of success commercial. As a rule, usual common sense or general experience in this sphere of activity will prompt attributes of exploration and production drilling success but frequently it is concerning technical success instead of commercial success. The factor of technical success always exceeds factor of commercial success, therefore the decision on investment can not be accepted without precise understanding of distinctions between them.

It is possible to look at this problem from other position: the factor of technical success is probability of oil discovery. Factor of commercial success is probability of its oil discovery in volume paid off development of the reserve. Thus, the difference between technical and commercial success is defined by threshold capacity of the reserve. Some areas or kinds of activity are appreciably characterized by difference between commercial and technical success, and also by their degree and probability.