case study 115
Most decisions in the petroleum industry involve elements of risk and uncertainty, particularly in the area of oil exploration. When a decision is made to drill an exploratory oil well, company geologists and engineers are not able to measure or define specific values of factors contributing to overall profit (or loss) at the time of the decision. In addition, future events that could affect timing and/or size of projected cash flows from the prospective well (e.g., government price controls, cessation of oil imports from Iraq) cannot be reliably predicted. These risks and uncertainties have decision-makers in the oil industry relying more and more on decision analysis techniques. Chi U. Ikoku, Associate Professor and Associate Director of Drilling Research at the University of Tulsa, writes: “Decision analysis methods provide new and much more comprehensive ways to evaluate and compare the degree of risk and uncertainty associated with each [oil] investment choice. The net result is that the decision-maker is given a clearer insight of potential profitability and the likelihoods of achieving various levels of profitability than older, less formal methods of investment analysis. Because of rising drilling costs, the need to search for petroleum in deeper horizons or in remote areas of the world, increasing government control, etc., most petroleum exploration decision-makers are no longer satisfied to base decisions on experience, intuition, rules of thumb, or similar approaches. Instead, they recognize that better ways to evaluate and compare drilling investment strategies are needed. Decision analysis is fulfilling this need.” Ikoku lists several distinct advantages that decision analysis has over the less formal oil drilling decision-making techniques used in the past:
1. Decision analysis forces the decision-maker to consider all possible alternatives and their corresponding outcomes. 2. Decision analysis provides an excellent way to evaluate the sensitivity of various oil-drilling factors to overall profitability.
3. Decision analysis provides a means to compare the relative desirability of drilling prospects having varying degrees of risk and uncertainty.
4. Decision analysis is a convenient and unambiguous way to communicate judgements about risk and uncertainty.
5. Exceedingly complex oil investment options can be analyzed using decision analysis.
The decision-making technique discussed in his World Oilarticle is the expected value criterion. This procedure requires the decision-maker to assess the probability of occurrence of each possible state of nature. “Assigning probabilities of occurrence to various outcomes of a petroleum venture,” says Ikoku, “requires the cooperative judgement and skills of geologists, engineers, and geophysicists.” Some of the types of risks that oil investors commonly encounter and consequently need to assess are: risk of an exploratory or development dry well; political risk; economic risk; risk relating to future oil and gas prices; risk of storm damage to offshore installation; risk that an oil discovery will not be large enough to recover initial exploratory costs; risk of at least a given number of oil discoveries in a multi-well drilling program; environmental risk; and risk of a gambler’s ruin. Because of certain characteristics that are unique to a petroleum exploration, these state-of-nature probabilities cannot be determined exactly, and furthermore, their estimates often must be made on the basis of very little or no statistical data or experience. (Additional data can be obtained from additional wells, but, says Ikoku, ” normally, delaying decisions until there is sufficient data upon which to base probability estimates cannot be afforded.” Thus, the decision-maker usually must rely on his or her subjective judgment or past success ratios in order to assess the state-of-nature probabilities. As an illustration of how decision analysis may be applied to the petroleum industry, Ikoku presented the following example: A company is considering the purchase of 320 net acres in a proposed 640-acre oil unit.
Three decision alternatives or actions are available to the company:
a1: Participate in the unit (i.e., drill) with non-operating 50% working interest.
a2: Farm out, but retain 1/8 of 7/8 overriding royalty interest.
a3: Be carried under penalty with a back-in privilege after recovery of 150% of investment by participating parties. The possible outcomes or states of nature and their corresponding probabilities, based on detailed geological and engineering analyses of the prospect and surrounding wells, are given in Table 19.17. Since the company will base its decision on the objective variable Net Profit, the projected net profits for the action/state-of-nature combinations were determined as shown in Table 19.18
(a) Construct a payoff table for the oil-investment decision problem.
(b) Using the expected payoff criterion, which of the three alternative actions should the company accept?
(c) What is the maximin decision? The maximin dicision?
(d) Construct an opportunity loss table for the oil investment decision problem and find the minimax regret decision.
Table 19.17 state of nature= probability
Unit produces 20000 barrels=.25
unit produces 40000 barrels=.25
unit produces 80000 barrels=.10
unit produces 100000 barrels=.10
farm out/dry hole=0
farm out/20000 bbls=12000