A Dissertation Report

On

“RISK ANALYSIS IN OIL & GAS SECTOR: A SPECIAL FOCUS ON UPSTREAM”
A Dissertation report submitted in partial fulfillment of the requirements for

MASTERS OF BUSINESS ADMINISTRATION (OIL & GAS MANAGEMENT)
Of

UPES, DEHRADUN, UTTARAKHAND, INDIA
By:

SANDEEP KUMAR

Roll No. R020207053 Under the Guidance of:
Mr. Ambuj gupta ASSISTANT PROFESSOR, CMES

College of Management and Economics Studies University of Petroleum and Energy Studies Dehradun

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CERTIFICATE
This is to certify that the dissertation report on “Risk Analysis in Oil & Gas Sector: A Special Focus on Upstream” completed and submitted by Sandeep Kumar in partial fulfillment of the requirements for the award of degree of Masters of Business Administration (Oil and Gas Management), is a bonafide work carried out by him under my supervision and guidance. To the best of my knowledge and belief the work has been based on investigation made, data collected and analyzed by him and this work has not been submitted anywhere else for any other University or Institution for the award of any degree/diploma.

Mr. Ambuj Gupta Assistant Professor CMES, UPES Dehradun

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DECLARATION

This dissertation report is entirely my own work. It has not been submitted in any previous application for a degree. All quotations in the report have been distinguished by quotation marks, and the sources of information specifically acknowledged.

Signed: Sandeep Kumar MBA (Oil and Gas Management) CMES, Dehradun

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I would like to express my deep gratitude to Mr. I would thank you from the bottom of my heart. Shalinder Pokhriyal for providing me with this opportunity to work in this project.ACKNOWLEDGEMENT Action springs not from thought. Special thanks to Dr. Ambuj Gupta and for engaging me in different responsibilities and guiding all through the project. but from a readiness for responsibility. I also take this opportunity in expressing my sincere gratitude to my friends and class fellows for their opinions and maintaining a cordial and helping environment. but for you all my heart has no bottom iv . I hope with all your best wishes and blessings i deliver my best to any responsibility assigned.

1 Risk and uncertainity Defined 4.31 Estimation of the risk of the project 8.21 NPV of the project’s cash flow 8.6 What is Political Risk? 4.4 Discussions and implications 25 25 36 38 38 40 40 40 44 45 50 52 v .3 What is Credit Risk? 4. Value of Information and Flexibility 6. K.Table of Contents Topic 1.3 Analysis of a capital-intensive project 8. 4.4 What is Liquidity Risk? 4.22 Optimal working interest (W) 8.2 Risk Analysis: Field Appraisal and Development 6.1 Need for Risk Management 7.7 What is Market Risk? 4.3 Decision Making Process.2 The Risk Management Process 7.5 What is Operational Risk? 4.1 Risk Analysis: Exploration 6. V*) 8.3 Types Of Risk Management 8.2 Types Of Risks 4.1 Introduction 8.33 The optimal working interest in the project (W) 8.4 Portfolio Management and the Real Options Valuations 7. Introduction Literature Review A New Era in Petroleum Exploration and Production Management Risk And Uncertainty 4.32 The optimal rule of investment (F.2 The integrated model 8. Investment Decision in Oil and Gas Projects Using Real Option and Risk Tolerance Models 8. 2. Risk Management 19 19 21 22 23 25 7. 01 03 08 09 10 11 11 11 12 12 13 13 14 5.8 Foreign Exchange Risk and Risk Management Page No. Top Ten Risks in Oil and Gas Industry 6. 3. Risks in Exploration & Production Projects in Oil and Gas Industry 6.

Market Risk – The viewpoint of Three participants Threats: Oil And Gas Industry Risk Management Process Stakeholders In Small Business Cumulative Frequency Of The NPV And Project’s Risk Level Sensitivity Of NPV. 4. 7. 7. Risk and uncertainity Defined Examples of risk criteria for a project in small business Effects of diversification on portfolio risk and return level Analogy of the determinants of financial and real-option pricing models Geological. Cumulative Distribution for AFE 13 15 26 27 46 49 51 51 56 List of Tables 1. 8.3 Conclusions and Final Remarks 55 55 56 56 10. 6. Risk assessment & management crucial to thrive amidst uncertainty (Upstream Focus) 11. 3. 3. F And K To Project Current Value Sensitivity Of RAV To Optimal Working Interest (W) Sensitivity of rav to optimal working interest: different values of Corporation’s tolerance 9.Well Cost Estimation 9. 5.1 Example of Application . 6. 8. 2. 5.2 Analysis of Results 9. technical and economic characteristics of the project Inputs of decision-making based on real-options models Results from the two valuation and decision models Authorization for Expenditure Range of Costs 10 30 41 44 45 47 53 57 58 vi . 9. 2. Conclusion 12. Bibliography 59 63 64 List of Figures 1.9. 4. Use and Implementation of Risk Analysis 9.

While international economic and political events increasingly affect all businesses. liquidity risk (inability to buy or sell commodities at quoted prices). Derivatives have also been associated with some spectacular financial failures and with dubious financial reporting. volatility. and greater exposure to possible liabilities and compliance requirements. and electricity industries are particularly susceptible to market risk—or more specifically. credit/default risk. vii . the industry remembers the downtimes in the ‘90s and is wary of the current high prices. or commodity prices). fraud). exchange rates. Because of this. Today. exploration presents considerable uncertainty. operational risk (equipment failure. price risk—as a consequence of the extreme volatility of energy commodity prices. The challenge for Oil & Gas industry is to manage the political and other risks that are unavoidable in the industry with effective returns. such issues have long been concerns for oil and gas companies. but they are particularly vital concerns for companies operating within the upstream sector of the oil and gas industry. especially price risk. The Forex market behaves differently from other markets! The speed. Businesses operating in the petroleum. Derivative contracts transfer risk. Actuarial analysis is needed to project the life spans of discovered reserves and their market value over several decades. and political risk (new regulations.PREFACE Assessing and managing risks are essential functions for any organization. reserves in oil and money are being shored up. Although the price per barrel has increased dramatically in recent months. to those who are able and willing to bear it. Even with the best seismic technology and geological expertise. stock prices. natural gas. additional expertise. Asian oil and gas companies are placing more emphasis on managing assets and streamlining business processes to maximize profitability. and enormous size of the Forex market are unlike anything else in the financial world. expropriation). Extracting that oil or gas demands greater investment. There are five general types of risk that are faced by all businesses: market risk (unexpected changes in interest rates. How they transfer risk is complicated and frequently misinterpreted.

For instance. with no guarantee of successfully discovering and developing hydrocarbons. in the petroleum industry. economic evaluations contain uncertainties related to costs. operational costs. this introduction covers a brief review of previous applications involving the following topics: (1) Risk and Decision Analysis in Petroleum Exploration. On the other hand. In this sense. (2) Field Appraisal and Development. production schedule. Based upon that scenario new forms of reservoirs exploitation and managing will appear where the contributions of risk and decisions models are one of important ingredients. These uncertainties originated from geological models and coupled with economic and engineering models involve high-risk decision scenarios. In this sense. Even at the development and production stage the engineering parameters embody a high level of uncertainties in relation to their critical variables (infrastructure. Geologic concepts are uncertain with respect to structure. Technological advances allowed the exploration in well-established basins as well as in new frontier zones such as ultra-deep waters. (3) Decision Making Process and Value of Information and (4) Portfolio Management and Valuations Options Approach. The wildcat drilling decision has long been a typical example for the application of decision analysis in classical textbooks. and Production Forecast under Uncertainty. The new internationally focused exploration and production strategies were driven in part by rapidly evolving new technologies. reservoir seal. managers are increasingly using decisionanalytic techniques to aid in making these decisions. This trend can be seen in the last two decades. Those technology-driven international exploration and production strategies combined with new and unique strategic elements where risk analysis and decision models represent important components of a series of investment decisions. probability of finding and producing economically viable reservoirs. it provides an ideal setting for the investigation of risk corporate behavior and its effects on the firm’s performance. The future trends in oil resources availability will depend largely on the balance between the outcome of the cost-increasing effects of depletion and the cost-reducing effects of the new technology.). Corporate managers continuously face important decisions regarding the allocation of scarce resources among investments that are characterized by substantial geological and financial risk and uncertainty. 1 . and oil price. etc.Chapter 01 INTRODUCTION Introduction Exploration and production of hydrocarbons is a high-risk venture. the petroleum industry is a classic case of decision-making under uncertainty. reservoir characteristics. quality of oil. This introduction describes some of the main trends and challenges and presents a discussion of methodologies that affect the present level of risk applications in the petroleum industry aimed at improving the decision-making process. and hydrocarbon charge.

Therefore. a mass of deep-seated random variables which will affect risks are not included in the mathematical models. Now the major risk analysis methods for oil and gas exploration are include subjective probability method. (2)There will be insurmountable difficulties for resolving correlation problems between risk factors. and the relationship among these factors are very complex. However. the results based on these assumptions will have some deflection. risk analysts are required to enumerate risk variables of the project and the relationship between them. Therefore. and the additive factors are independent or linear correlation. exploration supervisors and technicians with exploration system analysis knowledge. (3)Whether the discovered oil and gas could be exploited economically is unknown.. project evaluation and economy evaluation. they could not dig out geological. they could not indicate the relations among stochastic factors in the exploration process. and they are only equivocally included in risk evaluation. Some methods could simplify correlation problems to single problems. etc. They could not combine the knowledge of decision-makers.Oil and gas exploration is a complicated open system that needs high investment and long running term. and amend the models according to new issues emerging during the system analysis process. but this is actually based on assumptions: only additive operation or multiplicative operation will occur between factors relative to total risks. (3)These methods could not indicate the important influences of latent variables which are not included in the model studied or do not have a proper mathematical expression. so oil and gas exploration is an uncertain process that means: (1)Geologist and geophysicist have to analyze the possibility of oil and gas reserve in a certain area. There are many risk factors that could affect the system. exploitation evaluation. divert and reduce the risks. Furthermore. 2 . by applying the knowledge of risk management. project managers could avoid. when using traditional risk analysis methods. project and economic factors relative to the whole exploration process which includes oil and gas storage evaluation. but they have following defects: (1)These methods cannot construct the whole frame of the researching problems. the multiplicative factors are independent. So it is not convenient for system analyzers to communicate with decision makers and specialists. three-phase risk assessment and Monte Carlo method. (2)The possibility of finding the oil and gas storage must be determined. or share them with other participants.

Authors stated that the method would minimize subjective decisions and conclusions for a drilling investment project. Even though the article did not deal specifically with any particular drilling process or operation.Chapter 02 LITERATURE REVIEW Risk analysis is a very powerful tool for certain engineering processes where decision under uncertainty is involved. for a certain operation. possible outcomes from reserves should be analyzed carefully and risk analysis should be implemented on exploration prospects to measure the effects of uncertainties on the financial outcome. it presented a method to handle uncertainties that clearly could be extrapolated for situations faced regularly on ordinary well operations. the correct decision. sensitivity analysis can be conducted and variables highly affecting the profitability could be isolated and better analyzed. Cowan stated that the two distinctive characteristics of oil and gas exploration are high uncertainties involved and significant amount of capital expenditures. Newendorp and Root2 conducted a pioneer study on the possibility of using risk analysis methods while deciding on drilling investments. Specifically for oil well operations. objective and precise for assessment of drilling prospects than the type of qualitative analysis commonly used by the time of publication of the article. Authors suggested that. this article was not specifically aimed at 3 . For that reason. The proposed method is much more sophisticated. effects of unlimited number of variables on drilling prospects can be analyzed. a number of articles have been presented illustrating how risk analysis methods can be used to maximize the possibility of adopting. Risk analysis can clearly examine various possible outcomes and compare different options for investment with different levels of risk and uncertainties. Since risks associated in drilling investments contain uncertainties due to geological and engineering factors that affect profitability of investment. quantitatively. it is wiser to estimate range and distribution of possible outcomes of a drilling investment to investigate the profitability of a prospect. even though not extensively used. With the use of the method. which involves a dedication of significant amount of capital under highly uncertain conditions. For drilling operations. In this section a review of those important applications is presented. a decision theory technique could be used making possible to asses and estimate the risks associated with drilling investments. Again. Cowan proposed a risk analysis model that could be used to quantify the elements of risks associated with exploring and developing a hydrocarbon prospect. instead of reaching decisions qualitatively under the influence of subjective observations in a personal and intuitive process. a variety of applications have been developed.

Level 2 which accounts for four possible outcomes (three possible reserve values and no hydrocarbons) can be used. He considered the first three models (Level 1. he suggested using one of the five risk analysis models to analyze drilling prospects. Level 1 being the most basic one with two possible outcomes and Level 5 being the most comprehensive Monte Carlo simulation analysis. The model is able to handle five different phases of prospect operation. These last two phases are analyzed based on increasing production. Level 3 provide six possible discrete outcomes.” Initially. engineering and economic data to produce possible distribution functions related to potential outcomes of exploiting new reserves. Finally. Target rate and preliminary economic evaluation on development program are carried out in this stage of the model. depending on the risks accounted and uncertainties available. if the field has some potential value. stable production and declining production cases. Cowan pointed out the superiority of using probabilistic methods compared to single value estimates. Following. then the model accounts for the third phase. Newendorp stated that to go beyond five possible reserve outcomes. There are many different ways for implementing risk analysis techniques for a drilling prospect and the paper aimed to classify them in five categories. First of these phases is the “exploration period” which incorporates the cost of the exploration studies in a given field. Level 2 and Level 3) as “discrete-outcome models” while the latter two models (Level 4 and Level 5) are “continuous-outcome models. due to lack of information. challenging environments and improved new technologies. the model should be converted to a continuous outcome model so that the entire reserve distribution could be characterized. Newendorp pointed out that the awareness of industry on risk analysis increases with the increasing trend of the exploration activities towards smaller. Level 4 is similar to Level 3 except by the fact that geology related probability distribution functions are determined using simulation and economic factors are obtained using deterministic methods. but certainly pointed out some directions that would be used later on drilling engineering problems. respectively. which is “delineating the field”.drilling operations. The proposed model combined probabilistic geological. If the chance of success in “drilling the wildcat” is high. The author stated that. Level 1 can be used and one of two possible outcomes (hydrocarbons or no hydrocarbons) can be analyzed. each level of risk analysis model provides valuable information in different stages of a drilling prospect analysis. He suggested using a higher level of risk analysis model as more data is obtained from the activities being implemented. Then. As more data becomes available. phases 4 and 5 are applied. Probabilistic solution method enables to display possible outcomes depending on variation of various input elements and uncertainties and allows more realistic analysis. Level 5 is the most sophisticated model accounting for uncertainties in both geologic data and economic uncertainties. harder to find traps. comes the second phase which involves the analysis of wildcat drilling and analyzes the chance of finding hydrocarbon resources in a given location. five being possible reserve values and one being no hydrocarbons. These phases are “developing the field” and “producing the field”. Based on the available data. 4 .

For that reason. (3) quitting drilling and setting the casing to that depth or (4) even by abandoning the well if this is the most indicated due to safety and borehole integrity considerations. abandoning the well and sidetracking.6 presented a study on an area where qualitative and quantitative risk assessment can be implemented to a great extend. it would be possible to estimate quantitatively the cost of drilling further with existing mud. the risk analysis model developed is very sensitive to cost distribution of the intractable kick and degree of uncertainty in formation pressure. 5 . since all the decisions are related to the formation pressure and other drilling parameters. setting a casing. They have defined and explained the Concept Safety Evaluation (CSE). neither the countries nor the companies would risk having another similar experience. Ostebo et al. CSE is being applied to all production platform design in Norway and its main goals are to determine areas where problems might occur and evaluate those areas to reduce the possibility of accidents. The proposed wellbore stability analysis method is not only capable of quantifying the risks associated with the operational failure but also enables the engineer to choose the appropriate mud density to avoid wellbore instability problems. or loss. (2) with weighted drilling fluid. the authors showed different ways of applying risk analysis in the areas of reliability and availability analysis. this one directed to a much common dilemma present in certain drilling operations.7 developed a new wellbore stability analysis method. hydraulics necessary to allow efficient cuttings transport in highly deviated wells. to promote use of risk analysis techniques in offshore operations. As a result of that. Authors analyzed the regulations issued by the Norwegian Petroleum Directorate (NPD). Norway and UK issued new regulations in which risk analysis has great importance. weighted mud.) Using a Monte Carlo simulation technique. (EMV) of different drilling situations. operational procedures and orderliness together with safety and cost. Those limits are determined by quantitative risk analysis (QRA) principles. Knowing that offshore operations have potential safety and operational problems and after experiencing the Piper Alpha accident. The author proposed a technique to determine whether the minimum cost while drilling is attained by (1) drilling the hole further with the drilling fluid currently in the hole. Using the technique.Another very interesting application. It should be noted that. After the Piper Alpha accident. In the case that it is decided to drill further. for example. risk analysis became a very useful tool in the process of decision making to enhance platform layout. which is a method of quantified risk analysis. expected costs will also be ultimately related to the same factor (the formation pressure. Ottesen et al. He pointed out that. In addition. during actual drilling operation these four options are always available. these two variables should be accounted accurately in order to estimate precisely the expected mean value. safety management techniques and human and organizational factors during offshore operations. The authors have defined the limits for failure and success and generated a limit state function to create a link between classical wellbore stability model and operational failure. then it is always possible to experience a kick or loss of circulation depending on formation pressures. which combines a classical mechanical wellbore stability model with viability operational limits. the author developed a way to evaluate the risks associated with the given set of drilling parameters. This risk analysis model stated that.

penetration rate. In addition. but also accounts for unplanned/undesired events. which depend on the assessment of the tolerable risk. more specific applications started to be developed. Such risks can be minimized or controlled by changing some of the drilling parameters such as mud weight. By doing so.Liang8 presented a method to determine pore pressure and fracture gradient using quantitative risk analysis (QRA). 6 .10 presented a riskanalysis based solution to the subsurface well collisions problem. numbers of unexpected events are decreased and consequently better development/execution can be achieved. It is recommended to build a probabilistic model at the early stages of the operation and evolve the model continuously as more data is obtained from successive operations. operators are able to manage most critical and unexpected events. probabilistic modeling/processing does not only take into account the planned order of events. actual events in well-construction operations are described more precisely. It is also possible to model the applicability of new technology and compare the possible outcome of new technologies with the conventional methods for a given project. mud rheological properties. and “nonproductive time” decreases effectively. risks associated with taking a kick or loss-return can be analyzed quantitatively. The results of the collision risk analysis can be compared with the predefined limits on the probabilities of the various outcomes. The method included a mathematical analysis of the probability of collision combined with a decision tree to describe the consequences. It was stated on this study that it is possible to approximate the probabilistic distribution of pore pressure. tripping speed. etc. Thorogood et al. QRA methods presented in the paper makes possible to identify risks associated to having a kick or circulation loss. As more exploration activities are taking place in increasingly hostile areas such as deeper waters and remote locations. the drilling engineers can plan their well operations with a flow chart of the directional-drilling procedures. For daily use. more realistic information for casing design and more accurate selection of casing shoe depth is attained using pore pressures and fracture gradients calculated with QRA approach. Clearly defined levels of risk can be properly established. flow rate. equivalent mud weight and fracture gradient using Gaussian distribution. As a result of that. By using probabilistic distribution functions for pore pressure. fracture gradient and equivalent mud weight. With the increasing use of risk analysis to analyze problems closely related to drilling operations. McIntosh9 emphasized the need for use of probabilistic methods to manage well construction performances effectively under challenging conditions where uncertainties exist all the time. which would be possible due to the randomness of the statistical ranges of those parameters at any given depth. Compared to deterministic models. risks and uncertainties associated with the operations are also escalating and operators should look for more reliable and cost-effective models for oil well drilling activities.

An example case was presented. such as reservoir size. the high-level decision trees were constructed for two different designs. 7 . good understanding of dependency between variables and the proper result interpretation. For the case presented the key uncertainty was the reservoir size and the most important factor influencing the investment payback was the development timing steps.13 described applications of decision-tree analysis in the oil and gas industry through a case study where a deepwater production system was analyzed. number of wells and drilling schedule. it can improve the evaluation and help to reach the correct decision. Coopersmith et al. Alexander and Lohr12 summarized seven essential elements for a successful risk analysis project. Through the comparison of final NPV calculations of both designs under consideration the one with the best result could be chosen. A good risk analysis process is always supported by well prepared guidelines. After defining some parameters of the project. production rates. Even though risk analysis can not replace professional judgment. They described the integration of decision and risk analysis tools with economic engineering application. the oil company could analyze the range of possible outcomes. adaptable evaluation software.Virine and Rapley11 presented a practical approach to use risk analysis toolsets in economic evaluation applications for the oil and gas industry. They emphasized that the commitment and endorsement from both management and technical teams are essential to the risk analysis progress. Using decision tree analysis. This chapter emphasized the importance of data input as well as analysis result.

say. 8 . affect the impact of price uncertainty on my portfolio? What projects should we be seeking to reduce the effects of political instability in a given part of the world? What are the effects on financial risk and return if we insist on a minimum of. Decision analysis has traditionally been applied to the information derived from G&G to rank projects hole by hole. In the 1930’s and 1940’. It thereby reduces risks associated with price fluctuations and political events in addition to the physical risks addressed by traditional G&G analysis. determining on an individual basis whether or not they should be explored and developed. such as: • • • • • If we want a long-term expected return of. It does not provide all the answers. as contrasted from gas projects. The resulting geology and geophysics (G&G) revolutionized petroleum exploration. given the projects already in our portfolio? How would oil projects. the development of seismic data collection and analysis substantially reduced the risk in finding petroleum. how can we insure against a cash flow shortfall over the first three years while minimizing our long-term risk? What should we pay for a new project. 40% ownership of any project? As we shall see. 15% on our investment. Today this “ole-istic”approach is being challenged by a holistic one that takes into account the entire portfolio of potential projects as well as current holdings. It then takes into account global uncertainties by adding two additional G’ : geo-economics and geo-politics. but encourages E&P decision-makers to ask the right questions. This portfolio analysis starts with representations of the local uncertainties of the individual projects provided by the science and technology of G&G. analytical models can help in directly addressing these and similar questions once decision-makers in the petroleum industry become comfortable with the holistic perspective. say. The holistic approach is based on but not identical to the Nobel-prize winning portfolio theory that has shaped the financial markets over the past four decades. Thus the best possible management of risk is crucial.Chapter 03 A NEW ERA IN PETROLEUM EXPLORATION AND PRODUCTION MANAGEMENT Exploration and Production (E&P) is the business of finding petroleum and getting it out of the ground. Portfolio thinking in petroleum E&P is based on understanding and exploiting the interplay among both existing and potential projects. It is a risky business in that most exploration projects are total failures while a few are tremendously successful.

Chapter 04 RISK AND UNCERTAINITY “Any uncertain event that could significantly enhance or impede a Company’s ability to achieve it’s current or future objectives. including failure to capitalize on opportunities……” The possibility of good things not happening (risk as opportunity) The potential that actual events will not equal anticipated outcomes (risk as uncertainty) The threat of bad things (risk as hazard) 4.1 shows the definitions of risk and uncertainity as given by different authors 9 .1) Table 4.

1: Risk and uncertainity Defined 10 .Table 4.

Systematic risk influences a large number of assets. 6.Unsystematic risk is sometimes referred to as "specific risk". Liquidity Risk . 11 . 4. Liquidity risk factors include competition among commercial banks for larger market share in deposits. Unsystematic Risk . A significant political event. An example is news that affects a specific stock such as a sudden strike by employees..3) CREDIT RISK: Credit Risk is the risk that a loss will be incurred if counterparty does not fulfil its financial obligations in a timely manner. 2. It is virtually impossible to protect yourself against this type of risk. 3. 5. Credit risk Liquidity risk Operational risk Market risk Political risk Foreign exchange risk 4. 4. 1.Factors. Diversification is the only way to protect yourself from unsystematic risk. an unstable or potentially violent domestic political situation. (We will discuss diversification later in this tutorial). The purpose of the Bank’s liquidity risk management is to maintain suitable and sufficient funds to meet present and future liquidity obligations whilst utilizing the funds appropriately to take advantage of market opportunities as they arise.4. specific types of risk that are faced by all businesses…. This is one of the most critical aspects of business.4) LIQUIDITY RISK It is the risk that the Bank may not be able to meet cash flow obligations within a stipulated timeframe. the fluctuation of the Rupee-Dollar. and implementation of government policies which may affect capital movements in and out of India. This kind of risk affects a very small number of assets. could affect several of the assets in your portfolio. for example.2) TYPES OF RISKS: In general there are TWO broad categories of risk Systematic Risk .

Significant operational risk factors include: • Operational processes which may have flaws or weak control systems. while enabling the Bank to quickly respond to and pursue new business opportunities under appropriate risk controls and monitoring. cheating. In general. or management or operational failure arising from external causes. macro risk and micro risk. there are two types of political risk. document falsification. • Malfunctions in information processing systems. All in all. regardless of the type of political risk that a multinational corporation faces. • Catastrophic events. 4. Macro risk refers to adverse actions that will affect all foreign firms. whereas micro risk refers to adverse actions that will only affect a certain industrial sector or business. The objective of the operational risk management framework is to ensure that the Bank has in place appropriate policies.5) Operational Risk is the risk of potential losses from a breakdown in internal processes and systems.OPERATIONAL RISK 4. and gathers relevant information relating to operational risks so as to avoid operational failures and minimize relevant losses. • Potential fraud by outsiders in terms of robbery. • Inadequate staffing which may make it difficult for staff to perform their work effectively and efficiently. processes and procedures. Operational Risk . companies usually will end up losing a lot of money if they are unprepared for these adverse situations.6) POLITICAL RISK The likelihood that political forces will cause drastic changes in a country's business environment that will adversely affect the profit and other goals of a particular business enterprise. etc. human error. computer hacking.Factors. credit and debit cards fraud. such as expropriation or insurrection. 12 . such as corruption and prejudicial actions against companies from foreign countries. • Technological developments which may affect the security of Bank data or information held on behalf of customers.

4. with a consequent impact on underlying costs. 13 . Fluctuations in exchange rates can therefore give rise to foreign exchange exposures. while sales of refined products may be in a variety of currencies. Fig.7. Currency Risk Management Currency risk arises because the value of the Indian Rupee or any domestic currency fluctuates due to the market forces of supply and demand. foreign currency value.8) FOREIGN EXCHANGE RISK AND RISK MANAGEMENT Crude oil prices are generally set in US dollars.4. market risk 4.7) MARKET RISK Market Risk is the potential loss in value in a security from changes in market factors such as interest rates. and/or prices of commodities and equities.

What follows are the top 10 identified strategic risks for oil and gas companies. prioritizing them and thinking about how they can manage and monitor all risks in a coordinated way. Project delays and abandonment are as much a result of capacity constraints as financial calculations.Chapter 05 TOP TEN RISKS IN OIL AND GAS INDUSTRY Risks are inherent in every forward-looking business decision. In collaboration with Oxford Analytical. 1. Human Capital Deficit The growing human capital deficit in the sector has become a significant strategic threat to the industry. companies have started including operational risks.” 14 . although the two are intimately linked. not least in terms of staff. there has been a great deal of work done and resources invested in risk management in the oil and gas industry in recent years. This study was not a random selection exercise but rather a structured consultation with industry leaders and subject matter professionals from around the world. As a result. But more recently. Ernst & Young examined the strategic risks facing oil and gas companies. One study participant set out the issue: “The ability of the oil and gas services sector to expand sufficiently to meet future demand growth is questionable. Financial and regulatory risks have been the focus of much of this effort.

Russia. The impact of political opportunism and high prices is a device that has been seen in both the developing and non developing world. In some cases.1 threats: oil and gas industry 2. 15 . Venezuela. this is due to energy nationalism.Fig 5. although in others it is purely the result of political opportunism and high prices. and Algeria. Worsening Fiscal Terms Worsening fiscal terms are seen as a high risk. Tax regime changes can spur additional oil and gas industry restructuring in countries such as Canada.

5. impacting everything from refinery build costs to pipeline construction. this has been well publicized in recent years. 4. For the major IOCs.” Another participant. this could pose a greater strategic and competitive threat than that resulting from supply disruptions. the problem is one of strategy: “Western IOCs will find it hard to compete as deals are struck not through bidding or tenders but at a state-to-state level. and environmental goals can lead to a regulatory regime that ignores cost/benefit analysis to the detriment of business. bundled with development aid. This observation follows evidence of such deals in the market. Demand Shocks Demand shocks could be triggered by a number of global economic crises. Participants agreed that the problem extends from exploration all the way through the value chain. for example. A global financial meltdown emerging from derivatives and hedge funds was the threat rated highest by the economists who participated in the study. making these companies the gatekeepers of the world’s oil and gas supplies. Cost Controls The third operational threat is the inability to control costs. a Harvard University-based economist. Political Constraints on Access to Reserves Recent estimates suggest that NOCs control 75% of proven global reserves. Unlike unexpected shocks. This threat was considered great enough to have a strategic impact. that echoed a frequently made observation. “Social value regulation in the form of measures designed to reduce risk and achieve health. which measures cost inflation in oil and gas projects. has gone up by 79% since 2000.3. Competition for Reserves Competition for reserves by national oil companies (NOCs) is a major threat to international oil companies (IOCs). This was defined by one participant: “Energy policy goals include security of supply and climate change considerations. The Upstream Capital Costs Index.” wrote one study participant. The noncommercial goals will shape policy and result in increasing intervention in the market in areas such as carbon pricing. One comment. contended. strategic reserve requirements. Uncertain Energy Policy An increasing risk for the oil and gas industry is the uncertainty of energy policy. Again. 6. with most of that increase coming since May 2005. and subsidization of favored sources of energy. safety. as well as more commercial goals such as affordability and meeting demand growth. was that “credit disintermediation has replaced international banking as a finance source with a range of specialized credit instruments held widely with risk exposures that 16 . and a failure to manage the threat could undermine the competitiveness of oil and gas companies.” 7.

Possible consequences include extreme price volatility. Climate Concerns Our oil and gas panel may have been encouraged to rank the rise of climate change concern as a significant risk by the sobering comments of one of our subject matter experts. it would be prudent to expect greater international economic volatility.e. Energy Conservation Not unexpectedly. the ones that most scientists agree are likely]. “The most powerful tool available to policymakers is energy conservation and it is the most under exploited. a specialist in science and international affairs: “[Current] climate predictions are based on models and. An event that throws the country off track would have a big impact on expectations of future oil and gas demand growth.” Several economists believed systemic risks in finance have increased dramatically and. who wrote.” 8. as well as potential competitive impacts on affected firms.regulators find it difficult to assess. 10. A global recession could also be triggered by an energy supply disruption. Thus the scope for improved energy efficiency and indeed switching away from oil is potentially very large.’ energy conservation comes close.. While our participants did not agree on what the most likely cause of such a shock would be. global recession. Another participant highlighted how further social or political threats could contribute to a demand shock. consequently. Supply Shocks Another risk for the industry is that of sudden and unexpected disruptions to global energy supplies. naturally. “China’s sustained expansion in recent years has underpinned robust world growth but is producing tensions both internally and externally.” An oil and gas analyst appeared to agree. and ill-considered regulatory responses. an energy economist.” 9.” wrote one analyst.” 17 . While there are no ‘silver bullets. it is possible that the hazard is actually more imminent than is commonly understood. Perhaps this ranking was swayed by the opinions of one of the subject matter experts. The uncertainty is not so much one of policy failure but of policy success. noting that. could plunge the global economy into severe recession. as well as an increased policy response that is more abrupt than most firms are currently planning for. the group voted for the possible success of energy conservation as the number 10 risk. we may see physical climate surprises. Yet. the scenarios communicated to the policy world are the scientifically conservative scenarios [i. scientifically conservative scenarios are not necessarily what will happen. “The energy intensities of developing countries are very much higher than in most of the Organization for Economic Cooperation and Development (OECD) countries. especially if it lasted for a few months. In this case. “A [price] spike. they did agree that unexpected shocks could pose a severe challenge.

It is important to note that this is only a snapshot and risks are subject to change at any time. 18 . These are not predictions. leading to dialogue and action plans that deliver value. Working through scenarios and impact studies can result in opportunities to tighten processes and controls. but considering them can help companies to prepare.

1984.. 1977. the applications of these concepts in business and general management appeared only after the Second World War (Covello and Mumpower. (2) Pareto distribution applied to petroleum field-size data in a play (Crovelli. 1963. and Bernoulli. Allais was a French economist who was awarded the Nobel Prize in Economics in 1988 for his development of principles to guide efficient pricing and resource allocation in large monopolistic enterprises. At that time governmental agencies were also beginning to employ risk analysis in periodic appraisals of the oil and gas resources. Krumbein and Graybill. 1967. Harris. Newendorp (1975. Laplace. During the 1980´s and 1990´s. 1984. is 19 . Thus.Chapter 06 RISKS IN EXPLORATION & PRODUCTION PROJECTS IN OIL AND GAS INDUSTRY 6. However. Allais´s work was a useful mean to demonstrate Monte Carlo methods of computer simulation and how they might have been used to perform complex probability analysis had they been available at that time instead of the simplifications for risk estimation of large areas. During the 1960´s. 1995) and (3) fractal normal percentage (Crovelli et al. edited as Newendorp and Schuyler. Bernstein. Drew. 1996). 1985). During this period Newendorp emphasized that decision analysis does not eliminate or reduce risk and will not replace professional judgment of geoscientists. new statistical methods were applied using several risk estimation techniques such as: (1) lognormal risk resources distribution (Attanasi and Drew. During this period. Harbaugh. 2000) and Megill (1977). there were several attempts to define resource level probabilities at various stages of exploration in a basin using resources distribution and risk analysis (Kaufman. The problem involving decision-making under conditions of risk and uncertainty has been notorious from the beginnings of the oil industry. as it will be discussed later in this paper. 1965. The study by Allais (1956) on the economic feasibility of exploring the Algerian Sahara is a classic example because it is the first study in which the economics and risk of exploration were formally analyzed through the use of the probability theory and an the explicit modeling of the sequential stages of exploration. Harris 1990).. engineers. one objective of the decision analysis methods. 1997).1) Risk Analysis: Exploration The historical origins of decision analysis can be partially traced to mathematical studies of probabilities in the 17th and 18th centuries by Pascal. the concepts of risk analysis methods were more restricted to the academia and were quite new to the petroleum industry when appear the contributions of Grayson (1960). and managers. Harbaugh et al. 1985. Early attempts to define risk were informal. Arps and Arps (1974).

Risk considerations involve size of investment with regard to budget. 20 . An important contribution that provides rich insight into the effects of integrating corporate objectives and risk policy into the investment choices was made by Walls (1995) for large oil and gas companies using the multi-attribute utility methodology (MAUT). known as the risk premium. 1992).to provide a strategy to minimize the exposure of petroleum projects to risk and uncertainty in petroleum exploration ventures. then their implied risk behaviors can be described by the parameters of a utility function. Walls and Dyer (1996) employed the MAUT approach to investigate changes in corporate risk propensity with respect to changes in firm size in the petroleum industry. Based upon these premises the exploration could be seen as a series of investment decisions made under decreasing uncertainty where every exploration decision involves considerations of both risk and uncertainty (Rose. Uncertainty refers to the range of probabilities that some conditions may exist or occur. 1987). Nepomuceno et al. Despite Bernoulli’s attempt in the 18th century to quantify an individual’s financial preferences. Pratt (1964). and probability of outcome. and Schailfer (1969). Lerche and MacKay (1999) showed a more comprehensible form of risk tolerance that could intuitively be seen as the threshold value whose anticipated loss is unacceptable to the decision maker or to the corporation. Cozzolino (1977) used an exponential utility function in petroleum exploration to express the certainty equivalent that is equal to the expected value less a risk discount. More recently. the parameters of the utility function were formalized only 300 hundred years later by von Neumann and Morgenstern (1953) in modern utility theory. The Utility Theory provides a basis for constructing a utility function that can be employed to model risk preferences of the decision maker. which measures the curvature of the utility function. These aspects lead to a substantial variation in what is meant by risk and uncertainty. If companies make their decisions rationally and consistently. several contributions devise petroleum explorations consisting of a series of investment decisions on whether to acquire additional technical data or additional petroleum assets (Rose. (1999) and Suslick and Furtado (2001) applied the MAUT models to measure technological progress. This seminal work resulted in a theory specifying how rational individuals should make decisions under uncertainty. Megil (1977) considered risk an opportunity for loss. environmental constraints as well as the financial performance associated with exploration and production projects located in deep waters. For example. potential gain or loss. Acceptance of the exponential form of risk aversion leads to the characterization of risk preference (risk aversion coefficient). The theory includes a set of axioms of rationality that form the theoretical basis of decision analysis and descriptions of this full set of axioms and detailed explications of decision theory are found in Savage (1954).

empirical correlations or previous simulation runs. The situation is more critical in offshore fields and for heavy-oil reservoirs. As the level of information increases. using just the recovery factor may not be sufficient. treatment of attributes and in the way several types of uncertainties are integrated. Alternatives may vary significantly according to the possible scenarios. in the modeling tool. Schiozer et al. (1993). One of the simplest approaches is to work with the recovery factor (RF) that can be obtained from analytical procedures.2) Risk Analysis: Field Appraisal and Development During the exploration phase. as presented by Salomão (2001). The integration of risk analysis with production strategy definition is one of the most time consuming tasks because several alternatives are possible and restrictions have to be considered.Rose pointed out that each decision should allow a progressively clearer perception of project risk and exploration performance that can be improved through a constructive analysis of geotechnical predictions. review of exploration tactics versus declared strategy. for instance. Another possible approach is to use faster models such as streamline simulation as proposed by Hastings et al. These findings showed the importance of assessing the risk behavior among firms and managerial risk attitudes. (2) great effort required to predict production with the necessary accuracy and (3) dependency of the production strategy definition with the several types of uncertainty with significant impact on risk quantification. Over any given budgetary period. some simplifications are always necessary. 6. In order to avoid excessive computation effort. field management decisions are complex issues because of (1) number and type of decisions. (2003†) proposed an approach to integrate geological and economic uncertainties with production strategy using geologic representative models to avoid large computational effort. Ballin et al. Simplifications are possible. 21 . In the preparation of development plans. major uncertainties are related to volumes in place and economics. response surface methods and proxy models were used by several authors (Dejean. The key point is to define the simplifications and assumptions that can be made to improve performance without significant precision loss. these uncertainties are mitigated and consequently the importance of the uncertainties related to the recovery factor increases. When higher precision is necessary. and year-year comparison of exploration performance parameters. Techniques such as experimental design. 1999) in order to accelerate the process. or when the rate of recovery affects the economic evaluation of the field. Subbey and Christie (2003) . utilization of an established risk aversion level will result in consistent and improved decision making with respect to risk. (2001). Continued monitoring of the firm’s level of risk aversion is necessary due to a changing corporate and industry environment as well as the enormous contribution generated by the technological development in E&P.

2002). (2) optimization of production under uncertainty. and environmental risk. managers have a growing need to employ improved and systematic decision processes that explicitly embody the firm’s objectives. Although geoscientists and engineers may be willing to make predictions about unknown situations in petroleum exploration and production. (3) mitigation of risk and (4) treatment of risk as opportunity. especially in applications involving health. risk analysis applied to the appraisal and development phase is a complex issue and it is no longer sufficient to quantify risk. In the last two decades. Over the last two decades. (2) calculate the value of information. Many complex decision problems in petroleum exploration and production involve multiple conflicting objectives. Under these circumstances.3) Decision Making Process. Therefore. articulated by a set of logical axioms. and a methodology and collection of systematic procedures. All these issues are becoming possible due to hardware and software advances. and complex value issues into the decision model. multiple alternatives. The understanding of these concepts is important to correctly investigate the best way to perform risk mitigation and to add value to E&P projects. Techniques today are pointing to (1) to quantification of value of information and flexibility. Decision analysis can be defined on different and embedded levels in petroleum exploration and production stages. based upon those axioms. and resource constraints. Kirkwood. for responsibly analyzing the complexities inherent in decision problems (Keenney. An effective way to express uncertainty is to formulate a range of values. 1982. there is a need to assess the level of uncertainty of the projects. Keenney and Raifa. desired goals. safety. Value of Information and Flexibility Making important decisions in the petroleum industry requires incorporation of major uncertainties. Decision analysis is a philosophy. 1976. allowing an increasing number of simulation runs of reservoir models with higher complexity (Gorell and Basset 2001). as proposed by Demirmen (2001) and (3) quantify the value of flexibility (Begg and Bratvold. Howard. So. 6. 1996). the advances in computer-aided decision making processes have provided a mechanism to improve the quality of decision making in modern petroleum industry.The integration is necessary in order to (1) quantify the impact of decisions on the risk of the projects. the theoretical and methodological literature on various aspects of decision analysis has grown substantially in many areas in the petroleum sector. it’s necessary to define the value of information associated with important decisions such as deferring drilling of a geologic prospect or seismic survey. Information only has value in a decision problem if it 22 . long time horizons. Walls (1996) developed a decision support model that combines the toolbox systems components to provide a comprehensive approach to exploration petroleum planning from geological development through the capital allocation process. with confidence levels assigned to numbers comprising the range. 1988.

1998. risk may be mitigated by more information or flexibility in the production strategy definition. 6. 23 . thus helping to guide managers in evaluating a portfolio of exploration prospects. Fichter. projects are selected based upon quantitative information on their contribution to the company long-term strategy and how they interact with the other projects in the portfolio. As the number of project opportunities grows. not just according to their value. This work has been adapted for the petroleum industry. The decision to invest in information or flexibility is becoming easier as more robust methodologies to quantify VoI and VoF are developed. 1999). Orman and Duggan. the concept of Value of Information (VoI) must be integrated with the Value of Flexibility (VoF). the petroleum industry is faced with an increasingly difficult task in selecting an ideal set of portfolios. so the value of information depends on both the amount of uncertainty (orthe prior knowledge available) and payoffs involved in the petroleum exploration and production projects. Under this approach employed extensively in financial markets. Back. and if no other portfolio has less risk while having equal or greater value. The value of information can be determined and compared to its actual cost and the natural path to evaluate the incorporation of this new data is by Bayesian analysis. The information is seldom perfectly reliable and generally it does not eliminate uncertainty. A portfolio is said to be efficient if no other portfolio has more value while having less or equal risk. Reservoir development in stages and smart wells are good examples of investments in flexibility. 1998. winner of the 1990 Nobel Prize in Economics.results in a change in some action to be taken by a decision maker. but also by their inherent risk. The original idea states that a portfolio can be worth more or less than the sum of its component projects and there is not one best portfolio. Therefore. 2000. Chorn and Croft. the decision making process becomes more complex because of the necessity of (1) more accurate prediction of field performance and (2) integration with production strategy. Garcia and Holtz (2003) combined optimal portfolio management with probabilistic risk-analysis methodology. The most important principle in portfolio analysis theory is that the emphasis must be placed on the interplay among the projects (Ball and Savage.4) Portfolio Management and the Real Options Valuations Asset managers in the oil and gas industry are looking to new techniques such as portfolio management to determine the optimum diversified portfolio that will increase company value and reduce risk. 2001. 2001). Erdogan and Mudford. but a family of optimal portfolios that achieve a balance between risk and value. This theory of financial market and efficient portfolio was proposed by Markowitz (1952). At this point. As the level of information increases. Mathematical search and optimization algorithms can greatly simplify the planning process and a particularly well suited class of algorithms has been developed recently for the oil and gas applications in portfolio management (Davidson and Davies. 1995.

suggested the use of option-based techniques to value implicit managerial flexibility in investment opportunities. Bjerksund and Ekern (1990) showed that it is possible to ignore both temporary stopping and abandonment options in the presence of the option to delay the investment for initial oilfield development purposes. Trigeorgis. By the mid 1990’s. After the real options theory became widely accepted in financial markets. over the past few years. (1988) evaluated offshore oil leases. in exploration phase the project can be viewed as an infinitely compounded option that may be continuously exercised as the exploration investment is undertaken. oil price uncertainty delays all option exercises (from exploration to abandonment). Laughton (1998) found that although oil prospect value increases with both oil price and reserve size uncertainties. several textbooks had been published (Dixit and Pindyck. an increasing number of institutions and organizations have been experimenting with the use of other valuations approaches to overcome some limitations imposed by the DCF approach. Paddock et al. The real options approach is appealing because exploration and production of hydrocarbons typically involve following several decision stages.no mention about the value of embodied managerial options. decision-tree and Monte Carlo simulation in petroleum applications. 1998) and the range of applications had widened to include applications in several economic sectors. and Luenberger. (1999) discussed real options. and Myers (1987). 24 .For several decades in the petroleum industry. among others. mothballing and timing. Chorn and Croft (2000) studied the value of reservoir information. Galli et al. 1996. Kester (1984) was the first to recognize the value of this flexibility and Mason and Merton (1985). such as those of abandonment reactivation. Brennan and Schwartz (1985) applied option techniques to evaluate irreversible natural resources assets and McDonald and Siegel (1985) developed similar concepts for managerial flexibility. Some important earlier real options models in natural resources include Tourinho (1979). first to evaluate oil reserves using option-pricing techniques. each one with an investment schedule and with associated success and failure probabilities. Traditional methods based upon discounted cash flow (DCF) reported in the finance literature are always based upon static assumptions . However. whereas exploration and delineation occur sooner with reserve size uncertainty. For example. 1994. the most common form of asset valuation has been the standard discounted cash-flow (DCF) analysis. applications in the oil industry followed rapidly.

Chapter 07 RISK MANAGEMENT Risk management is “A systematic way of protecting the concern’s resources and income against losses so that the aims of the business can be achieved without interruption” • • • • Risk Management is the process of defining all the risks that an organization faces Building a framework to not only monitor and mitigate those risks but to use risk management to increase shareholder value The point of risk management is not to eliminate it. enable continual improvement in decision-making.1 .2) THE RISK MANAGEMENT PROCESS The risk management process consists of a series of steps that. that would eliminate reward The point is to manage it……… 7.1) NEED FOR RISK MANAGEMENT • • • • • • Uncertainty in Enterprise Growing Complexity in Business Environment Statutory Obligations Contractual Obligations Social Obligations High Profile Corporate Failures 7. The elements of the risk management process are summarized in Figure 7. when undertaken in sequence. 25 .

Communication and consultation aims to identify who should be involved in assessment of risk (including identification. Communicate and consult This is shown in Figure 7. 7.Fig.1 risk management process Step 1. analysis and evaluation) and it should engage those who will be involved in the treatment. monitoring and review of risk. 26 . communication and consultation will be reflected in each step of the process described in this guide. As such.1 by the arrows against each step.

As an initial step. It is very rare that only one person will hold all the information needed to identify the risks to a business or even to an activity or project. as well as address issues relating to risk management. Eliciting risk information Communication and consultation may occur within the organization or between the organization and its stakeholders. Managing stakeholder perceptions for management of risk There will be numerous stakeholders within a small business and these will vary depending upon the type and size of the business (Figure 7. 7.2). so their 27 . It can provide access to information that would not be available otherwise. there are two main aspects that should be identified in order to establish the requirements for the remainder of the process. It is important that stakeholders are clearly identified and communicated with throughout the risk management process. a business owner may decide to develop and implement a communication strategy and/or plan as early as possible in the process. Consultation is a two-way process that typically involves talking to a range of relevant groups and exchanging information and views. This should identify internal and external stakeholders and communicate their roles and responsibilities. fig. To ensure effective communication. It is therefore important to identify the range of stakeholders who will assist in making this information complete.2 stakeholders in small business Stakeholder management can often be one of the most difficult tasks in business management. These are communication and consultation aimed at: • eliciting risk information • Managing stakeholder perceptions for management of risk. They can have a significant role in the decision-making process.

systems. Step 2. should be identified. Establish the internal context As previously discussed. For example. In establishing the internal context. in conducting a risk analysis for a new project. processes. the objectives and goals of a business. Establish the risk management context Before beginning a risk identification exercise. project or activity must first be identified to ensure that all significant risks are understood. A business owner may ask the following questions when determining the external context: • What regulations and legislation must the business comply with? • Are there any other requirements the business needs to comply with? What is the market within which the business operates? Who are the competitors? • Are there any social. risk is the chance of something happening that will impact on objectives. This approach encourages longterm and strategic thinking. objectives and scope of the activity or issue under examination. This ensures that risk decisions always support the broader goals and objectives of the business. As such. opportunities and threats to the business in the external environment. their benefits and planned effectiveness. it is 28 . understood. such as the introduction of a new piece of equipment or a new product line. it is important to define the limits. as such the information collected will pertain only to that area of risk. the business owner may also ask themselves the following questions: • Is there an internal culture that needs to be considered? For example. cultural or political issues that need to be considered? Establishing the external context should also involve examining relationships the business has with external stakeholders for risk and opportunity. 1. it is important to first establish some boundaries within which the risk management process will apply. A five-step process to assist with establishing the context within which risk will be identified. weaknesses. Stakeholder communication should incorporate regular progress reports on the development and implementation of the risk management plan and in particular provide relevant information on the proposed treatment strategies. For example.perceptions of risks. recorded and addressed. as well as their perceptions of benefits. are staff resistant to change? Is there a professional culture that might create unnecessary risks for the business? • What staff groups are present? • What capabilities does the business have in terms of people. Establish the external context This step defines the overall environment in which a business operates and includes an understanding of the clients’ or customers’ perceptions of the business. the business owner may be only interested in identifying financial risks. An analysis of these factors will identify the strengths. Establish the context When considering risk management within a small business. equipment and other resources? 2.

4. The amount of analysis required for this step will depend on the type of risk. Establishing the parameters and boundaries of the activity or issue also involves the determination of: • Timeframe (e. 29 . external stakeholders) • Record-keeping requirements • Depth of analysis required. risk criteria may include the acceptable level of risk for a specific activity or event. other projects. To determine the amount of analysis required consider the: • Complexity of the activity or issue • Potential consequence of an adverse outcome • Importance of capturing lessons learned so that corporate knowledge of risk associated with the activity can be developed • Importance of the activity and the achievement of the objectives • Information that needs to be communicated to stakeholders • Types of risks and hazards associated with the activity. In this step the risk criteria may be broadly defined and then further refined later in the risk management process. the information that needs to be communicated and the best way of doing this. Where a risk exists that may cause any of the objectives not to be met.g. how long will it take to integrate a new piece of equipment?) • Resources required • Roles and responsibilities • Additional expertise required • Internal and external relationships (e. Develop risk criteria Risk criteria allow a business to clearly define unacceptable levels of risk.important to clearly identify the parameters for this activity to ensure that all significant risks are identified.1) provides a number of examples of risk criteria for a project. it is deemed unacceptable and a treatment strategy must be identified.g. Conversely. The table below (Table 4. It is against these criteria that the business owner will evaluate an identified risk to determine if it requires treatment or control.

1. This will provide greater depth and accuracy in identifying significant risks. Step 3. It’s easier to believe something if it has happened before. such as incidents or accidents. its complexity and the context of the risks. Once the context of the business has been defined. and the easiest. Identifying retrospective risks Retrospective risks are those that have previously occurred. The chosen structure for risk analysis will depend upon the type of activity or issue. either negatively or positively. The aim of risk identification is to identify possible risks that may affect. Examples of risk criteria for a project in small business Define the structure for risk analysis Isolate the categories of risk that you want to manage. Answering the following questions identifies the risk: There are two main ways to identify risk: • Retrospectively • Prospectively. There are many sources of information about retrospective risk. Retrospective risk identification is often the most common way to identify risk. It is also easier to quantify its impact and to see the damage it has caused. the next step is to utilize the information to identify as many risks as possible. Identify the risks Risk cannot be managed unless it is first identified.Table 7. the objectives of the business and the activity under analysis. These include: • Hazard or incident logs or registers • audit reports 30 . Examples of risk categories for a particular risk analysis are provided in the following case study.

or the likelihood of it occurring. The result is a ‘level of risk’. Identifying prospective risks Prospective risks are often harder to identify. These are things that have not yet happened. in order to make a decision about committing resources to control the risk. A SWOT analysis is a tool commonly used in planning and is an excellent method for identifying areas of negative and positive risk at a business level. or impact. The rationale here is to record all significant risks and monitor or review the effectiveness of their control. Analyze the risks During the risk identification step. This will assist in providing a better understanding of the possible impact of a risk. legislative and operating environment • conducting interviews with relevant people and/or organizations • undertaking surveys of staff or clients to identify anticipated issues or problems • flow charting a process • reviewing system design or preparing system analysis techniques. of an event. Identification should include all risks. It is important to remember that risk identification will be limited by the experiences and perspectives of the person(s) conducting the risk analysis. That is: Risk = consequence x likelihood This is discussed further later in this section. whether or not they are currently being managed. The risk analysis step will assist in determining which risks have a greater consequence or impact than others. What is risk analysis? Risk analysis involves combining the possible consequences. but might happen some time in the future. Step 4. such as journals or websites.• Customer complaints • Accreditation documents and reports • Past staff or client surveys • Newspapers or professional media. weaknesses. political. Risk categories will help break down the process for prospective risk identification. So how is the level of risk determined? 31 . Methods for identifying prospective risks include: • Brainstorming with staff or external stakeholders • researching the economic. opportunities and threats (SWOT) analysis. with the likelihood of that event occurring. a business owner may have identified many risks and it is often not possible to try to address all those identified. SWOT analysis An effective method for prospective risk identification is to undertake a strengths. Problem areas and risks can be identified with the help of reliable sources.

3. It is necessary to estimate the impact of a risk or opportunity on the identified objectives. For example. An example is the likelihood that a non-maintained piece of machinery will malfunction and result in major injury requiring hospitalization.Elements of risk analysis The elements of risk analysis are as follows: 1. * Likelihood = probability x exposure Likelihood relates to the probability of a risk occurring combined with the exposure to the risk. 1. 5. of an employee. and can be expressed in quantitative or qualitative terms and are considered in relation to the achievement of objectives. the risk of theft from a business is reduced by the employment of a security camera. or possible death. However. Determine the likelihood of a negative consequence or an opportunity. risk analysis involves combining the consequence of a risk with the likelihood of the risk occurring: Risk = consequence x likelihood* 32 . This means that although the probability of a risk resulting in a negative outcome may be deemed rare. 2. e. 3. of an employee. this has not eliminated the risk – a residual risk remains. based upon experience. Determine the consequences of a negative impact or an opportunity (these may be positive or negative) Consequences are the possible outcomes or impacts of an event. For example. Identify existing strategies and controls that act to minimize negative risk and enhance opportunities To provide a clear understanding of the possible impact of a risk. However. Identify existing strategies and controls that act to minimize negative risk and enhance opportunities. For example. Determine the likelihood of a negative consequence or an opportunity Likelihood relates to how likely an event is to occur and its frequency. a higher frequency of exposure to that risk can increase the overall likelihood of a negative outcome. Estimate the level of risk by combining consequence and likelihood As previously introduced. They can be positive or negative. this probability increases considerably when exposed to heavier traffic. Estimate the level of risk by combining consequence and likelihood. Consider and identify any uncertainties in the estimates. 2.g. the probability that an experienced courier company will encounter an increased accident rate is low when delivering within regional areas. to determine the level of risk. 4. if the business decides to relocate to a larger city. or possible death. the consequence of failing to maintain a major piece of machinery may be major injury requiring hospitalization. Determine the consequences of a negative impact or an opportunity (these may be positive or negative). existing control measures should first be identified and then the risk analyzed to determine the amount of ‘residual risk’.

a doctor’s clinic will have very different types of risk from a software developer. These are further described later in this section. The most common type of risk analysis is the qualitative method. Not all businesses or even areas within a business will use the same risk analysis method. Techniques for determining the value of consequence and likelihood include descriptors. or balancing costs and benefits. the overall level of risk is determined by combining the identified consequence level with the likelihood level in a matrix (Figure 3. Types of analysis Three categories or types of analysis can be used to determine level of risk: • Qualitative • Semi-quantitative • Quantitative. For example. This is a common limitation of the risk management process. which can lead to the forming of bias and can degrade the validity of the results. It is important therefore to consider and identify any uncertainty. Evaluate the risks 33 . More information regarding the semiquantitative and quantitative techniques can be found within the Australian and New Zealand Standard Risk Management Guidelines (HB 436:2004). It produces a word picture of the size of the risk and is a viable option where there is no data available. what might happen in a worst case scenario). Qualitative risk analysis is simple and easy to understand.e. Consider and identify any uncertainties in the estimates In all estimates of likelihood and consequence. Analysis techniques The purpose of risk analysis is to provide information to business owners to make decisions regarding priorities. Qualitative risk analysis This form of risk analysis relies on subjective judgement of consequence and likelihood (i. Most commonly.This is known as the ‘risk analysis equation’. Methods for qualitative risk analysis include: • brainstorming • Evaluation using multi-disciplinary groups • Specialist and expert judgement • structured interviews and/or questionnaires • Word picture descriptors and risk categories. the information needed to make these decisions will also differ. As such. The type of analysis chosen will be based upon the area of risk being analyzed. It may not be necessary to act on that uncertainty. but be aware and monitor any increases in the risk level. uncertainties will exist. the risk analysis tools need to reflect these risk types to ensure that the risk levels estimated are appropriate to the context of the business.4). Just as decisions differ. or mathematically determined values. word pictures. Disadvantages include the fact that it is subjective and are based on intuition. treatment options. Step 5.

A risk may be accepted for the following reasons: • The cost of treatment far exceeds the benefit. A business owner should aim to choose. Risk acceptance Low or tolerable risks may be accepted. Risk treatment should also aim to enhance positive outcomes.5 overviews the risk treatment process. it is important to be able to determine how serious the risks are that the business is facing. The business owner must determine the level of risk that a business is willing to accept. This step is about deciding whether risks are acceptable or need treatment. Treating the root cause Before a risk can be effectively treated. ‘Acceptable’ means the business chooses to ‘accept’ that the risk exists. it is necessary to understand the ‘root cause’ of a risk. prioritize and implement the most appropriate combination of risk treatments. including what needs to be considered in choosing a risk treatment. either because the risk is at a low level and the cost of treating the risk will outweigh the benefit. The result of a risk evaluation is a prioritized list of risks that require further action. and deciding whether these risks require treatment. It is often either not possible or cost-effective to implement all treatment strategies.3. or how risks arise. Treat the risks Risk treatment is about considering options for treating risks that were not considered acceptable or tolerable at Step 5.As discussed in Section 3. Options for risk treatment The following options may assist in the minimization of negative risk or an increase in the impact of positive risk. Risk treatment involves identifying options for treating or controlling risk. This is also known as ALARP (as low as reasonably practicable). in order to either reduce or eliminate negative consequences. for example the risk that the business may suffer storm damage. Step 6. or to reduce the likelihood of an adverse occurrence. or there is no reasonable treatment that can be implemented. Risk evaluation involves comparing the level of risk found during the analysis process with previously established risk criteria. Figure 3. 34 . so that acceptance is the only option (applies particularly to lower ranked risks) • The level of the risk is so low that specific treatment is not appropriate with available resources • The opportunities presented outweigh the threats to such a degree that the risk is justified • The risk is such that there is no treatment available.

resulting in missed opportunities and an increase in the significance of other risks. Share the risk Part or most of a risk may be transferred to another party so that they share responsibility. Change the consequences This will increase the size of gains and reduce the size of losses. Identifying appropriate treatments Once a treatment option has been identified. If existing work environments need to be upgraded to fully meet codes of practice and standards.Avoid the risk One method of dealing with risk is to avoid the risk by not proceeding with the activity likely to generate the risk. that is. This may include business continuity plans. Risk avoidance should only occur when control measures do not exist or do not reduce the risk to an acceptable level. It is important to note that risks can never be completely transferred. Business owners are required by law to provide a safe workplace. insurance. because there is always the possibility of failures that may impact on the business. a risk management approach should be adopted to demonstrate due diligence. Uncontrolled or inappropriate risk avoidance may lead to organizational risk avoidance. and why the chosen one has been recommended • Effectiveness of the treatment timeframe • Total cost of treatment option • Total reduction in residual risk • Legislative requirements. and emergency and contingency plans. partnerships and business alliances. it is then necessary to determine the residual risk. Mechanisms for risk transfer include contracts. residual risk may be retained if it is at an acceptable level. 35 . Considerations include: • Number of treatments required • Benefit to be gained from treatment • Other treatment options available. Transfer of risk may reduce the risk to the original business without changing the overall level of risk. Conducting a cost–benefit analysis Business owners need to know whether the cost of any particular method of correcting or treating a potential risk is justified. Retain the risk After risks have been reduced or transferred. A staged action or risk treatment plan can be used to document the risks and to outline a remedy. Appropriate consultation with stakeholders should also occur. has the risk been eliminated? Residual risk must be evaluated for acceptability before treatment options are implemented.

the timeframe for implementing the strategy. the level of risk. • Business continuity planning The business moves beyond the initial response of a crisis or emergency and plans for recovery of business processes with minimal disruption. A business owner must monitor risks and review the effectiveness of the treatment plan. Risks need to be monitored periodically to ensure changing circumstances do not alter the risk priorities. Risk recovery Although uncertainty-based risks are difficult.Risk treatment plan A risk treatment plan indicates the chosen strategy for treatment of an identified risk. Monitor and review Monitor and review is an essential and integral step in the risk management process. Very few risks will remain static. if not impossible. The final documentation should include a budget. there are ways in which businesses can prepare for a significant adverse outcome. so that new risks are captured in the process and effectively managed. to predict. including the following: • Crisis or emergency management planning The business anticipates what might occur in a crisis or emergency. appropriate objectives and milestones on the way to achieving those objectives. such as a fire or another physical threat. resources required and individuals responsible for ensuring the strategy is implemented. and then plans to manage this in the short term. 36 . therefore the risk management process needs to be regularly repeated. Step 7. This planning may take many forms. • Contingency planning Contingency planning can be a combination of the above. include ensuring that there is sufficient documentation of processes if a key staff member is unavailable to return to work and another staff member is required to fulfill that role. Businesses should consider adopting a structured approach to planning for recovery. the planned strategy. identifying options for alternative premises if the existing premises are damaged. This is known as risk recovery. A contingency planning tool can help to identify what should be done to minimize the impact of a negative consequence on key business processes arising from an uncertainty-based risk. This would include the initial response (crisis management) and the delayed response (business continuity). This might. for example. or documenting alternate suppliers for key supply material if a key supplier does not fulfill their contract. This will include listing emergency contact details and training staff in evacuation and emergency response procedures. An effective way to ensure that this occurs is to combine risk planning or risk review with annual business planning. A risk management plan at a business level should be reviewed at least on an annual basis. strategies and management system that have been set up to effectively manage risk. It provides valuable information about the risk identified.

market risk. legal risk.7. Technology risk management: It is the process of managing the risks associated with implementation of new technology Software risk management: Deals with different types of risks associated with implementation of new softwares 37 . credit risk. and currency risk Credit risk management: Deals with the risk related to the probability of nonpayment from the debtors Quantitative risk management: In quantitative risk management. operational risk and reputational risk Nonprofit risk management: This is a process where risk management companies offer risk management services on a non-profit seeking basis Currency risk management: Deals with changes in currency prices Enterprise risk management: Handles the risks faced by enterprises in accomplishing their goals Project risk management: Deals with particular risks associated with the undertaking of a project Integrated risk management: Integrated risk management refers to integrating risk data into the strategic decision making of a company and taking decisions. In other words.3) TYPES OF RISK MANAGEMENT Operational risk management: Operational risk management deals with technical failures and human errors Financial risk management: Financial risk management handles non-payment of clients and increased rate of interest Market risk management: Deals with different types of market risk. an effort is carried out to numerically ascertain the possibilities of the different adverse financial circumstances to handle the degree of loss that might occur from those circumstances Commodity risk management: Handles different types of commodity risks. equity risk. for example. quantity risk and cost risk Bank risk management: Deals with the handling of different types of risks faced by the banks. and liquidity risk at the same time or on a simultaneous basis. such as interest rate risk. liquidity risk. it is the supervision of market. credit. such as price risk. which take into account the set risk tolerance degrees of a department. political risk. commodity risk.

when the market conditions. since the potential loss is too high compared to its budget. by investing today. If the management has the option to choose the time to invest. this risky investment might be tolerated. For example. the manager needs managerial flexibilities (real options) to adapt the project to new market conditions. On the other hand. in case of a crisis in the oil industry. irreversible investments in the development phase may reach billions of dollars. as well as other market components may be better. The irreversibility of investment gives rise to implications in the financial status of corporations. such as those in the oil and gas industry.1) Introduction The valuation and decision making of capital-intensive projects have been a topic of concern for large corporations and governments in the oil and gas business. Since unsuccessful results of an investment may give rise to serious financial impacts on the corporation. infrastructure. say. platforms. US$ 300 million. the corporation incurs in an 38 . Since the option to invest is alive until the time the decision is implemented. coupled with investment irreversibility. This positive asymmetry in the NPV generated by managerial flexibility has value and can be properly estimated using option pricing methods. whereas. it kills the opportunity of investing in the future. consider an investment of US$ 100 million in a risky oil project. have three important characteristics according to Dixit and Pindyck (1994): 1 uncertainty over the future operational cash flow 2 irreversibility of the investment 3 value of the timing or some leeway to implement decisions.for example. Then. this flexibility has value and must be considered in the model of valuation and decision making. will have a large reduction of value in a secondary market. Even equipment of more general applications will experience a value reduction due to a decrease of the oil-related assets. in part because the resource is finite and investment is high . uncertainties will tend to generate a symmetric distribution for Net Present Value (NPV). managers might postpone this risky project or sell a share of this project. This is clearly stated in Trigeorgis (1996) that without this managerial proactive role. equipments such as rigs. the irreversibility of investment is one of the main driving forces of investor’s risk aversion.Chapter 08 INVESTMENT DECISION IN OIL AND GAS PROJECTS USING REAL OPTION AND RISK TOLERANCE MODELS 8. For example. for a firm with a budget of. etc. Several studies concerning modern investments theory. The irreversibility of most part of the investment is a frequent characteristic of the capital intensive industries. technology. depending on capital exposed to risk and the magnitude of budget of the company. For a company with a budget as high as US$ 1 billion. if the corporation invests today. the NPV will have an asymmetric distribution to the right. with active management. In order to manage a project under a scenario of future uncertainty.

so that firms may prefer to participate with less than 100% in the project. should the corporation invest now or in the future? 3 What is the optimal working interest for the project? The solutions to these questions have been achieved using the traditional model of valuation and decision making. there is a long period of time (which may reach 20 years or more) of cash-flow exposure to risk. option-pricing and optimal working-interest to give decision makers more realistic information to make their choices. Section 2 applies the model to decision making of capital-intensive project for heavy-oil deep-water production. A model to find the optimal working interest (W) is suggested by Cozzolino (1980). Walls and Dyer (1996). Costa Lima (2004) suggests the use of an integrated model considering Monte Carlo simulation. contrarily. In addition. This chapter is structured in three sections. Dixit and Pindyck (1994). real-world practice shows that most large projects are financed by a pool of companies. in the process of investment valuation and decision making. The strategic decision rule is achieved according to the optionpricing model. McDonald and Siegel (1986). they suggest the use of option-pricing techniques. invest as long as NPV is positive and incur in 100% of working interest. because the corporation invests in a capital-intensive project. what is different from suggestions from the NPV approach. Section 3 presents some discussions and implications. Three questions are of paramount importance: 1 What is the current cash flow value of the investment? 2 What is the optimal decision rule to invest. Lerche and Mackay (1996) and Wilkerson (1998) for petroleum exploration and production projects. these two approaches have been applied in a separate way. The optimal working interest in joint venture projects is found according to the optimal working interest from concepts of preference theory. the process of valuation. in an integrated way. that is.opportunity cost by not waiting to allocate this capital in the future. In addition. But. corporations must consider. The risk of project is estimated by considering uncertainty in future cash flow inflow and outflow through Monte Carlo simulation. Therefore. that is. Trigeorgis (1996) and Copeland and Antikarov (2001) pointed out that results from the traditional model do not properly account for the role of uncertainty. Alternatively. But. 39 . irreversibility and managerial flexibilities. strategic decision making and tolerance to risk exposure. Walls (1995). Section 1 presents some details on the integrated methodology for valuation and strategic decision making. based on the NPV of the project’s cash flows.

In order to estimate the risk of the project. etc. take place. production rate. 2 Invest all of the money in five projects. Equation (1) gives the expected value of the NPV. Then. that is. The traditional decision-making model according to the NPV only considers the risk of a project by means of a premium in the discount rate . irrespective of magnitude of investment. etc. These issues will be discussed over the next sections. the corporation allocates 20% of its budget to each project.21) NPV of the project’s cash flow The first step in the process of investment decision making is the estimation of indicators from the project’s future cash flows. This model has three main drawbacks: 1 the potential gains from the positive side of uncertainty are not taken into account 2 the value of waiting to invest in the future if current market conditions are bad is ignored 3 the optimal working interest is always 100%. production. 1992) as theoretically correct to measure the creation of value for stakeholders. except via risk premium of the discount rate. NPV is a random variable whose future values will come from a probabilistic distribution. the NPV may change as long as fluctuations in price. a Monte Carlo simulation of the NPV may be carried out.……………………………………(1) t=0 (1+µ) t Where µ is capital cost of each cash flow. In this case. 8. but this is not sufficient to make a decision since this indicator does not account for the impact of uncertainty on future cash flows. Equation (1) provides the expected value of the NPV under static scenarios for price.22) Optimal working interest (W) In order to discuss the problem of optimal working interest in a risky project. the NPV is the main indicator for investment valuation and decision rule. If a project generates over time a stream of operational cash flow (X(t)) and requires a stream of investments (I(t)). the lower the NPV. cost.42 million. Traditionally. 40 . since it has been recognized in financial literature (Brealey and Myers. its NPV is (Equation (1)): N E[X t-I t] NPV=∑ ------------. consider an example involving the allocation of US$ 600 million between two alternative investments: 1 Invest all of the money in one large project with an expected NPV of US$ 300 million and a standard-deviation (risk) of US$ 141. cost.2) The integrated model 8.8. the corporation’s rate of return will have the following return/risk profile2: E[NPV] =US$ 300 million and σ [NPV] = US$ 63.25 million.the riskier the project. Since there is uncertainty about the future.

it is assumed that individuals as well as corporations are risk-averse in capital-intensive projects. Cozzolino. since all portfolios give the same return of US$ 300 million. the effects of diversification through different working interest values on risk and return of portfolios are shown.00% Portfolio risk (US$ * 10 6) 141. A risk-prone individual is one to whom uncertain outcome is valued by more than the expected value.These two alternatives have the same expected return.00 44.this is the remarkable role of diversification. for example. depending on the interaction among project risk profile. The investor’s risk tolerance will depend on the amount exposed to risk compared to the investor’s total stock of wealth and his risk preference characteristics.72 Portfolio return (US$ * 10 6) 300 300 300 The choice of working interest depends on the investor’s risk tolerance. 1996). A risk-averse investor has more concern with the potential of loss than that of gains and. the return of portfolio remains the same and its global risk drops . In Table 1. this individual values uncertain outcome by less than expected value. The complete exponential utility equation is: 41 . For the petroleum industry. paying no attention to the potential of gains and losses. Walls and Dyer. where investment irreversibility contributes to motivate management towards limiting risk exposure by taking. This is the case of large heavyoil projects.42 100. 1980. choices under uncertainty or risk attitudes of decision makers are organized into three main groups: 1 risk-neutral 2risk-averse 3 risk-prone According to Luenberger (1998). but different risk levels..00% 10. Newendorp and Schuyler. The theoretical foundations of decision making involving choices under uncertainty (such as selecting working interest in a project of high CAPEX) is the preference theory developed by Von Neumann and Morgenstern (1953) which advocates that the usefulness of things determines their attractiveness. In this paper.00% 50. Basically. to find the optimal working interest in this model. 2001. 1999. Just by increasing the number of non-correlated projects. 2000.. Cozzolino (1980) and Walls (1995) suggest the use of the exponential utility function to model the choices made under uncertainty. Table 1 Number of projects 1 2 10 Effects of diversification on portfolio risk and return level Working interest (W) 100. therefore. the risk-neutral individual is one to whom uncertain outcomes are valued as expected values. magnitude of the corporation’s financial budget and decision maker’s risk attitudes (Campbell et al. Nepomuceno et al. less than 100% working interest in the project.

U(x) = a-b*e –X i / T ……………………………………………………(2) where a and b are constants, X is the random monetary quantities and T is the corporation’s risk tolerance. The absolute value of utility (positive or negative) is just a number without much significance and is not enough for taking decisions. On the other hand, utility values are suitable for comparisons - for example, if U(X) = 11 and U(Y) = 8, then, X is preferable to Y.

On the other hand, the certainty-equivalent or Risk-Adjusted Value (RAV) is the main concept to estimate the optimal level of financial participation or working interest (W). According to Luenberger (1998), RAV is that value whose utility is equal to the expected value of utility of K possible monetary outcomes (X i) with probability p i .from Equation (2), if a = 0 and b = 1, the RAV is found from: K - (RAV/T) -e = ∑ p i (-e - (W*X i/T) ) ………………………………………………..(3) i=1
Where T is the corporation’s risk tolerance. From Equation (3), we get: k RAV = -T*ln [∑ p i * e -((W*X I )/T) ] ……………………………………………………(4)

i=1 The model to estimate the optimal working interest is given in Equation (4), that is, the decisionmaker should select W that maximize the RAV. In practice, W is found numerically. The use of Equation (4) requires two inputs: 1 corporate risk tolerance (T) 2 probability distribution of X i ---for example, the NPV of the project. 2.3 The optimal investment decision-rule The optimal investment decision rule must take into account not only the expected future cash flows but also the strategic or operational options that are available for management over the life of a project. As in the case of financial options, these real options are understood as a right, but not as an obligation to be implemented and have value to be added to the traditional NPV. As described by Trigeorgis (1986), the true project value is always equal to or greater than its traditional NPV. Most modern investments in exploration and production share the following characteristics: 1 future uncertainty in variables such as cost, price, exchange rate, etc. 2 irreversibility of investment, leading to new considerations in the process of the project’s acceptance and management of risk exposure 3 timing or strategic real option to implement decisions.

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Dixit and Pindyck (1994) consider that such investments should be analyzed using the flexible approach of real-option pricing. Costa Lima and Suslick (2002) pointed out that the interaction of uncertainty and timing may aggregate value to the project, in part because the investor’s loss is limited to the irreversible investment, whereas the upside potential is theoretically infinite. The first step in valuation and decision-rule from the option-pricing model is the modeling of the dynamics of the asset’s future price. Following Black and Scholes (1973), we assume that the changes in the present value of future cash flows evolve as a risk-neutral geometric Brownian motion:
dV =(r-δ) V d t +σVd Z …………………………………………………………….(5)

Where V is the present value of project’s cash flow, r is the risk-free interest rate, δ is the dividend rate, σ is the volatility and dZ is Wiener’s increment or white noise. In order to find the optimal investment decision-rule, let F(V) be the value of the option to invest in an oil and gas project. If we assume that option maturity is at least four years, the investment option can be regarded as independent of time. Then, by following standard procedures in financial economics, McDonald and Siegel (1986) and Dixit and Pindyck (1994) showed that, under the assumption of market efficiency and non-arbitrage opportunities, F(V) must satisfy the following ordinary differential equation (PDE)
½ σ 2 V 2 F”w (V) + (r-δ)VF’v (V) – rF(V) = 0 -------------------------------------------------(6) In order to use Equation (6), the following boundary conditions are considered:
F (0) = 0 ……………………………………………………………………………..….(7)

NPV (V*) = F (V*) = V*-I

……………………………………………………………….(8)

F’v (v) = 1

………………………………………………………………………………………………………………………(9)

Equation (7) means that if V = 0, F(0) = 0, that is, there is no chance of increase in V in the future, which is considered an absorbing property of the GBM. Equation (8) means that the corporation should invest as long as V reaches a trigger value (V * ) and not merely V ≥ I. Equation (9) is the smooth-pasting condition or the last boundary condition for optimization. The solution of F(V) is:
β = 1/2 – (r-δ)/σ2 + {{(r-δ)/σ2-1/2}2 + 2r/σ2}1/2 …………………………………………………….(10) V* = β/ (β-1) * I ……………………………………………………………………………….. (11) F (v) = (V*-I/ (V*) β) * Vβ F (v) = NPV (V) = V-I if V<V* ………………………………………………. (12) if V≥V* …………………………………………………………
(13)

where β is positive root of a quadratic equation derived from the ordinary differential Equation (6), I is the present value of investment cost and V * is the trigger value, that is, the minimal project value to invest immediately. Equation (12) is the value of the investment option if V<V * and Equation (13) gives the value of investment option if V ≥ V*, that is, Equation (13) has the same value as the traditional NPV. In order to use the set of Equations (10)-(13), as analogous to

43

the case of financial options, the real-options analyst needs those five input parameters of Table 2.

Table 2

Analogy of the determinants of financial and real-option pricing models Real options Present value of project’s cash flow ($) Present value of investment cost ($) Future volatility of project’s cash flow (%) Future dividend from project’s cash flow (%) Symbol V I σ δ r

Financial options Underlying asset Exercise price Financial asset’s future volatility Financial asset’s dividend rate Risk-free interest rate

Risk-free interest rate (%)

The estimation of these parameters is a condition to valuation and decision making in projects. In the case of financial options, except for future volatility, they can be estimated from past market data. On the other hand, in the case of projects, the procedure is much more complex, since these parameters, especially dividend and volatility, must be estimated by considering the dynamics in future cash flows. For example, Copeland and Antikarov (2001) suggest the use of Monte Carlo simulation to estimate the future volatility of projects, whereas Costa Lima and Suslick (2006) derive an analytical expression for volatility of projects considering two sources of uncertainty.
8.3) Analysis of a capital-intensive project

Recently, significant offshore heavy oil discoveries were made in ultra-deep-water of Brazil and West Africa. Among the new technologies required for commercial production of these heavy oil reservoirs in deep water, new artificial lift devices and long horizontal wells length can be detached, completed with efficient sand control mechanisms (Pinto et al., 2003). Besides providing commercial value for the heavy oil wells, it is expected that these new technologies will create a new value for such resources. Indeed, heavy oil reserves can become more available over time in these environments if the cost-reducing effects of new technologies (reduction of CAPEX and OPEX) more than offset the cost-increasing effects of depletion. Offshore heavy oil can be considered good assets for future revenues if new technologies are available to transform the potential reserves of heavy oil into viable projects. These heavy-oil projects are a good sample to evaluate the performance of the proposed methodology. Most heavy-oil development projects in this type of environment are typically capital-intensive, where irreversibility, uncertainty, timing and risk-aversion are present. In order to discuss some numerical results, consider a heavy-oil project with the geological, economic and financial characteristics shown in Table 3. The cash flow of this project is in Appendix. For simplicity, we use a simple linear taxation of 50% representing the ‘government take’ of this project based on its specific characteristics, such as water depth, operational conditions, etc. Under a static scenario of price, cost, production and fiscal regime, using Equation (1), we have E[NPV]  US$ 391.38 million. According to the traditional model of valuation and decision making, this project should be “accepted immediately because it creates value for stockholders and the corporation should incur in 100% of its funding
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50 887.00 25o API 68. which is a fair and rational motivation for risk analysis. For this project. whereas the optimistic cost is US$ 6/bbl and the pessimistic cost is US$ 18/bbl. There is a consensus that there is no reward for unsystematic risk because it can be eliminated by diversification in well developed markets.02 12.00 13. what is not always the case in specific domestic markets of the major oil companies. On the other hand. broadly speaking there are two types of risk: systematic and unsystematic.00% Technical and economic characteristics Oil Reserve (MMbbl) Water depth (metres) Oil quality Oil production peak (MMbbl/year) CAPEX (US$ MM) OPEX (US$/bbl) Oil spot price (US$/bbl) Discount rate (%) Government take (%) However.38 million. a natural complement to a static NPV is its risk analysis. whose most likely value is US$ 12/bbl. a risk analysis consists of finding the probabilistic distribution of the NPV from uncertainty in its primary variables such as price. such as the chance of a negative NPV. Although the NPV of this project is highly positive. the true values of price. 8. cost.4 • Future values of oil price: this variable is modeled according to a lognormal distribution where mean price is US$ 30/bbl and standard deviation is US$ 15/bbl. we use the following assumptions: • Future values of oil production cost (OPEX): this variable is modeled as a triangular distribution.31) Estimation of the risk of the project In finance. it has some risk because of a possible change in market conditions. cost and production. in non-mature financial markets such as in Brazil.00% 50. Since the NPV is a random variable. among others. we will know its true value only when the oil production reaches economic exhaustion. over the entire project life. the real NPV may be quite different and. but should also consider its uncertainty because even a positive expected NPV may become negative if market conditions change over time.30 1500. In this paper. actually. For example. the optimal decision making should not be based solely on expected values. in practice.and get 100% of its profits”. As a result. technical and economic characteristics of the project Properties value 389. production and tax may differ from those expected ones from the static scenario and the NPV may become more positive or even negative. In this sense.00 30. the real NPV is a random variable whose expected value is US$ 391. we consider risk as the possibility of an unfavorable outcome. that is. Table 3 Geological.3 the total risk (unsystematic) is what is of concern. 45 . It is important to note that this is true for investors in markets with a large menu of assets.

3 billion to US$ 2. whereas the yearly optimistic production is 50% above the most likely production.6 In practice. Then. together with the ability to invest in the future in a scenario of less risk. but there is a concentration of values around the mean of US$ 276. which is according to the real-option pricing approach • Secondly. etc. 46 .0 billion. although in reality.000 iterations. most of these extreme values of the NPV have little significance. the probability of a negative NPV is 30.07 million. This means that. From Figure 1. after carrying out a simulation with 10. since most variables are directly linked to oil price to some degree. The next step consists of simulating thousands of possible paths for these uncertain variables using the Monte Carlo technique. Since investment is irreversible. apart from their dependency on the non-linearity in tax structure. with pessimistic yearly production equal to 50% of the most likely value. for oil production projects. the irreversibility of investment.• Future values of production: oil production is expected to reach a yearly peak production of 68. since they occur in very unlikely situations. This modeling assumes that the components of the project’s cash flow are statistically independent. logistics.5 The uncertainty in oil production is modeled considering that future production will be distributed as triangular distribution. Figure 1 Cumulative frequency of the NPV and project’s risk level Simulation of the NPV shows that its values range from US$ −1. we get the histogram of the NPV shown in Figure 1. in the case of unfavorable events. that is. this assumption is incorrect. gives rise to a new decision-making rule. together with corporation risk aversion. may imply in a working interest of less than 100% in the project. the corporation must adopt two complementary policies in order to decide if it should invest in this project or not: • firstly.5 million bbl and drop year after year to the ending value of 2.95%. the irreversibility of investment. the corporation may not be able to recover its full investment allocated to the project.9 million bbl. high cost and low price and vice-versa.

41 887.00% Input parameter Project’s cash flow value Project’s investment value Project’s dividend rate Project’ future volatility Risk-free interest rate The optimal decision rule based on the theory of an option-pricing model requires. so that each reservoir has its own geological. the NPV has been the indicator for static valuation and decision-making. if we take the effect of investment irreversibility and future uncertainty. As an alternative solution.Another possibility is to make price hedging. we use Monte Carlo simulation in order to access the project volatility as the standard deviation of rate of return of the project. K. but this will also reduce profits because of the cost of hedge. Therefore. V*) Traditionally. The expected rate of return of the project (µV) at time 1 is: 47 . over the project’s entire operational life. there is a chance of an infinite number of different cash flow trajectories. According to this theory. These different cash flow trajectories are the cause of the project’s volatility. The required input parameters of Equations (11)-(13) are shown in Table 4. as suggested by Copeland and Antikarov (2001). Table 4 Inputs of decision-making based on real-options models Symbol V(MM US$) I(MM US$) δ σ r Value 1278. Firstly. the application of the theory of exercising a financial option to the case of investment decision in projects is proposed. there is a critical project value (V*) to trigger investment. this approach is no longer right. It is not easy to find the project’s volatility and dividend rate. the benefits are in excess over the costs and the project should be accepted. Under the static approach. due to possible fluctuations in the expected value of the NPV from future cash flows. operational and environmental particularities. but only if it is sufficiently high. the option is not exercised simply if the value of underlying asset is just above its exercise cost. The estimation of future project volatility is always a complex task (even for financial assets when there is a long time series available to be used as a proxy) because: 1 there are no marked transactions for project cash flows 2 petroleum projects are unique. we calculate the expected project NPV under static scenarios. which we call NPV 0. technical. But.95% 51.32) The optimal rule of investment (F. Analogously. 8. in this paper.3. In Section 2. among other factors. Over the next sections.00% 5. If it is even merely positive. the corporation should exercise its option to invest only when project value is sufficiently above its investment cost. characteristics of project cash flow and of the market interest rate. this logic is correct but.02 11. these two approaches will be applied to the case of an offshore oil project. The risk-free interest rate is assumed to be that paid by government to its bondholders whose maturity is similar to that of the managerial flexibility.

if the volatility of oil price is around20%.00%.00% as in this paper. In an investment in stocks. we estimate project dividend rate (δv) as a weighted average between cash flows and production: N t=0 N t=0 δv = ∑ Q(t) * f(t) / ∑ Q(t) ………………………………………………(15) Where Q(t) is the annual production and f(t) is ratio of the yearly cash flow to the sum of total cash flows. but this simple approach has many shortcomings.76 million. As a result. According to Costa Lima and Suslick (2006).09 million. the volatility is much higher . and create wrong critical values to exercise the option to invest.29 million. In other words. we have all inputs necessary to estimate the investment option value.38 million).05 times the investment cost and not merely a positive NPV”. which comes from the uncertainty in future cash flows. can be associated with the reserve’s production flow over time. such as oil projects. According to this new decision rule. for typical oil projects.91% and it means a fraction of the project’s total value that is generated each year.09 million. From Equation (11). The estimation of a project’s dividend yield is also complex. 13%. This means that the corporation should exercise its option to invest only if the current value of the project is at least US$ 1821. V * is US$ 1821.(14) NPV0 The expected project rate of return is very close to the cost of capital (or discount rate). In this paper. the 48 . investors receive dividends as a result of profit distributed by a corporation.8 Dividends for exhaustible resources.7 These numbers show that project volatility is usually much higher than price volatility. But.04 million. it means that the “decision to invest immediately requires V equal to at least 2. Note that expected rate of return is close to the discount rate and the standard deviation of rate of return is the volatility of this project. which is higher than the traditional NPV ($ 391. there is a chance that thousands of µV may occur.00% and σ(µV) = 51.). the common assumption that project’s volatility is equal to price volatility may give rise to significant errors. undervalue projects. especially in the case of long-lived projects with irregular cash flows. even if the NPV is positive today. that is. volatility of projects. with the flexibility of choosing to exercise the right to invest at some moment in the future during option’s maturity. The dividend of project can be understood as the cash flows per unit of time (month. The value of the option to invest (F). since cash flows in the future are uncertain. nearly 12. optimal decision rule and value of waiting to invest in the future. we get a distribution of the rate-of-return with the following two moments: E [µV] = 13.around 51. year. Now.CFo (1+µ) + NPV1 E [µ V] = ----------------------------1 ……………………………….00% of the asset’s value is produced. The value of waiting to invest in the future (K) is US$ 100. the optimal decision is to wait to invest in the future. dividend rate is δv= 11. Since the current value of this project is US$ 1278. etc. is US$ 491. After a simulation. that is. Using Equation (15).

The NPV is positive. in the real-options model.09 million or more. This condition will hold and be true when the project’s current value is sufficiently above its cost. but not sufficiently high. a positive NPV. because of volatility. the NPV is US$ 391. On the other hand. From Equation (1). that is. the investment option is much higher than the intrinsic value. from Equation (12). Consequently. the effect of irreversibility and uncertainty implies that the optimal policy to maximize the option value is to wait until the project value 49 . The intrinsic value of the option (NPV) is negative and the corporation will not invest. V > V*>I. the investment right is exercised as long as V ≥ V* and both F and NPV have the same value. F and K to project current value As the current value of project increases. we have that F (V*) = V * . the corporation should invest right now. Another understanding is: when V = V *. In the real option pricing model.29 million and clearly the option value is above the NPV stand alone. that is.02 million. F may be considered as the intrinsic option value plus its time value. which captures the value of the flexibility to invest not only now. but also in the future. that is. F (investment option) and K (value of waiting option) are nonnegative functions. is US$ 491. Contrarily.38 million and.volatility of project is 51%. • II: US$ 887. Therefore. F and K (option value) to project current value.I and.09 million. whereas the NPV can be negative if I > V. that is. we always have V* > I and not V * ≥ I. F is positive. Then. project value is represented by its NPV and the optimal decision is: invest as long as V > I. Figure 2 Sensitivity of NPV. according to traditional decision making. we can see F as part of the cost to invest now instead of waiting for a better opportunity in the future.02 million ≤ V < US$ 1821. the optimal policy is to invest when the flexibility to wait has no more value (K = 0). Then. the option value. The entire results of both approaches in valuation and decision making can be seen in Figure 2 through a sensitivity analysis of the NPV. V * = F (V *) I. the strategic value of the option to invest (F) and the intrinsic option value (NPV) are equal. when F = NPV. Why? Since the future is uncertain . There are three important regions for decision making: • I: 0 ≤ V ≤ US$ 887. Meanwhile. Thus.act of waiting is able to create more value for shareholders. that is. F and a decrease in K. Once again. According to the classic investment theory. there is a potential that project value increases to US$ 1821. The volatility of projects plays a very important role in both option valuation (Equations (12) and (13)) and decision making (Equation (11)). Figure 2 shows an increase of NPV.

for example. For example.in some cases.09 million. from this approach. T = 40% of the budget. that is. From Equation (4). This equation requires two main inputs: 1. Wilkerson (1988) argues that T can be estimated as a fraction of.09 million. the results of valuation and decision making for this project. An alternative solution can be found using the theory of finding the optimal working interest to maximize the RAV in Equation (4). particularly volatility and dividends.14 times the investment cost. corporation market value. III: V ≥ US$ 1821. corporation risk tolerance and project risk profile . In addition. Meanwhile. the corporation should incur in 100% of investment and revenue as long as the NPV is positive. The main objective is to estimate 50 . considering different assumptions and characteristics of the corporation and of the project. it is a decreasing or even constant function. technology availability to develop the project alone 3. it is assumed that the corporation budget is US$ 300 million and its risk tolerance is US$ 120 million. even though the project value is sufficiently above its investment cost. Costa Lima (2004) has shown that for some oil projects. 8. many corporations prefer to develop it in partnership (such as a joint venture). V* may be two times the investment cost or even higher. The corporation risk tolerance is difficult to estimate. But this practice in capital-intensive projects has some reasons due to the following characteristics: 1. for other phases in the E&P chain.• reaches the value of US$ 1821. are in agreement with the literature. As shown in Equation (4). synthesized in Figure 2. T may assume different values. the probabilistic distribution of NPV 2. the analyst can estimate the RAV for this project. V* is on the average 2.09 million.33) The optimal working interest in the project (W) In many cases. In this chapter. the corporation risk tolerance (T). budget and other strategic variables. search for synergy among different business units. in others. whereas. RAV depends on utility function. the magnitude of investment cost 2. In general terms. In such situations. the RAV is an increasing function of W. Observe Figure 2 to confirm that the option value of waiting (K) has no more value if V is above US$ 1821. Walls (1995) show empirically that T is around 25% of the capital allocated to petroleum explorations. but the option should therefore be exercised in the future. it is worth mentioning that for reasonable input parameters of the real options model. The option value is still high. which seems to contradict the optimal decision rule of the option-pricing theory. The investment option must be exercised immediately. a common question is: What is the optimal level of financial participation (working interest) in this project? The answer cannot be found through pure NPV analysis since.

As shown in Figure 3. an extended sensitivity of the RAV to W for different values of T is presented.38% because this value gives the highest RAV”. an increase in W will increase the satisfaction of decision maker up to around 44. in order to maximize the RAV. Higher values of W reduce the satisfaction of decision maker through the decrease in RAV. production and operational cost together with the corporation’s utility function. an increase in T tends to increase W in the project and viceversa. the sensitivity of RAV to W is shown in Figure 3. Nevertheless. but only 44. in order to get realistic results. The theory of maximizing the RAV shows that. For this case study of oil project. Note that the curve of the RAV to W takes into account the uncertainty in price. the RAV is a non-linear and concave function of W. given the corporation’s profile. Over the interval between 0 and 100%. numerically or analytically. that is.38%. Figure 3 Sensitivity of RAV to optimal working interest (W) Figure 4 Sensitivity of RAV to optimal working interest: different values of corporation’s tolerance 51 . if W is higher than 93%. the RAV becomes negative. contrarily to the traditional view. In Figure 4. it is important to search for the best estimation of T because of its impact on W. In addition. the “corporation will not take 100% working interest in the project’s cost and revenue.W. it is important to observe that.

risk quantification. 52 . In terms of valuation and strategic decision making. may be the choice of a small fraction of the project investment and revenues.4) Discussions and implications The proposed model provides a complement to results of the classic NPV in valuation and decision making. reduce the corporation’s portfolio risk. a rational policy intended to reduce the risk of losses and. Table 5 presents a comparison between the traditional and the proposed valuation and decision model. strategic flexibilities and decision making. If a negative outcome occurs. W is also increased to 75%. of financial troubles. in the base case. The result from preference theory and risk-adjusted analysis intends to complement the results of the NPV and option pricing because of two main reasons: 1 the investment cost may be quite high if compared to the corporation’s budget 2 even in the case of a project with a current value equal to two or more times its cost. this integrated model requires two input parameters that are difficult to estimate: corporation risk tolerance (T) and project volatility (σ). T = US$ 120 million and W = 44.38%.Note that. by taking a working interest of less than 100% in the project.38%. consequently. generate a scenario of high cost and low prices. In this case. consequently.66 million. the corporation may invest in more than one project and. Although more sophisticated. W is also reduced to only 30%. it may become profitless since volatility over the future may. It integrates valuation. the amount under risk is limited to that fraction of the investment. such as those of oil and gas industry. if T decreases to US$ 80 million. using theories of preference and real option pricing. In the present case study. that is. This policy of reduction in the project’s NPV may be understood as the price to limit risk exposure or as a hedge scheme against possible catastrophic losses. for example. This practice is very common in the oil exploration and production business and this framework may be a valuable tool for the decision process in capital-intensive projects. Finally.66 million in the investment and receive a NPV of only US$ 173. Analogously.69 million. by taking W = 44. we have pointed out the need to complement results of the traditional cash flow when analyzing investment in capital-intensive projects. the company will spend around US$ 393. 8. US$ 393. If T increases to US$ 200 million.

US$ 2.29 1821. The project NPV is US$ 276. Therefore. Nevertheless. because the result of the exercise of real options.38 30.09 million) and incur in a working interest of 44.41 887.41 887. global output may be very different.38 887. due to oscillation in price. as well as in other strategic variables.62% of the investment.38% Decision Making Optimal Decision According to the traditional cash flow model. In this context. invest now and take 100% working interest Proposed model 1278. costs and production.95% 391.38% Even though NPV is positive invest in the future (when V is US$ 1821. since the project’s investment is high compared to the corporation’s risk tolerance. where F is the valuation indicator and the decisions are made according to the results of V* and W. but depends on a cash flow from many years of operations. requiring that the analysis must be updated continuously in order to improve the corporation’s valuation and decision making in the search for an efficient resource allocation and value creation for stockholders.95% 491.09 44. The numerical analysis summarized in Table 5 shows that.34 30.07 million and the corporation should invest immediately and incur in 100% of the project. The proposed model has a complementary structure. the corporation follows a more conservative and risk-limiting policy.Table 5 Subjects Valuation and risk Results from the two valuation and decision models (some approximations have been used to the nearest round number) Main indicators V (million US$) I (million US$) NPV (million US$) F (million US$) Risk (%) NPV (million US$) V* (million US$) W (%) V *F Traditional approach 1278.00% Since NPV is positive. the option to invest is not deep-in-the-money. volatility or operational cost.07 452. this procedure does not assure that the option exercise is profitable. the corporation’s optimal working interest is 44. This may happen.10 billion. for example. If some of them undergo oscillations. at least.38%. This framework derives from the chosen parameters. the optimal decision is to wait for an increase in V to. whereas other partners must fund the remaining 55.02 100. This chapter presented an integrated framework. useful for valuation and decision making under uncertainty for capital-intensive 53 . contrary to financial options. which may not be constant over time. although the NPV is positive. which is an advance and is radically different from the traditional NPV. By choosing only projects whose V is at least equal to V*. is not immediate.02 276. for example.02 391. the NPV is the indicator for valuation and decision making. combining theories of real-options and preference.

risk tolerance.projects. The outputs of the real-options model may be used to complement those of the traditional NPV. The results from the preference theory allow the corporation to estimate its optimal level of financial participation in a risky project that is compatible with the utility function of the decision maker. findings from this new model is that its results tend to diverge from the traditional valuation and decision-making model as the level of uncertainties increases as in the case of heavy-oil in deep water projects where the timing and frequency of the unknown technologies for cost reductions are speculative and not fully dominated by oil industry. especially by incorporating the value of uncertainty and irreversibility. This integrated model represents a significant gain when compared with the traditional one (based solely on expected values) by considering the relationship among irreversible investment. In addition. 54 . timing and risk-aversion.

” The first step was considered the simplest part of the process since it is recognized that many are the decisions under uncertainty occurring during well drilling operations. will allow deviation from the proposed AFE. variables where no uncertainty exist. the accounting department will rely on the recommendation from engineers to prepare the company’s budget. following clauses established in a Joint Operating Agreement (JOA). the possible gains. of course. within the possible outcomes. In this case. Those values are added with the fixed costs. will be in the lower side at the same time that supervision and P&A costs reach a minimum. The second and third steps are more complex and involve issues related to data availability and reliability. Any amount above this limit will require mandatory approval from the partners. Since cost estimation for drilling operations naturally carries a great deal of uncertainty. The total estimated cost is $6. maximum and mode value are known (as given in Table 2). in certain high-risk exploration ventures. rig costs.Well Cost Estimation Engineers involved in well planning and budgeting know how sensitive this subject is.Chapter 09 USE AND IMPLEMENTATION OF RISK ANALYSIS Implementation of risk analysis involves three basic steps: “identifying an opportunity” (or event) where the tool can be applied.1)Example of Application . this area appears to be suitable for risk analysis application.000. only to a certain extent. let us say. Assuming that all cost variations are independent. The normal approach. which may not be the case with certain related item like casings with different diameters. The simulation is run consecutively. resulting in a total 55 . From that premise. Externally. partners will do the same and. It is regular in these cases to allow a 10% over spending on the planned costs. Table 1 presents an actual AFE for a vertical offshore well. Normally. There is no guarantee that. of considering a “best case” with all the lower costs occurring at the same time and a worst scenario with all the higher costs happening simultaneously cannot be applied here. a Monte Carlo simulation can be performed.456. A poorly prepared well budget or AFE (Authorization for Expenditure) will have effect on the company’s internal functioning as well as in its relation with possible partners. the estimated best economic or operational result. cost analysis. with all uncertain costs being randomly varied combined with the other costs. probability determination and economic assessment. an AFE will have to be approved by all partners before drilling operation takes place. we can further assume that the costs will vary according to a triangular distribution where the minimum. it is very common for oil companies to look for partners to share the risks involved. potential losses and. Internally. Let us assume now that the engineer in charge of well planning has uncertainties related to 16 items (see Table 2) on the proposed AFE. In the next section an example of application is presented 9. “quantifying the consequences of various possible decisions” and “assessing. which may cause operational delays and doubts about the operating partner’s technical proficiency. every time taking one possible cost from the distribution of each of the 16 uncertain variables.

Notice that the analysis itself does not substitute the engineer’s evaluation or company’s policy. Figure 1 . in our case.54 and $6. $6. 1.3) Conclusions An overview on most important works relating use of risk analysis applications for drilling operations was presented. 56 . Monte Carlo simulation was used to determine a cumulative distribution function for the expected well costs.cost for the well. A simple example for application in well cost estimation was presented. On the other hand it provides the professional with means to best estimate contingency costs and determine P(10). 9. P(50) and P(90) costs. The resulting CDF is presented in Fig. the engineer now has a much more reliable tool to be used on the AFE’s preparation. $6. however. In this case the simulation was repeated 500 times and the results used to form a cumulative distribution function (CDF) for the well. Use of risk analysis on oil and gas investment decision is a common procedure in all major oil companies.83 millions. use of QRA methods as an auxiliary tool for decisions under uncertainty in well engineering process is not as prevalent as it should be.Cumulative Distribution for AFE 9.32.2) Analysis of Results After establishing the distribution of possible costs for the well.

600 $96.000 3500 30" 20" 16" 9-5/8" 7-5/8" 220 60 16 30 13.000 $25.000 $47.000 $4.000 $23.000 $26.Daywork Fuel.300 $5.250 $140.000 $180.000 $93.670 $9.000 $4.000 $111.100 $62.000 $62.000 $35.000 $31.000 $15.090 $11.000 $27.700 $0 $450.000 $56.250 $20. Cost $5.000 Rate $75.000 $56.Use of decision methods with risk analysis required reliable database and careful analysis of possible outcomes.864.708.000 $74.000 $180.600 $5. its use is simple and will provide great benefit for the company.Authorization for Expenditure (AFE) Preliminary Estimate for a 9000 ft Straight Hole.000 $18.000 $2.000 Days 7 31 31 31 Days $525.600 3.000 $0 $120.000 $40.750 $21.250 $17.000 $350.000 $25. Drive Pipe Conductor Surface Casing Intermediate Casing Production Liner Wellhead Equipment TOTAL TANGIBLES TOTAL AFE COSTS 800 1.000 $15.500 6. & Demob.500 $3.000 6 6 6 $2.000 PRECOMPL.000 $5.000 31 31 31 5 6 6 6 0 $800 31 5 6 DRILLING COST $20.420 $1.300 $747.183.000 $350. once the method is implemented.000 $400.000 $67.) Drilling .000 $2.000 $180.100 $2.900 $6.500 $525.000 $591.000 $5.325.100 $5.600 $12.000 $0 $0 $50.000 $130.800 $72.000 $484.000 $75.600 $96. However.000 $50.456. Precompletion Estimate Included ESTIMATED INTANGIBLE COSTS Surveys and Permits/Environmental Location Cleanup Rig Move (Mob.000 $406.000 $0 $0 $78.000 57 .300 $0 $0 $0 $0 $47.450 $600.000 $55. TABLE 1 .000 $850 $120. Lubes and Water Rental Equipment Drill Bits Drilling Mud & Chemicals Mud Logging Cement & Squeeze Services Casing Crews & Tools OH Logging+MWD/LWD Cores & Analysis Transportation Labor + Dock Charges Supervision P&A Costs Pipe Inspection Overhead Insurance Communications $750 $570 $300 31 31 31 6 6 6 $13.000 $65.100 TANGIBLE COSTS $/FT.100 $0 $10.000 $524.350 $600.700 $74.000 TOTAL AFE $25.800 $680.000 $400.000 $4.5 $72.000 $12.000 $3.775.

450 $600.500 $9.700 $122.600 $96.500 $81. Lubes and Water Rental Equipment Drilling Mud & Chemicals Mud Logging Transportation Labor + Dock Charges Supervision P&A Costs Insurance Communications Drive Pipe Conductor Surface Casing Intermediate Casing Production Liner Total Cost Lower Limit $3.000 $64.000 $47.300 $675.000 $52.500 $3.500 $198.250 58 .000 $400.500 $27.Range of Costs Total Cost Base Case Total Rig Cost Fuel.700 $55.000 $180.750 $550.100 $500.000 $111.250 $69.700 $74.300 $80.000 $31.000 $59.250 Total Cost Higher Limit $3.000 $18.000 $484.000 $40.000 $49.000 $168.TABLE 2 .000 $21.090 $11.000 $3.960.300.000 $4.250 $299.080.500 $499.000 $4.210 $75.000 $56.000 $77.750 $92.100 $72.000 $22.900 $104.000 $74.400 $33.500 $350.570 $12.

Although the price per barrel has increased dramatically in recent months. such as the pharmaceutical industry and aerospace engineering. and even space in fabrication yards across the region. Asian oil and gas companies are placing more emphasis on managing assets and streamlining business processes to maximize profitability. Even with the best seismic technology and geological expertise. and greater exposure to possible liabilities and compliance requirements. typically long payback periods. Extracting that oil or gas demands greater investment.most Asian oil and gas companies are now practicing risk management at the highest professional levels. Actuarial analysis is needed to project the life spans of discovered reserves and their market value over several decades. however. and companies operating in that sector generally maintain higher risk profiles than most corporations. exploration presents considerable uncertainty. but they are particularly vital concerns for companies operating within the upstream sector of the oil and gas industry. particularly in resource availability.Chapter 10 RISK ASSESSMENT & MANAGEMENT-TO THRIVE AMIDST UNCERTAINTY (UPSTREAM FOCUS) Assessing and managing risks are essential functions for any organization. Due to such factors. the upstream sector of the oil and gas industry presents a higher degree of inherent risk than most industries. The main problems are the steel shortage. Because of this. 59 . With this in mind . experienced labor shortage (all levels). have caused the industry to begin implementing detailed planning and risk management. Getting oil fields and equipment (onshore and offshore installations) working as fast as possible is important. These problems. The upstream oil and gas industry shares with some other businesses.and a strong risk management knowledge base . While international economic and political events increasingly affect all businesses. the industry remembers the downtimes in the ‘90s and is wary of the current high prices. coupled with reserves becoming more difficult to locate and more expensive to develop. Maintaining a higher risk profile. additional expertise. such issues have long been concerns for oil and gas companies. Today. also heightens the importance of assessing and managing risks to ensure that any potential internal or external threats an entity faces do not exceed its risk appetite. this period is typically between ten to fifteen years Shortages compel Asian upstream sector to focus on risk management The Asian oil and gas industry is facing difficult times. The main problem with risk management in the industry is the lack of tool usage to help in the automation of the risk processes being used. reserves in oil and money are being shored up. Payback is defined as the length of time between the initial investment in a project by the company and the generation of accumulated net revenues equal to the initial investment In the oil industry.

and electric power take center stage for investment in this growing and emerging market. The Asia Pacific region continues to be the most dynamic oil market in the world with demand at 25. has repeatedly failed. India. Thailand. making it among the highest of any commodity. Taiwan. This area has surpassed Europe and will soon eclipse North America as the primary region of world oil demand. Most of this increased consumption will be sourced from the Middle East from where over 70% of the supply currently originates. gas. Deregulation and globalization of energy markets are bringing the need for active management of risks. In this environment. and the Association of Southeast Asian Nations (ASEAN) countries by the year 2010. Coupled with governmental policy changes encouraging deregulation. the future appears bright. and foreign investment. Risk avoidance . That is about to change due to the twin engines of deregulation and privatization driving competition.4 million b/d in 2010. especially as the giant US market shifts away from the Middle East to a greater dependence on Latin American producers. Oil exhibits annualized price volatility of 40% to 50% per year. less flexible Asian refineries that have 60 . Growing commercial ties between Persian Gulf producers and Asian consumers seem inevitable. Fortunately. with projections of 29.has long been the operative word in Asian oil markets.rather than risk management .4 million b/d in 2005. Taiwan. The markets are becoming more price sensitive with the rapid dissemination of price and market information. Yet risk prevails. the overriding concern has always been security of supply rather than price risk. the effectiveness of available risk management tools is more established and the knowledge base wider. particularly on futures exchanges. Asia Pacific oil and gas markets The Asia Pacific region is now recognized as the major growth area for energy demand. South Korea. and Singapore are expected to be importing oil at over one million b/d each. privatization. Japan. Oil is still the key fuel of the industrial world. It is estimated that 80% of Persian Gulf oil production will be exported to China. Japan. The need to automate risk management now exists out of competitive necessity. Since 1985. Oil. Deregulated markets bring competitive risks not previously experienced and energy risk management rises in importance dramatically changing market environments such as these. This region has vastly inadequate local crude oil production relative to its expanding needs and will need increased imports from outside the region. India. It will also touch on the technology that can help managers automate the process of identifying and mitigating risk.This article will explore the current problems the Asian oil and gas industry are facing and how risk management is helping to solve those problems. In the Asia Pacific region. Asia has accounted for more than 70% of total world oil demand growth. By 2006. While some Atlantic Basin crude oil from West Africa and the North Sea may supply some of the older. South Korea. China. the use of energy risk management tools. Oil markets The importance of the Asia Pacific region in terms of world oil demand and refining cannot be understated.

With about half of world oil growth projected to continue to be in the Asia Pacific region. Deregulation as a market driver The most significant political driver of the market in Asia is the deregulation effort underway in the energy sector in most countries. 61 . This increased dependency on oil presages an era of continued price volatility and the growing need for additional risk management instruments to be developed and utilized in the Asian markets. Indonesia. the need for managing energy price risk seems poised for explosive growth over the next several years. rising product demand and tightening fuel quality standards driven by rising environmental awareness. This movement to freer competitive markets will mean that risk will increasingly be shifted to energy companies and away from government protection. it has taken an inordinately long time to get started in the region compared to the North American and European experiences. In fact. Another reason is the need for strategic stockpiling of oil and products for energy security reasons. Asia will need more imported crude oil in the coming years as output declines in Indonesia and only some oil production increases in China. Sour crude barrels will come from Mexico and the United States. seems to be slipping from being a global supplier to being a net user of petroleum. South Korea. has already undergone more storage capacity increases.an appetite for those sweet crudes. the key issue is the growing Asia Pacific dependency on Middle Eastern sources of crude. Fundamental changes in Asian oil markets For refiners and traders. These and other projects are an attempt to reduce the transshipment costs of Singapore facilities. However. India. Malaysia. product import dependency is also rising at an astounding rate. China became a net oil importer during 1993 and its needs will continue to grow. Singapore. Moreover. Papua New Guinea. regional storage seems to be taking hold as evidenced by Chinese oil stockpiling this year. China. as an active regional transshipment center. petroleum storage requirements are another area affected by deregulation and are a growing area for risk management. and Vietnam. which is still a dominant part of the Asian energy puzzle. despite the expected short-term increases in output from Australia. particularly because of the more protectionist Asian economies. Changing markets and oil trade patterns presage rising price volatility. Many storage expansions have been announced throughout the region. and Thailand have all announced that large-scale storage projects are underway. Subic Bay in the Philippines is another strategic location. an OPEC member and current oil exporter.

it seems likely that this is the beginning of the change to a more financial rather than physical orientation in energy trading. In the Asia Pacific markets.While the Asia Pacific oil trade is still centered on security of supply rather than price risk management. Once considered a peripheral concept. have focused attention on risk management. securing market share. and others. reducing earnings volatility or increasing margins. New risks need to be intelligently managed. The key is reduction of risk. political changes in Asian countries should bring increased trade activity in both futures and derivatives.” These goals can include lower fuel costs. Fed by growing oil demand in the region and the growing interest in making Singapore the energy derivatives center for Asia. WorldCom. credit. the Asia Pacific markets are just beginning to emerge as the next opportunity for growth for the markets in energy. and operational risks remain pervasive in the Asian markets. particularly since oil. risk management is now a key management tool. Consequently. There is no cookie cutter approach of “one size fits all. effective risk management can be essential to achieving industry leadership. gas and power are the most volatile commodities traded. The objective of using risk management tools is simply to achieve corporate goals. such as Enron. not risk elimination (since that is impossible). there is actually less uncertainty than previously on the regulatory side as countries are making their deregulation plans known. The highly publicized financial debacles in recent years. As they move towards deregulation. 62 . Nonetheless. creating more interest in hedging and the use of energy risk management tools. Most importantly. market. a company’s risk tolerance must be identified.

the graying of experienced project managers is reducing available capabilities. At the same time. Such actions would probably void any political risk insurance that was obtained. although it is not as prevalent as it once was. which may seem obvious. The challenge therefore is to manage the political and other risks that are unavoidable in the industry. Effective techniques include keeping a low profile. and so-called "creeping nationalization" as evidenced by punitive taxation. maintaining close relationships with the host government. strategic alliances and partnering. by taking some actions. it will be faced with the need to consider political risk when investing outside its home country. How well these risks are analyzed and managed will often be key to a project's success. or pollutes the environment. pose a greater and probably more likely risk today. price and monetary controls. While political risk can be managed through insurance. no form of political risk insurance can protect a company if it engages in bribery or corruption. anticipating change and working with it. Risks of contract repudiation such as was experienced by Enron in India. Classic political risk in the form of expropriation and nationalization remains a threat. These factors combined increase the level of project-related risk within the sector. being a good corporate citizen and utilizing local suppliers and personnel to the greatest extent possible so as to create an economic link with the host country that establishes a national constituency with a stake in your continued political survival. or entering into the space from adjacent energy sectors. Unless a company follows a strategy of complete risk avoidance and stays solely within its national boundaries. However. 63 . Remember. avoiding geographical concentration. burdensome labor and environmental regulations.CONCLUSION Upstream projects today are getting larger and more complex. but are too often ignored. it can also be minimized. that expropriation or nationalization does not in and of itself violate international law. provided there is prompt. moving from investor to operator. fair and adequate compensation to the investor. The attraction of upstream profits is also driving many companies to consider expanding their investments.

ey.com www. proceedings of a conference held by the International Economic Association. University of Aberdeen.bseindia.nseindia.com 64 .org www. Sloan Management Review Journal of Business Finance and Accounting. submitted in partial fulfillment of the degree of Master of Business Administration. New York Thinking small about oil. The London International Petroleum Exchange (IPE) Asian Petroleum Price Index: Tapis Crude & Dubai Crude www. volume 27 Journal of Petroleum Technology A financial calculus: An introduction to derivative pricing Journal of Political Economy Harvard Business Review Risk and Uncertainty.BIBLIOGRAPHY Energy Price risk by Tom James Coping with strategic uncertainty. Management Today Applications of Risk Analysis and Investment Appraisal Techniques in Day to Day operations of an upstream oil company. June. Derivatives and Risk management in Oil & Gas industries by KPMG Caspian Oil and Gas: Mitigating Political Risks for Private Participation Shortages compel Asian upstream sector to focus on risk management by : Steve Cook Risk Management in Oil & natural Gas industry by NYMEX.com www. Macmillan.dghindia.

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