03/03/2019

Koya University
Faculty of Engineering
Department of Petroleum Engineering
Third Stage

Petroleum Economics
Expected Value Concept

Farhad Abdulrahman
Assistant Lecturer

Expected Monitory Valve (EMV)

• Statistical Analysis
• Calculates average outcomes of future scenarios.
• Adopts a risk-neutral assumption
• Probability X Impact
• Decision Trees
• EMV of opportunities: +ve Values
• EMV of threats: -ve values

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Expected Value Concept (EVC)

 Previously discussed measures were all “no risk”
parameters.

 But petroleum exploration involves a high degree of

risk!

 Two way out:

 Doing direct risk analysis or
 trying to consider risk and uncertainty in a logical,
quantitative manner.

 Expected value concept combines profitability

estimates and risk estimates
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Risk and Uncertainty

 Risk:
– Addresses discrete (separate) events (e.g. discovery or dry hole)
– Can be both: A threat or an opportunity
• Uncertainty:
– Result depends on unknown circumstances (e.g. oil price)
– Occurrence probability of an event is not quantifiable
• Deterministic:
– Calculations using exact values for their parameters are called
deterministic
• Stochastic:
– Calculations which use probabilities within their model are called
stochastic.

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Definitions and EVC

 Expected Value (EV):
 The EV is the probability-weighted value of all possible outcomes.
 Expected Monetary Value (EMV):
 The EMV is the expected value of the present values of the net
cashflows
 EMV = EV (NPV)
• “Conditional”
– In this context “conditional” means that a value will be received only if a
particular outcome occurs.
– Often it is omitted/absent!
• Simple Example:
– EV Cost of Stuck Pipe = P(Stuck Pipe) * (Cost to remedy Stuck Pipe)
• More generally:

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Example 1.0 of EMV

 Situation in a drilling prospect evaluation:
 Probability of a successful well 0.6
 Two decision alternatives:
 Farm out: A producer is worth $50,000, a dry hole
causes no profit or loss
 Drilling the well: A dry hole costs $200,000, a hit brings
(after all costs) $600,000
 EMV Decision Rule:
 When choosing among several mutually
exclusive decision alternatives, select the
alternative having the greatest EMV.

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Solution

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Characteristics of the EVC

 Mutually exclusive outcomes
 Collectively exhaustive outcomes
 The sum of probabilities for one event must be
one
 Any number of alternatives can be considered
 Normally values are expressed in monetary profit,
therefore “expected monetary value”
 The EMV does not necessarily have to be a
possible outcome

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Concerns about the EV Concept

 Is there a need to quantify risk at all?
 No benefit seen in using the EV!
 We don’t have probabilities anyway…
 Every drilling prospect is unique,
 therefore we have no repeated trail!
 Isn’t EV only suitable for large companies?
 For sure other concerns override EV!
 “…EMV is not perfect. It is not an oil finding tool,
and it is not (…) the ‘ultimate’ decision parameter.”

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UTILITY THEORY
• Utility theory states that each individual has a
measurable preference when faced with choices
among alternatives uncertainty, which is called his
“utility”.

– It has unit called utiles

– The relationship between utiles and dollars is called an

individual’s utility function (curve).

– The function is strictly personal and differs among

individuals

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Utility Key Points

• Want satisfying power of commodity
• Subjective
• Not same as usefulness
• Ethically neutral (Economy does not
differentiate between ethical and unethical
goods)
• Anticipated satisfaction

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Example 2.0 of EMV

A company is planning to embark on a drilling
venture. The possible outcomes of the venture are
given below and the utility curve of the company is
attached:

Alternatives
Outcomes Probability Farm Out
Drill
(1/8 RI)
Dry Hole 0.4 - 200,000 0
5 BCF 0.6 + 600,000 +50,000

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Solution of Example 2.0

 EMV of Drill = (0.4)(-200,000) + (0.6)(600,000) = $280,000

 EMV of Farm Out = (0.4)(0) + (0.6)(50,000) = $30,000

Drill is the preferred choice.

 EUV of Drill = (0.4)(-8) + (0.6)(2) = -0.80 utiles

 EUV of Farm Out = (0.4)(0.4) + (0.6)(0.6) = 0.28 utiles

Farm Out is the preferred choice.

 The difference between the EMV and EUV decisions occurs
because the potential loss of $200,000 overrides the potential gain
of $600,000.

 Without the use utility theory, the company would have made the
wrong decision.
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Decision Factors Controlling EMV

• In the oil industry, the decision for making
investment is controlled mainly by the
following two phenomena:

1. Depreciation / Applicable to Equipment.

2. Depletion / Applicable to Mines, Quarries

and Other such wasting assets.

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Depreciation
• Remember that DEPRECIATION is just an
Estimate.

Depreciation is an accounting
estimate of the fall in value of a
fixed asset over time

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Methods of Computing
Deoreciaition
• Straight Line
𝐶−𝑆
𝐷=
𝑛

• Double Declining Balance

𝑚−1
2 2
𝐷= 𝐶 1−
𝑛 𝑛
Where:
D = Depreciation Allowance ($/year)
C = Original Investment ($)
n = Estimated Asset life (years)
m = Life of asset up to the time of calculation (years)

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Example 1.0
• A drilling bit with an estimated life of 5
years is purchased for $33,000. Its
salvage value at the end of the fifth year is
estimated to be $3000.

• Calculate the annual depreciation using

both methods (Straight-Line & DDB) .

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End

Next: Decision Tree Analysis

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