From discovery to development

SUMMARY

This article provides insight into the use of structured analytical methods to increase value creation for oil and gas projects. We start with a exploration prospect and describe how important decisions and uncertainties can be addressed through the different phases from exploration to development. We review how a project of this type is organised and how decision-making depends on good interdisciplinary collaboration. We also take a closer look at different analytical concepts such as real options and value of information, and we demonstrate how these can be applied in practice. The example we use is derived from the oil and gas sector, but it provides insights into issues that are relevant to many different industries.

INTRODUCTION

Oil exploration involves cooperation between various experts from many different areas of expertise. The collection and analysis of seismic data forms the basis and helps to create a picture of sub-surface geological structures. When structures that may contain hydrocarbons are identified, one can perform exploration drilling.

In the exploration phase there are two main types of exploration wells; wildcats and appraisal wells. Wildcats are drilled to confirm whether a geological structure contains hydrocarbons. If hydrocarbons are found, one or several appraisal wells are usually drilled to obtain more information. Such information is used to assess whether the discovery is commercial and to evaluate how the discovery should be developed.

This example is based on a geological structure in the North Sea where it is considered to drill an exploration well. One of the main challenges in the North Sea is to find additional resources near existing and planned infrastructure. It is important to prove additional resources while the large facilities are still in production. Even very small discoveries can be profitable if they can be produced from existing infrastructure. In addition, tie-in of new discoveries to existing fields can extend the life of the host field and contribute to continued profitable production and increased recovery from the field. To succeed with this strategy, various aspects of the exploration phase must be carefully considered, including the location of the exploration well, the cost/benefit of appraisal wells and the final selection of development solution.

The petroleum industry in Norway

The petroleum industry is Norway's most important industry in terms of contribution to government revenue, the size of capital investments and share of total value creation in the country. Since production on the Norwegian continental shelf started in the early 1970's, petroleum activities have contributed more than NOK 12 trillion to Norway's gross national product measured in today's value. Still, only about 50 percent of what one expects to be the total recoverable resources on the Norwegian continental shelf, is currently produced. In the period 2007 to 2016, about 330 exploration wells were drilled, of which 170 resulted in discoveries, while a significantly smaller number was considered commercially viable.

PROJECT TEAM

The project team is a multi-discipline team consisting of representatives from each contributing discipline. The decision analyst has a key role and is responsible for the decision analysis as such, including framing, problem structuring and the overall economic evaluation. The decision analyst brings the project team’s combined experience together. The decision analyst needs to be able to apply a logical and consistent framework to provide the team with important insights to the decision problem and ensure that the team arrives at proper decision basis. Any of the involved disciplines could in principle take the decision analyst role of integrating all discipline contributions throughout the different iterations of the decision analysis work process.

Sub-surface uncertainties are usually the key value driver in exploration projects. The decision analyst therefor needs to have particularly close communication with the G&G discipline. This is to ensure that all geological aspects that will influence on the technical and economic evaluation of the field development case are included in the evaluation. Typical G&G challenges such as alternative conceptual geo-models, depositional system, compartmentalisation and degree of vertical connectivity may have influence on the economic value of the prospect both directly and indirectly. It may also have influence on project decisions related to the optimum appraisal strategy, drainage strategy, drilling strategy and development solution. All this needs to be captured in the evaluation.

PROJECT PHASES

THE STAGE-GATE MODEL

The prospect is evaluated as part of a stage-gated process, often referred to as a Capital Value Process (CVP). General to all stage-gated processes is that the project is divided into stages, each corresponding to a key decision point in the value chain. These decision points typically concur with the points in time where major capital investments have to be committed to move the project(s) forward.

The exploration process used by the company is shown below. The next decision gate to be passed for this project is EXP Gate 5. The decision is whether or not to drill the exploration well. The exploration well represents the capital investment to be committed.

The EXP decision gate 5 is similar to any other decision gate in the CVP process and can only be passed based on an appropriate decision proposal and approval from the project owner.

In order to get this approval it is not enough to show that a positive economic value is probable. The project competes for available funding with other projects and might not be prioritised if other projects yield higher return. It is therefore necessary to develop a more comprehensive decision support package that represents a realistic economic evaluation of the project, including a benchmark to other projects if applicable.

The decision support package should be subject to appropriate quality assurance by an independent team (peer review) before presented to management for decision. Proper quality assurance and benchmarking provides confidence that the project has been evaluated in a consistent way according to company guidelines. A proper evaluation and presentation of a realistic economic value allows the project to be compared with other projects as part of an exploration well prioritisation process – resulting in a final drill or no drill decision. It also allows for portfolio modelling activities and higher level strategic business decisions.

DECISION PROCESS

DIALOGUE AND COLLABORATION

The process of establishing the decision proposal for the drill/no drill decision for the exploration prospect is achieved through a collaborative process that consists of the 5 main steps (A-E) illustrated below. This is the same decision process as used for development projects. However, a somewhat simplified evaluation is appropriate due to the nature of exploration projects and the purpose of the evaluation:

Close interactions between the management group and the project team is important throughout the evaluation. The project team is responsible for the evaluation as such and the management group approves each step and approves the ultimate decision proposal.

In larger corporations the Exploration management group usually consists of an Exploration Area manager, Exploration Strategy and portfolio manager, Exploration Finance and control manager and representatives from other supporting functions. The project team consists of a decision analyst, representatives from the different technical disciplines, a commercial representative and last, a representative from health-safety-environment (HSE).

REALISTIC ECONOMIC VALUE

Exploration projects are usually characterized by limited data and significant uncertainties. It is therefore also a limit to the level of sophistication in the modelling and evaluation that is meaningful to carry out. The purpose of the evaluation is to arrive at a realistic economic value that can be used in the well prioritisation process and as part of portfolio modelling and strategic updates. The main evaluation requirement is therefore to arrive at a sensible decision sequence and representative development solution that provides a realistic economic value. This is different from typical development projects where the decision process is used to prepare the ground for a development decision – thus requiring much more detailed studies of alternative drainage strategies and development concepts.

THE FIVE MAIN STEPS

The decision process typically consists of five main steps as described below. Identifying the uncertainties that have the most impact on value helps the project team and the management group to focus on the right issues. Real option analysis helps to identify additional value creating potential by taking advantage of inherent uncertainties. Probabilistic modelling and reasoning is used to quantify risk/uncertainty and determine whether additional information has value creating potential and should be collected before committing to a given course of action.

To enable the management group to make a sensible decision, the decision basis should include informative results plots that typically include decision trees, influence diagrams, waterfall diagrams and sensitivity plots – in addition to an overview of the technical basis itself.

If the exploration well is drilled with a successful result, the exploration team is responsible for the handover of the new discovery to project development. Some of the exploration team members may transfer with the project to the new phase, but additional manning – and knowledge transfer – is usually required.

SETTING THE FRAME

Setting the right frame is the initial activity in the decision process. The objective is to reach agreement on the frame among all team members and receive management approval and support to kick off the project. Approving the frame is the responsibility of the exploration management team, but developing the frame is a joint effort by the management team and the exploration team. The strategic dimensions are developed by the management team, whereas the technical dimensions are developed by the project team. Guiding questions are often used to develop the frame for a project. After the frame has been set, issues (decisions,uncertainties and facts that the project need to consider) and feasible alternatives to move the project forward are identified and assessed.

Guiding questions	Answer
What and when is the next decision point we need to pass?	The next decision point is EXP Gate 5, 15th July
What is the main decision criteria?	The main decision criteria is NPV
Are there any other factors of concern that can influence on the decision?	Drillex is a factor of concern since this year’s exploration commitments already take a significant portion of the exploration budget
What are the most important technical dimensions that need to be addressed?	An optional appraisal well may provide critical information to prove that a potential discovery is commercial
Have opportunities or threats been identified that should be included in the decision basis?	The project needs to be seen in relation to two prior exploration wells that are being drilled by the same rig
Who are the main stakeholders, both internal and external?	The largest partner has a bigger portfolio and different risk profile from us and is willing to take bigger risks
Who should be involved in the project at the current stage to move it forward?	This is a multi-discipline project with required input from G&G, reservoir, drilling, facilities, economics and HSE

THE AGREED FRAME

A decision support package needs to be developed in time for the next decision point, EXP Gate 5, that is planned for 15th July. The main decision criteria is NPV, but the project should also present the capital efficiency indicator NPV/Drillex, for use in the well prioritisation process given the tight exploration budget. The most important technical dimension is perceived to be commercial/non-commercial reserves, and the project team needs to address this in the decision proposal by presenting a recommended appraisal program. Schedule is also of concern and the project needs to look into the rig timing and availability. Since the largest partner is probably willing to take bigger risks than us, the decision proposal needs to evaluate the option to go directly for development. It is likely that such a fast-track option is preferred by the partner and hence will be debated in the next license committee meeting. The core exploration team is responsible for the evaluation and no outside expertise is required at this stage.

ALTERNATIVES

IDENTIFY KEY DECISIONS, RISKS AND UNCERTATINTIES

After the frame for the exploration project has been agreed upon, the next step is to identify key decisions, risks and uncertainties. This should be done as early as possible to ensure that the team has its focus on relevant issues from day one. The project manager calls for a kick-off meeting where the frame is presented and relevant issues are raised and sorted. The objective of the meeting is to surface all material that needs to be dealt with by the project.

As preparation for the meeting, each team member is encouraged to note down issues that might be of interest to the project. When the team members come together later they can pool their issues and ideas as part of a semi-creative brainstorming session. Using post-it notes (or specialised brainstorming software) allows for easy sharing and sorting. Red is typically used for decisions, green for uncertainties and yellow for facts.

Decisions
Drill or no drill
Exploration well location
Development concept
Appraisal well
Platform deck space
# of free well slots
4D seismic
WAG injection
Drainage strategy
Length of horizontal well section
...

Uncertainties
Direct fluid indicator
In-place volumes
Expected recovery
Oil or gas?
Rig availability
Drilling time
Commerciality
Depositional system
...

Facts
EXP Gate 5
Water depth
Pc
Trap (rotated fault block)
...

WHICH DECISIONS ARE THE MOST CRITICAL

After all issues that need to be dealt with by the project have been identified and documented, the next step is to agree on which decisions are the most critical and which can be taken later. The decisions are separated into three groups: Policy decisions, strategy decisions and tactical decisions.

It is critical that the whole team agrees on which decisions to focus on initially and which decisions can be dealt with later. No project team can work on every decision at once. In this step of the decision process we identify the decisions that matter most—the project’s focus (strategy) decisions. Some decisions clearly stand out as important, for instance the development concept and a first-pass drainage strategy. However, decisions that initially seem insignificant from an economic value perspective, may turn out to have a significant value creating potential that must not be overlooked. In this exploration project, such decisions relate to the exploration well location and appraisal strategy. Proving (non-)commerciality early rather than late can save a significant amount of cash.

The agreed decision hierarchy for the exploration project is shown below. It is further agreed that a number of additional “later”-decisions will have to be dealt with given exploration success and if the project is approved for further appraisal and development. However, this is not the focus point at the current stage of the project, where the main objective is a realistic economic value for use in the well prioritisation process.

DEFINING THE ALTERNATIVE STRATEGIES

After the decision hierarchy has been completed, and the focus decisions have been agreed upon, the next step is to transform this set of decisions into alternative strategies. Strategy tables help the project team to clearly define and structure the alternative strategies. It is also a good communication tool in order to receive approval and feedback from the management team.

The focus decisions that are the basis for the strategy table in our exploration project are shown below.

STRATEGY THREADS

A strategy table can be developed using different formats and tools. In this exploration eCase example, a simple Excel table is used, where each decision is entered as a column header and possible decision alternatives are listed down the rows of each column. One complete strategic alternative can then be generated by tying different decision alternatives into strategy threads.

Three strategic alternatives that are significantly different from each other have been identified in our exploration project. Each of the three strategies have the same objective, namely to maximise NPV. However, the means by which to accomplish this differs. This is further explained below.

COMMON DIRECTION

The strategy table allows the team to work in a common direction. Having agreed upon the different strategy alternatives, it also becomes clear what data/studies/information is required to evaluate each alternative.

Note: Each strategy thread in the strategy table represents a set of actions that fit together. There may be a multitude of possible combinations, but not all of them go logically together. Depending on the context, a handful of possible strategies can usually be defined that are significantly different from the others. In exploration projects, the number of focus-decisions are often limited resulting in a simple strategy table with few entries. It should take little time to construct, but nevertheless serves its purpose of providing a common direction for the team and represents a basis for dialogue between the project team and management.

VISUAL COMMUNICATION

Influence diagrams are used for visual communication of different decision situations. They are closely related to decision trees and use a flowchart like structure to show relationships between decisions, uncertain outcomes and value. In addition, influence diagrams can be used to show the dependencies among variables more clearly than can be achieved using a decision tree. Influence diagrams can be particularly useful to brainstorm and communicate ideas at an early stage, and they provide a more compact representation of a decision situation compared to decision trees. The following steps have been taken to construct the influence diagram:

Step 01 – Decision sequence with main alternatives for each decision
Step 02 – The exploration report is determined based on the decision to drill the exploration well or not and the information from the well represented by the indicator node
Step 03 – The information from the exploration and appraisal wells (indicators) is relevant for our understanding of the physical reality of the reservoir illustrated by the arrows between the indicator and physical reality nodes
Step 04 – Additional information from the exploration and appraisal reports becomes known as the decision sequence unfolds
Step 05 – The reservoir, concept decision and drainage strategy decision are relevant for the production profile
Step 06 – Each of the decisions in the decision sequence has direct influence on the CAPEX/OPEX profiles
Step 07 – The revenue profile is a direct function of the production profile and the oil and gas prices
Step 08 – Resulting Influence Diagram with economic value represented by the hexagon, decisions by rectangles and uncertainties by ovals

This has resulted in the influence diagram below that is used as a visual representation of the main aspects of the decision situation (click for animation of each of the steps taken to construct the diagram). The diagram is also used as basis for the economic modelling of the project together with a decision tree.

DECISION TREES

Decision trees can be used both as a visual communication tool and as an analytical tool. Decision trees are closely related to influence diagrams and use a flowchart like structure to show relationships between decisions and uncertain outcomes. Drawing decision trees is seldom straightforward and a significant degree of experience is required to get it right.

A good theoretical foundation in economic theory and general decision analysis methodology is required to construct decision trees that are fit for purpose and contain the right level of detail. In our exploration example, the decision tree below is used as a representation of the problem structure covering the main aspects of the decision situation (click to enlarge).

The tree may need to be revised later as decision analysis is often an iterative process, where intermediate results can shift the focus of the team or uncover the need for additional information before proceeding with the evaluation. New information may also become available in the middle of the decision process, and this needs to be reflected in updated models.

Each of the event nodes in the decision tree (green circles) represents a point were information is revealed and uncertainty is (partly or fully) resolved. This is an important distinction from points were uncertainty exists, but is not resolved. The remaining unresolveduncertainty is represented by expected cash flows at the end nodes. The project will have to live with this remaining uncertainty. Note that the remaining uncertainty may differ between end nodes, and may be partly relevant (systematic or non-diversifiable) or irrelevant (diversifiable).

The event nodes, where information is revealed, corresponds to the “Indicator” and “Report” nodes in the influence diagram. It becomes clear from the decision tree above and the influence diagram discussed in the previous topic that the information available at the point of each of the development decisions, will be different from the present information about the “physical reality” (the reservoir). This needs to be reflected in the evaluation of the decision tree.

EVALUATE

ESTABLISHING THE TECHNICAL BASIS

After the problem structure has been established the next activity in the decision process is to evaluate the strategic alternatives. The project team starts the collaborative phase of establishing the technical basis, the time frame and the cost estimates for the agreed alternatives and the possible outcomes. This lesson covers key aspects of the modelling and evaluation of the exploration project.

The project team starts the modelling by establishing the technical basis, including the time frame and the cost estimates for the agreed alternatives and the possible outcomes. Relevant contractual elements, HSE (health, safety and environment) requirements and country risk issues are also assessed in this phase.

The main deliverables from the different contributing disciplines in our exploration project are discussed below and constitutes the technical basis.

G&G

The geological evaluation is the basis for the analysis and includes geological details about the prospect, the regional geological setting as well as the current play understanding. The geological evaluation results in a geological probability of discovery (Pg) and an in-place volume distribution for the prospect given discovery.

In our exploration project, Pg is estimated to be 40%. The main uncertainty driver for the in-place volume distribution is the Oil-Water-Contact (OWC). The In-place volume distribution and tornado diagram are illustrated below.

RESERVOIR

The reservoir discipline evaluates reservoir and fluid properties based on the input from the G&G discipline. This is used to establish a potential drainage strategy with a corresponding recovery factor, production profile and the required number of production and injection wells.

For the tie-back solution, the drainage strategy is pure depletion, whereas for the stand-alone development, the drainage strategy is water injection. The production wells are placed on the top of the structure for both drainage strategies. The expected recovery for the depletion case is 30% and the expected recovery for the water injection case is 50%.

DRILLING

The drilling discipline establishes a drilling strategy in accordance with input from the reservoir discipline. This includes determining the likely rig rates and establishing a drilling schedule. The main delivery from the drilling discipline is the estimated well cost, typically complemented with a risk table describing the key drilling risks.
The exploration well is planned to be drilled either up-dip or down-dip, and up to three appraisal wells are planned. For the tie-back solution, two four slot-templates are used in the expected case, whereas the stand-alone solution has 12 well slots. All combinations need to be evaluated.

FACILITIES

The facilities discipline establishes the design basis for the development based on compiled Met ocean data. This includes determining a suitable development concept, infrastructure requirements that include all elements from reservoir to market, and an overall schedule for the project. Capex and opex estimates, together with a key risk list are also among the main deliverables.
As mentioned previously, there are two development options under consideration – a tie-back solution and a small stand-alone solution. The differences in CAPEX and yearly OPEX is illustrated below. Note that the tie-back solution also requires tariff payments to the host platform.

ECONOMICS

The economics discipline establishes the cash flow and fiscal models and evaluates contract terms and country risk where applicable. The economics discipline will also make sure that an appropriate price assumptions set is used. Depending on the size and inherent risk of the project, the economics discipline will also be responsible for establishing an appropriate discount rate for the project, unless a “standard” discount rate can be used.

In our exploration project, an already established economic model is used, and a standard discount rate of 10% is applied. This is under the assumption that the project is part of a fairly large portfolio and does not contribute to an increase in the overall risk level for the total portfolio. A pre-liminary project cash flow is illustrated below for one of the strategy outcomes.

HEALTH, SAFETY AND ENVIRONMENT

The HSE discipline establishes the health, safety and environmental risk assessment. These deliverables are usually not included directly in the decision modelling, with the exemption of Co2 emission estimates (direct costs) and any identified risks that may have a direct and substantial impact on the economic value of the project. Such risks are normally identified as part of the issue raising session and included in the influence diagram and decision tree structure. Most HSE risks are typically handled during project execution and therefore not included in the problem structure at this stage.

ADVANCED MODELLING

REAL OPTIONS

A real option is “the right, but not the obligation, to undertake a certain business initiative”. It is linked to the flexibility to make a decision some time into the future based on revealed information. This allows the project to avoid downsides and / or exploit upsides. The value potential of the information has to be weighted against the cost of revealing the information.

In exploration, the whole sequence of exploration – appraisal – development – production can be seen as a compound option problem. Success in the exploration phase gives the real option to appraise further or to start development of the project. In each phase, information is revealed and underlying uncertainties need to be updated to reflect this information.

The exploration – appraisal – development sequence is so well incorporated into exploration projects that we do not always see this as solving a real options problem. However, discussing it in a real options context ensures that (learnable) uncertainties are updated correctly for different strategies and outcomes. It also increases the likelihood of identifying additional real options and value potentials.
Identifying real options

One way to identify real options is to take different decisions and pick uncertainty(-ies) you would be able to «learn» (know outcome of) before you have to make the next decision. An example with basis in our exploration project is explained and illustrated below:
If the point is reached where commercial reserves has been proven, the next decision would be to choose between either going for a tie-back solution or to drill additional appraisal wells to see if the reserves basis is large enough for a stand-alone solution*
Given that the decision is taken to drill additional appraisal wells, information will be revealed about whether or not the reserves basis is large enough to justify a stand-alone development solution. The decision maker can then exercise the option to go for a tie-back or a stand-alone development solution based on the new information

VALUE OF INFORMATION

Each of the three exploration strategies has specific real option and value of information aspects that need to be looked into as part of the modelling and evaluation of the project.

The potential value of a real option is connected to the magnitude of the underlying uncertainty. It is therefore critical to start the real options evaluation by identifying the main uncertainty drivers for the project.
In our exploration project the main uncertainty drivers are Pg and the oil-water-contact. The focus-point of the exploration and appraisal strategy is therefore to reveal information about these underlying uncertainties.

The geological risk represents a minimum producible volume where shows, non-producible reservoir and similar are categorised as a dry well. Other factors such as well location, may impact on the probability of proving a volume larger than the minimum volume.

In our project the exploration well is planned to be drilled either at the top of the structure (Strategy 1 and 2) or down-dip (Strategy 3). The motivation for drilling up-dip is to maximise the chance of proving hydrocarbons (proving hydrocarbons may have a strategic value in itself), whereas the motivation for drilling down-dip is to maximise the value of information (commercial/non-commercial) and minimise the needs for further appraisal.

The probability for discovery will depend on which of the two well locations that are chosen. For Strategy 1 and 2, the probability for discovery will be equal to Pg (the geological risk). For Strategy 3, the probability for discovery will have to be adjusted in accordance with the probability for proving a minimum commercial volume. This probability is denoted Pc (the commercial risk) and is explained in more detail below.

MINIMUM COMMERCIAL VOLUME

The minimum commercial volume is defined as the minimum producible volume that is required for the project to be commercial. The minimum commercial volume is usually different from the minimum producible volume as defined by the geological risk. The minimum commercial volume can be calculated from the Volume (V) where NPV=0.

In our exploration project, the minimum commercial volume is illustrated below and is mainly a function of the oil-water-contact, and secondly the reservoir quality. The two curves representing Economic value versus Recoverable oil are extrapolated from a few economic realisations with different reserves outcomes and reservoir characteristics. The probability for proving a minimum commercial volume is approximated to be around 80%. Pc (the commercial risk) is now given and equals Pg x P (minimum commercial volume) = 40 x 80% = 32%

INITIAL APPRAISAL WELL

The objective of the initial appraisal well is to identify whether or not the discovery is commercial before rather than after a subsequent development decision.

If the planned exploration well is drilled at the top of the structure it cannot reach far enough down-dip on the structure to prove a deep contact / commercial reserves. An appraisal well is therefore considered to reveal this information. The probability of proving a minimum commercial volume has already been estimated (80%) and the decision tree can be populated with this information as shown below.

FURTHER APPRAISAL

The optimal number of appraisal wells depends on the total potential to optimise the project based on additional information. A more extensive appraisal program may be required to prepare the ground for a subsequent development decision or for example to optimise the drainage strategy and increase the recovery.

In our exploration project the reserves basis may be large enough to justify a stand-alone development, hence the main objective for further appraisal is to test the upside of the prospect. The number of appraisal wells required to prove an upside case large enough for a stand-alone development therefore needs to be evaluated. The probability for the upside case is given by the reserves distribution and the decision tree can be updated as illustrated below.

RESERVES BASIS FOR THE DIFFERENT CASES

The reserves basis used in the different branches of the decision tree also need to be updated reflecting the relevant information that has been revealed for each case/outcome. This is illustrated below. Note that the drainage strategy will also be different for the tie-back and stand-alone solution, where the tie-back solution is pure depletion, whereas the stand-alone solution is water injection. Reservoir models, drilling plans and more need to reflect this when evaluating the different branches of the tree.

NON-LINEARITIES

We use the term non-linearities to represent skewness in the relationships between model input parameters and model results. Non-linearities usually limit the upside, whereas leaving the project fully exposed to the downside. Such imbalances may have a significant impact on decision-making and economic value.

In oil and gas projects, the most important non-linearities are often linked to volumetric uncertainty and uncertainty in prices. Typical examples include:

Capacity constraints or other technical restrictions
Economies of scale
Learning curves
Commercial arrangements, for instance price ceilings
Non-linear tax systems

In our exploration example, the capacity constraint for the tie-back solution may represent a non-linearity that can have a significant impact on the economic value and that would require an appropriate modelling approach to be captured. The capacity constraint will limit the upside by the time-value-of-money-effect of delayed production for high volume outcomes, as illustrated below.

There is also a capacity constraint present for the stand-alone solution, but due to the short plateau period it can be assumed that the impact is insignificant.

ASSESSING NON-LINEARITIES

The results from sensitivity analyses may be used to reveal the effects of possible non-linearities. In this type of analyses, the analyst can quickly test if the relationship between an input parameter and a result parameter (typically economic value) is linear or non-linear by varying the input parameter between two set values, e.g. +/-30%, and keeping all other values constant.

In our exploration project the sensitivity analyses for the capacity constraint is shown below, where the volume is varied +/- 50% around the expected value. As can be seen from the illustration, the resulting value is not symmetrical around the expected value and we therefore have a non-linear relationship between input and output as we expected.

ESTIMATING THE ECONOMIC VALUE

At this point, the exploration project is in position to start solving the decision tree. Part of this is to choose an appropriate modelling approach. The recommended modelling approach depends on the size and risk level of the project, its complexity and the presence of real options and non-linearities. The two main modelling approaches are:

A deterministic approach based on expected cash flows
A stochastic approach (typically Monte Carlo simulation) with probability distributions for all uncertainties that have a significant influence on value

In our exploration project, it is decided to use a deterministic modelling approach. This is mainly based on the fact that the main evaluation requirement for the project is to arrive at a realistic economic value that can be used in the well prioritisation process.

Expected cash flows for all decision alternatives and possible outcomes are calculated making sure that they are truly expected. To achieve this, all relevant data is combined – at a suitable detail level – from the separate tools and models that are used on a disciplinary level in the project.

HANDLING OF THE NON-LINEARITY

In order to handle the non-linearity identified in the previous step of the evaluation, namely the capacity constraint, the decision tree structure needs to be slightly modified. The expected value for the tie-back solution is approximated using P10, P50 and P90 volume scenarios* that are weighted with 30% / 40% / 30% probabilities. This gives a more accurate estimate of the expected cash flows for the tie-back solution. This approach is often referred to as Swanson’s rule and provides a reasonable approximation to the expected value as long as the underlying uncertainty is modestly skewed and LogNormal.

The modified decision-tree structure is illustrated below.

RISK ASSESSMENT

Identifying and handling key risks and uncertainties are integrated parts of the project evaluation – through all the modelling steps.

It starts during problem structuring, where all the main issues – including risks and uncertainties – are discussed and systemised. It continues through the modelling phase where risk tables are among the main deliverables from each discipline. The main risks and uncertainties are thereafter used to discuss and identify real options and non-linearities, as well as taken into consideration when choosing an appropriate modelling approach.

In our exploration project, the main risks are Pg and the oil-water-contact. However, there may also be other risks and uncertainties in the project that have not yet received the required attention or been adequately treated. Critical review of all potential risks and uncertainties should therefore be performed at this stage in an economic value context.

There is not always a direct relationship between the magnitude of uncertainty inherent in an input parameter and the associated impact on economic value. To identify key value drivers, sensitivity analysis can be used. Each model input is adjusted from low to high (which are not necessarily symmetrical around the expected outcome value) and the response is compared with the other uncertain inputs. Different decisions can themselves represent sensitivities. This process can reveal which decisions are the most value driving decisions.

If additional key risks and uncertainties are identified, it is recommended to go through the different modelling steps again. The focus is the same, namely to consider the potential for additional real options or non-linearities and whether the selected modelling approach is still appropriate.

Reminding the team about the main risks and uncertainties may also help to keep the team’s focus on what really matters in an economic value context. This is particularly useful when results are calculated and compared and presented to management for decision.

DECIDE AND IMPLEMENT

DECISION BASIS

The optimum path is the optimum combination of decisions over uncertain outcomes, in order to satisfy a specific decision criteria, usually NPV.

The optimum path is determined by first working all values backward from the end nodes to the initial decision node:

At each event node, the value is determined by the probability-weighted average of the successor node values
At each decision node, the value is determined by the highest value of the immediate successor nodes

After all values have been calculated for the nodes in the tree, the optimal path can be identified by working forward through the tree and by choosing the decisions that maximise value creation following each uncertain outcome.

In our exploration project the decision tree structure has already been reviewed and approved by the management team as part of the decision process. The focus at this point is therefore on the calculated results for each of the alternative strategies and on the economic value of the optimum path.

The optimum path is highlighted in the illustration and corresponds to Strategy 1: “Minimise Risk”. The optimum path consists of 3 possible outcome paths:

There is a 32% probability to have a successful project with a tie-back solution that has an economic value of 324 MUSD after tax
There is a 8% probability to have a successful exploration well with an appraisal well that proves the reserves basis to be non-commercial
There is a 60% probability to have a dry exploration well

The economic value of the project is 84 MUSD after tax.

COMPARING ALTERNATIVES

In order to assess the robustness of the recommended strategy for the project, the optimal decisions are compared to the best alternative decisions at the different stages of the project. It is often easiest to follow the logic by working backwards from the end nodes to the initial decision node.

In our exploration project, there are two major decisions that are part of the optimum path. One is to either go for a tie-back solution or to appraise further to test if the reserves basis is large enough for a stand-alone development solution.

There is a 19% chance that the reserves basis is large enough for a stand-alone development solution, but the optimisation of the development decision is not enough to compensate for the extra appraisal cost and delayed time-to-first-oil.

EXPLORATION WELL POSITION

The second main decision that is part of the optimum path is to either place the exploration well up-dip or down-dip on the structure.

Strategy 1 and 3 are almost identical. Both have tie-back as the development option given success, but strategy 1 has an additional appraisal well. One would therefore intuitively believe that Strategy 3 would have the highest NPV, but this is not the case. The reason is that a lower recovery factor is used for Strategy 3 compared to Strategy 1, since it is believed that an appraisal well is required to optimise the placement of the production wells.

MAIN FINDINGS

To summarise the main findings of the project, a waterfall diagram is produced. There are many ways to produce and present a waterfall diagram. In our exploration project, the main focus is on the value of information aspects as shown below. The reason is that these aspects need to be communicated to management in order to justify the recommended appraisal well.

The non-linearity of the capacity constraint is also included in the waterfall diagram, since there may be an option to have a higher production capacity made available on the host platform. Management should be made aware of this issue too.

Strategic value is any value that can be created by the company that is greater than the inherent value of the project itself. That is, the company is able to generate greater profits than those that can be attributed to the project alone. A typical example in exploration is a play-opener. If the play proves to be successful, a number of exploration opportunities may materialise. This added value can be assigned to a project in order to make sure that the strategic dimensions are also discussed when the project is up for decision.

No strategic value has been identified in our exploration project, and the project value is therefore equal to the business case value.

SUMMARY

All the steps that explain how decision analysis methodology can be applied as an integrated part of project evaluations in oil and gas has been covered in this white paper. The case example may however, go to a detail level that is beyond what would be practical in actual exploration projects given the often limited number of sensible strategies and options. Nevertheless, it should allow the reader to gain a deeper understanding of the general process and the benefits of following a structured process in any evaluation. The main principles of the decision process can easily be adapted to suit projects with different characteristics.

With the right team, the time used for this type of evaluation is insignificant compared to the benefits: It allows the team to share insights about the main alternatives and uncertainties, test assumptions and make robust recommendations about the best path forward. Sub-optimal decisions in this project would cost the company an estimated 84 - 56 = 28 MUSD for choosing a sub-optimal well location and 324 - 281 = 43 MUSD for choosing a sub-optimal appraisal strategy. Choosing a sub-optimal development concept could potentially be disastrous for the company.

Collaborative problem solving

Ny teknologi, Offentlig sektor, Oil and energy, Olje og energi, Porteføljestyring, Privat sektor, Selskapsstyrer