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

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

ii

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

iii

ACKNOWLEDGEMENT
Action springs not from thought, but from a readiness for responsibility.

I would like to express my deep gratitude to Mr. Ambuj Gupta and

for engaging me in different responsibilities and guiding all through
the project. Special thanks to Dr. Shalinder Pokhriyal for providing
me with this opportunity to work in this project.

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.
I hope with all your best wishes and blessings i deliver my best to
any responsibility assigned.

I would thank you from the bottom of my heart, but for you all
my heart has no bottom

iv

Table of Contents
Topic
1.
2.
3.
4.

Page No.

Introduction
Literature Review
A New Era in Petroleum Exploration and Production Management
Risk And Uncertainty
4.1 Risk and uncertainity Defined
4.2 Types Of Risks
4.3 What is Credit Risk?
4.4 What is Liquidity Risk?
4.5 What is Operational Risk?
4.6 What is Political Risk?
4.7 What is Market Risk?
4.8 Foreign Exchange Risk and Risk Management

5. Top Ten Risks in Oil and Gas Industry

6. Risks in Exploration & Production Projects in Oil and Gas Industry
6.1 Risk Analysis: Exploration
6.2 Risk Analysis: Field Appraisal and Development
6.3 Decision Making Process, Value of Information and Flexibility
6.4 Portfolio Management and the Real Options Valuations
7. Risk Management

01
03
08
09
10
11
11
11
12
12
13
13
14

19
19
21
22
23
25

7.1 Need for Risk Management

7.2 The Risk Management Process
7.3 Types Of Risk Management

25
25
36

8. Investment Decision in Oil and Gas Projects Using Real Option and Risk
Tolerance Models
8.1 Introduction
8.2 The integrated model
8.21 NPV of the projects cash flow
8.22 Optimal working interest (W)
8.3 Analysis of a capital-intensive project
8.31 Estimation of the risk of the project
8.32 The optimal rule of investment (F, K, V*)
8.33 The optimal working interest in the project (W)
8.4 Discussions and implications

38

38
40
40
40
44
45
50
52

9.

Use and Implementation of Risk Analysis

9.1 Example of Application - Well Cost Estimation
9.2 Analysis of Results
9.3 Conclusions and Final Remarks

55
55
56
56

10. Risk assessment & management crucial to thrive amidst uncertainty

(Upstream Focus)

59

11. Conclusion

63

12. Bibliography

64

List of Figures
1.
2.
3.
4.
5.
6.
7.
8.

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 Projects Risk Level
Sensitivity Of NPV, 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
Corporations tolerance
9. Cumulative Distribution for AFE

13
15
26
27
46
49
51
51
56

List of Tables
1.
2.
3.
4.
5.
6.
7.
8.
9.

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, 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

vi

10
30
41
44
45
47
53
57
58

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

vii

Chapter 01
INTRODUCTION
Introduction
Exploration and production of hydrocarbons is a high-risk venture. Geologic concepts are
uncertain with respect to structure, reservoir seal, and hydrocarbon charge. On the other hand,
economic evaluations contain uncertainties related to costs, probability of finding and producing
economically viable reservoirs, and oil price. Even at the development and production stage the
engineering parameters embody a high level of uncertainties in relation to their critical variables
(infrastructure, production schedule, quality of oil, operational costs, reservoir characteristics, etc.).
These uncertainties originated from geological models and coupled with economic and engineering
models involve high-risk decision scenarios, with no guarantee of successfully discovering and
developing hydrocarbons.
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. For instance, in the petroleum industry, managers are increasingly using decisionanalytic techniques to aid in making these decisions. In this sense, the petroleum industry is a classic
case of decision-making under uncertainty; it provides an ideal setting for the investigation of risk
corporate behavior and its effects on the firms performance. The wildcat drilling decision has long
been a typical example for the application of decision analysis in classical textbooks.
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. 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. This trend can
be seen in the last two decades. The new internationally focused exploration and production
strategies were driven in part by rapidly evolving new technologies. Technological advances allowed
the exploration in well-established basins as well as in new frontier zones such as ultra-deep waters.
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.
In this sense, this introduction covers a brief review of previous applications involving the
following topics: (1) Risk and Decision Analysis in Petroleum Exploration; (2) Field Appraisal and
Development, and Production Forecast under Uncertainty, (3) Decision Making Process and Value of
Information and (4) Portfolio Management and Valuations Options Approach. 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.

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

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

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

Another very interesting application, this one directed to a much common dilemma present in
certain drilling operations. 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,
(2) with weighted drilling fluid, (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.
He pointed out that, during actual drilling operation these four options are always available. In the
case that it is decided to drill further, then it is always possible to experience a kick or loss of
circulation depending on formation pressures. This risk analysis model stated that, since all the
decisions are related to the formation pressure and other drilling parameters, expected costs will also
be ultimately related to the same factor (the formation pressure.)
Using a Monte Carlo simulation technique, the author developed a way to evaluate the risks
associated with the given set of drilling parameters. Using the technique, it would be possible to
estimate quantitatively the cost of drilling further with existing mud, weighted mud, setting a casing,
abandoning the well and sidetracking. It should be noted that, the risk analysis model developed is
very sensitive to cost distribution of the intractable kick and degree of uncertainty in formation
pressure. For that reason, these two variables should be accounted accurately in order to estimate
precisely the expected mean value, or loss, (EMV) of different drilling situations.
Ostebo et al.6 presented a study on an area where qualitative and quantitative risk assessment
can be implemented to a great extend. After the Piper Alpha accident, Norway and UK issued new
regulations in which risk analysis has great importance. Knowing that offshore operations have
potential safety and operational problems and after experiencing the Piper Alpha accident, neither the
countries nor the companies would risk having another similar experience. As a result of that, risk
analysis became a very useful tool in the process of decision making to enhance platform layout,
operational procedures and orderliness together with safety and cost. Authors analyzed the
regulations issued by the Norwegian Petroleum Directorate (NPD), to promote use of risk analysis
techniques in offshore operations.
They have defined and explained the Concept Safety Evaluation (CSE), which is a method of
quantified risk analysis. 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. In addition, the authors showed different ways of applying risk analysis in
the areas of reliability and availability analysis, safety management techniques and human and
organizational factors during offshore operations.
Ottesen et al.7 developed a new wellbore stability analysis method, which combines a
classical mechanical wellbore stability model with viability operational limits, for example,
hydraulics necessary to allow efficient cuttings transport in highly deviated wells. Those limits are
determined by quantitative risk analysis (QRA) principles. 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. 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.
5

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

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

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. It is a risky business in that most exploration projects are total failures while a few are
tremendously successful. Thus the best possible management of risk is crucial.
In the 1930s and 1940, the development of seismic data collection and analysis
substantially reduced the risk in finding petroleum. The resulting geology and geophysics (G&G)
revolutionized petroleum exploration. Decision analysis has traditionally been applied to the
information derived from G&G to rank projects hole by hole, determining on an individual basis
whether or not they should be explored and developed.
Today this ole-isticapproach is being challenged by a holistic one that takes into account
the entire portfolio of potential projects as well as current holdings. This portfolio analysis starts with
representations of the local uncertainties of the individual projects provided by the science and
technology of G&G. It then takes into account global uncertainties by adding two additional G :
geo-economics and geo-politics. It thereby reduces risks associated with price fluctuations and
political events in addition to the physical risks addressed by traditional G&G analysis. 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.
Portfolio thinking in petroleum E&P is based on understanding and exploiting the interplay
among both existing and potential projects. It does not provide all the answers, but encourages E&P
decision-makers to ask the right questions, such as:

If we want a long-term expected return of, say, 15% on our investment, 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, given the projects already in our portfolio?
How would oil projects, as contrasted from gas projects, 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, say, 40%
ownership of any project?

As we shall see, analytical models can help in directly addressing these and similar questions
once decision-makers in the petroleum industry become comfortable with the holistic perspective.

Chapter 04
RISK AND UNCERTAINITY
Any uncertain event that could significantly enhance or impede a Companys ability to achieve
its 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) Table 4.1 shows the definitions of risk and uncertainity as given by different authors

Table 4.1: Risk and uncertainity Defined

10

4.2) TYPES OF RISKS:

In general there are TWO broad categories of risk
Systematic Risk - Systematic risk influences a large number of assets. A significant political
event, for example, could affect several of the assets in your portfolio. It is virtually impossible
to protect yourself against this type of risk.
Unsystematic Risk - Unsystematic risk is sometimes referred to as "specific risk". This kind of
risk affects a very small number of assets. An example is news that affects a specific stock such
as a sudden strike by employees. Diversification is the only way to protect yourself from
unsystematic risk. (We will discuss diversification later in this tutorial).
specific types of risk that are faced by all businesses..
1.
2.
3.
4.
5.
6.

Credit risk
Liquidity risk
Operational risk
Market risk
Political risk
Foreign exchange risk

4.3) 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. This is one of the most critical aspects of business.
4.4) LIQUIDITY RISK
It is the risk that the Bank may not be able to meet cash flow obligations within a stipulated
timeframe. The purpose of the Banks 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.
Liquidity Risk - Factors.
Liquidity risk factors include competition among commercial banks for larger market share in
deposits, an unstable or potentially violent domestic political situation, the fluctuation of the
Rupee-Dollar, and implementation of government policies which may affect capital movements
in and out of India.

11

OPERATIONAL RISK
4.5) Operational Risk is the risk of potential losses from a breakdown in internal processes and
systems, human error, or management or operational failure arising from external causes. The
objective of the operational risk management framework is to ensure that the Bank has in place
appropriate policies, processes and procedures, and gathers relevant information relating to
operational risks so as to avoid operational failures and minimize relevant losses; while enabling
the Bank to quickly respond to and pursue new business opportunities under appropriate risk
controls and monitoring.
Operational Risk - Factors. Significant operational risk factors include:
Operational processes which may have flaws or weak control systems.
Inadequate staffing which may make it difficult for staff to perform their work effectively and
efficiently.
Technological developments which may affect the security of Bank data or information held on
behalf of customers.
Malfunctions in information processing systems.
Potential fraud by outsiders in terms of robbery, cheating, computer hacking, document
falsification, credit and debit cards fraud, etc.
Catastrophic events.
4.6) 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.
In general, there are two types of political risk, macro risk and micro risk.
Macro risk refers to adverse actions that will affect all foreign firms, such as expropriation or
insurrection, whereas micro risk refers to adverse actions that will only affect a certain industrial
sector or business, such as corruption and prejudicial actions against companies from foreign
countries. All in all, regardless of the type of political risk that a multinational corporation faces,
companies usually will end up losing a lot of money if they are unprepared for these
adverse situations.

12

4.7) MARKET RISK

Market Risk is the potential loss in value in a security from changes in market factors such as
interest rates, foreign currency value, and/or prices of commodities and equities.

Fig. 4.7. market risk

4.8) FOREIGN EXCHANGE RISK AND RISK MANAGEMENT

Crude oil prices are generally set in US dollars, while sales of refined products may be in a
variety of currencies. Fluctuations in exchange rates can therefore give rise to foreign exchange
exposures, with a consequent impact on underlying costs.

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.

13

Chapter 05
TOP TEN RISKS IN OIL AND GAS INDUSTRY

Risks are inherent in every forward-looking business decision. As a result, there has been a great
deal of work done and resources invested in risk management in the oil and gas industry in
recent years. Financial and regulatory risks have been the focus of much of this effort. But more
recently, companies have started including operational risks, prioritizing them and thinking about
how they can manage and monitor all risks in a coordinated way. In collaboration with Oxford
Analytical, Ernst & Young examined the strategic risks facing oil and gas companies. This study
was not a random selection exercise but rather a structured consultation with industry leaders and
subject matter professionals from around the world. What follows are the top 10 identified
strategic risks for oil and gas companies.

1. Human Capital Deficit

The growing human capital deficit in the sector has become a significant strategic threat to the
industry. 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, not least in terms of staff.
Project delays and abandonment are as much a result of capacity constraints as financial
calculations, although the two are intimately linked.

14

Fig 5.1 threats: oil and gas industry

2. Worsening Fiscal Terms

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

15

3. Cost Controls
The third operational threat is the inability to control costs. This threat was considered great
enough to have a strategic impact, and a failure to manage the threat could undermine the
competitiveness of oil and gas companies. Participants agreed that the problem extends from
exploration all the way through the value chain, impacting everything from refinery build costs
to pipeline construction. The Upstream Capital Costs Index, which measures cost inflation in oil
and gas projects, has gone up by 79% since 2000, with most of that increase coming since May
2005.
4. Competition for Reserves
Competition for reserves by national oil companies (NOCs) is a major threat to international oil
companies (IOCs). Again, 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, bundled
with development aid, for example, wrote one study participant. This observation follows
evidence of such deals in the market.
5. Political Constraints
on Access to Reserves Recent estimates suggest that NOCs control 75% of proven global
reserves, making these companies the gatekeepers of the worlds oil and gas supplies. Unlike
unexpected shocks, this has been well publicized in recent years. For the major IOCs, this could
pose a greater strategic and competitive threat than that resulting from supply disruptions.
6. Uncertain Energy Policy
An increasing risk for the oil and gas industry is the uncertainty of energy policy. This was
defined by one participant: Energy policy goals include security of supply and climate change
considerations, as well as more commercial goals such as affordability and meeting demand
growth. The noncommercial goals will shape policy and result in increasing intervention in the
market in areas such as carbon pricing, strategic reserve requirements, and subsidization of
favored sources of energy. Another participant, a Harvard University-based economist,
contended, Social value regulation in the form of measures designed to reduce risk and achieve
health, safety, and environmental goals can lead to a regulatory regime that ignores cost/benefit
analysis to the detriment of business.
7. Demand Shocks
Demand shocks could be triggered by a number of global economic crises. A global financial
meltdown emerging from derivatives and hedge funds was the threat rated highest by the
economists who participated in the study. One comment, that echoed a frequently made
observation, 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

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

17

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

18

Chapter 06
RISKS IN EXPLORATION & PRODUCTION PROJECTS IN OIL
AND GAS INDUSTRY
6.1) 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, Laplace, and Bernoulli.
However, the applications of these concepts in business and general management appeared only
after the Second World War (Covello and Mumpower, 1985; Bernstein, 1996). The problem
involving decision-making under conditions of risk and uncertainty has been notorious from the
beginnings of the oil industry. Early attempts to define risk were informal.
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. 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. Allaiss 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 this period, there were several attempts to define resource level probabilities at various
stages of exploration in a basin using resources distribution and risk analysis (Kaufman, 1963;
Krumbein and Graybill, 1965; Drew, 1967; Harbaugh et al., 1977; Harris, 1984, Harbaugh, 1984;
Harris 1990). At that time governmental agencies were also beginning to employ risk analysis in
periodic appraisals of the oil and gas resources.
During the 1980s and 1990s, new statistical methods were applied using several risk estimation
techniques such as: (1) lognormal risk resources distribution (Attanasi and Drew, 1985), (2)
Pareto distribution applied to petroleum field-size data in a play (Crovelli, 1995) and (3) fractal
normal percentage (Crovelli et al., 1997).
During the 1960s, 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),
Arps and Arps (1974), Newendorp (1975, edited as Newendorp and Schuyler, 2000) and Megill
(1977). During this period Newendorp emphasized that decision analysis does not eliminate or
reduce risk and will not replace professional judgment of geoscientists, engineers, and managers.
Thus, one objective of the decision analysis methods, as it will be discussed later in this paper, is

19

to provide a strategy to minimize the exposure of petroleum projects to risk and uncertainty in
petroleum exploration ventures.

The Utility Theory provides a basis for constructing a utility function that can be employed to
model risk preferences of the decision maker. If companies make their decisions rationally and
consistently, then their implied risk behaviors can be described by the parameters of a utility
function. Despite Bernoullis attempt in the 18th century to quantify an individuals financial
preferences, the parameters of the utility function were formalized only 300 hundred years later
by von Neumann and Morgenstern (1953) in modern utility theory. This seminal work resulted
in a theory specifying how rational individuals should make decisions under uncertainty. 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), Pratt (1964); and Schailfer (1969). 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, known as the risk premium. Acceptance of the exponential
form of risk aversion leads to the characterization of risk preference (risk aversion coefficient),
which measures the curvature of the utility function. 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.

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). 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. Nepomuceno et al. (1999) and Suslick
and Furtado (2001) applied the MAUT models to measure technological progress, environmental
constraints as well as the financial performance associated with exploration and production
projects located in deep waters.

More recently, several contributions devise petroleum explorations consisting of a

series of investment decisions on whether to acquire additional technical data or additional
petroleum assets (Rose, 1987). 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, 1992). These aspects lead to
a substantial variation in what is meant by risk and uncertainty. For example, Megil (1977)
considered risk an opportunity for loss. Risk considerations involve size of investment with
regard to budget, potential gain or loss, and probability of outcome. Uncertainty refers to the
range of probabilities that some conditions may exist or occur.

20

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, and year-year comparison of exploration performance parameters. These
findings showed the importance of assessing the risk behavior among firms and managerial risk
attitudes. Continued monitoring of the firms 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. Over any given budgetary period, utilization of an
established risk aversion level will result in consistent and improved decision making with
respect to risk.

6.2) Risk Analysis: Field Appraisal and Development

During the exploration phase, major uncertainties are related to volumes in place
and economics. As the level of information increases, these uncertainties are mitigated and
consequently the importance of the uncertainties related to the recovery factor increases. The
situation is more critical in offshore fields and for heavy-oil reservoirs.
In the preparation of development plans, field management decisions are complex issues because
of (1) number and type of decisions, (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.
In order to avoid excessive computation effort, some simplifications are always necessary. The
key point is to define the simplifications and assumptions that can be made to improve
performance without significant precision loss. Simplifications are possible, for instance, in the
modeling tool, treatment of attributes and in the way several types of uncertainties are integrated.
One of the simplest approaches is to work with the recovery factor (RF) that can be
obtained from analytical procedures, empirical correlations or previous simulation runs, as
presented by Salomo (2001). When higher precision is necessary, or when the rate of recovery
affects the economic evaluation of the field, using just the recovery factor may not be sufficient.
Techniques such as experimental design, response surface methods and proxy models were used
by several authors (Dejean, 1999) in order to accelerate the process. Another possible approach
is to use faster models such as streamline simulation as proposed by Hastings et al. (2001), Ballin
et al. (1993), Subbey and Christie (2003) .
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.
Alternatives may vary significantly according to the possible scenarios. Schiozer et al. (2003)
proposed an approach to integrate geological and economic uncertainties with production
strategy using geologic representative models to avoid large computational effort.
21

The integration is necessary in order to (1) quantify the impact of decisions on the risk of the
projects, (2) calculate the value of information, as proposed by Demirmen (2001) and (3)
quantify the value of flexibility (Begg and Bratvold, 2002). 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.
Therefore, risk analysis applied to the appraisal and development phase is a
complex issue and it is no longer sufficient to quantify risk. Techniques today are pointing to (1)
to quantification of value of information and flexibility, (2) optimization of production under
uncertainty, (3) mitigation of risk and (4) treatment of risk as opportunity.
All these issues are becoming possible due to hardware and software advances, allowing an
increasing number of simulation runs of reservoir models with higher complexity (Gorell and
Basset 2001).

6.3) Decision Making Process, Value of Information and Flexibility

Making important decisions in the petroleum industry requires incorporation of major
uncertainties, long time horizons, multiple alternatives, and complex value issues into the
decision model. Decision analysis can be defined on different and embedded levels in petroleum
exploration and production stages. Decision analysis is a philosophy, articulated by a set of
logical axioms, and a methodology and collection of systematic procedures, based upon those
axioms, for responsibly analyzing the complexities inherent in decision problems (Keenney,
1982, Keenney and Raifa, 1976; Howard, 1988, Kirkwood, 1996). In the last two decades, the
theoretical and methodological literature on various aspects of decision analysis has grown
substantially in many areas in the petroleum sector, especially in applications involving health,
safety, and environmental risk.
Many complex decision problems in petroleum exploration and production involve multiple
conflicting objectives. Under these circumstances, managers have a growing need to employ
improved and systematic decision processes that explicitly embody the firms objectives, desired
goals, and resource constraints. Over the last two decades, the advances in computer-aided
decision making processes have provided a mechanism to improve the quality of decision
making in modern petroleum industry. 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.
An effective way to express uncertainty is to formulate a range of values, with
confidence levels assigned to numbers comprising the range. Although geoscientists and
engineers may be willing to make predictions about unknown situations in petroleum exploration
and production, there is a need to assess the level of uncertainty of the projects. So, its 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

results in a change in some action to be taken by a decision maker. The information is seldom
perfectly reliable and generally it does not eliminate uncertainty, 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. 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.
As the level of information increases, 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. At this point, the concept of Value of Information (VoI) must be
integrated with the Value of Flexibility (VoF). Therefore, risk may be mitigated by more
information or flexibility in the production strategy definition. Reservoir development in stages
and smart wells are good examples of investments in flexibility. The decision to invest in
information or flexibility is becoming easier as more robust methodologies to quantify VoI and
VoF are developed.

6.4) 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. Under this approach employed extensively in financial markets, 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. This theory of financial
market and efficient portfolio was proposed by Markowitz (1952), winner of the 1990 Nobel
Prize in Economics. This work has been adapted for the petroleum industry. A portfolio is said to
be efficient if no other portfolio has more value while having less or equal risk, and if no other
portfolio has less risk while having equal or greater value. The most important principle in
portfolio analysis theory is that the emphasis must be placed on the interplay among the projects
(Ball and Savage, 1999). 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, but a family of optimal
portfolios that achieve a balance between risk and value.
As the number of project opportunities grows, the petroleum industry is faced with an
increasingly difficult task in selecting an ideal set of portfolios. 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; Chorn and Croft, 1998, Orman and Duggan, 1998;
Fichter, 2000; Back, 2001; Erdogan and Mudford, 2001). Garcia and Holtz (2003) combined
optimal portfolio management with probabilistic risk-analysis methodology, thus helping to
guide managers in evaluating a portfolio of exploration prospects, not just according to their
value, but also by their inherent risk.
23

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

24

Chapter 07
RISK MANAGEMENT

Risk management is
A systematic way of protecting the concerns 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; 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

7.2) THE RISK MANAGEMENT PROCESS

The risk management process consists of a series of steps that, when undertaken in sequence,
enable continual improvement in decision-making.
The elements of the risk management process are summarized in Figure 7.1 .

25

Fig. 7.1 risk management process

Step 1. Communicate and consult

This is shown in Figure 7.1 by the arrows against each step. Communication and consultation
aims to identify who should be involved in assessment of risk (including identification, analysis
and evaluation) and it should engage those who will be involved in the treatment, monitoring and
review of risk. As such, communication and consultation will be reflected in each step of the
process described in this guide.

26

As an initial step, there are two main aspects that should be identified in order to establish the
requirements for the remainder of the process. These are communication and consultation aimed
at:
eliciting risk information
Managing stakeholder perceptions for management of risk.
Eliciting risk information
Communication and consultation may occur within the organization or between the organization
and its stakeholders. 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. It is therefore important to
identify the range of stakeholders who will assist in making this information complete. To ensure
effective communication, a business owner may decide to develop and implement a
communication strategy and/or plan as early as possible in the process. This should identify
internal and external stakeholders and communicate their roles and responsibilities, as well as
address issues relating to risk management. Consultation is a two-way process that typically
involves talking to a range of relevant groups and exchanging information and views. It can
provide access to information that would not be available otherwise.
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 7.2).

fig. 7.2 stakeholders in small business

Stakeholder management can often be one of the most difficult tasks in business management. It
is important that stakeholders are clearly identified and communicated with throughout the risk
management process. They can have a significant role in the decision-making process, so their
27

perceptions of risks, as well as their perceptions of benefits, should be identified, understood,

recorded and addressed. 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, their benefits and planned
effectiveness.

Step 2. Establish the context

When considering risk management within a small business, it is important to first establish
some boundaries within which the risk management process will apply. For example, the
business owner may be only interested in identifying financial risks; as such the information
collected will pertain only to that area of risk.
A five-step process to assist with establishing the context within which risk will be identified.
1. Establish the internal context
As previously discussed, risk is the chance of something happening that will impact on
objectives. As such, the objectives and goals of a business, project or activity must first be
identified to ensure that all significant risks are understood. This ensures that risk decisions
always support the broader goals and objectives of the business. This approach encourages longterm and strategic thinking. In establishing the internal context, the business owner may also ask
themselves the following questions:
Is there an internal culture that needs to be considered? For example, 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, systems, processes, equipment and
other resources?
2. 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. An analysis of these
factors will identify the strengths, weaknesses, opportunities and threats to the business in the
external environment. 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, 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.
Establish the risk management context
Before beginning a risk identification exercise, it is important to define the limits, objectives and
scope of the activity or issue under examination. For example, in conducting a risk analysis for a
new project, such as the introduction of a new piece of equipment or a new product line, it is
28

important to clearly identify the parameters for this activity to ensure that all significant risks are
identified.
Establishing the parameters and boundaries of the activity or issue also involves the
determination of:
Timeframe (e.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.g. other projects, external stakeholders)
Record-keeping requirements
Depth of analysis required.
The amount of analysis required for this step will depend on the type of risk, the information that
needs to be communicated and the best way of doing this.
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.
4. Develop risk criteria
Risk criteria allow a business to clearly define unacceptable levels of risk. Conversely, risk
criteria may include the acceptable level of risk for a specific activity or event. In this step the
risk criteria may be broadly defined and then further refined later in the risk management
process. It is against these criteria that the business owner will evaluate an identified risk to
determine if it requires treatment or control. Where a risk exists that may cause any of the
objectives not to be met, it is deemed unacceptable and a treatment strategy
must be identified.
The table below (Table 4.1) provides a number of examples of risk criteria for a project.

29

Table 7.1. 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. This will provide greater depth and
accuracy in identifying significant risks. The chosen structure for risk analysis will depend upon
the type of activity or issue, its complexity and the context of the risks. Examples of risk
categories for a particular risk analysis are provided in the following case study.

Step 3. Identify the risks

Risk cannot be managed unless it is first identified. Once the context of the business has been
defined, the next step is to utilize the information to identify as many risks as possible. The aim
of risk identification is to identify possible risks that may affect, either negatively or positively,
the objectives of the business and the activity under analysis. Answering the following questions
identifies the risk: There are two main ways to identify risk:
Retrospectively
Prospectively.
Identifying retrospective risks
Retrospective risks are those that have previously occurred, such as incidents or accidents.
Retrospective risk identification is often the most common way to identify risk, and the easiest.
Its easier to believe something if it has happened before. It is also easier to quantify its impact
and to see the damage it has caused.
There are many sources of information about retrospective risk. These include:
Hazard or incident logs or registers
audit reports
30

 Customer complaints
Accreditation documents and reports
Past staff or client surveys
Newspapers or professional media, such as journals or websites.
Identifying prospective risks
Prospective risks are often harder to identify. These are things that have not yet happened, but
might happen some time in the future. Identification should include all risks, whether or not they
are currently being managed.
The rationale here is to record all significant risks and monitor or review the effectiveness of
their control.
Methods for identifying prospective risks include:
Brainstorming with staff or external stakeholders
researching the economic, political, 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.
Risk categories will help break down the process for prospective risk identification. It is
important to remember that risk identification will be limited by the experiences and perspectives
of the person(s) conducting the risk analysis. Problem areas and risks can be identified with the
help of reliable sources.
SWOT analysis
An effective method for prospective risk identification is to undertake a strengths, weaknesses,
opportunities and threats (SWOT) analysis. 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.

Step 4. Analyze the risks

During the risk identification step, a business owner may have identified many risks and it is
often not possible to try to address all those identified. The risk analysis step will assist in
determining which risks have a greater consequence or impact than others. This will assist in
providing a better understanding of the possible impact of a risk, or the likelihood of it occurring,
in order to make a decision about committing resources to control the risk.
What is risk analysis?
Risk analysis involves combining the possible consequences, or impact, of an event, with the
likelihood of that event occurring. The result is a level of risk. That is:
Risk = consequence x likelihood
This is discussed further later in this section. So how is the level of risk determined?
31

Elements of risk analysis

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

This is known as the risk analysis equation. Techniques for determining the value of
consequence and likelihood include descriptors, word pictures, or mathematically determined
values. These are further described later in this section. Most commonly, the overall level of risk
is determined by combining the identified consequence level with the likelihood level in a matrix
(Figure 3.4). Consider and identify any uncertainties in the estimates In all estimates of
likelihood and consequence, uncertainties will exist. This is a common limitation of the risk
management process. It is important therefore to consider and identify any uncertainty. It may
not be necessary to act on that uncertainty, but be aware and monitor any increases in the risk
level.
Analysis techniques
The purpose of risk analysis is to provide information to business owners to make decisions
regarding priorities, treatment options, or balancing costs and benefits. Just as decisions differ,
the information needed to make these decisions will also differ. Not all businesses or even areas
within a business will use the same risk analysis method. For example, a doctors clinic will have
very different types of risk from a software developer.
As such, 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.
Types of analysis
Three categories or types of analysis can be used to determine level of risk:
Qualitative
Semi-quantitative
Quantitative.
The most common type of risk analysis is the qualitative method. The type of analysis chosen
will be based upon the area of risk being analyzed. More information regarding the semiquantitative and quantitative techniques can be found within the Australian and New Zealand
Standard Risk Management Guidelines (HB 436:2004).
Qualitative risk analysis
This form of risk analysis relies on subjective judgement of consequence and likelihood (i.e.
what might happen in a worst case scenario). It produces a word picture of the size of the risk
and is a viable option where there is no data available. Qualitative risk analysis is simple and
easy to understand. Disadvantages include the fact that it is subjective and are based on intuition,
which can lead to the forming of bias and can degrade the validity of the results. 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.

Step 5. Evaluate the risks

33

As discussed in Section 3.3, 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. Risk evaluation involves comparing the level of risk found during the analysis
process with previously established risk criteria, and deciding whether these risks require
treatment. The result of a risk evaluation is a prioritized list of risks that require further action.
This step is about deciding whether risks are acceptable or need treatment.
Risk acceptance
Low or tolerable risks may be accepted. Acceptable means the business chooses to accept that
the risk exists, either because the risk is at a low level and the cost of treating the risk will
outweigh the benefit, or there is no reasonable treatment that can be implemented. This is also
known as ALARP (as low as reasonably practicable). A risk may be accepted for the following
reasons:
The cost of treatment far exceeds the benefit, 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, for example the risk that the
business may suffer storm damage.

Step 6. Treat the risks

Risk treatment is about considering options for treating risks that were not considered acceptable
or tolerable at Step 5. Risk treatment involves identifying options for treating or controlling risk,
in order to either reduce or eliminate negative consequences, or to reduce the likelihood of an
adverse occurrence. Risk treatment should also aim to enhance positive outcomes. It is often
either not possible or cost-effective to implement all treatment strategies. A business owner
should aim to choose, prioritize and implement the most appropriate combination of risk
treatments. Figure 3.5 overviews the risk treatment process, including what needs to be
considered in choosing a risk treatment.
Treating the root cause
Before a risk can be effectively treated, it is necessary to understand the root cause of a risk, or
how risks arise.
Options for risk treatment
The following options may assist in the minimization of negative risk or an increase in the
impact of positive risk.

34

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

35

Risk treatment plan

A risk treatment plan indicates the chosen strategy for treatment of an identified risk. It provides
valuable information about the risk identified, the level of risk, the planned strategy, the
timeframe for implementing the strategy, resources required and individuals responsible for
ensuring the strategy is implemented. The final documentation should include a budget,
appropriate objectives and milestones on the way to achieving those objectives.
Risk recovery
Although uncertainty-based risks are difficult, if not impossible, to predict, there are ways in
which businesses can prepare for a significant adverse outcome. This is known as risk recovery.
Businesses should consider adopting a structured approach to planning for recovery. This
planning may take many forms, including the following:
Crisis or emergency management planning
The business anticipates what might occur in a crisis or emergency, such as a fire or another
physical threat, and then plans to manage this in the short term. This will include listing
emergency contact details and training staff in evacuation and emergency response procedures.
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. This might, for example, 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, identifying options for alternative
premises if the existing premises are damaged, or documenting alternate suppliers for key supply
material if a key supplier does not fulfill their contract.
Contingency planning
Contingency planning can be a combination of the above. 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).

Step 7. Monitor and review

Monitor and review is an essential and integral step in the risk management process. A business
owner must monitor risks and review the effectiveness of the treatment plan, strategies and
management system that have been set up to effectively manage risk. Risks need to be monitored
periodically to ensure changing circumstances do not alter the risk priorities. Very few risks will
remain static, therefore the risk management process needs to be regularly repeated, so that new
risks are captured in the process and effectively managed.
A risk management plan at a business level should be reviewed at least on an annual basis. An
effective way to ensure that this occurs is to combine risk planning or risk review with annual
business planning.

36

7.3) 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, such as interest rate risk,
equity risk, commodity 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, 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, such as price risk,
political risk, quantity risk and cost risk
Bank risk management: Deals with the handling of different types of risks faced by the banks,
for example, market risk, credit risk, liquidity risk, legal risk, 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, which take into account the set risk
tolerance degrees of a department. In other words, it is the supervision of market, credit, and
liquidity risk at the same time or on a simultaneous basis.
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

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

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

39

8.2) The integrated model

8.21) NPV of the projects cash flow
The first step in the process of investment decision making is the estimation of indicators from
the projects future cash flows. Traditionally, the NPV is the main indicator for investment
valuation and decision rule, since it has been recognized in financial literature (Brealey and
Myers, 1992) as theoretically correct to measure the creation of value for stakeholders. If a
project generates over time a stream of operational cash flow (X(t)) and requires a stream of
investments (I(t)), its NPV is (Equation (1)):
N E[X t-I t]
NPV= ------------- (1)

t=0 (1+) t
Where is capital cost of each cash flow. Equation (1) provides the expected value of the
NPV under static scenarios for price, cost, production, etc. Since there is uncertainty
about the future, the NPV may change as long as fluctuations in price, cost, production
rate, etc. take place. Then, NPV is a random variable whose future values will come from
a probabilistic distribution. Equation (1) gives the expected value of the NPV, but this
is not sufficient to make a decision since this indicator does not account for the impact
of uncertainty on future cash flows, except via risk premium of the discount rate.
In order to estimate the risk of the project, a Monte Carlo simulation of the NPV may be
carried out.
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 - the riskier the project, the lower the NPV. 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%, irrespective of magnitude
of investment.
These issues will be discussed over the next sections.
8.22) Optimal working interest (W)
In order to discuss the problem of optimal working interest in a risky project, 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$ 141.42 million.
2 Invest all of the money in five projects, that is, the corporation allocates 20% of
its budget to each project. In this case, the corporations rate of return will have
the following return/risk profile2: E[NPV] =US$ 300 million and
[NPV] = US$ 63.25 million.

40

These two alternatives have the same expected return, but different risk levels. Just by increasing
the number of non-correlated projects, the return of portfolio remains the same and its global risk
drops - this is the remarkable role of diversification. In Table 1, the effects of diversification
through different working interest values on risk and return of portfolios are shown.

Table 1

Effects of diversification on portfolio risk and return level

Number of projects

Working interest (W)

1
2
10

100.00%
50.00%
10.00%

Portfolio risk
(US$ * 10 6)
141.42
100.00
44.72

Portfolio return
(US$ * 10 6)
300
300
300

The choice of working interest depends on the investors risk tolerance, since all portfolios give
the same return of US$ 300 million. The investors risk tolerance will depend on the amount
exposed to risk compared to the investors total stock of wealth and his risk preference
characteristics.
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. Basically, 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), the risk-neutral individual is one to whom uncertain
outcomes are valued as expected values, paying no attention to the potential of gains and
losses. A risk-prone individual is one to whom uncertain outcome is valued by more than
the expected value. A risk-averse investor has more concern with the potential of loss
than that of gains and, therefore, this individual values uncertain outcome by less than
expected value.
In this paper, to find the optimal working interest in this model, it is assumed that individuals as
well as corporations are risk-averse in capital-intensive projects. This is the case of large heavyoil projects, where investment irreversibility contributes to motivate management towards
limiting risk exposure by taking, for example, less than 100% working interest in the project,
depending on the interaction among project risk profile, magnitude of the corporations financial
budget and decision makers risk attitudes (Campbell et al., 2001; Cozzolino, 1980;
Nepomuceno et al., 1999; Newendorp and Schuyler, 2000; Walls and Dyer, 1996). For the
petroleum industry, Cozzolino (1980) and Walls (1995) suggest the use of the exponential utility
function to model the choices made under uncertainty. The complete exponential utility equation
is:
41

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 corporations 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 corporations 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
projects acceptance and management of risk exposure
3 timing or strategic real option to implement decisions.

42

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 investors 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 assets 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-) V d t +Vd Z .(5)

Where V is the present value of projects cash flow, r is the risk-free interest rate, is the
dividend rate, is the volatility and dZ is Wieners 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)
2 V 2 Fw (V) + (r-)VFv (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

Fv (v) = 1

.(8)

(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:
= 1/2 (r-)/2 + {{(r-)/2-1/2}2 + 2r/2}1/2 .(10)
V* = / (-1) * I .. (11)
F (v) = (V*-I/ (V*) ) * V

if V<V* . (12)

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

if VV*

(13)

where 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

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

Real options
Present value of projects cash flow ($)
Present value of investment cost ($)
Future volatility of projects cash flow (%)
Future dividend from projects cash flow (%)

Risk-free interest rate (%)

Symbol
V
I

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
44

and get 100% of its profits. On the other hand, over the entire project life, the true values of
price, cost, production and tax may differ from those expected ones from the static scenario and
the NPV may become more positive or even negative.
Table 3

Geological, technical and economic characteristics of the project

Technical and economic characteristics

Properties value

Oil Reserve (MMbbl)

Water depth (metres)

389.30
1500.00

Oil quality

25o API

Oil production peak (MMbbl/year)

CAPEX (US$ MM)
OPEX (US$/bbl)

68.50
887.02
12.00

Oil spot price (US$/bbl)

Discount rate (%)

30.00
13.00%

Government take (%)

50.00%

However, in practice, the real NPV may be quite different and, actually, we will know its true
value only when the oil production reaches economic exhaustion, that is, the real NPV is a
random variable whose expected value is US$ 391.38 million. Since the NPV is a random
variable, the optimal decision making should not be based solely on expected values, but should
also consider its uncertainty because even a positive expected NPV may become negative if
market conditions change over time. As a result, a natural complement to a static NPV is its risk
analysis.
8.31) Estimation of the risk of the project
In finance, broadly speaking there are two types of risk: systematic and unsystematic. There is a
consensus that there is no reward for unsystematic risk because it can be eliminated by
diversification in well developed markets. It is important to note that this is true for investors in
markets with a large menu of assets, what is not always the case in specific domestic markets of
the major oil companies. For example, in non-mature financial markets such as in Brazil,3 the
total risk (unsystematic) is what is of concern.
In this paper, we consider risk as the possibility of an unfavorable outcome, such as the chance
of a negative NPV. In this sense, a risk analysis consists of finding the probabilistic distribution
of the NPV from uncertainty in its primary variables such as price, cost and production, among
others.
Although the NPV of this project is highly positive, it has some risk because of a possible change
in market conditions, which is a fair and rational motivation for risk analysis. For this project, we
use the following assumptions:
Future values of oil production cost (OPEX): this variable is modeled as a
triangular distribution, whose most likely value is US$ 12/bbl, whereas the
optimistic cost is US$ 6/bbl and the pessimistic cost is US$ 18/bbl.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.

45

 Future values of production: oil production is expected to reach a yearly peak

production of 68.5 million bbl and drop year after year to the ending value of 2.9 million
bbl.5 The uncertainty in oil production is modeled considering that future production
will be distributed as triangular distribution, with pessimistic yearly production equal to
50% of the most likely value, whereas the yearly optimistic production is 50% above the
most likely production.
This modeling assumes that the components of the projects cash flow are statistically
independent, although in reality, for oil production projects, this assumption is incorrect, since
most variables are directly linked to oil price to some degree, apart from their dependency on the
non-linearity in tax structure, logistics, etc.
The next step consists of simulating thousands of possible paths for these uncertain variables
using the Monte Carlo technique. Then, after carrying out a simulation with 10,000 iterations, we
get the histogram of the NPV shown in Figure 1.

Figure 1 Cumulative frequency of the NPV and projects risk level

Simulation of the NPV shows that its values range from US$ 1.3 billion to US$ 2.0 billion, but
there is a concentration of values around the mean of US$ 276.07 million.6 In practice, most of
these extreme values of the NPV have little significance, since they occur in very unlikely
situations, that is, high cost and low price and vice-versa.
From Figure 1, the probability of a negative NPV is 30.95%. This means that, in the
case of unfavorable events, the corporation may not be able to recover its full
investment allocated to the project. Since investment is irreversible, the corporation must
adopt two complementary policies in order to decide if it should invest in this project
or not:
firstly, the irreversibility of investment, together with the ability to invest in the
future in a scenario of less risk, gives rise to a new decision-making rule, which is
according to the real-option pricing approach
Secondly, the irreversibility of investment, together with corporation risk aversion, may
imply in a working interest of less than 100% in the project.
46

Another possibility is to make price hedging, but this will also reduce profits because of the cost
of hedge. Over the next sections, these two approaches will be applied to the case of an offshore
oil project.

8.32) The optimal rule of investment (F, K, V*)

Traditionally, the NPV has been the indicator for static valuation and decision-making. If it is
even merely positive, the benefits are in excess over the costs and the project should be accepted.
Under the static approach, this logic is correct but, if we take the effect of investment
irreversibility and future uncertainty, this approach is no longer right. In Section 2.3, the
application of the theory of exercising a financial option to the case of investment decision in
projects is proposed. According to this theory, the option is not exercised simply if the value of
underlying asset is just above its exercise cost, but only if it is sufficiently high. Analogously, the
corporation should exercise its option to invest only when project value is sufficiently above its
investment cost. Therefore, there is a critical project value (V*) to trigger investment. The
required input parameters of Equations (11)-(13) are shown in Table 4.
Table 4

Inputs of decision-making based on real-options models

Input parameter
Projects cash flow value
Projects investment value
Projects dividend rate
Project future volatility
Risk-free interest rate

Symbol
V(MM US$)
I(MM US$)

Value
1278.41
887.02
11.95%
51.00%
5.00%

The optimal decision rule based on the theory of an option-pricing model requires, among other
factors, characteristics of project cash flow and of the market interest rate. 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. It is not easy to find the projects volatility and dividend rate. 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, so that each reservoir has its own geological,
technical, operational and environmental particularities.
As an alternative solution, in this paper, we use Monte Carlo simulation in order to access the
project volatility as the standard deviation of rate of return of the project, as suggested by
Copeland and Antikarov (2001). Firstly, we calculate the expected project
NPV under static scenarios, which we call NPV 0. But, over the projects entire operational life,
there is a chance of an infinite number of different cash flow trajectories. These different cash
flow trajectories are the cause of the projects volatility, due to possible fluctuations in the
expected value of the NPV from future cash flows.
The expected rate of return of the project (V) at time 1 is:
47

CFo (1+) + NPV1

E [ V] = ----------------------------

-1 .(14)

NPV0
The expected project rate of return is very close to the cost of capital (or discount rate), 13%.
But, since cash flows in the future are uncertain, there is a chance that thousands of V may
occur. After a simulation, we get a distribution of the rate-of-return with the following two
moments: E [V] = 13.00% and (V) = 51.00%.
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. According to Costa Lima and Suslick (2006),
for typical oil projects, if the volatility of oil price is around20%, the volatility is
much higher - around 51.00% as in this paper.7 These numbers show that project
volatility is usually much higher than price volatility. As a result, the common
assumption that projects volatility is equal to price volatility may give rise to significant
errors, undervalue projects, and create wrong critical values to exercise the option
to invest.
The estimation of a projects dividend yield is also complex. In an investment in stocks,
investors receive dividends as a result of profit distributed by a corporation. The dividend of
project can be understood as the cash flows per unit of time (month, year, etc.), but this simple
approach has many shortcomings, especially in the case of long-lived projects with irregular cash
flows. In this paper, we estimate project dividend rate (v) as a weighted average between cash
flows and production:
N

v = Q(t) * f(t) / Q(t) (15)

t=0

t=0

Where Q(t) is the annual production and f(t) is ratio of the yearly cash flow to the sum of total
cash flows.8 Dividends for exhaustible resources, such as oil projects, can be associated with the
reserves production flow over time. Using Equation (15), dividend rate is v= 11.91% and it
means a fraction of the projects total value that is generated each year, that is, nearly 12.00% of
the assets value is produced.
Now, we have all inputs necessary to estimate the investment option value, optimal decision rule
and value of waiting to invest in the future. From Equation (11), V * is US$ 1821.09 million.
This means that the corporation should exercise its option to invest only if the current value of
the project is at least US$ 1821.09 million. Since the current value of this project is US$ 1278.04
million, the optimal decision is to wait to invest in the future. In other words, it means that the
decision to invest immediately requires V equal to at least 2.05 times the investment cost and
not merely a positive NPV.
The value of the option to invest (F), with the flexibility of choosing to exercise the right to
invest at some moment in the future during options maturity, is US$ 491.29 million, which is
higher than the traditional NPV ($ 391.38 million). The value of waiting to invest in the future
(K) is US$ 100.76 million, which comes from the uncertainty in future cash flows, that is,
volatility of projects. According to this new decision rule, even if the NPV is positive today, the
48

act of waiting is able to create more value for shareholders. Thus, the optimal policy is to invest
when the flexibility to wait has no more value (K = 0), that is, when F = NPV. This condition
will hold and be true when the projects current value is sufficiently above its cost, that is, V >
V*>I.
The volatility of projects plays a very important role in both option valuation
(Equations (12) and (13)) and decision making (Equation (11)). According to the classic
investment theory, project value is represented by its NPV and the optimal decision is: invest as
long as V > I, that is, a positive NPV. Contrarily, in the real-options model, the investment right
is exercised as long as V V* and both F and NPV have the same value, that is, the strategic
value of the option to invest (F) and the intrinsic option value (NPV) are equal. Then, F may be
considered as the intrinsic option value plus its time value. Another understanding is: when V =
V *, we have that F (V*) = V * - I and,
Consequently, V * = F (V *) I, that is, we can see F as part of the cost to invest now instead of
waiting for a better opportunity in the future. Therefore, because of volatility, we always have
V* > I and not V * I.
From Equation (1), the NPV is US$ 391.38 million and, according to traditional decision
making, the corporation should invest right now. On the other hand, from Equation (12), the
option value, which captures the value of the flexibility to invest not only now, but also in the
future, is US$ 491.29 million and clearly the option value is above the NPV stand alone.
In the real option pricing model, F (investment option) and K (value of waiting option) are nonnegative functions, whereas the NPV can be negative if I > V. The entire results of both
approaches in valuation and decision making can be seen in Figure 2 through a sensitivity
analysis of the NPV, F and K (option value) to project current value.

Figure 2 Sensitivity of NPV, F and K to project current value

As the current value of project increases, Figure 2 shows an increase of NPV, F and a decrease in
K. There are three important regions for decision making:
I: 0 V US$ 887.02 million. The intrinsic value of the option (NPV) is
negative and the corporation will not invest. Meanwhile, F is positive. Why?
Since the future is uncertain - volatility of project is 51%, there is a potential
that project value increases to US$ 1821.09 million or more. Then, the
investment option is much higher than the intrinsic value.
II: US$ 887.02 million V < US$ 1821.09 million. The NPV is positive, but not
sufficiently high. Once again, the effect of irreversibility and uncertainty implies
that the optimal policy to maximize the option value is to wait until the project value
49

reaches the value of US$ 1821.09 million. The option value is still high, but the option
should therefore be exercised in the future.
III: V US$ 1821.09 million. The investment option must be exercised
immediately. Observe Figure 2 to confirm that the option value of waiting (K)
has no more value if V is above US$ 1821.09 million.

In general terms, the results of valuation and decision making for this project, synthesized in
Figure 2, are in agreement with the literature. For example, Costa Lima (2004) has shown that
for some oil projects, V* is on the average 2.14 times the investment cost. In addition, it is worth
mentioning that for reasonable input parameters of the real options model, particularly volatility
and dividends, V* may be two times the investment cost or even higher.

8.33) The optimal working interest in the project (W)

In many cases, even though the project value is sufficiently above its investment cost,
many corporations prefer to develop it in partnership (such as a joint venture), which
seems to contradict the optimal decision rule of the option-pricing theory. But this
practice in capital-intensive projects has some reasons due to the following
characteristics:
1. the magnitude of investment cost
2. technology availability to develop the project alone
3. search for synergy among different business units.
In such situations, 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, from this approach,
the corporation should incur in 100% of investment and revenue as long as the NPV is
positive. An alternative solution can be found using the theory of finding the optimal
working interest to maximize the RAV in Equation (4). This equation requires two main
inputs:
1. the probabilistic distribution of NPV
2. the corporation risk tolerance (T).
The corporation risk tolerance is difficult to estimate. Wilkerson (1988) argues that T can be
estimated as a fraction of, for example, corporation market value, budget and other strategic
variables. Walls (1995) show empirically that T is around 25% of the capital allocated to
petroleum explorations. Meanwhile, for other phases in the E&P chain, T may assume different
values.
In this chapter, it is assumed that the corporation budget is US$ 300 million and its risk tolerance
is US$ 120 million, that is, T = 40% of the budget. From Equation (4), the analyst can estimate
the RAV for this project, considering different assumptions and characteristics of the corporation
and of the project. As shown in Equation (4), RAV depends on utility function, corporation risk
tolerance and project risk profile - in some cases, the RAV is an increasing function of W,
whereas, in others, it is a decreasing or even constant function. The main objective is to estimate
50

W, numerically or analytically, in order to maximize the RAV, given the corporations profile.
For this case study of oil project, the sensitivity of RAV to W is shown in Figure 3.
As shown in Figure 3, an increase in W will increase the satisfaction of decision maker up to
around 44.38%. Higher values of W reduce the satisfaction of decision maker through the
decrease in RAV. In addition, if W is higher than 93%, the RAV becomes negative. Over the
interval between 0 and 100%, the RAV is a non-linear and concave function of W. The theory of
maximizing the RAV shows that, contrarily to the traditional view, the corporation will not take
100% working interest in the projects cost and revenue, but only 44.38% because this value
gives the highest RAV.
Note that the curve of the RAV to W takes into account the uncertainty in price, production and
operational cost together with the corporations utility function. Nevertheless, it is important to
observe that, in order to get realistic results, it is important to search for the best estimation of T
because of its impact on W, that is, an increase in T tends to increase W in the project and viceversa. In Figure 4, an extended sensitivity of the RAV to W for different values of T is presented.

Figure 3 Sensitivity of RAV to optimal working interest (W)

Figure 4 Sensitivity of RAV to optimal working interest: different values of

corporations tolerance

51

Note that, in the base case, T = US$ 120 million and W = 44.38%. If T increases to US$ 200
million, W is also increased to 75%. Analogously, if T decreases to US$ 80 million, W is also
reduced to only 30%. In terms of valuation and strategic decision making, by taking W =
44.38%, the company will spend around US$ 393.66 million in the investment and receive a
NPV of only US$ 173.69 million. If a negative outcome occurs, the amount under risk is limited
to that fraction of the investment, that is, US$ 393.66 million. This policy of reduction in the
projects NPV may be understood as the price to limit risk exposure or as a hedge scheme
against possible catastrophic losses.
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 corporations budget
2 even in the case of a project with a current value equal to two or more times its
cost, it may become profitless since volatility over the future may, for example,
generate a scenario of high cost and low prices.
In this case, a rational policy intended to reduce the risk of losses and, consequently, of financial
troubles, may be the choice of a small fraction of the project investment and revenues.
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, by taking a working interest of less than 100% in the project, the corporation
may invest in more than one project and, consequently, reduce the corporations
portfolio risk.
8.4) Discussions and implications
The proposed model provides a complement to results of the classic NPV in valuation and
decision making. It integrates valuation, risk quantification, strategic flexibilities and decision
making, using theories of preference and real option pricing. Although more sophisticated, this
integrated model requires two input parameters that are difficult to estimate: corporation risk
tolerance (T) and project volatility ().
In the present case study, we have pointed out the need to complement results of the traditional
cash flow when analyzing investment in capital-intensive projects, such as those of oil and gas
industry. Table 5 presents a comparison between the traditional and the proposed valuation and
decision model.

52

Table 5
Subjects
Valuation
and risk

Decision
Making

Optimal
Decision

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
1278.41
887.02
391.38
30.95%
391.38
887.02
100.00%
Since NPV is positive, invest
now and take 100% working
interest

Proposed model
1278.41
887.02
276.07
452.34
30.95%
491.29
1821.09
44.38%
Even though NPV is positive
invest in the future (when V is
US$ 1821.09 million) and
incur in a working interest of
44.38%

According to the traditional cash flow model, the NPV is the indicator for valuation and decision
making. The project NPV is US$ 276.07 million and the corporation should invest immediately
and incur in 100% of the project. The proposed model has a complementary structure, where F is
the valuation indicator and the decisions are made according to the results of V* and W.
The numerical analysis summarized in Table 5 shows that, although the NPV is
positive, the option to invest is not deep-in-the-money. Therefore, the optimal decision is
to wait for an increase in V to, at least, US$ 2.10 billion. This may happen, for example,
due to oscillation in price, costs and production, as well as in other strategic variables.
By choosing only projects whose V is at least equal to V*, the corporation follows a more
conservative and risk-limiting policy, which is an advance and is radically different from
the traditional NPV. Nevertheless, this procedure does not assure that the option exercise
is profitable, because the result of the exercise of real options, contrary to financial
options, is not immediate, but depends on a cash flow from many years of operations.
In this context, since the projects investment is high compared to the corporations
risk tolerance, the corporations optimal working interest is 44.38%, whereas other
partners must fund the remaining 55.62% of the investment. This framework derives
from the chosen parameters, which may not be constant over time. If some of them
undergo oscillations, for example, volatility or operational cost, global output may be
very different, requiring that the analysis must be updated continuously in order to
improve the corporations valuation and decision making in the search for an efficient
resource allocation and value creation for stockholders.

This chapter presented an integrated framework, combining theories of real-options and

preference, useful for valuation and decision making under uncertainty for capital-intensive
53

projects. The outputs of the real-options model may be used to complement those of the
traditional NPV, especially by incorporating the value of uncertainty and irreversibility.
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. 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, risk tolerance, timing and risk-aversion.
In addition, 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.

54

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, quantifying the consequences of various possible
decisions and assessing, within the possible outcomes, the estimated best economic or
operational result. 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. The second and third steps are more complex and involve issues related to data
availability and reliability, cost analysis, probability determination and economic assessment. In
the next section an example of application is presented

9.1)Example of Application - Well Cost Estimation

Engineers involved in well planning and budgeting know how sensitive this subject is. A poorly
prepared well budget or AFE (Authorization for Expenditure) will have effect on the companys
internal functioning as well as in its relation with possible partners. Internally, the accounting
department will rely on the recommendation from engineers to prepare the companys budget.
Externally, partners will do the same and, only to a certain extent, will allow deviation from the
proposed AFE.
Normally, in certain high-risk exploration ventures, it is very common for oil companies
to look for partners to share the risks involved, potential losses and, of course, the possible gains.
In this case, following clauses established in a Joint Operating Agreement (JOA), an AFE will
have to be approved by all partners before drilling operation takes place. It is regular in these
cases to allow a 10% over spending on the planned costs. Any amount above this limit will
require mandatory approval from the partners, which may cause operational delays and doubts
about the operating partners technical proficiency.
Since cost estimation for drilling operations naturally carries a great deal of uncertainty,
this area appears to be suitable for risk analysis application.
Table 1 presents an actual AFE for a vertical offshore well. The total estimated cost is
$6,456,000. 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. The normal approach, 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. There is no guarantee that, let us
say, rig costs, will be in the lower side at the same time that supervision and P&A costs reach a
minimum.
Assuming that all cost variations are independent, which may not be the case with certain
related item like casings with different diameters, we can further assume that the costs will vary
according to a triangular distribution where the minimum, maximum and mode value are known
(as given in Table 2).
From that premise, a Monte Carlo simulation can be performed, with all uncertain costs
being randomly varied combined with the other costs. The simulation is run consecutively, every
time taking one possible cost from the distribution of each of the 16 uncertain variables. Those
values are added with the fixed costs, variables where no uncertainty exist, resulting in a total

55

cost for the well. In this case the simulation was repeated 500 times and the results used to form
a cumulative distribution function (CDF) for the well.
The resulting CDF is presented in Fig. 1.

Figure 1 - Cumulative Distribution for AFE

9.2) Analysis of Results

After establishing the distribution of possible costs for the well, the engineer now has a much
more reliable tool to be used on the AFEs preparation. Notice that the analysis itself does not
substitute the engineers evaluation or companys policy. On the other hand it provides the
professional with means to best estimate contingency costs and determine P(10), P(50) and P(90)
costs, in our case, $6.32, $6.54 and $6.83 millions.

9.3) Conclusions
An overview on most important works relating use of risk analysis applications for drilling
operations was presented.
Use of risk analysis on oil and gas investment decision is a common procedure in all major oil
companies; however, use of QRA methods as an auxiliary tool for decisions under uncertainty in
well engineering process is not as prevalent as it should be.
A simple example for application in well cost estimation was presented. Monte Carlo
simulation was used to determine a cumulative distribution function for the expected well
costs.

56

Use of decision methods with risk analysis required reliable database and careful analysis of
possible outcomes. However, once the method is implemented, its use is simple and will provide
great benefit for the company.
TABLE 1 - Authorization for Expenditure (AFE)
Preliminary Estimate for a 9000 ft Straight Hole, Precompletion Estimate Included
DRILLING
COST

ESTIMATED INTANGIBLE COSTS

Surveys and Permits/Environmental
Location Cleanup

Rate

Days

PRECOMPL.
Cost

TOTAL AFE

$20,000

$5,000

$25,000

$525,000

$0

$525,000

Days

Rig Move (Mob. & Demob.)

$75,000

Drilling - Daywork

$75,000

31

$2,325,000

$450,000

$2,775,000

Fuel, Lubes and Water

$2,000

31

$62,000

$12,000

$74,000

Rental Equipment

$3,000

31

$93,000

$18,000

$111,000

$50,000

$5,000

$55,000

31

$400,000

$0

$400,000

$4,000

$0

$4,000

$130,000

$50,000

$180,000

$40,000

$25,000

$65,000

$350,000

$0

$350,000

$15,000

$0

$15,000

Drill Bits
Drilling Mud & Chemicals
Mud Logging

$800

Cement & Squeeze Services

Casing Crews & Tools
OH Logging+MWD/LWD
Cores & Analysis
Transportation
Labor + Dock Charges

$13,100

31

$406,100

$78,600

$484,700

$2,000

31

$62,000

$12,000

$74,000

Supervision

$850

31

$26,350

$5,100

$31,450

P&A Costs

$120,000

$600,000

$0

$600,000

$25,000

$10,000

$35,000

Pipe Inspection
Overhead

$750

31

$23,250

$4,500

$27,750

Insurance

$570

31

$17,670

$3,420

$21,090

Communications

$300

31

$9,300

$1,800

$11,100

$5,183,700

$680,500

$5,864,100

TANGIBLE COSTS
$/FT.
Drive Pipe

800

30"

220

$72,600

$0

$72,600

Conductor

1,600

20"

60

$96,000

$0

$96,000

Surface Casing

3,500

16"

16

$56,000

$0

$56,000

Intermediate Casing

6,000

9-5/8"

30

$180,000

$0

$180,000

Production Liner

3500

7-5/8"

13.5

$0

$47,250

$47,250

$120,000

$20,000

$140,000

Wellhead Equipment
TOTAL TANGIBLES

$524,600

$67,300

$591,900

TOTAL AFE COSTS

$5,708,300

$747,800

$6,456,000

57

TABLE 2 - Range of Costs

Total Rig Cost

Fuel, 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

Total Cost

Total Cost

Base Case

Lower Limit

Higher Limit

$3,080,000

$3,960,000

$64,750

$77,700

$92,500

$122,100

$350,000

$500,000

$3,250

$4,500

$299,700

$499,500

$55,500

$81,400

$27,750

$33,300

$550,000

$675,000

$18,500

$22,570

$9,250

$12,210

$3,300,000
$74,000
$111,000
$400,000
$4,000
$484,700
$74,000
$31,450
$600,000
$21,090
$11,100
$72,600
$96,000
$56,000
$180,000
$47,250

$69,300

$75,900

$80,000

$104,000

$49,000

$59,500

$168,000

$198,000

$40,250

$52,500

58

Chapter 10
RISK ASSESSMENT & MANAGEMENT-TO THRIVE AMIDST
UNCERTAINTY (UPSTREAM FOCUS)
Assessing and managing risks are essential functions for any organization, but they are
particularly vital concerns for companies operating within the upstream sector of the oil and gas
industry.
Even with the best seismic technology and geological expertise, exploration presents
considerable uncertainty. Actuarial analysis is needed to project the life spans of discovered
reserves and their market value over several decades. Extracting that oil or gas demands greater
investment, additional expertise, and greater exposure to possible liabilities and compliance
requirements. While international economic and political events increasingly affect all
businesses, such issues have long been concerns for oil and gas companies.
Due to such factors, the upstream sector of the oil and gas industry presents a higher degree of
inherent risk than most industries, and companies operating in that sector generally maintain
higher risk profiles than most corporations. Maintaining a higher risk profile, however, 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.
The upstream oil and gas industry shares with some other businesses, such as the pharmaceutical
industry and aerospace engineering, typically long payback periods. 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, 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, particularly in resource availability. The
main problems are the steel shortage, experienced labor shortage (all levels), and even space in
fabrication yards across the region.
These problems, coupled with reserves becoming more difficult to locate and more expensive to
develop, have caused the industry to begin implementing detailed planning and risk
management.
Today, Asian oil and gas companies are placing more emphasis on managing assets and
streamlining business processes to maximize profitability. Although the price per barrel has
increased dramatically in recent months, the industry remembers the downtimes in the 90s and
is wary of the current high prices. Because of this, reserves in oil and money are being shored up.
Getting oil fields and equipment (onshore and offshore installations) working as fast as possible
is important. With this in mind - and a strong risk management knowledge base - most Asian oil
and gas companies are now practicing risk management at the highest professional levels. 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.

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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. It will also touch on the technology that can
help managers automate the process of identifying and mitigating risk.
Asia Pacific oil and gas markets
The Asia Pacific region is now recognized as the major growth area for energy demand.
Oil, gas, and electric power take center stage for investment in this growing and emerging
market. This region has vastly inadequate local crude oil production relative to its expanding
needs and will need increased imports from outside the region.
Coupled with governmental policy changes encouraging deregulation, privatization, and foreign
investment, the future appears bright. Yet risk prevails. Deregulated markets bring competitive
risks not previously experienced and energy risk management rises in importance dramatically
changing market environments such as these.
Oil is still the key fuel of the industrial world. In the Asia Pacific region, the overriding concern
has always been security of supply rather than price risk. In this environment, the use of energy
risk management tools, particularly on futures exchanges, has repeatedly failed.
Risk avoidance - rather than risk management - has long been the operative word in Asian oil
markets. That is about to change due to the twin engines of deregulation and privatization driving
competition. Oil exhibits annualized price volatility of 40% to 50% per year, making it among
the highest of any commodity.
Deregulation and globalization of energy markets are bringing the need for active
management of risks. The markets are becoming more price sensitive with the rapid
dissemination of price and market information. The need to automate risk management now
exists out of competitive necessity. Fortunately, the effectiveness of available risk management
tools is more established and the knowledge base wider.
Oil markets
The importance of the Asia Pacific region in terms of world oil demand and refining cannot be
understated. Since 1985, Asia has accounted for more than 70% of total world oil demand
growth. This area has surpassed Europe and will soon eclipse North America as the primary
region of world oil demand.
The Asia Pacific region continues to be the most dynamic oil market in the world with demand at
25.4 million b/d in 2005, with projections of 29.4 million b/d in 2010. Most of this increased
consumption will be sourced from the Middle East from where over 70% of the supply currently
originates.
It is estimated that 80% of Persian Gulf oil production will be exported to China, India, Japan,
South Korea, Taiwan, and the Association of Southeast Asian Nations (ASEAN) countries by the
year 2010. Growing commercial ties between Persian Gulf producers and Asian consumers seem
inevitable, especially as the giant US market shifts away from the Middle East to a greater
dependence on Latin American producers.
By 2006, Japan, South Korea, China, India, Taiwan, Thailand, and Singapore are expected to be
importing oil at over one million b/d each. While some Atlantic Basin crude oil from West
Africa and the North Sea may supply some of the older, less flexible Asian refineries that have
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an appetite for those sweet crudes, the key issue is the growing Asia Pacific dependency on
Middle Eastern sources of crude.
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. China became a net oil importer during 1993 and its needs will continue to grow.
Indonesia, an OPEC member and current oil exporter, seems to be slipping from being a global
supplier to being a net user of petroleum.
With about half of world oil growth projected to continue to be in the Asia Pacific region, rising
product demand and tightening fuel quality standards driven by rising environmental awareness,
the need for managing energy price risk seems poised for explosive growth over the next several
years. However, it has taken an inordinately long time to get started in the region compared to
the North American and European experiences, particularly because of the more protectionist
Asian economies.
Asia will need more imported crude oil in the coming years as output declines in Indonesia and
only some oil production increases in China, despite the expected short-term increases in output
from Australia, Malaysia, Papua New Guinea, and Vietnam. Sour crude barrels will come from
Mexico and the United States. Moreover, product import dependency is also rising at an
astounding rate. Changing markets and oil trade patterns presage rising price volatility.
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. This movement to freer competitive markets will mean that
risk will increasingly be shifted to energy companies and away from government protection.

Fundamental changes in Asian oil markets

For refiners and traders, petroleum storage requirements are another area affected by
deregulation and are a growing area for risk management. Many storage expansions have been
announced throughout the region.
Singapore, as an active regional transshipment center, has already undergone more storage
capacity increases. Subic Bay in the Philippines is another strategic location. China, India, South
Korea, and Thailand have all announced that large-scale storage projects are underway. These
and other projects are an attempt to reduce the transshipment costs of Singapore facilities.
Another reason is the need for strategic stockpiling of oil and products for energy security
reasons, which is still a dominant part of the Asian energy puzzle. In fact, regional storage seems
to be taking hold as evidenced by Chinese oil stockpiling this year.
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While the Asia Pacific oil trade is still centered on security of supply rather than price risk
management, the Asia Pacific markets are just beginning to emerge as the next opportunity for
growth for the markets in energy. Fed by growing oil demand in the region and the growing
interest in making Singapore the energy derivatives center for Asia, it seems likely that this is the
beginning of the change to a more financial rather than physical orientation in energy trading. As
they move towards deregulation, political changes in Asian countries should bring increased
trade activity in both futures and derivatives.
The highly publicized financial debacles in recent years, such as Enron, WorldCom, and others,
have focused attention on risk management, creating more interest in hedging and the use of
energy risk management tools.
New risks need to be intelligently managed. Consequently, risk management is now a key
management tool. Once considered a peripheral concept, effective risk management can be
essential to achieving industry leadership.
In the Asia Pacific markets, there is actually less uncertainty than previously on the regulatory
side as countries are making their deregulation plans known. Nonetheless, market, credit, and
operational risks remain pervasive in the Asian markets. Most importantly, a companys risk
tolerance must be identified, particularly since oil, gas and power are the most volatile
commodities traded.
The objective of using risk management tools is simply to achieve corporate goals. There is no
cookie cutter approach of one size fits all. These goals can include lower fuel costs, securing
market share, reducing earnings volatility or increasing margins. The key is reduction of risk, not
risk elimination (since that is impossible).

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

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BIBLIOGRAPHY
Energy Price risk by Tom James
Coping with strategic uncertainty, Sloan Management Review
Journal of Business Finance and Accounting, June, volume 27
Journal of Petroleum Technology
A financial calculus: An introduction to derivative pricing
Journal of Political Economy
Harvard Business Review
Risk and Uncertainty, proceedings of a conference held by the International Economic Association,
Macmillan, New York
Thinking small about oil, Management Today
Applications of Risk Analysis and Investment Appraisal Techniques in Day to Day operations of an
upstream oil company, submitted in partial fulfillment of the degree of Master of Business
Administration, University of Aberdeen.
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.
The London International Petroleum Exchange (IPE)
Asian Petroleum Price Index: Tapis Crude & Dubai Crude

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