Prudent Risk-Taking
Authors: Arps J.J. , Arps J.L. 
Published: December 2007

If you're forced - or inclined - to take a series of big risks, wouldn't it be comforting to have a guarantee that you won't go under completely? Here is a way to determine for any specific project the minimum ratio of risk to reward for a given amount of capital.

Introduction

At first glance, the title of this paper is somewhat contradictory since prudence and risk-taking usually are not compatible. Nonetheless, it is possible to use a prudent approach to a program of risk-oriented undertakings so that the probability of complete failure of such a program is reduced to manageable proportions. This paper presents such an approach as proportions. This paper presents such an approach as applied to exploration for oil and gas when capital funds are limited, as is usually the case.The prudent risk-taking approach is a combination of two concepts. The first concept is that successive risk-taking ventures should be undertaken only in such a manner that the risk money in each venture is less than the amount that would create a "break-even" situation in the long run. This break-even concept was originally defined by Whitworth and first applied to exploratory ventures by Hayward.The second concept is that the amount of money risked on any one venture should not exceed the amount that would increase the risk of "gambler's ruin" beyond acceptable limits. "Gambler's ruin" is defined as a situation in which a risk-taker with limited funds goes broke through a continuous string of failures that exhausts his available funds. It may best be illustrated by an example of two boys flipping pennies. This is a "fair" game in that the odds are pennies. This is a "fair" game in that the odds are 50-50 for each toss and the reward of two pennies is twice the amount wagered. Yet, if one of the boys starts the game with only 5 pennies, while the other has 100 pennies, there is a high probability that the first boy may at some point suffer a losing streak that would exhaust his capital. At the same time, the larger capital of the second boy makes him much less vulnerable to "gambler's ruin" through a losing streak that would cause him to run out of funds.Decision-making in exploration for oil or gas is concerned with risk-taking for high stakes and normally involves the following basic parameters:1. The amount of available risk capital, C.2. The risk money, X, that an operator stands too lose if a specific venture fails or is submarginal. In exploration ventures for oil or gas this risk money, X, for a given prospect comprises lease bonuses and rentals, (including legal expenses and brokerage), geological and geophysical expenditures, and the cost of exploratory test wells less dry-hole or bottom-hole contributions.3. The potential value of the reward, R, if theproposed venture is successful as expected. In exploration ventures for oil or gas the potential reward for a given prospect includes the future net operating income expected from oil and gas sales, discounted at a rate of return high enough to attract the necessary capital for such investments. The amount is then reduced by the development cost of the prospect, if successful. This development cost includes the completion cost of the discovery well, but not the risk money, X, as defined above.

JPT

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