Holistic vs. Hole-Istic E&P Strategies
Authors: Ball B.C. , Savage S.L. 
Published: June 2014

A New Era in Petroleum E&P Management

E&P is a risky business because, while a few exploration projects are tremendously successful, most are total failures. This makes management of uncertainty crucial. development of seismic technology in the 1930's and 1940's substantially reduced the risk in finding petroleum. The resulting geology and geophysics (G&G) revolutionized petroleum exploration.

Decision analysis traditionally has been applied to rank projects hole by hole, determining (on an individual basis) whether they should be explored and developed. Today this "hole-istic" approach 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 geology and geophysics. It then takes into account global uncertainties by adding two additional G's: geoeconomics and geopolitics, thereby reducing risks associated with price fluctuations and political events in addition to those addressed by traditional G&G analysis. The holistic approach is based on, but not identical to, the Nobel-prize winning portfolio theory1 that has shaped the financial markets over the past 4 decades. Our approach deals with the following primary differences between investments in stocks and E&P projects.Stock portfolios depend only on uncertain returns. E&P projects face both local uncertainties, which involve the discovery and production of oil at a given site, and global uncertainties, which involve prices, politics, and other such factors. Furthermore, uncertainties in stock returns usually follow a bell-shaped curve while E&P uncertainties are highly skewed and stress rare events.Historical data exist for stock prices. E&P uncertainties must be modeled by decision trees, Monte Carlo simulation, or other computational means.Risk in stock portfolios usually is measured in terms of volatility—i.e., the degree to which the portfolio swings in value. E&P portfolios must specifically track downside risk.The stock market is quite efficient, whereas the market for E&P projects may be inefficient. (The term "efficient" is used here in its technical, economic sense. An efficient market is one in which there are no barriers to each item being priced at its actual value as determined by all buyers and sellers; i.e., there are no "bargains").Stocks can be bought or sold at will. E&P projects pay out over long time periods.A stock portfolio generally contains a small fraction of the outstanding shares of any one company. An E&P portfolio, on the other hand, often contains 100% of its constituent projects, creating budgetary effects.

Ref. 2 provides a more detailed list.

Portfolio thinking in petroleum E&P is based on understanding and exploiting the interplay among both existing and potential projects. It assists in the following areas.Selecting a set of E&P projects to fund.Illuminating trade-offs between long- and short-term goals.Dealing with political and environmental risk.Evaluating a project for purchase or sale.Determining the risk-related cost of constraints and policies.Determining the criteria for projects that would reduce the risk of the portfolio.Increasing the value of the firm.

We show that analytical models can help to address directly these and similar issues once decision makers become more comfortable with the holistic perspective. First, we present a simple example that shows how to build intuition into portfolio analysis.

Retraining Our Intuition

You are responsible for investing U.S. $10 million in E&P. Only two projects are available, and each requires the full U.S. $10 million for a 100% interest. One is relatively "safe," the other relatively "risky." The chances of success are independent. Table 1 provides the information. The expected net present value (ENPV), vpE, of the two projects, respectively, can be shown to be the same.

Equation 1

Equation 2

If you lose money, you also lose your job. Thus, you have only a 40% chance of unemployment with the safe project, and a 60% chance with the risky one. Both have an ENPV of U.S. $26 million, so you cannot increase ENPV by investing in the risky project. Therefore, if you had to choose between one or the other, you should choose the safe project.

Diversification Effect

Suppose, however, that you could split your investment evenly between the two. Intuition cautions against taking 50% out of the safe project and putting it in the risky one. Examine the four possible joint outcomes. Because the projects are independent, the probability of any particular joint outcome is the product of the probabilities of the associated individual outcomes (Table 2). Note that the sum of the probability column must be 100% because we have exhausted all possibilities.

This allocation of funds still provides an ENPV of U.S. $26 million. Now the only way you can lose money is with two dry holes, for which the probability is 40%×60%=24%; this cuts your risk of unemployment nearly in half! You can reduce risk by moving money from a safe project to a risky one. Intuition misleads. Although this answer is correct, it is not so obvious.

This is known as the diversification effect, popularly referred to as not putting all your eggs in one basket. This line of reasoning is so fundamental that one wonders how the petroleum industry could do otherwise. However, a recognized authority summarizes the conventional selection process with "Just rank exploration projects by expected present worth." 3