The Consideration and Applicability of Game Theory to Reserve Valuation
Authors: Kimbrell William Clay 
Published: October 2008

Petroleum engineers follow guidelines set forth by the SPE/WPC/AAPG/SPEE for reserve classification when estimating reserves. Once these classifications have been defined, the reserves are risked accordingly. This classification allows uncertainty and risk to be incorporated into the reserve estimate itself, but not necessarily the dynamics of the chosen strategies for recovering and marketing the reserve.

Because of the many unknowns and uncertainties inherent in accurately identifying a reserve amount, the process includes an element of chance and, therefore, incorporates probability theory. By the same logic, the process of identifying a reserve value, which is realized by implementing a recovery strategy, should incorporate game theory.

Probability theory deals with chance, while game theory deals with strategy. Probability theory assists with the classification of the risk associated with the actuality of the reserve amount, while game theory assists with the classification of the strategy associated with the recovery of the reserve, which defines the fair market value of the reserve.

Estimating a fair market value for a reserve must incorporate a whole new set of parameters. A consideration that should be incorporated into a reserve valuation is the entities attempting to recover and market the oil and gas reserves through their designed and implemented strategies. These entities' decisions will affect the efficiency of recovering the reserves. These decisions are typically made by more than one decision maker and they may be in conflict and they may be negotiated or non-negotiated.

For example, consider operators that are small independents with capital constraints. Decisions and strategies may be decided upon that are more for short term financial reasons, rather than efficient production of the reserves. Additional examples might include the involvement of unstable governmental regimes that are unable to protect the recovery operations or companies with dynamic economic focus that lower priorities for recovering specific reserves. All of these different "player strategies" can affect the time and cost of recovering the estimated reserves and, ultimately, affect the fair market value of the defined reserves.

The payoff is defined as a proportionate amount of the total value of the reserves to each player. The payoff is, therefore, the variably defined fair market value. There are three players; the owner of the reserves (the lessor), the operator of the recovery operations (the lessee) and the service providers. All three players are concerned with having their maximum payoff from the recovery of the defined reserves. The lessor of the reserves, by virtue of its lease to the lessee, has assigned its associated costs to the lessee for a defined proportionate share of the defined reserve. The lessee assumes all costs. Its payoff is the total value of the reserves, less the costs and royalties. The lessee's costs are the service providers' payoff.

This paper discusses practical concepts of game theory for the inclusion of "player affects or strategies" that may include "conflicting decision makers" and "negotiated" or "non-negotiated strategies" in the methodology for arriving at a fair market value of estimated reserves.