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Oil and .Carlisle Associates

MIZ.Y~1996

In recent years here has been ncreasing concern in theinternational oil and gas industry regarding the poorresults ofhigh risk exploration. * Among these concernsare the following:

Institutional FactorsBy definicion, most of the companieswho engage nhigh risk exploration are arge and substantial irms forwhom renewal of their reserve base s 3.deeply heldcorporate goal. Many of thesecompanieshave at theircore one or several sustaining long-lived assetswhichserve as living proof of the importance of .company-builders.. The resulting predisposition for big fidds,and the kind of high risks associated ith the ~ forbig fidds, can easily and unconsciouslyaffect how theorganization as a whole views risk.

. High risk ventures as a classhave DOC een creatingvalue.

. There appears co be a systematic cendency o under-estimate he risk and to overestimate eservesor suchventures.

. For many companies, high risk ventUreshave riddedno commercial dUcoveriesover rdativdy long periodsof time. Much has been written about Rgambler's uin" andrisk-aversion in oil industry investment beha-rior.Butthe persistent readinessof large oil companies o investin high risk exploration suggests hat. at least n thisportion of their investment portfolios, they are n faCtrisk-prone. Whereas the risk-averse nvestor is moretroubled by the prospeCt of loss than excited by theprospect of gain. dephant-minded companies re moredrawn to the potential for a giant discovery han fearfulof the greater ikdihood of loss.

The purpose of this paper is to examine the reasonswhy high risk international exploration has ailed to liveup to itS expectations and to suggestwhat companiescan do about it.We believe hat the trouble with high risk explorationhas three causes:. Many companies, particularly big companies with

large reservebasesand cash low, are risk-prone withrespect co the high risk portion of their explorationportfolios.Predisposition toward taking big risk for big potencialrewards is partly rooted in resource economics. Thelure of elephants is strong not only because theyprovide renewal of reserv~ but beause they generatehigh profitability and sustaining cash Bow. In effect,giant discoveri~ resulting from successfulhigh riskexploration provide the reserve growth and largedevelopment investment opportunities which aredifficult co find elsewhere.

The analysis ools and methods which are mostcommonly used n the industry fail to accuratelycaptUre he riskinessof ventUres t the extremes fthe risk spectrum.. Adequatediversification s much more difficult to

achieve for high risk ventUres han is generallyrecognized.

The psychology of risk-taking also comes nto play. Itb2Soften been noted that oil companiesover-risk lowrisk opportUnities and under-risk high risk ones. Thisphenomenon b2Sbeen very resist2nt o improvement,and says something fundamental about howapectations affect risk taking. In devdopment and lowrisk exploration. where successs apeaed, dry holesare

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-failures"and risk-averse ehavior s the norm. But inhigh risk aploration. "failure" is much more he rulethan the aception. There is no stigmaattached o it.So t becomeselatively e2SYo be drawn to the prizeand nsensitiveo the bet.

crossing at comers are statistically more likdy to behit by an oncoming vehicle than jaywalkers. becausethey rdy on the relative safety of the crosswalk andare less cautious. As applied to exploration. thisphenomenon suggestschat the risk-reducing effect oftechnology n one area s likely to be offset by rakingstill higher risks elsewhere.Misjudging the Risks The tendency or explorationistS o under-risk high riskventures s especiallyworrisome becausehe economicsofhigh risk ventUresare more sensitive o under-riskingthan for lower risk prospeCtS.Chart 1 demonstrates hiseffect. It illustrates the negative impact of an assumed5% deviation betWeen expected and aCtUalprobabilityof success (for example 25% actual versus 30%expeCted)on economic resultS. Economic impact isme3Sured y the ratio of the negative present value ofthe mis-estimation to exploration investment. It can beseen hat the r~!ativ~ negative mpaCt of mis-estimationbecomesprogressively more severe as probability ofsuccess ecreases.t hurtS more, on a per dollar investedbasis, o be wrong by the same degree when the risksarehigh.

Many companiesadmit that they misjudge he ris~and overstate he economicsof high risk explorationmore severely han for other kinds of ventUres. hisremains rue despite he steps aken n recentyears ymany or~izations to strengthen their risk analysisskills and improve their performance n estimatingrisks.UnfortUnately, many of me biases and defeCts n meway explorationiscsperceive and estimate risk are morepronounced in high risk exploration than in othercategories f activity:. People, even nformed people, tend to underestimate

the extent of their uncertainty. When asked toestimate the range of possible outcomes for anuncertain variable, they consistently produce a rangemuch narrower than their real uncertainty. Thisinherent tendency to underestimate uncertainty isespeciallyproblematic in high risk aCtivities, n whichuncertainties are great and informed decision-makingdependson having a good handle on them.

In effect, our ability to clearly discern risk is theweakest or exactly those kinds of projects where tneeds to be the sharpest.

Ch2rt 1: Impact of U udcr-RiIkiDg OnF.xploatioD Eoooomia(Aaual Pa5% Bdow &pa:tal PI) Our ability to discriminate risk deteriorates at theextremes of the risk spectrum. Most people have amuch easier ime judging whether the chancesof anevent are more like one in two than one in three(50% versus 33% probability) than they woulddifferentiating between the 5% and 10% successatescharacteristicof high risk exploration.

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. Getting out or cutting back on high risk ventUres nresponse o poor performance may be aacdy thewrong thing to do, if lack of sufficient diversificationis the underlying cause. We should throw in thetowel when we don't like the odds, not becausewemisjudgedmem.

DiversificationThe third major factor which we believe hascontributed greatly to the dissatisfaction with high riskexploration is the difficulty, even for the largest andbest unded companies, to adequatelydiversify the highrisk component of their exploration portfolios.

. The expected value analysis tools which mostcompaniesuse o evaluateexploration economics donot work very well for high risk exploration. Asshown earlier, expected value is highly leveragedagainst probability of successn high risk ventures.Very small variations in probability of successcanswing economic resultsdramaticaally. What's more,expected value does not give us any informationabout risk. It doesnot tell us how patient we have tobe to achievemathematical expectation, and it lullsus into a falsesenseof comfort where the risks arevery high. Mathematical expectation becomesmanagementexpectation.The danger is that we endup like the man who drowned in a lake whoseaverage depth W2S our feet.

Basic probabilities suggest hat even high risk ventUrescan be relatively easily diversified. Chart 2 shows that,at 10% probability of success,participation in 20-25ventUres s sufficient to give a high degreeof confidenceof achieving at least one success, level of activity thatmost large companies can achieve n a few years ime.The defeCt in this simplistic view is the ambiguity ofdefining success.Exploration risk analysis has ong been plagued by theneed o differentiate technical from commercial success.In the caseof high risk exploration, the gap becweenthe cwo is larger than for other types of exploration.Because hey are most often removed from proved areaswith infrastructure, discoveries need to be larger tojustify development. And they must be larger still toprovide a rerum on the unproductive costsof the highrisk program as a whole. In many areas,gasdiscoveries,even arge ones,cannot be commercially exploited. As aresult of these factors, the chances of making adiscovery which minimally justifies development aremuch lower than the chancesof technical success, ndthe chancesof a discovery which provides a full-cyclereturn on program investment are ower scill.

Chan 2: Cwnulative Probability of FailureAt VarioosVmtme Success ates

The impact of commercial success ates on requireddiversification are dramatic. Chart 2 shows clearly thata much larger program is needed to give reasonableassuranceof successat commercial success ates below1 YJIo.In effect,high-risk exploration may be failing becausecompanies re underestimating he time and moneythey need o commit to the high risk g-ame. his hasseveralmplications:. Even for the largest companies. and even for 3.high

quality program. it may take a long time for high riskexploration to prove out. This makes it difficult todifferentiate luck from skill in the shon run. andperformance cannot be measured with confidenceexcept over time periods which may be too long formanagement comfort. Operating on this much faithand nerve s difficult for many organizations. t is notsurprising that some have thrown in the towel.

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But there are issuesof stntegy here aswdl as methodand skills. If high risk exploration is mum harder todiversify than we thought, companiesneed o be clearof eye regarding he role of high risk exploration ntheir portfoli~ For thosecompmi~ who wish o havesome exposure o opportUnitieswith large upsidepotential, but who are not rdying upon it as aimportant element n their strategy,concerns boutdiversification are not paramount.Those companiesshould be nvestingonly asmuch apital md effort astheY can afford to lose.

What To Do About ItIn our view. the issue s not whether o do high-riskexploration.but how to do it better.One way o do itbetter is to improve risk analysis erformance.Manycompanies avehad goodsu~ in narrowing he ga.pbetWeen estimates and outcomes. But high riskexploration s where he rubbermeets he ro3d n riskanalysis.and further improvementsare needed.We~uggcstseveral specific adaptations o help in chisl1nprovemencrocess: However. companies who commit large resources ohigh risk venturesand who depend on largediscoveriesfor corporate renewal may need to lengthen the timehorizon over whidl they apea high risk exploration tobear fruit. and to develop alternativewaysof measuringthe quality of the exploration effort over shorter time

periods. For example. measuring risk analysisperformance rather than economic su~ess n the shortterm can provide a sound measurement asis.

.Oeveloe and actively use re2lirv checks. Because thereis lirde information in high risk areas, subjective~timat~ play a larger than d~irable role. Data basedon experience in comparable basins, regional andworld discovery size statistics, and field sizedistribution patterns can be used o test the re2lism ofthese udgments.

. EmEhasize Eeer and expert review. For the samereason,high risk ventUresshould be exposed o activeand continuing review by senior technical staff.These reviews should focus on inquiry versusadvocacy. They should emphasize dentifying andevaluating multiple interpretations rather thanpardmetric thinking.

Finally, cxcepc or chose wich uncommon nerve andpatience, companies active in high risk explorationshould probably be ooking co spread heir risks urther.This argues or increased eliance on joint srudy groupsfor conducting high risk explor2tion, and more activeefforts to arrange reciprocal farmin/farmoutrdationships. In &ct, high risk exploration representsan excdlenc opportUnity for strategicallian~ in whid1like-minded companies can share de2S, esour~ andskills. as well as risk.

&tablish risk criteria. Having clear ideas on whatkind and how much risk you are prepared o cUe canhelp avoid the risk" consumption" effect notedearlier. One company, for example, has concludedthat they cannot afford to pursue any ventUJewheremore than one key success parameter (source,~rvoir, crap, seal) has a risk of 50% or more. Conclusion

The trouble with high risk exploration is that theelements described above aa to reinforce and amplifye2d1 other. Large field bias predisposes oward takinghigh risks. Lack of information gives broad scope tosubjective estimate, which is especially mperfect 3.thigh risks. All this leads o under-risking. And under-risking has he combined effect of r2dically overstatinga:onotnics and understating the levd of divelSificationrequi~ Increased3.wareness f these orces and howthey interact is the first step toward more effectiv~managementofhigh risk. .

We also recommend that expected value analysis bereplaced or at l~t supplemented in the C2Se f highrisk exploration by other methods which focus moredirectly on risk and provide a clearer definicion ofsu~. Probabilistic simulation is a much better coolfor analyzing high risk ventUres.And making ~timacesof minimum commercial (devdopable) field size andminimum full-cycle field size would allowcxplorationistS co explicitly consider the probability ofvarious levels of commercial su~ rather than purelygeological success.

Carlisle Associates s a ma1Utgtmmtnt consulting company Spt'C~g in economic.stratt'gic andorganizational ~ affiaing th~ oil ana'gas ndustry.For ftrthn info17n4tion, contactAI Boaoia. Car/iskAssociates..O. Box 572, Carlisle.Massachustm.508) 369-6609. w~ w~lc~ your comment! na'questionsqardin.!Oil andGasBriefs.