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JGE

Techno-Economic Evaluation of Exploration & Production

Sumeet Gupta1 and Manvinder Singh Pahwa2
Due to the role of energy in the global economy, oil is a crucial global commodity,
with a world market of more than $1.5 trillion per year, investment in oil and gas
exploration and production is very high, amounting every year to more than $200
billion. The total fleet of tankers amount to more than 10,000 vessels and 350 million
tonnes of oil capacity. The oil and gas upstream sector is capital intensive sector.
Globally, the ratio of investment to revenue is around 8% for the whole sector. For
the upstream segment of international oil companies, the ratio of capital expenditure is
much higher, around 17%.This can be compared to a global industrial ratio of around
6-7% in the US and Europe. Today more than 150 oil and gas projects with
expenditure over $1 billion are ion development.
Economic characteristic of oil and gas industry
Deciding to develop new E&P projects is the main task of the Executive
committee of major oil and gas companies and capital discipline is a necessity to
balance technologies, geological, financial and geopolitical risks. The decision of
capital is very important because of the uncertain nature of oil and gas production.
Using cost estimates, oil and gas price assumptions and fiscal and contractual term, oil
companies can develop a revenue model for the entire life of the field.
Oil and gas exploration and production remains a risky business, despite
technological progress. Discovering and producing new resources is a very
challenging process, with physical, environmental, technological conditions becoming
even more difficult. During exploration activity, despite constant progress is our
understanding of the subsurface, a percentage of an oil and gas exploration investment
vanish in dry well. Between 1990 and 2003, technical costs were decreasing,
accompanied by technological improvements and strong competition in the service.
Since 2004, with the strong surge in oil demand, the pattern costs have changed. With

1
Head Center for Infrastructure and Project Finance, University of Petroleum and Energy
Studies, Dehradun,
2
Manvinder Singh Pahwa, Associate Prof and Head, Department of Accounting and Finance,
University of Petroleum and Energy Studies, Dehradun

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higher oil price, oil companies have raced to develop new resources quickly. A long-
term trend of decreased costs has been replaced by a strong increase in many of the
service sectors.
All business decisions including oil and gas projects require assignment of
commerciality of the propose project. While basic theories and rules of such analysis
remain same for all the ventures, the details usually are field specific. I n this project,
an attempt has been made to understand and record the basic principles of Techno-
Economic analysis undertaken in oil and gas sector which broadly includes:
 Reserve estimation
 Preparation of production profile and revenue generation
 Cost estimation
 Calculation of economic indicators evaluation

All the parties involved in such projects undertake Techno-Economic analysis.

The present project also involves hands on analysis of numerical examples designed
specifically for the purpose to impart a total understanding of the nature and practical
aspects of such a work. The importance of the study is immense in the sense that for
any venture it is imperative to be techno-economically viable to be undertaken. Such
studies also help to access and compare the available investment opportunities. The
knowledge gained from the project can be utilized in various realistic situations where
techno-economic analysis acts as one of the main decision aiding method. This report
gives an idea of the methodology adopted for techno-economic appraisals in the
petroleum sector. An oil and gas companies may be involved in four different types of
functions or segments:

 Exploration and production

 Transportation
 Refining and as processing
 Marketing and distribution
Understanding Techno-economic analysis
Economic evaluations of petroleum projects include, in addition to assumptions
about the value of hydrocarbons, three types of data:
 Production profiles, constructed by reservoir engineers from analysis of the
drainage mechanisms.
 Capital and operating costs evaluated by cost estimators and managed by the
project manager and the field manager respectively.
 Contractual and fiscal conditions, which can have a decision role.
In the evaluation process these three types of data have to be analyzed
independently of one another, but also subjected to an overall optimization cycle such

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as to maximize value added. These optimization processes almost always leads to a
choice being made between alternative development options in which the
minimization of capital and operating costs is a fundamental and on-going
requirement. The company’s profitability and competitiveness depends on this. This
imperative applies at all stages of the project.
Choosing the right development architecture, accurate costing and controlling
expenditure across the board are the keys to success.
Literature Review
Oil and gas exploration and production by center of Economics and
Management (IFP- School)
Oil and gas producing industry, which is extractive in nature, involves activities
related to acquisition of minerals interests in properties, exploration, development and
production of oil and gas. Oil and Gas companies consist of many types of activities
before it starts its operation in the field. It involves bidding procedure, acquiring
mining lease, petroleum exploration licence. It consists of high risk and uncertainties
which may cause financial distress for company. In order to ensure the receipt of fair
market value for oil and gas asset economic evaluation is performed. Economic
evaluation consists of the assessment of oil and gas resources the valuation of
resources in the market and the use of evaluation in considering the bid, exchange
offer or other action. Full development of all three components of economic
evaluation is essential if it is to be successful evaluation. Economic evaluation process
embraces a range of procedures which, when applied to available data leads to an
estimation of the right’s and property’s value. So to quantify the risk and uncertainties
a good economic evaluation process is needed.
1) Project economics and decision analysis: volume 2 by Miamian
Deciding to develop new E&P projects is the main task of the executive
committee of major oil and gas companies and capital discipline is a necessity to
balance technologies, geological, financial and geopolitical risks. The decision of
capital is very important because of the uncertain nature of oil and gas production.
Estimation of the right’s and property’s value. So to quantify the risk and uncertainties
a good economic evaluation process is needed.
All business decisions including oil and gas projects require assignment of
commerciality of the propose project. In this project, an attempt has been made to
understand and record the basic principles of Techno-Economic analysis undertaken in
oil and gas industry.
Research Methodology
Objective

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To analyze how to quantify the risk and uncertainties in Oil and Gas companies in
Exploration and Production.
- To conduct economic evaluation process like internal rate of return,
Net Present Value, discounted payback period, etc.
- To comprehend that how the best project is decided among many
projects on economic basis.
Theoretical framework:
The whole framework for collecting the data for carrying this research will be
based upon secondary data.
Source of data:
Secondary data will be used for this study and it will be collected from different
sites through internet, previous research papers, etc. and I will giving the conclusion of
this study with the help of secondary data and by analysing the various factors such as
IRR, NPV, Sensitive analysis,etc.
Types of costs
0il and gas accounting relates to accounting for the four basic cost
incurred by companies with oil and gas exploration and production
activities. These four basic types of costs are as follows:
 Exploration costs: Cost incurred in exploring properly.
They are incurred mainly before the discovery of a hydrocarbon
deposit. Exploration involves identifying areas that may warrant
examination and examining specific areas, including seismic
geophysics, the geological and geophysical (G&G) interpretation,
drilling exploratory wells along with test wells.
 The Investment costs: Incurred In the delineation and
appraisal phase, necessary to gain knowledge of the reservoir;
 Development costs: costs incurred in preparing proved
reserves for production, i.e. costs incurred to obtain access to
proved reserves and to provide facilities for Drilling the production
wells and, if appropriate, the injection wells, Construction of the
surface installations such as the collection network. Separation and
treatment plants, storage tanks, and pumping and; Construction of
transport facilities such as pipelines and loading terminals.
 Operating costs: including transportation costs,
Exploration costs
Exploration costs are generally less than other items of
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expenditure. On the other hand they are incurred before the discovery
of hydrocarbons, and will therefore have a direct impact on the
accounts of the company, the recovery of these costs being linked to
the likelihood of the success of the exploration programme, in
general between 10% and 30 %.
Analysis of data
Once the seismic data have been acquired and processed, they have to be
transformed into data which can be used by the decision makers (maps,
drilling profile, reservoir models, etc.), whether in the exploration or
development phase. The processing and the interpretation of data using
software are carried out under the control of specialists. This work involves
personnel and data processing cost which may be in the range $100,000 to $1
million in seismic survey.
Trends in costs
a. Effect of technological progress
3D seismic techniques are in a constant state of evolution. Unit costs have
fallen considerably since the late 1970s when the technique was first
introduced. This reduction in costs has been achieved through technological
progress in the following areas:
 Optimization of parameters so as to eliminate data
redundancy;
 Multiflute/multisource 3D data acquisition which allows
several traces to be acquired simultaneously;
 On-board automation
Significant reductions in the length and expenses of the projects have been
achieved thanks to fail in cost of information technology.
Methodology for estimating development costs
Here a rapid overview of the principal methods used by estimators during the
various study phases.
ESTIMATE
An estimate is a statement of the most likely cost of an industrial project,
elaborated before all the parameters of the investment have been defined
Structure of a cost estimate
 Direct costs

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These consist of the cost of the main equipments, required for process plant and
the utilities and the cost of the secondary equipment.

 Indirect costs
These include the cost of transporting the equipment, materials and the different
structures. The general expenses referred to as EMS covers (engineering, management
and supervision):
1. The engineering, i.e. the basic engineering and the detailed engineering
2. The commissioning of the structures
3. The management and supervision of the team in change of the project
Principal cost estimation methods
Various methods are:
1. Analogies with the known costs
This method is suitable for exploratory studies. The cost is estimated by reference to
the known cost of an existing installation of the same type but the different capacity. It
is assumed that the ration of the costs of the two installations is equal to the ratio of
their capacities raised to the power of approx 0.6.

2. Factoring method
These methods are particularly used for preliminary and conceptual studies. They are
based on the observation that there is a fairly constant relationship between direct
installed cost of an item of processing plant and the cost of the main items of the
equipment.
Operating costs
The operating costs are the total expenditure to the operation of a production plant
the abbreviation Opex is used to refer to the operating expenditures a distinct form
Capex the capital expenditures However the boundary between these two categories is
sometimes somewhat grey and depends on the organization and the site some
companies for example prefer for legal or fiscal reasons to hire equipment rather than
purchase it thereby giving rise to operating rather than capital cost.
About two thirds of the operating costs consist of four major items i.e. general
support provided by the operating companies (about 20% of the total costs),well
operations(about 15%),maintenance and logistics(each about 15%). Personnel costs
usually represent a large percentage of this total, but depend in the first instance on the
level of subcontracting. The balance includes contracts, purchases and services. The
remaining one-third of expenditure comprises various items which account for
between 1.5 and 8 of the total costs and include for example, inspection, security,
walkovers and new-works.
Classification of operating costs
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The operating costs can be classified either by their nature (personnel services
suppliers) or by the purpose (production maintenance security etc.) Where items are
classified by the nature, they should generally conform to the accounting conventions,
which may have a statutory character in the particular country concerned. They will
include in particular personnel costs accommodation subsistence transport,
Consumables, telecommunication costs, service and maintenance contract. The
classification by purpose allows the costs to be analyzed in a manner which
corresponds more closely to the objectives of the operator. The following breakdown
is an example:
The direct costs comprise down hole and surface production and indirect cost
include technical assistance, operating company staff and head office staff. The
transport costs are the costs related to the transmission pipelines and the terminals.
The indirect costs include technical assistance, operating company staff and head
office staff. This breakdown must be made according to very precise rules so that the
costs can be monitored throughout the life of the field, compared between installations
and so that the costs of planned installations can be estimated.
Optimisation
An n analysis of expenditure, beginning with the large items will allow areas to be
identified where economics are possible by reviewing current practices and technical
specifications. Example of areas in which savings might be possible is:
 Personnel cost
 Consumption of chemical products
 Use of spares
 Storage costs
 Review maintenance policy
Reducing operating costs
Opportunities to reduce the operating costs present themselves in both design and
operating phase.
Design phase
 Make use of modern techniques of installation management
 Simplify the control systems, concentrate on the instrumentations
which is really necessary
 Allow rapid and easy access to machinery and equipment
 Minimize the number of machines installed
 Select equipment based criteria of maintainability, reliability, ease of
diagnosis and quality

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Operating phase

 Outsource all or some operating and management functions

 Increase versatility of some workers
 Optimize maintenance, plan major maintenance as a function of
remaining life of project
 Limit measures on reservoir to those which are really justified
 Renegotiate contracts.

Cash flow analysis

Cash flow
In addition to being the link, in accounting terms, between the profit and loss
account and balance sheet, it is the cash flow statement which provides the link
between the accounting of a company and its economic evaluation through discounted
cash flow techniques
Cash-in items
The main cash-in is a company’s share of its gross revenues, which mainly arise
from the production and the sale or crude oil, natural gas.
Cash-out items
The initial cash-out items are the technical costs associated with the development
and operations of the project technical costs can be divided into either cape for goods
that last for more than one year and Opex for goods and services that have a lifetime
of less than one year. Capex is the dominant cash flow items in the earlier years of a
project.
Cash flow is simply the cash received minus cash expenditure over a defined
period of time.
Net cash flow = cash received – cash expended
Main elements of cash flow for an oil and gas project
1. Gross revenue
Gross revenue from a petroleum investment is in general derived from the oil or gas
reserve volume multiplied by the expected price.
2. Capital costs
The main characteristic of capital cost is that they are one-off costs. Incurred at the
beginning of a project .capital expenditures consist of the costs of drilling tankers,
offshore platform construction and installation, process facilities.

3. Operating costs
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They occur periodically and are necessary to maintain productions from the field.
Operating costs consists of field labour costs, maintenance costs, office, tariffs, etc.
operating costs are not normally incurred until production is underway
4. Abandonment costs
These are a specific category of capital expenditure associated with banding an oil and
gas field life once it has become uneconomic to continue production.

Economic life
A critical aspect of the cash flow profile of an oil and gas project is its role in
determining the economic life of the field. If we ignore fiscal costs, it becomes
uneconomic to continue operating the field, when gross revenue less operating cost
becomes zero. Under such circumstances the field would be shut in and the economic
life of the field would be the period from the start of production to the year of shut in.
Net cash flow and profit

1. Net cash flow is a measure or estimate of money actually received and actually
spent during a period.
NCF=cash received-capital expenditure-operating expenditure-royalties, taxes,
profit sharing
2. Profit is an artificial measure used in annual accounts or tax calculations.

Profit=cash received-depreciated Capex-Opex-royalties, taxes, profit sharing etc.

Different approach for Economic evaluation

The four main economic indicators or measures of economic benefits, which
currently used in the oil and gas industry, are as follows:
1. Net present value
2. Internal rate of return
3. Payback period
4. Capital productivity index

Risk in the Petroleum Industry

Accounting for risk in petroleum investment analysis is important because the

outcome of the investment decision depends on a wide range of uncertain estimates.
This uncertainty is further compounded by the uncertainty in product prices, expenses,
future investments and tax laws. In addition, the mechanical risks associated with
production facilities, human error and new technologies add to the geologic and

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investment uncertainties. The role of good investment plan is to accurately define the
level of risks assumed and expected yield from the investment in light of the identified
risks and uncertainties. An efficient plan of action has to be provided to justify the
exposure of funds to risk and for managing risk.
Uncertainties are largest at the exploration stage. At the stage of appraising the
discovery, it is still far from certain that discovery will be developed and provides a
return to shareholders. The production stage is associated with the lowest level of risk,
but the potential for unexpected reservoir performance problems, accidents.
Risk and required return
We need to take all different kinds of risks into account when making oil industry
investment decisions. In theory, we can classify the risks associated with decision to
invest in an oil or gas field development project in terms of different components of
the return required from the project.
 Risk free return: is the interest rate which shareholders could earn by investing
in “safe” long term investments such as term deposit accounts Treasury bond etc.
 Company risk premium: is measured by the extra return which shareholders of
the company expect on their share. It includes aspects of the company’s overall
performance rather than aspects of any particular proposed project.
 Risk of project proposed: it is the total of the project risks of the particular
investment which are evaluating. This covers exploration, appraisal and development
risks about which, the shareholders of the company might not have complete
information.
Treatment of risks
The logic behind a require discount rate for discounting net cash flow for new
project evaluation is that it establishes the opportunity cost of capital for the company.
The opportunity cost of capital is the return lost by not investing in the average
project.
The cost of capital or the required or expected return is compared of a risk free
rate plus the premium which takes into account company risk.
r= rf + company risk premium
Where, r= expected return
rf= risk free rate
Estimating the company’s risk premium
The company risk premium can be assessed by examining the past behaviour of
the returns to company shareholders. Measure of total share market performance can
be represented by movement in share market index.

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The slope of the line tells us how much an average; an individual company’s
return to shareholders has varied by comparison to the return obtained from a share
market index. Slope is called company’s beta.
 Slope = 1,if they move together
 Slope < 1, if they return on company’s share value less than the share market
as a whole
 Slope > 1, if they return on company’s share varies more than the share
market.

Expected value
While sensitivity analyses implicitly recognize the existence of risk and
uncertainty, they do not take into account quantitatively and explicitly. We must rely
on risk weighted and expected value concept and probability theory in general to
allow us to assess the quantitative effects of risk. Expected value analysis is a good
place to start. It is the main criterion used to summarize a probabilistic future is the
expected value of the net present value, i.e. the weighted average of the possible
values of the NPV, the weights corresponding to their probability.
There are several concepts used in expected value analysis which require
definition at the outset. These are:
Decision alternatives
A decision alternative is an option, or choice, open to the decision makers. The
choice might be for instance, to drill or not to drill an exploration well, to develop a
discovery, or to gamble on a coin tossing game.
Outcome and Expected value of an outcome
An outcome or an event is something which would occur once a decision is made.
Risk analysis recognizes that there will be more than one outcome to a decision
alternative.
The expected value of an outcome is the conditional value an event is called the
conditional value of the event, if it is distinct from its expected value.
EV = (Vs * Ps) + (Vf * Ps)
Where, EV = Expected value
Vs = Conditional value of success
Ps = Probability of success (%)
Vf = conditional value of failure
Pf = Probability of failure
Decision tree analysis

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Expected value analysis can be extended to cover more complicated problems
which involve a series of connected decisions and more than two outcomes. The
analysis of series of connected decisions is called “decision-tree analysis”. The logic
and philosophy remains the same as expected value analysis, but can handle problems
which are more complicated.
A decision tree is a simply a diagram showing a sequence of decision points and
their possible outcomes.
Handling uncertainty in Capital investments
Many approaches, with varying degree of sophistication are used in the industry
for treating uncertainty in capital investment decisions. These are:

1. Sensitivity analysis: Sensitivity analysis referred to as what if analysis.

2. Scenario analysis: It is the technique that considers the sensitivity of the
investment’s profitability to changes in key variable and the range of likely variables
used. In scenario analysis, a bad set of circumstances (such as lower production), an
average set, and a good or optimistic are then calculated and compared. The bad set,
average set, good set are typically referred to as worst-case scenario, most-likely
scenario and best case scenario respectively.
3. Probability approach 1: Probability approach utilizing the expected values of
the decision criterion for each alternative and determining the preferred course of
action based on expected value.
4. Probability approach 2: Probability approach where an explicit measure of
risk is used in additional to the expected value.
5. Computer simulation: Computation simulation where different combinations
of
Uncertain variables are derived from profitability distributions of each variable.
The outcome for a measure is determined for each for each combination. Thousands of
randomly generated combinations for each variable are normally tried.

Sensitivity analysis
Sensitivity analysis is one of the simplest methods of investigating the impact of
variables.
Sensitivity analysis, referred to as what if analysis, is a technique indicating
exactly how much the profitability of a project will change in response to a given
arbitrary change in an input variable, other variables held constant, the analysis begins
with a base case situation using the most likely input values. Then each variable is
changed at a time by a specific percentage above the expected value and profitability
calculated. The derived profitability measures are then plotted against the changed
variables. The plot shows how sensitive the profitability of the investment is to change
in each of the input variables.
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A base case is generated, using mean of each variable, which yields the base case
NPV at required discount rate or at different discount rated and IRR or any other
economic indicator.
For instance, suppose a base case economic analysis of a potential field
development establishes that it has a net present value of $ 100 million. Varying the
capital costs of the development by plus 20 % and Minus 20 % give the NPVs as
shown in table.

Percentage of base case variable NPV in $ MM

120 % $ 50
110% $ 75
100% $ 100
90% $ 125
80% $ 150
Sensitivity of changes in capital costs
This example of sensitivity analysis shows that the project is very sensitive to
variations in capital costs. For instance, a 10% increase in capital costs results in
.25% reduction in the project’s NPV.
Sensitivity analysis can assist us in showing what happens to the project if the
assumptions are different to our original assumptions. However, sensitivity analyses
do not take into account the probability of different assumptions applying. We must
turn to risk assessments to help us in this aspect of economic analysis.
Case Study: Oil and Gas Exploration and ProductionTechno-Economic
calculation Fast computational models, split up in modules
In this case study, we explore a practical model of drilling prospect taking into the
account many of the risk factors. While the model is hypothetical, the general
parameters we use are consistent with those encountered drilling in a mature, oil-rich
basin in United States (e.g... Permian Basin of west Texas) in terms of the risk factors
and related revenues and expensed. This model is of great interest as a Techno-
Economic framework and approach than it as an evaluation of any particular drilling
prospect; its value is in demonstrating the approach to quantify important risk
assumptions in oil profitability forecasts of the project. The techniques described
herein are extensible to many other styles and types of oil and gas prospects.
Cash –Flow Models
The model was constructed using Risk simulator, which provides all of the
necessary Monte Carlo simulation tools as an easy –to –use, comprehensive add –in
to Microsoft Excel . The model simulates the drilling outcomes as being a dry –whole
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or an oil discovery using dry-hole risk factors for the particular geological formation
and basin. Drilling seismic and land lease costs are incurred whether the well is dry or
a discovery, if the well is discovered; a revenue stream is computed for the production
oil over time using assumptions for the product price and for the oil production rate as
it declines over time from its initial value. Expenses are deducted for royalty payments
to land-owners, operating costs associated with producing the oil, and severance taxed
levied by state on the produced oil. Finally the resulting net cash flows are discounted
at the weighted average cost of capital (WACC) for the discounted at the firm and
summed to a net present value (NPV) for thru project. Each of these sections of the
model is now discussed in more the detail
Dry –Hole Risk
Companies often have proprietary schemes for quantifying the risk associated with
not finding any oil or gas in their drilled well. In general, though there are four
primary and
Independent conditions that must all be encountered in order for hydrocarbons to
be found by the drill bit:
1. Hydrocarbons must be present.
2. A reservoir must be developed in the rock formation to hold the hydrocarbons
3. An impermeable seal must be available to trap the hydrocarbons in the reservoir
and prevent them from migrating somewhere else.
4. A structure or closure must be present that will cause the hydrocarbons (sealed
in the reservoir) to pool in a field where the drill bit will penetrate.
Because these four factors are independent and must each be true in order for
hydrocarbons to be encountered by the drill bit ( and a dry hole to be avoided ) the
provably of a producing well is defined as:
P Producing well = P hydrocarbons * P Reservoir * P seal * P Structure
the model section labelled “ Dry – Hole Risk “ along with the probability
distribution for each factor’s Monte Carlo assumption, while a project team most often
describes each of these factor as a single point estimate, other methods are sometimes
used to quantify these risks. The most effective process involved the presentation of
geological, geophysical and engineering factors by the prospect team to a group of
expert peers with a of the risk factors. The resulting distribution of risk factors are
often appeared near- normally distributed, with strong central tendencies and
systematically fails. This approach was very amenable to Monte Carlo simulation. It
highlights those factors where there was general agreement about risk brought the
riskiest factors to the foreground where they were examined and specifically
addressed.
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As described earlier , the Net producing Well Probability fields in the model
corresponds to the product of the four previously described risk factors These four
risk factors are drawn at random samples from their respective normal distributions for
each trial or iteration of the simulation finally as each iteration of the Monte Carlo
simulation is conducted, the field labelled producing well generates a random number
between zero and one to determine if that simulation resulted in a discovery of oil or
a dry hole . If the random number is less than the net producing well probability, it is a
producing well and shows the number one. Conversely, if the random number is
greater than the net producing well probability, the simulated well is a dry hole and
shows zero.
Production Risk
A multiyear stream of oil can be characterized as an initial oil production rade
(measured in barrels of oil per day, bopd) followed by a decline in production rates as
a natural reservoir energy and volumes are depleted over time. Reservoir engineers
can characterize production declines using a wide array of mathematical models,
choosing those that closely match the geology and producing characteristics of the
reservoir. Our hypothetical production stream is described with two parameters
1. IP. The initial production rate tested from the drilled well;
2. Decline Rate. An exponentially decline production rate that describes the
annual decrease in production from the beginning of the year to the end of the same
year .production rates in BOPD for our model are calculated by:
Rate Year End = (1-Decline Rate) *Rate Year begins
Yearly production rotes volumes in barrels oil are approximated as
Oil volume year = 365 * (Rate year begin * Rate yearend)/2
For Monte Carlo simulation, our model represents the IPs with a log - normal
Distribution with a mean of 441 BOPD and a standard deviation of 165 BOPD
The decline rate was modelled with a uniform probability of occurrence between 15%
and 28% to add interest and realism to our hypothetical model, we incorporated on
additional by imposing a correlation coefficient of .60 between the IP and decline rate
assumptions that are drawn from their respective distributions during each trial of the
simulation.
The production and operating expense sections of the model are shown, Although
only the first 3 years are shown the model as courts for up to 25 year of production
However when production declines below the economic limit, it will be zeroed for the
year and very subsequent year ending the production life of the well as a shown the ip
is assmumde to o occur at the end of year with the fast full year of production
accounted for at the end of the year 1.
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There are two assumptions in our model that represents risks in our prospect:
1. Price. Over the past 10 years oil prices have varied from $13.63/barrel model
assumes a normal price distribution with a mean of $20.14 and standard deviation of
$4.43/barrel.
2. Net Revenue Interest. Oil companies must purchase leases from minerals
interest holders. Although with paying cash to retain the lessee also generally retains
some percentage of the oil revenue produced in the form of royalty. The percentage
that the producing company retained after paying all royalties is the net revenue
interest (NRI). Our model represents a typical West Texas scenario with an assumed
NRI distributed normally with a mean of 75% and a standard deviation of 2%.
The revenue portion of the model is also shown in table 2 immediately below the
production stream.
The yearly production volumes are multiplied by sampled price per barrel, and
then multiplied by the assumed NRI to reflect dilution of revenue from royalty
payment to lessees.
Operating Expenses Section
Below the revenue portion are operating expenses, which include two
assumptions.
1. Operating Costs. Companies must pay for manpower and hardware involved in
the production process. These expenses are generally described as a dollar amount per
barrel. A reasonable West Texas cost would be $4.80 barrel with a standard deviation
of $0.60 per barrel.
2. Severance taxes. State taxes levied on produced oil and gas are assumed to be a
constant value of 6% of revenue.
Operating Expenses are subtracted from the grass sales to arrive at net sales,

Drilling costs $ 1,209,632

Competition cost $ 287,000
Professional overheads $ 160,000
Lease costs/well $ 469,408
Seismic costs/well $ 81,195

Table: Year 0 expenses

Table shows the year 0 expenses to be incurred before oil production from the
well (and revenue) is realized. These expenses are:
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1. Drilling costs. These costs can vary significantly as previously discussed due to
geologic engineering and mechanical uncertainty. It is end tail consisting of a small
number wells with very large drilling costs due to mechanical failure and unforeseen
geologic or serendipitous with a mean of $1.2 million and a standard deviation of
$200,000.
2. Completion Costs. If it is determined that there is oil present in the reservoir (and
we have not drilled a dry hole), engineers must prepare the well (
mechanically/chemically) to produce oil at the optimum sustainable this cost is
normally distributed with a mean of $287,000, and a deviation of $30,000.
3. Professional Overhead. This project team costs about $320,000 per year in salary
and benefits, and we believe the time they have spent is best represents by a triangular
distribution, with a most likely percentage of time spent as 50% with a minimum of
40% a maximum of 65%.
4. Seismic and lease costs. To develop the proposal, our team needed to purchase the
right to drill on much of the land in the vicinity of the well. Because this well is not
the only well to be drilled on the seismic data and land, the cost of these items is
distributed over the planned number of wells in the projects. Uncertain assumptions
are shown in table4, and include leased acres, which were assumed to be normally
distributed with a mean of 12,000 and a standard deviation of 1.000 acres. The total
number of planned wells over which to distribute the costs was assumed to be uniform
between 10 and 30.
Net Present Value Section
The final section of the model sums all revenues and expenses for each year
starting at year 0 discounted at the weighted average cost of capital(WACC-which we
assume for this model in9%per year) and summed across years to compute the
forecast of NPV for the project .In addition, NPV/I is computed, as it can be used as it
can be used as a threshold and ranking mechanism for the portfolio decisions as the
company determines how this project fits with its other investment opportunities
given a limited capital budget.
Monte Carlo Simulation Results
As we assess the result of running the simulation with the assumption defined
previously, it is useful to define and contrast the point estimate of project value
computed from our model using the mean or most likely values of the earlier
assumptions. The expected value of the project is defined as:
Project = EDry Hole + EProducing Well
= PDry Hole NPVDRY Hole+ PPRODUCING Well NPV Producing well

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Where PProducing Well= Probability of a producing well and PDRY Hole
=Probability of a dry Hole= (1 – Pproducing Well). Using the mean or most likely
point estimate values from our model, the expected NPV of the project id $1,250,000
which might be a very attractive prospect in the firm`s portfolio.
In contrast, we can now examine the spectrum of outcome their probability of
occurrence. Our simulation was run with *, 450 trials (Trial sixe selected by previous
control) to forecast NPV, which provided a mean NPV plus or minus $50,000 with
95% confidence. The distribution is obviously bimodal, with a large, sharp negative
NPV peak to the left representing the outcome of a dry hole. The smaller, broader
peak towards the higher NPV ranges represents the width range of more positives
NPVs with a producing well.
All negative NPV outcomes are to the left of the NPV =0 Line (with a lighter
shade) while positive outcomes NPVs are represented by the area to the right of the
NPV = 0 line with a probability of a positive outcome (breakeven or better) shown as
63.33% of interest, the negative outcome possibility include not only the dry-hole
population of outcomes as shown, but also a small but significant portion of
producing-well outcomes that could still lose money for the firm. From this
information, we can conclude that there is a 30.67% that this project will have a
negative NPV.
IP. The initial production rate of the well has a driving influence on value of this
project, and our uncertainty in predicted project outcomes. Accordingly, we could
have out team of reservoir and production engineers further examine known
production IPs from analogous reservoirs in this area, and perhaps attempt to stratify
the data further refine prediction of IPs based on drilling or completion techniques,
geogical factors or geophysical data.
Oil Price (year1) and Drilling Costs. Both of these items are closely related in
their power to affect NPB Price uncertainty could best be addressed by having a
standard price prediction for the firm against which all would be compared Drilling
could be minimized by improvements in the drilling team that would tighten the
variation of predicted costs from actual costs. The firm could seek out companies
with strong records in their project area for reliable, low cost drilling.
Decline rate. The observant reader will note a positive signed correlation between
decline rate and project NPV. At first glance this is unexpected, because we would
normally expect that a higher decline rate would reduce the volumes to be sold and
hurt the revenue realized by our project.
Conclusion
Monte Carlo simulation can be an ideal tool for evaluating oil and gas prospects
under conditions of significant and complex uncertainty in the assumptions that would

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render any single point estimate of the project outcome nearly useless. The technique
provides each member of multidisciplinary work teams a straightforward and effective
framework for quantifying and accounting for each of the risk factors that will
influence the outcome of his or her drilling project. In addition, Monte Carlo
simulation provides management and team leadership something much more valuable
than a single forecast of the project’s NPV. It provides a probability distribution of the
entire spectrum of the project’s NPV. It provides a probability distribution of the
entire spectrum of project outcomes, allowing decision makers to explore any
pertinent scenarios associated with the project value. These scenarios could include
breakeven probabilities as well as scenarios associated with extremely poor project
results that could damage the project team’s credibility and future access to capital or
outcome that results in highly successful outcomes. Finally Monte Carlo simulation of
oil and gas prospects provides managers and team leaders critical information on
which risk factors and assumptions are giving them the all-important feedback they
need to focus their people and financial resources on addressing those risk
assumptions that will have the greater positive impact on their business improving
their efficiency and adding profits to their bottom line.
Findings
For oil companies the deployment of capital is also influenced arming other
things by firms tolerance risk Most companies generally do not have a systematic
process in place that educates true when companies are faced with rapid market
changes or when changes in the corporate of entire investment decision. A techno –
economics analysis system allows decision makers to see what the marginal of each
asset is to their overall portfolio is which will help the firm identify the optimal
decision for the project because of the various risks with take away project from the
moreover management will see what kind of effect arises as they add and take the
some risk exposure levels with a significant decrease in capital spending
As a further benefit, integrating techno economic analysis to the preference
analysis approach the form to incoporance their financial into the portfolio selection
process. This step is generally intuitive to the decision maker who has an abundance
of knowledge about the individual characteristics of the assets in the portfolio and
what financial risks he faces. This integrated approach goes beyond what the decision
maker can cognitively process by systematically analyzing the interdependencies
among assets, the diversification effects, and the impact of risk aversion on the firm’s
choice of portfolio along the efficient frontier. This approach enables the manager to
evaluate and understand the explicit tradeoffs between risk and return and the impact
of the firm’s attitudes about those tradeoffs.
The oil and gas projects typically have large cash outlays over several years at the
beginning of the project. That is, initially cash flows are negative and revenues are not
received until production starts. Revenues are typically maximum at or near the start
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of production and decline in real terms as the field becomes depleted. Therefore net
cash flows typically become positive as production starts and remain positive until end
of field life. To remain competitive, companies must efficiently deploy their capital in
ways that maximize returns and minimize risks. Economic evaluations of investment
project using discounted cash flows are are the rule in oil companies. As in other large
exploration.
It is important that these evaluations are carried out in a rigorous manner because
although the techniques are very simple, this very simplicity can lead the novice to
forget the snare awiting the unwary practitioners. Some of these traps are: going, other
things being equal, for the project with the highest rate of return when choosing
between projects; unreflective use of the discount rate which includes a high risk
premium; mixing values in current and constant prices, etc. Whether one sticks to a
sensitivity analysis, always a must, or goes more for the more sophisticated
techniques for analyzing risk, capital budgeting techniques are intended to summarize
in a single or a small number of numerical values a large set of data. They are a tool
for ensuring coherence between the assumptions used by different sectors in the
company. Of course the economic evaluation is only one of the factors to be taken into
account when making a decision, because it is never possible to quantify all the
consequences of a decision. But the object should be for it to be used by all the
different factors involved in investment projects: technical, financial mad management
specialist, etc.
In this regard economic evaluation can provide a means of communication
between specialists with different backgrounds: a genuine common language.
References
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4. Fundamentals of oil and gas accounting by Rebecca A. Gallun, J. Wright, Linda M.
Nicolas John W. Stevenson
5. Petroleum economics and offshore mining legislation: a geological evaluation by
Anton Pedro Hendrix Van Moors
6. The financial Economies of privatisation by William L. Megginson
7. International petroleum accounting by Charlotte J. Wright and Rebecca A.Gallun
8. Valuing oil and gas companies: a guide to the assessment and evaluation of assets,
performance and prospects by Robert Arnott
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