Imre Szilágyi, Exploration Geologist and Petroleum Economist, Budapest, Hungary
Oil industry economists are often puzzled when they face the challenge of evaluating investments made in the seismic surveys they use to determine drillable prospect generation. The problem, on one hand, goes with the versatility and the elusive timeframes of the cash-flow scenarios, and second, with the consideration of chances for the exploration success.
In the business of petroleum exploration the industry standard and commonly applied economic evaluation practices are designed for prospect drilling investments. The implementation of the well-known methodology is based on the principles of Decision Analyses and results in the Expected Net Present Value (ENPV), which considers the discounted cash-flows and probabilities pertaining to the successful and unsuccessful project scenarios.
According to the prevailing paradigm, the chance for success equals with Probability of Geological Success (PoGS), which is derivable from the Geological Probabilities (Pg) of the prospects planned to drill. However, we face several practical questions as we look to apply a similar approach for the investments made into geophysical surveys what in the oil business are almost exclusively seismic mappings.
Seismic surveys are exploration tools of drillable prospect generation. Needless to say, they are financial investments, and therefore, oil company shareholders rightfully expect to be informed on their returns. It leads to the conclusion that discounted cash-flow models should be defined for the correct financial evaluations. Unfortunately in the case of the seismic projects, it is not very obvious and on the other hand it is not simple at all.
It is a common agreement within the geoscience community that the primary goal of the seismic surveys is the increase of the prospects' Pg, indirectly the PoGS of the future drilling projects. The seismic surveys, however, rarely focus on the delineation of a single prospect. They usually have multiple purposes including, but not limited to, the mapping of several zones of a possible petroleum accumulation in a petroleum play. Moreover, they can be tailored to develop and analyze new play concepts.
For these cases, the prospect generations – if they happen at all – may take place in the far distant future, suggesting that the positive yearly cash-flows are discounted to an amount that results in a few, sometimes almost negligible contributions to the project's successful case NPVs. If so, the question arises whether it makes rational sense to add these small cash-flows.
The next issue is the versatility of the project scenarios. Imagine that a play concept develops in several directions, resulting in practically indefinite possible outcomes. Additional complications come with the implementation of conditional probabilities pertaining to the various "branches" of the project's "decision tree."
Handling scenarios that can reach 50 or more is no longer a problem for software capacities. The limit is our rational thinking and "poor" fantasy. We cannot predict the probability of drilling success if the well is conditional to the success of a future seismic data capture what is conditional to the success of a new play concept what is conditional to the technical success of the actual seismic survey. Thinking of more than two conditional probabilities may be beyond our human capacity. At least for most of us.
An acceptable compromise
To manage these dilemmas, we have to introduce several constraints. First, the project scope must be narrowed down into a reasonable timeframe. I would suggest the period of our exploration license, generally four to five years, as a reasonable one. Normally the seismic data acquisition, data processing, interpretation, the prospect evaluation, and the subsequent well drilling comprise the work program fitting this time horizon.
Assuming we will drill the "best" prospect to be delivered by the actual seismic survey – "best" here is a synonym for the optimal risk-reward expectation – we have to "imagine" what the prospect will be like. Less sophistically, we have to pre-define on one hand the Pg, and on the other hand the quantity of the prospective recoverable resources of the prospect that we are going to find at first with our actual seismic survey.
The question is not how much probability we can assess for the exploration success now but how much the drilling success chance will be when the seismic survey is successfully completed. After all, the motivation to shoot the seismic is to increase of the odds of drilling success.
The well drilling is conditional to the success of the seismic survey. More precisely it is conditional to the successful prospect delineation. Therefore we have to assess the probability of the seismic survey success (hereinafter abbreviated as PoSS), too.
Unlike the estimation of Pg of an actual (existing) prospect, the traditional play and prospect evaluation methodologies do not apply for the assessments of future (planned) geological probabilities. These may be true geotechnical expert opinions, but they rely on past experiences and good geo-scientific intuitions.
Once we surpass these compromises, the investment evaluation exercise turns to be very clear and simple. Our decision tree has only three discrete outcomes, each attributed with well-defined discounted cash-flow expectations and probabilities.
For the successful case scenario, the cash-flow includes the total exploration and field development expenditures, plus the difference of the production revenues and costs (including taxes, royalties, etc.). The discounted cash-flow gives the NPV of the successful case while the scenario probability equals with the multiplication product of PoSS and the future (planned) PoGS of the drilling project.
The second scenario is the case when the seismic survey results in the successful prospect delineation but the subsequent well is dry. In this case, the cash-flow is the sum of the seismic expenditure and the dry-hole cost while the scenario probability is the product of PoSS and the chance of failure of the well drilling (1-PoGS).
The third and final scenario is where the prospect delineation proves unsuccessful and the cash-flow is the lost expenditure of the seismic survey, and the scenario probability equals with the chance of failure of the seismic mapping (1-PoSS).
Then the project investment's ENPV can be easily computed as the sum product of the scenario discounted cash-flows and probabilities.
Conclusions and consequences
Due to the simplifications described above, the ENPV does not include the financial value of the upside potential which is undoubtedly characterizing the most of the seismic surveys. Taking a very conservative financially based decision-making approach, we can give a green light to any seismic project for which the actual ENPV satisfies our shareholders' expectations.
Obviously any foreseen but not quantified upside potentials increase the attractiveness of the project. It gains special importance when exploration managers face the project ranking exercise. In the case of seismic projects, the upside potential indicators have nearly as high a priority ranking as the ENPV itself.
Last but not least, I have to mention that seismic and drilling project investments, based on their ENPVs, are not valid comparisons. The prospect mapping and prospect drilling projects comprise two separate exploration portfolios.
About the author
Imre Szilágyi is an independent exploration geologist and petroleum economist based in Budapest, Hungary. He previously filled several management and advisory roles at MOL Hungarian Oil and Gas Plc. Szilágyi, as part of his current sabbatical, recently completed a study analyzing the methodology of seismic investments' financial evaluations. He holds an MS degree in geology from Eötvös Loránd University of Budapest and an MBA from Budapest University of Technology and Economics. He can be reached at firstname.lastname@example.org.