The Value of Flexibility in Managing Uncertainty in Oil and Gas Investments

Abstract

Abstract This paper deals with improving the oil and gas industry's ability to manage the impacts of uncertainty on investment evaluations. We first review the economic performance of the industry and conclude that it is not good. Under-performance is attributed largely to poor investment decision-making, which is in turn due to inaccurate evaluation of the economic impacts of uncertainty. We describe how undue focus on Value of Information (VoI) and classical DCF techniques can prevent full value creation from an investment opportunity, by not encouraging exploration of the use of flexibility to manage, or even exploit, uncertainty. A Real Options (RO) approach has considerable appeal in overcoming this problem. However, its widespread application has yet to occur due to unfamiliarity, issues around its robust implementation and a focus on valuation rather than value creation. Here, the VoI concept is extended to assessing the Value of Flexibility (VoF). Building on a previously published framework (SPE 71414), we show how VoI and VoF analyses can be performed using a Stochastic Integrated Asset Model and thus offer a practical means to capture some of the benefits of a real options approach. The VoI concept is reviewed and illustrated by the example of executing a seismic study to reduce OOIP uncertainty. VoF is illustrated by planning extra slots on a platform to manage residual OOIP uncertainty and by estimating the value of incremental water injection facilities to manage uncertainty in aquifer strength. Value creation from flexibility is illustrated by considering the potential to change production rate as oil price changes. Introduction This paper discusses how to make better decisions regarding the investment of intellectual and/or financial capital at the asset or project level, when the economic outcome of the decision is uncertain. We show how understanding the consequences of uncertainty leads to much more than an assessment of the risks associated with a decision. It can change the decision, and in more ways than just a go/no-go sense. We address questions such as, what is the value of acquiring data and/or performing analysis? Is it better to deal with uncertainty by paying to reduce it and/or by planning to manage its possible consequences? How can uncertainty be exploited to create maximum value? The work is relevant to a broad range of types of decision, large or small, such asre-perforating to increase production ratetaking core or seismic to reduce uncertainty in reservoir parametersassigning human resources to support an equity re-determinationdrilling an in-fill wellinvesting in R&Dplanning processing facility capacitiescommitting to a major off-shore development to name but a few. The focus is on improving the economic returns of such investment opportunities by better estimation of their true value and/or increasing their value. There are other important aspects to better decision-making, which we do not address here. Examples are improving the decision-making process1 and selecting the best portfolio of investments at the corporate level2,3. Industry Performance The context for this paper is an assessment of the economic performance of the oil and gas industry.Companies, whether public, private or national, exist as intermediaries to make and implement decisions that are in the best interests of their owners.Whilst there are many components to the definition of "best", and it may be different for different types of owner, there is no doubt that the magnitude of economic return is one of the most important. In the case of publicly held companies, management has a fiduciary responsibility to the shareholders, meaning that they should not willfully, or negligently, make decisions that are not "best".