Chapter 6 Petroleum Economics – Uncertainty and Risk

INTRODUCTION

*Explain the difference between uncertainty and risk, in the context of investment

Uncertainty relates to a lack of knowledge about future events. There’s a quote from one of the US presidents that goes “there’s things we know we know, there’s things we know that we don’t know, but there’s also things we don’t know that we don’t know”. It’s a pretty thick quote but illustrates a point in the final section. That’s where uncertainty is born from.

Risk infers that there is some material implication in the outcome. Risk and uncertainty can be related at times, however sometimes uncertainty carries no material risk.

Our main concern is the impact uncertainty has on petroleum investment.

*Describe a simple system of classification for factors, giving rise to investment risk

We can classify risk into several difference sections:

  • Geological Risk
  • Facilities Risk
  • Political Risk
  • Economic Risk
  • Partner Risk

Geological Risk

Geological risk is the uncertainty due to incomplete data sets that are an intrinsic part of exploiting unseen reserves subsurface. We must make our best estimations and predictions about formations and pay areas. These predictions involve uncertainties that relate to material risk.

Facilities Risk

The materials used to transport and house the migration of petroleum products from reservoir to refining facilities must tolerate corrosive fluids and harsh environments. There is risk that these facilities may be damaged through a project life cycle resulting in loss of produced materials and loss of money.

Political Risk

Political risk arises from uncertainty in nations with regards to their rules, laws or legislation. If there is a change to a contract this can have a significant impact on the projected profitability of a project.

Economic Risk

Oil and gas as a commodity is incredibly volatile – and I mean that in a financial sense. In the past 10 years 2005 – 2015 we have seen the price of a barrel of oil rise from $50 to $150 down to $40 in 2009 back up to $120 and most recently down to $45 in 2015. This increases risk as with any financial instrument: the greater the volatility, the greater the uncertainty. Companies are also exposed to inflation and exchange rate fluctuations.

Partner Risk

Finally, partner risk arises from operations where two companies are involved, typically from joint ventures. Two companies may choose to work together to exploit a reservoir because of complimentary services or economies of scale.

GEOLOGY

*Explain the concept of exploration success

Apparently there is no singular definition of exploration success however we can give a general idea with the following statements:

  • There are hydrocarbons in the well
  • The well has been tested and is flowing at a minimum rate (say 5000bopd)
  • Discovery of petroleum, which was sufficient to justify further investigation
  • Sufficient petroleum delineated to justify commercial development

This definition of success should imply that something of value has been found, however commercial success may take another 5 to 20 years to determine.

*List and describe the issues pertinent to appraisal

The following issues are important to appraisal:

  1. Existing dataset

Appraisal expenditure can be authorized depending on how significant or interesting the discovery data is. If the well flows at 50,000 or 1000 bopd, we can such it is much more likely to have expenditure authorized for the higher flow rate.

  1. Reserve potential

We can make an estimate for reserves from the STOOIP equation. An optimistic interpretation of early data can give us a maximum likely volume and will tell us commercial limits. The greater the potential and likelihood the greater the more likely expenditure will continue.

  1. Geological complexity

If a basin or trapping structure is complex this will increase the cost relating to building a representative reservoir model and the more expensive the operational program is likely to be. Additionally, there is a greater risk that the production model will be incorrect.

  1. Drilling program and cost

Drilling is still the only reliable method for verifying the distribution of petroleum materials in the subsurface. The more complex the reservoir, the more wells required to delineated the petroleum spread. Deeper targets and more complicated geological environments result in more expensive wells.

  1. Data collection and cost

We want to optimize the amount of information we receive from detailed seismic, core logging and well testing to our relative uncertainties and cost. Each add significantly to knowledge of the reservoir but are also very costly. Justifying the use of such equipment by analyzing the perceived uncertainty, nature of the data and cost is the trick.

  1. Development economics

The purpose of appraisal is to establish commercial viability. We can track the evolution of the geological model and incorporate an appropriate technical development plan and speculative economics to guide us through what further information is required, and whether we can justify further expenditure.

  1. Tax incentives

Depending on the government and the tax structure, it may be the case that early on the government bears the majority of the risk during appraisal. An example of this can be found historically in the UK before changes were made to PRT regulation – a might marginal tax rate of 75% meant that expenditure could be claimed against existing production and thus the government would become the primary risk taker. In countries where expenditure can only be claimed against future revenue, the company carries all the risk.

  1. License relinquishment

Most licenses today incorporate a license relinquishment clause, which limits the time permitted to perform an assessment of the area. It is a smart incentive to ensure that appraisal activity progresses quickly and efficiently, especially if reserve potential is great.

  1. Corporate view

Finally, we must also take into account the appetite for risk of the company, their investment criteria, tax situation and relationship with the country. These will influence the types of projects the company seeks to explore before a decision is made to develop.

*Explain the relationship between appraisal time and field size

  1. Fields larger than 1000 million barrels took no more than one year
  2. Fields larger than 500million barrels took no longer than five years
  3. Fields larger than 100 million barrels generally took no longer than 10 years

Most fields with appraisal extending beyond 10 years had less than 100 million barrels.

*Describe some examples of reservoir model inaccuracy, leading to development and production discrepancies

If the geological model (which includes details of static architecture, volume, dynamic properties and fluid distribution) has errors, this will lead to errors in recoverable reserves, production profiles and plans for well distribution and reservoir management as each of these are derived from the geological model.

FACILITIES

*List facilities problems resulting from contained fluids

  • High pressure gas at depth is high pressure gas at surface due to gas having a low-pressure gradient. Facilities need be able to withstand high pressures.
  • Sand or silt particles entrained in production materials can cause significant corrosion of exposed metallic surfaces if fluid production is at a high enough speed.
  • Valve operation can be hampered by solid gas hydrates which form in the presence of water and at low temperatures. These can also reduce pipeline capacity.
  • Low viscosity materials such as paraffin oils or heavy oils can cause systems to become blocked at low temperatures. A viscosity management system must be put in place to prevent this.
  • Non-organic materials can be a serious threat to humans and steel surfaces. Hydrogen Sulphide is the main culprit and it must be properly contained, this is an expensive process.
  • Lastly, salt and carbon dioxide gas produced from connate water have corrosive tendencies and these must also be identified and treated accordingly.

*Describe the type of facilities problems encountered in the subsurface

  • Maintaining correct overpressure and anticipating conditions to prevent blow out or loss of primary well control.
  • With increasing depth, tools and equipment are exposed to increasing temperatures, pressures and stress. Equipment must be able to bear changes in each of these conditions.
  • There is particular uncertainty when drilling as the drill bit is constantly moving through the unknown. The sedimentary structure can change significantly from soluble salt, to sloughing shale or high permeability reef, or even a sand lens containing high pressure gas. The drill bit must be selected in order to optimize rate of penetration through the anticipated formations.
  • Stuck pipe is another facilities problem encountered in the subsurface.

*Describe the type of facilities problems encountered at the surface

  • Long term projects are particularly susceptible to stress fatigue failure and corrosion.
  • The biggest problem encountered at surface is surviving the extreme and hostile conditions. Surface facilities include well control, fluid separation, power generation, accommodation, transportation and support above sea level (offshore). Each of these may be subjected to arctic permafrost, desert heat, tropical rainforest downpours and offshore deep waters.

*List some important environmental issues pertaining to oilfield development

  • Disposal of drilling fluids and cuttings
  • Treatment of produced water
  • Leaks from operations (valves, pipelines)
  • Seismic impact on marine mammals
  • Flaring of surplus or un-economic gas
  • Disposal of general industrial and human detritus

*Describe an example of human failure

The development of a petroleum field is a human related activity; we design, construct and maintain all components of a system and are an extension of all the operations within that system. If something breaks down, or fails we are directly responsible for that failure. Failure can occur through human error due to lack of knowledge, improper training, it can be related to the efforts of a single person or the cumulative effect of an entire corporation. It can result from mismanagement, greed or ignorance and everything in between.

Perhaps the most difficult area to control is maintenance. Without a diligent technician or a proper maintenance system in place, even the best equipment and intentions can be undermined. Successful maintenance and thus the success of an operation is as much about keeping meticulous records and work ethics as it is about technical competence.

Piper Alpha is described singlehandedly as the worst offshore petroleum accident in history and is attributed to human failure – both system design and working practice. Let’s run through the failures:

  • Routine maintenance of a backup condensate pump was incomplete
  • The reporting system failed to prevent the pump from being used
  • Fluid leaked at high pressure and ignited
  • An inadequate firewall was destroyed permitting the fire to spread
  • The water deluge system had been switched off
  • The fire weakened and destroyed two large diameter gas risers
  • These contained no safety cut-off system and gas continued to flow for an hour

167 people died. The billion dollar platform was destroyed. Production from Piper and five other linked fields were suspended.

GOVERNMENT

*Describe some of the ways in which a government might impose change on a project

  1. Ownership and Licensing

Uncertainty can be introduced where property becomes the subject of a dispute in international law, or where the country in question has undergone a political upheaval or change. Companies can quickly lose their production rights or find out that new rules or legislation have been put into place.

  1. Health and Safety

For the most part health and safety is self-regulating within the industry. We have an interest in maintaining both of these standards because injuries and illness cost time and money. But there is also an ethical aspect as well. Following the Piper disaster was a massive public enquiry that lead to fundamental changes in design criteria for new projects with a wide range of modifications to safety equipment and procedural practices on all existing and new platforms. The government’s involvement in this was probably the public enquiry.

  1. Environmental Standards

Governments regulate all stages of company activity from exploration to production and field abandonment to ensure the protection of the environment. All legislation and requirements are known before an investment decision is made and do not constitute any material risk.

It is possible for standards to change as a result of knowledge or experience gained. Standards can also change due to political changes or international agreements.

A good example is in the changes introduced with gas flaring. In the past it was seen as an acceptable method to deal with gas that was economically unviable. Today however with the knowledge of global warming, the ability to gas flare has changed and we see more projects using gas re-injection or developing transportation technology to deal with gas supplies.

  1. Taxation

Most countries are able to change their tax structure, thus creating a source of uncertainty for a petroleum company. Taxation represents a significant part of cash flow and therefore any uncertainty can generate serious risk. We can see in the UK that over the years it has changed its marginal rate of tax from 58% (before North Sea Oil came on stream) to 91.9% in 1982, before falling back to 30% currently.

*Describe an example of such a process

?

*Explain the relationship between taxation policy and investment decisions

If taxation is too high, companies are deterred from investing in the region and will seek out investment opportunities to seek a greater return. In this instance the government earns nothing. If taxation is too low, the government is not capitalizing on the amount of activity and profit that petroleum companies experience from exploiting the nations natural resources. So there exists some balance between taxation and activity such that the government can maximize its taxation and earnings while ensuring companies can undertake projects of sufficient economic feasibility. The taxation rate will also vary with the price of oil. Another factor in investment decisions relates to the stability of a countries taxation policy, petroleum company seek out stable tax regimes as it allows them to mitigate uncertainty and risk.

ECONOMICS

*Explain the basis of the world market for oil

 

*Describe three important reasons why concurrent oil prices may differ

The main reasons why concurrent oil prices may differ relate to:

  • Geographical location of the source
  • Hydrocarbon composition
  • Inorganic impurities
  • Security of supply
  • Price fixing and political intervention

Geographical Location of the Source

Crude oils compete for market share at refineries and so each must be price competitive on delivery. Therefore, the greater the distance between the source and refinery (or market), the lower the price must be at the source – to allow for cost of transportation.

Hydrocarbon Composition

The value of a barrel of oil is directly derived from the market value of the products, which the refiner can generate from the barrel. It is common for lighter hydrocarbon products to command a higher price and heavier products a lower price. The price in the marketplace also depends on supply and demand. Ultimately, the composition of the barrel of oil in the form of light and heavy hydrocarbons will result in oil price differences.

Inorganic impurities

Sulphur is the main culprit here. Price differentials are introduced because Sulphur needs to be removed and therefore becomes an additional cost. Suppliers of oil must discount their barrels to remain cost effective to the market. Other elements include Vanadium which can poison catalysts and render them ineffective.

*Explain the concept and implications of demand elasticity

Elasticity is a measure of the response of the market to changing price. Numerically, it is proportional change in quantity divided by proportional change in price. If price changes by 30% and quantity changes by more than 30%, the commodity is price elastic (the ratio is greater than one). If the proportion of quantity change is less than price change, the commodity is price inelastic (ratio less than one).

Elasticity is an important concept because it relates to revenue (the product of price and volume).

Price inelasticity is associated with commodities for which there is no simple substitute and where the reduced consumption would lead to perceived reduction in standard of living. In contrast, demand for a specific petrol such as BP petrol is price elastic. This is because we can go out and fill up our tanks with Shell petrol.

*Describe in broad terms OPEC influence on the oil market 1970 onwards

Oil had been in a large surplus in the pre 1970s era due to large discoveries in the Middle East, North Africa and elsewhere. Ranging from 1965 – 1973 OPEC produced increased production significantly, essentially doubling output and captured 55% of the total market and a higher proportion of export trade. During 1973/74 there were large scale changes, conflict about oil prices between companies and governments, and political and military tensions, lead to the power shifting from company to government, a deliberate reduction in the supply of oil and a rapid increase in price from less than $3 to more than $10 per barrel.

OPEC reduced production in 1974 by 260,000 barrels per day and maintained a level output for the rest of the 1970s.

From the 1980s onwards OPEC and more specifically, Saudi Arabia, attempted to maintain an inflated oil price by curtailing production. The OPEC cartel were defeated from within and from outside. Control of the market will only be successful if members are disciplined and honest. A danger of such high oil prices is that new supply will be attracted to the market leading to new competitors entering the industry and control being removed from OPEC and in the long term, it could encourage investment in non-petroleum based energy technology.

Due to the high oil price, non-OPEC production increased by 5 million barrels per day between 1980 and 1985. In 2001 OPEC market share was 40%, down from 55% in 1974. Since 1986, when Saudi Arabia abandoned its role as residual or swing producer the market has changed and now functions like many other commodities which vary due to market fundamentals.

*Describe the function of spot markets and marker crudes

Spot markets allow for short term trading based on current price. The contracts apply to markets where there is a critical mass of oil companies with significant infrastructure, refineries, storage, transportation and access to consumers.

Marker crude is representative of a market, such as Brent crude. When we ask what the oil price is, we can refer to the Brent crude price and this will encompass a wide variety of chemical makeups of oil.

*List and explain the factors contributing to current oil price uncertainty

Factors that contribute to oil price uncertainty are anything that can influence supply and demand. The following is a list of these factors:

Demand

  • Levels of economic activity in developed countries
  • Growth of less developed economies
  • Availability of alternative energy technologies
  • Price in relation to alternative technologies
  • Weather and climate change

Supply

  • OPEC market share
  • OPEC policy
  • UN policy on Iraq
  • Growth of non-OPEC production (Russia, Caspian)
  • Evolution of production technology
  • Political discontinuity

*Explain why the market for gas is not global

The nature of gas (large volume it occupies at ambient conditions) requires it to be compressed or liquefied for transportation, storage and distribution resulting in much higher costs than oil. As a result, gas produced in one region is at a distinct disadvantage is at a distinct disadvantage when competing for markets in another region. Consequently, we have regional markets rather than global for gas.

*Describe important elements of a gas sales contract

Gas sales contracts should normally include reference to time, quantity, specification and price. Gas can be sold on spot markets or long term. Quantity is regulated to meet seasonal demands, during winter it is common to see a several fold increase in the demand for gas, since it is expensive to store, the produce will usually increase output during this period.

Gas specification defines the chemistry and physical properties of the material. The more pertinent issues with regards to sales price are Sulphur content (concerns human safety and environmental pollution), Wobble Index (concerns the flow of energy to the burner) and dew point (for water and hydrocarbons, concerns liquid accumulation in pipelines). Gas price operates on a regional basis, because of the prohibitively high cost of storage and transportation, isolated gas fields cannot compete with remote markets.

At current production rates, USA reserves would be depleted in 9 years and Canada’s in 10 year. Clearly there are supply problems ahead.

*Describe the principle issues with respect to gas pricing

The principle issue is that each market has its own unique supply / demand characteristics and therefore each can sustain a different price regime for gas. Gas prices are also tied to equivalent oil price through a variable correlation. Long term gas prices are usually tied, linked or indexed to other commodity prices.

*Explain why exchange rate variation might influence project economics

Exchange rate variation directly impacts the profitability of a project if a significant portion of the gas to be sold is in the country of strengthening currency. Operating in a country with a weakening currency means they will be getting less in the future.

*Explain the risk associated with borrowing money

There may be a high variable interest rate if the companies is highly specialized and within the exploration domain. The banks need some form of guarantee that interest payments will be made. A large multidisciplinary international company would be able to raise money with low interest rates and spend a portion of this on exploration as it can provide payment security from other aspects of its business.

Debt ratio is the proportion of capital that is supplied by debt financing. With gearing and leveraging there is additional risk that profit earned will be insufficient to meet the interest commitment. At low debt spreads this is not so much of an issue, with higher debts the company needs to profit progressively more.

*Explain the possible impact of changing rate of inflation

A changing rate of inflation suggests an element of uncertainty, and uncertainty with a material outcome introduces risk. A changing rate of inflation will impact fixed price contracts, taxation and rate divergence.

Fixed Price Contracts – This form of contract has now become defunct due to the issues surrounding inflation. There is now a form of indexation applied to protect both parties.

Taxation – Taxation is calculated in money of the day terms, allowances are carried forward and thus an unpredicted increase in inflation results in diminishing real value of allowances. Higher inflation implies higher incidence of tax, but there is not fixed relationship.

Rate Divergence – Retail Price Index is the mathematical link between money of the day and real terms cash flows and return on capital. If all forms of cash flow are subject to the same changes there is less of a problem. If some cash flows are not subject to the average rate of inflation, distortion can arise. Oil price, for example is independent of RPI, so a shift in the rate of inflation almost inevitably implies a shift in the real price of oil. Because oil sales continue throughout the life of the project, this is potentially a significant issue.

PARTNERS

*List and explain the factors, which might compromise partnership.

Technical Preference

Companies will have established rapport with other organizations that provide technical services. Each company has its own preferences with respect to equipment, software and procedures. These are further supported by familiarity, and training and experience. It can be difficult for companies to abandon such investment of time and effort.

Conflict of interest

It can be difficult for companies to be fully objective if they have part ownership of a pipeline or other service or facility which may prove beneficial to the partnership.

Analysis and perception

Conflict can also arise from the differing opinions of professionals in each company with regards to the quality of an investment opportunity.

Corporate Issues

Differences in values, policy, appetite for risk, discounting values, planning, strategy and corporate statues all can contribute to conflict in a partnership.

Human Relationships

Partnerships require senior managers to trust one another, and at a smaller scale all staff to behave and be trusting

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