Oil and

.
Carlisle Associates
MIZ.Y~1996

In recent years there has been increasingconcern in the international oil and gas industry regarding the poor results ofhigh risk exploration. * Among theseconcerns are the following:

Institutional Factors
By definicion, most of the companieswho engagein high risk exploration are large and substantialfirms for whom renewal of their reservebaseis 3.deeply held corporate goal. Many of thesecompanieshave at their core one or several sustaining long-lived assets which serve as living proof of the importance of .companybuilders.. The resulting predisposition for big fidds, and the kind of high risks associated with the ~ for big fidds, can easily and unconsciouslyaffect how the organization as a whole views risk. Much has been written about Rgambler'sruin" and risk-aversion in oil industry investment beha-rior.But the persistent readinessof large oil companies to invest in high risk exploration suggeststhat. at least in this portion of their investment portfolios, they are in faCt risk-prone. Whereas the risk-averseinvestor is more troubled by the prospeCt of loss than excited by the prospect of gain. dephant-minded companies are more drawn to the potential for a giant discoverythan fearful of the greaterlikdihood of loss. Predisposition toward taking big risk for big potencial rewards is partly rooted in resourceeconomics. The lure of elephants is strong not only because they provide renewal of reserv~ but beause they generate high profitability and sustaining cash Bow. In effect, giant discoveri~ resulting from successfulhigh risk exploration provide the reserve growth and large development investment opportunities which are difficult co find elsewhere. The psychology of risk-taking also comesinto play. It b2Soften been noted that oil companiesover-risk low risk opportUnities and under-risk high risk ones.This phenomenon b2Sbeen very resist2ntto improvement, and says something fundamental about how apectations affect risk taking. In devdopment and low risk exploration. where success is apeaed, dry holesare

. High risk ventures as a classhave DOC been creating

value.

. There appearsco be a systematic cendencyto underestimate the risk and to overestimatereserves for such ventures.

. For many companies, high risk ventUreshave ridded

no commercial dUcoveriesover rdativdy long periods of time. The purpose of this paper is to examine the reasons why high risk international exploration has failed to live up to itS expectations and to suggestwhat companies can do about it.

We believethat the trouble with high risk exploration

has three causes:

. Many companies, particularly big companies with

large reservebasesand cash flow, are risk-prone with respect co the high risk portion of their exploration portfolios.

The analysis tools and methodswhich are most commonly used in the industry fail to accurately captUrethe riskinessof ventUres at the extremes of the risk spectrum.

. Adequatediversification is much more difficult to

achieve for high risk ventUresthan is generally recognized.
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-failures"and risk-averse behavioris the norm. But in high risk aploration. "failure" is much more the rule than the aception. There is no stigmaattached to it. So it becomes relatively e2SY to be drawn to the prize and insensitive to the bet.

crossing at comers are statistically more likdy to be hit by an oncoming vehicle than jaywalkers. because they rdy on the relative safety of the crosswalk and are less cautious. As applied to exploration. this phenomenon suggestschat the risk-reducing effect of technology in one area is likely to be offset by raking still higher risks elsewhere. The tendencyfor explorationistS to under-risk high risk venturesis especiallyworrisome because the economics ofhigh risk ventUresare more sensitiveto under-risking than for lower risk prospeCtS. Chart 1 demonstratesthis effect. It illustrates the negative impact of an assumed 5% deviation betWeenexpected and aCtUalprobability of success (for example 25% actual versus 30% expeCted)on economic resultS. Economic impact is me3Sured by the ratio of the negative presentvalue of the mis-estimation to exploration investment. It can be seenthat the r~!ativ~ negative impaCt of mis-estimation becomesprogressively more severe as probability of success decreases. It hurtS more, on a per dollar invested basis,to be wrong by the same degreewhen the risks arehigh.

Misjudging the Risks

Many companiesadmit that they misjudgethe ris~ and overstate the economicsof high risk exploration more severely than for other kinds of ventUres. This remainstrue despitethe stepstaken in recentyears by many or~izations to strengthen their risk analysis skills and improve their performance in estimating risks.
UnfortUnately, many of me biases and defeCtsin me way explorationiscsperceive and estimate risk are more pronounced in high risk exploration than in other categories of activity:

. People, even informed people, tend to underestimate

the extent of their uncertainty. When asked to estimate the range of possible outcomes for an uncertain variable, they consistently produce a range much narrower than their real uncertainty. This inherent tendency to underestimate uncertainty is especiallyproblematic in high risk aCtivities,in which uncertaintiesare great and informed decision-making dependson having a good handle on them.

In effect, our ability to clearly discern risk is the weakest for exactly those kinds of projects where it
needs to be the sharpest.

. Our ability to discriminate risk deteriorates at the

extremes of the risk spectrum. Most people have a much easiertime judging whether the chancesof an event are more like one in two than one in three (50% versus 33% probability) than they would differentiating between the 5% and 10% success rates characteristicof high risk exploration. Most estimators tend to derive their views about uncertain events by making adjustments co a wbest guess"or most likdy estimate, rather than by a more fundamental consideration of alternative outcomes. This mental procedure rarely produces a true pictUre of uncertainty, particularly when it is very large.

Ch2rt 1: Impact of U udcr-RiIkiDg On F.xploatioD Eoooomia (Aaual Pa5% Bdow &pa:tal PI)
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. Human beings have a strong tendency to "consume"

rather then "save" reductions in risk. Researchers have been surprised to find, for example, that the incidence of automobile accidentswas actually higher for vehicleswith anti-lock braking systemsthan chose without the system, not because the technology didn't work, but becausepeople with ABS carsdrove more aggressively than chose without. Pedestrians

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Ratio of Net PresentValue Loss From Mis-&timation to Exploration Investment

Diversification
The third major factor which we believe has contributed greatly to the dissatisfaction with high risk exploration is the difficulty, even for the largest and best funded companies, to adequatelydiversify the high risk component of their exploration portfolios. Basic probabilities suggestthat even high risk ventUres can be relatively easily diversified. Chart 2 shows that, at 10% probability of success,participation in 20-25 ventUresis sufficient to give a high degreeof confidence of achieving at least one success, a level of activity that most large companies can achieve in a few years time. The defeCt in this simplistic view is the ambiguity of defining success. Exploration risk analysis has long been plagued by the need to differentiate technical from commercial success. In the caseof high risk exploration, the gap becween the cwo is larger than for other types of exploration. Because they are most often removed from proved areas with infrastructure, discoveries need to be larger to justify development. And they must be larger still to provide a rerum on the unproductive costsof the high risk program asa whole. In many areas,gasdiscoveries, even large ones,cannot be commercially exploited. As a result of these factors, the chances of making a discovery which minimally justifies development are much lower than the chancesof technical success, and the chancesof a discovery which provides a full-cycle return on program investment are lower scill. The impact of commercial successrates on required diversification are dramatic. Chart 2 shows clearly that a much larger program is needed to give reasonable assuranceof successat commercial success rates below 1(YJIo.

. Getting out or cutting back on high risk ventUresin

responseto poor performance may be aacdy the wrong thing to do, if lack of sufficient diversification is the underlying cause. We should throw in the towel when we don't like the odds, not becausewe misjudgedmem.

. The expected value analysis tools which most

companiesuseto evaluateexploration economics do not work very well for high risk exploration. As shown earlier, expected value is highly leveraged against probability of success in high risk ventures. Very small variations in probability of successcan swing economic resultsdramaticaally. What's more, expected value does not give us any information about risk. It doesnot tell us how patient we have to be to achievemathematical expectation, and it lulls us into a falsesenseof comfort where the risks are very high. Mathematical expectation becomes managementexpectation.The danger is that we end up like the man who drowned in a lake whose
average depth W2S four feet.

Chan 2: Cwnulative Probability of Failure At VarioosVmtme Success Rates

In effect,high-risk explorationmay be failing because companies are underestimatingthe time and money they needto commit to the high risk g-ame. This has several implications: . Even for the largest companies. and even for 3.high
quality program. it may take a long time for high risk exploration to prove out. This makes it difficult to differentiate luck from skill in the shon run. and performance cannot be measured with confidence except over time periods which may be too long for management comfort. Operating on this much faith and nerve is difficult for many organizations.It is not surprising that some have thrown in the towel.

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What To Do About It
In our view. the issueis not whetherto do high-risk exploration.but how to do it better.One way to do it better is to improve risk analysis performance. Many companies havehad goodsu~ in narrowingthe ga.p betWeen estimates and outcomes. But high risk explorationis where the rubbermeets the ro3d in risk analysis.and further improvementsare needed.We ~uggcstseveral specific adaptationsto help in chis l1nprovemenc process:

But there are issuesof stntegy here aswdl as method and skills. If high risk exploration is mum harder to diversify than we thought, companiesneed to be clear

of eye regardingthe role of high risk explorationin their portfoli~ For thosecompmi~ who wishto have some exposureto opportUnitieswith large upside potential, but who are not rdying upon it as a important elementin their strategy,concerns about diversification are not paramount.Those companies should be investingonly asmuch apital md effort as
theY can afford to lose.

Oeveloe and actively use re2lirv checks. Because there

is lirde information in high risk areas, subjective ~timat~ play a larger than d~irable role. Data based on experience in comparable basins, regional and world discovery size statistics, and field size distribution patterns can be usedto test the re2lism of thesejudgments.

However. companies who commit large resourcesto high risk venturesand who depend on largediscoveries for corporate renewal may need to lengthen the time horizon over whidl they apea high risk exploration to bear fruit. and to develop alternativewaysof measuring the quality of the exploration effort over shorter time periods. For example. measuring risk analysis performance rather than economic su~ess in the short term can provide a sound measurement basis. Finally, cxcepcfor chose wich uncommon nerve and patience, companies active in high risk exploration should probably be looking cospreadtheir risksfurther. This arguesfor increasedrelianceon joint srudygroups for conducting high risk explor2tion, and more active efforts to arrange reciprocal farmin/farmout rdationships. In &ct, high risk exploration represents an excdlenc opportUnity for strategicallian~ in whid1 like-minded companies can share ide2S,resour~ and
skills. as well as risk.

. EmEhasize Eeer and expert review. For the same

reason,high risk ventUresshould be exposedto active and continuing review by senior technical staff. These reviews should focus on inquiry versus advocacy. They should emphasize identifying and evaluating multiple interpretations rather than pardmetric thinking. &tablish risk criteria. Having clear ideas on what kind and how much risk you are preparedto cUe can help avoid the risk" consumption" effect noted earlier. One company, for example, has concluded that they cannot afford to pursue any ventUJewhere more than one key success parameter (source, ~rvoir, crap, seal) has a risk of 50% or more. We also recommend that expected value analysis be replaced or at l~t supplemented in the C2Se of high risk exploration by other methods which focus more directly on risk and provide a clearer definicion of su~. Probabilistic simulation is a much better cool for analyzing high risk ventUres.And making ~timaces of minimum commercial (devdopable) field size and minimum full-cycle field size would allow cxplorationistS co explicitly consider the probability of various levels of commercial su~ rather than purely geologicalsuccess.

Conclusion
The trouble with high risk exploration is that the elements describedabove aa to reinforce and amplify e2d1 other. Large field bias predisposes toward taking high risks. Lack of information gives broad scope to subjective estimate, which is especially imperfect 3.t high risks. All this leadsto under-risking. And underrisking has the combined effect of r2dically overstating a:onotnics and understating the levd of divelSification requi~ Increased3.wareness of theseforces and how they interact is the first step toward .more effectiv~ managementofhigh risk.

Carlisle Associatesis a ma1Utgtmmtnt consulting company Spt'C~g

organizational ~

affiaing th~oil ana'gasindustry.For ftrthn

in economic.stratt'gic and info17n4tion, contact AI Boaoia. Car/isk

Associates. P.O. Box 572, Carlisle. Massachustm. (508) 369-6609. w~ w~lc~ your comment! ana' questions rqardin.!Oil andGasBriefs.