EXPLORATION How to overcome difficulties with reserves replacement

Jerry Paul Brashear
The Brashear Group LLC
Potomac, Md.
Alan B. Becker
Modern Energy Concepts
Jefferson City, Mo.
Michael L. Godec, Peter M. Crawford
ICF Resources Inc. Fairfax, Va.

The first part of this article discussed the challenge of replacing reserves while maintaining high levels of profitability.

An examination of the 82 largest U.S.-based, publicly traded exploration and production (E&P) companies, grouped by size, suggested a potential conflict between reserves replacement and profitability-a "devil's dilemma" between long term viability and financial performance.

The 10 largest companies failed to replace their production in the U.S. or worldwide (although they did in non-U.S. operations). They were, however, the most profitable on a per-barrel-equivalent basis. In general, the smaller the company, the higher its reserves-replacement ratio, reflecting greater relative effort but lower unit profitability.

This article examines the difficulties that companies face in reserves replacement planning, the accommodations they make to these difficulties, and the problems caused by these accommodations. It then suggests an analytical structure for reserves replacement planning that contributes to overcoming the difficulties.

The third article concludes the series with the description of new integrated analysis approaches that use this structure to select an optimal portfolio of reserves replacement options consistent with risk, financial performance, and available capital.

Developing strategies

Conceptually, reserves replacement planning can be conceived of either as "capital rationing," if a deterministic approach is used, or as "portfolio planning," if a more explicit treatment of risk is desired.

The essence of the capital rationing approach is to:

Evaluate all available options relative to a suitable "measure of merit," usually one of several that reflect the company's strategy (including reserves replacement) and the return on capital invested;
Rank order the options by the measure of merit, while aggregating the required capital committed to the options; and
select all those options that can be financed with the available capital. the result is the set of options that maximizes the measure of merit relative to available capital-generally, the amount of reserves replaced or the predicted financial return that can be afforded by the available funds and a specified corporate strategy.

An advancement on capital rationing that treats risk explicitly is to conceive of the selection of reserves replacement projects as the optimization of a portfolio of risky investments. The structure of the approach is similar to capital rationing except that the options are characterized by the expected values (means) of their returns and risks (variation around the means), and the portfolio is optimized by its expected return (sum of the project expected values) and its risks, reflecting the risk reduction through diversification and the risks due to interdependency among project performance.

These interdependencies arise from geological relatedness (e.g., prospects in the same "play") or such larger "macro" factors as oil and gas prices, and changes in infrastructure, technology, regulations, public policy, etc.

Application difficulties

In application, either approach is difficult to implement for several reasons.

First, the number of reservoir or prospect options-concrete investment opportunities that could contribute to reserves replacement-is vast. There are more than 12,000 significant known oil and gas reservoirs in the U.S. and thousands more potential prospects for exploration.

Moreover, while data and often models are generally available for the reservoirs and prospects in which the company holds an interest, they are generally available only in summary form for reservoirs for which the company holds no current interest. The exception is when such reserves are actively being offered for sale.

Further, depending on the rock and fluid properties of the reservoir or prospect and its current state of development, the number of available technology options for each reservoir can also be large (e.g., produce without further investment, continue development under the current technology, or enhance production performance through any of a number of technically feasible possibilities).

Each prospect and reservoir can be characterized by uncertain potential future outcomes. Exploratory dry plays, dry holes, and subeconomic field sizes, reservoir/ technological risks of poor performance, and unexpected costs represent a range of outcomes that translate into project risk.

So, a large number of reservoirs and prospects, each with several potentially viable development options and a range of outcomes, must be evaluated under a common set of standard conditions.

Among those standard conditions are a number of possible but unpredictable futures that can pose risks inherent in a specific project, for instance:

Technology improvements will add reserves, reduce costs, or shift the relative economic advantages of some potential reserves relative to others.
New pipelines, storage facilities, or changes in market requirements will affect some potential reserves differently from others.
Changing regulation can differentially affect specific potential reserves due to different jurisdictions, environmental settings, or technologies employed.
Policy choices by various governments can introduce new competitive and logistical elements (e.g., Mexico's decision whether to develop nonassociated gas for export, Quebec's choice of hydro or thermal power expansion, U.S. policies toward federal lands or unconventional resources, state policies toward E&P, shifting tax and fiscal regimes at all levels).
Global market conditions are profoundly influenced by the geopolitics of potentially unstable or rapidly changing areas like the Middle East, former Soviet Union, Far East, and Latin America.

Such alternative futures are often examined at the company's highest strategic level, but seldom is such scenario analysis considered for individual reserves replacement options.

For most companies, not only is the number of elements to be evaluated- reservoirs and prospects times technologies times outcomes times futures-seemingly far too large for comprehensive, comparable assessments, but for most, a single, uni-dimensional "measurement of merit" is often inadequate to guide these important choices. While the marginal return on capital or economic value added is clearly important to any company, so are other considerations that can reflect important strategic issues. For example:

Maximizing reserves replacement given a minimum economic performance threshold may be seen by Wall Street as evidence of long-term viability.
Seeking to minimize the cost of a specific quantity of reserves replacements may be seen as critical to the long-term health of an E&P company.
Holding specific preferences or aversions may reflect strategic advantage, e.g., certain geographic aversions for cost control or preferences to assure participation in new plays; certain reservoir types or technologies, reflecting specific expertise with competitive advantages; or for certain "teaming partners" for farm-ins, farmouts, or strategic alliances.
Coping with the risks posed by project performance and divergent futures by portfolio diversification, contingency planning, or use of "robustness" criteria based on alternative scenarios can render simple measures of merit inappropriate to sophisticated strategies.

Even the capital constraint that would appear to discipline the capital rationing process is revealed to be flexible. Currently held reservoirs can be sold or farmed out to add to available capital, and investments can be flexibly adjusted in time to generate or absorb capital at any given point in time. Purchases and sales were seen earlier to represent a significant portion of reserves changes for all types and sizes of E&P companies.

If the portfolio approach is desired for its explicit risk management, the problem of multiple measures of merit is at least partially solved, as the method permits optimization of financial criteria relative to acceptable risk, available capital, and a reserves replacement target.

Beyond this, portfolio analysis encounters all the above difficulties plus the additional ones of requiring probability distributions of the critical variables (both project-level and macro-level) to describe their inherent risks and the computational ability to combine the distributions to estimate the range of possible outcomes, the mean of this range, its variances (or semi-variances, examining only the "downside" of the dispersion of outcomes), and co-variances of the combinations of options in all possible portfolios. This multiplies the already large number of options (reservoirs times technologies times outcomes times futures) by an often very large number of simulations.

How to simplify

Confronted with the daunting task of developing optimal reserves replacement strategies, companies seek ways to simplify it, to reduce it to proportions that can be managed within the intellectual, analytical, time, and budget resources available.

The simplifications take many forms. For example:

Subdividing the problem organizationally and assigning the pieces to units responsible for specific geographic areas and/or into units for the respective types of reserves replacement options, e.g., "exploration," "exploitation," or "business development" to purchase or sell properties, etc.
Limiting the search for reservoirs to those that are "nearby" current operations in some sense-geographically, geologically, technologically, or in other ways.
Limiting consideration of potential purchases to leases or blocks actively being marketed.
Conducting only a limited assessment of a limited set of technology options for each reservoir. Even where detailed reservoir assessments are made (e.g., in the company's own operations), this information is often difficult to incorporate systematically and comparably into division- or company-level considerations. Such assessments are seldom possible for reservoirs outside of the company's portfolio.
Evaluating options under only one view of future conditions or limited sensitivity analysis.
Limiting the consideration of risk by ignoring the full distribution of outcomes at the project level; or, if project-level risks are assessed, assuming the projects to be independent in portfolio analysis, i.e., ignoring geological and technology correlations and critical macro-level factors.
Concentrating the assessments on a simple "measure of merit" to grossly reflect the company strategy, then adjusting the results to incorporate more subtle considerations.

These simplifications are often combined and then formalized in the annual planning and budgeting processes. This formalization, however, does not change the fact that each of these simplifications potentially detracts from the quality of reserves replacement decision making.

The quality of the decisions made on the basis of these simplifications depends on the company's creativity in recognizing and managing its limitations. Clearly, while necessary, the simplifications reduce the ability to generate, evaluate, and select a comprehensive set of options that could yield important new or better means of replacing reserves and maximizing financial return.

Structure of analyses

One way to conceptualize the reserves replacement analysis is shown in Fig. 7 [23427 bytes] (a decision tree in which most of the "chance" nodes have been suppressed to emphasize the "decision" nodes).

The diagram represents all reservoirs and all the possible technological options, so the full set of possible investments is included. A company's specific preferences for certain geography, geology, or technologies could be introduced by subdividing this universe and attending only to the options that are relevant to the strategy.

The left side of the diagram is a logical sorting of all reservoirs into the current "circumstances" that give rise to the decision options on the right side. Thus, reservoirs are partitioned as follows:

Known reservoirs from those yet to be discovered;
Known reservoirs are partitioned into those for which the company is operator, versus those with non-operating participation, versus those with no present working or net interest;
Reservoirs operated by the company are further partitioned depending on whether the reservoir is fully developed under the technology currently in use;
Undiscovered reservoirs are partitioned into those in established versus frontier plays, and, for each, into whether the company has a current land position.

The middle section of Fig. 7 reflects ownership options that could alter the current circumstances in each reservoir based on a company's decision to buy or sell selected properties or interests. Each "diamond" represents a unique ownership decision for the company.

For example, Diamond I represents the company's choices for properties of which it is currently the owner and operator. It can continue to operate the property (alone), farm out the property (sell part interest or cede operating rights to a partner), or sell the entire property.

Each Diamond I represents a similar set of ownership options for properties currently under company management.

Alternatively, if the company holds a minority interest in the reservoir (Diamond II), it faces different ownership options: to buy out all or part of the interest(s) of the other partner(s), to continue in the unit as a minority partner, or to sell all or part of its interest to another party.

Finally, if the company has no current interest or land position, it must decide between buying the property in full, partnering, purchasing, or farming-in to achieve partial interest in the reservoir or unit, or not to buy (Diamond III). Parallel ownership issues face the company for unexplored properties that they currently lease or are considering leasing.

The technology decision options that are appropriate to each reservoir circumstance are illustrated on the right side of Fig. 7. Each lettered "box" represents the technological options. For example, Box A on the top line represents the analytical choice shown. Box A appears 12 more times, representing the same options by reference. At Box A, a known reservoir of which the company is operator is already fully developed under its current technology. The company has two basic choices:

Produce the reservoir to the point of abandonment without further technological enhancement. This choice primarily depends on prices, operating costs, and, possibly, tax and abandonment liabilities, but the capital requirement can be minimal.
Increase reserves by enhancing or intensifying the recovery technology.

The choice of technologies is represented by the decision at Box B. The technologies considered would depend on those that had already been applied and the rock and fluid properties and performance history of the reservoir. In principle, all known technologies (and even new ones emerging from R&D) could be considered.

If the reservoir operated by the company has not been fully developed under the current technology, the choices at Box C would be similar, but would include completing the deployment of the current technology in addition to consideration of choices at Boxes A and B.

If the company is currently a minority owner of a unit and is not the operator, it will face similar technology alternatives, but will have to negotiate with the operating company to assure appropriate reserves replacement strategies for the properties. The ownership decision (Diamond II) will depend on the evaluation of the alternative technology development options represented by Box C (if the current technology is not fully deployed), followed by options at Box A, and finally at Box B. If the interest is to be sold the analysis of Boxes C, A, and B must be completed to determine the price for the property based on its future reserves potential.

If the company has no current position in a known reservoir, its ownership choice is buy, partner, or pass it up. This choice is predicated on an analysis of its value in the same options as reflected in Boxes C, A, B structure.

For undiscovered reservoirs for which the company has a land position, the company faces the same ownership options as depicted in Diamond I discussed above. The operator evaluates technology options, based on the exploration and development technologies available to the specific reservoir setting, to decide whether the company should maintain its land position.

The choices (at Box D) are to explore, acquire more data to make the exploration decision (to limit risk and reduce overall cost), or to hold the land for possible later exploration. If the exploration is successful, the company has the option (at Box E) to immediately develop the prospect or to defer development. This decision is predicated on analysis of the choices reverting back to the structure represented by Boxes A and B. If the company does not hold a land position, the decision to acquire one (Diamond III) precedes the set of choices represented by Boxes D, E, F, A, and B.

The "established play" and "frontier play" are differentiated in Fig. 7 because they address different units of analysis. For an established play, the analysis focuses on the specific prospect, usually a structure or potential stratigraphic trap that promises to be a field if it contains an adequate quantity of hydrocarbons and acceptable rock and fluid properties. Such a prospect requires one well or at most a small number of wells to establish the magnitude and feasibility of developing the field. Conversely, for a frontier play, the unit of analysis is a program of exploratory drilling of multiple prospects to test both the presence of hydrocarbons in the play and to discover a number of individual fields and reservoirs.

The repetition of the structure of the decision options facilitates an orderly analysis and keeps the various options directly comparable. While the sorting of the strategically relevant set of reservoirs by their respective circumstances (as in the left side of Fig. 7) leads to different options of both ownership and technology (the right side), this framework makes it clear that many of the analytical formulations are structurally similar. That is, as few as three ownership options (Diamonds I, II, and III, each of which reduces to a zero-to-one continuum) and as few as six technology choices (Boxes A through F) can analytically meet the requirements for an optimal reserves replacement analysis. Incorporation of the suppressed "chance" nodes to represent a range of project-specific outcomes does not alter this conclusion.

The choices at each point can be programmed to optimize one or a set of measures of merit, a multidimensional indicator, or a multiobjective function, as the strategy might require. The results could then be ranked and the capital constraint applied, with buy-sell options at the margin to optimize the capital-to-reserves relationship or to diversify project-specific risks. A more sophisticated but analytically more demanding approach would be to use portfolio theory to optimize the diversification. Either approach results in a comprehensive, analytically based recommendation for optimal reserves replacement, incorporating specific, strategic objectives, risks, returns, and capital availability for the period under assessment. This assessment period could be an annual budget cycle or a strategy with implementation and contingencies over multiple years.

Next: The conclusion sketches new integrated analytical approaches that use this structure to overcome the difficulties described above, toward the construction of an optimal portfolio of reserves replacement options.