The Journal of the Society of Petroleum Evaluation Engineers

The Journal of the

Society of Petroleum Evaluation Engineers

Celebrating 50 Years of Promoting the Profession of

Petroleum Evaluation Engineering 1962 -2012

Volume VI, Issue 1 Spring, 2012

TheJournalofSPEE,Spring20122

3 TheJournalofSPEE,Spring2012

Table of Contents

Foreword...................................................................................................................................................5In.This.Volume.........................................................................................................................................6

Feature Articles

Well Performance and Economics of Selected U.S. Shales ........................................................7 Leslie.O’Connor.and.John.Seidle,.SPEE.Members

Shale Engineering ................................................................................................... 15 Rawdon.Seager,.SPEE.Member.Use and Mis-Use of the Graphical P/Z Plot ...................................................................... 27 Richard.F..Krenek,.SPEE.Member.The Need for an Inferred Resources Category in Reserves and Resources Reporting .......................... 31 Michael.T..Scott Key Issues in Determining Discount Rates for Valuing Real Property .......................................... 39. Dr..Hal.Heaton

The Exploration Game: Statistical Decision Theory Using Bayes Formula .................................... 45. Dr..E..L..Dougherty.

Abstracts and Reviews

Review of SPE 116731, Exponential vs. Hyperbolic Decline in Tight Gas Sands: Understanding the Origin and Implications for Reserve Estimates Using Arps’ Decline Curves ......... 62 . T..Scott.Hickman

Review of SPE 144489, Credit Ratings and Cash-Flow Analysis of Oil and Gas Companies: Competitive Disadvantage in Financing Costs for Smaller Companies in Tight Capital Markets ........ 65. John.Davis

Reference and Source Articles

Engineering and Geophysics ....................................................................................66

Assessment of Undiscovered Oil and Gas Resources of the Devonian Marcellus Shale of the Appalachian Basin Province, 2011

An Overview of Some Key Factors Controlling Well Productivity in Core Areas of the Appalachian Basin Marcellus Shale Play

Introduction to Aspects of Reserve Growth

Assessment of Undiscovered Oil and Gas Resources of the Cook Inlet Region, South-Central Alaska, 2011


Reference and Source Articles

Engineering and Geophysics (continued) .....................................................................66

Review of Emerging Resources: U.S. Shale Gas and Shale Oil Plays

Uncertainty and the Volumetric Equation

Economics and Finance ..........................................................................................69

The Role of WTI as a Crude Oil Benchmark

Factors Influencing Oil Prices: A Survey of the Current State of Knowledge in the Context of the 2007-08 Oil Price Volatility

Does ‘Paper Oil’ Matter? Energy Markets’ Financialization and Equity-Commodity Co-Movements

Petroleum Property Valuation

The Weak Tie Between Natural Gas and Oil Prices

On The Portents of Peak Oil (And Other Indicators of Resource Scarcity)

On the Relation between Expected Returns and Implied Cost of Capital

Legal and Regulatory Issues .....................................................................................72

Expert Testimony: Regression Analysis and Other Systematic Methodologies

Cross-examination Based on Draft Reports is an Uninformative Exercise

Daubert challenger reaps $4.7M in attorney/expert fees

Expert’s ‘hyberbole’ comes back to haunt in Daubert hearing

Oldies but Goodies ................................................................................................75

Government Influence On Industry Operations, Granville Dutton, Journal of SPEE 1969-70. Apparently.not.much.has.changed

Sources on the Internet ..........................................................................................82


Foreword

. Petroleum Evaluation Engineering is the application of scientific and economic principles to the estimation of the rate and volume of production of hydrocarbons that can be expected from development of a property or project and the amount and value of the income derived therefrom.

The.purpose.of.The Journal of the Society of Petroleum Evaluation Engineers.(JSPEE).is.twofold;..first,.to.provide.a.source.of.information.regarding.evaluation.principles.and.practices.that.can.be.applied.by.evaluation.professionals.in.their.daily.work.and,.second,.to.establish.a.forum.for.discussion.of.topics.of.interest..The.Journal of SPEE.is.intended.to.be.a.peer-reviewed.publication..that.will.cover.the.general.topic.of.evaluation.of.oil.and.gas.properties.and.projects.with.specific.emphasis.on.the.practical.application.of.(a).geoscience.theory.and.analysis,.(b).reservoir.and.production.engineering.theory.and.experience,.and.(c).economic.and.financial.theory.and.practice,.to.the.estimation.of.future.production,.income,.and.value.of.those.projects.and.properties.

To.provide.useful.information,.the.Journal.seeks.to.attract.original.papers.and.articles.from.SPEE.Members.(and.from.non-Members).on.a.range.of.topics.covering.as.many.aspects.of.evaluation.practice.as.possible.and.will.focus.on.those.areas.of.engineering.and.economic.practice.that.are.not.commonly.covered.in.other.publications..In.addition,.JSPEE.will.include.(i).reviews.and.excerpts.of.papers.and.articles.published.in.other.journals.and.reliable.sources,.(ii).references.to.books,.articles,.presentations.and.internet.sites.that.may.be.of.interest,.and.(iii).links.to.data.sources.and.other.information.of.use.to.evaluation.professionals..

The JSPEE.can.provide.the.foundation.for.discussion.by.offering.topics.that.provide.new.and.interesting.informa-tion.and/or.insights.and.suggest.improved.application(s).of.existing.methodologies,.some.of.which.may.elicit.differ-ences.of.opinion..In.this.way,.the.JSPEE.hopes.to.provide.a.forum.for.the.discussion.of.important.professional.topics..But.it.will.be.up.to.SPEE.Members.and.other.readers.to.determine.whether.the Journal has.utility.in.advancing.our.profession.and.fulfilling.the.objective.of.SPEE.“... to disseminate facts pertaining to petroleum evaluation engineering among its Members and the public.”

This.volume.is.a.“proto-type”.of.the.proposed.new.Journal..Some.aspects.of.the.JSPEE.may.be.changed,.expanded.or.discarded.in.future.issues.depending.upon.the.response.of.SPEE.Members.to.the.Journal..Accordingly,.along.with.this.publication,.you.will.find.a.link.to.a.Survey.Form.that.asks.a.number.of.questions.about.the.Journal.(as.presented.in.this.model).and.about.the.willingness.of.Members.to.provide.(a).content.for.the.Journal.in.the.form.of.full.papers.or.short.articles,.reviews.of.other.publications,.or.contribution.of.references.to.information.sources,.and.(b).provide.support.for.the.Journal.by.serving.on.editorial.and/or.peer-review.committees..The.support.of.Members.of.the.JSPEE, based.on.the.responses.to.the.survey.will,.in.large.part,.determine.the.future.of.the.Journal...Please.take.some.time.to.review.this.volume.and.provide.your.responses.to.the.Survey..

. . . . . . Thank.you,

. . . . . . The.JSPEE.Editorial.Committee.. . . . . . Richard.J..Miller,.James.W..Haag,.R..Keith.MacLeod,.and.Rod.Sidle


In This Issue

This.volume.of.The.Journal of the Society of Petroleum Evaluation Engineers.is.offered.as..a.model.for.future.issues..There.are.six.technical.papers.covering.a.range.of.topics.and.written.by.knowledgeable.authors..Two.of.the.papers,.one.by.Leslie.O’Connor.and.John.Seidle,.and.one.by.Rawdon.Seager.are.expansions.of.presentations.made.to.the.SPEE.Annual.Meeting.of.June,.2011,.and.deal.with.the.current.topic.of.Shale.Gas.Development..Another.paper.written.by.SPEE.Member.Rick.Krenek,.discusses.an.issue.that.many.of.us.who.have.worked.with.natural.gas.reservoirs.will.find.interesting..Three.other.papers.(solicited.for.this.issue).by.Michael.Scott,.Hal.Heaton,.and.E.L..Dougherty.address.the.topics.of.Reserves.Definitions/Classification.in.relation.to.the.PRMS,.Cost.of.Capital.Discount.Rates,.and.Statistical.Decision.Theory.respectively..

In. addition,. there. are. reviews. of. two. recent. SPE. papers. by. SPEE. Members. Scott. Hickman. and. John. Davis..This. is.a. segment.of. the. Journal. that.we.hope.would.be.expanded..There.are.many.papers.and.articles.written. for.SPE.and.AAPG.meetings.and.conferences.that.could.be.of.interest.to.SPEE.Members.if.brought.to.their.attention..The.Reference.and.Source.Articles.section.includes.a.number.of.papers.and.articles.on.Engineering.and.Geophysics,.Economics.and.Finance,.and.Legal.and.Regulatory.Issues.that.have.been.gathered.from.a.wide.range.of.sources..The.JSPEE also.includes.a.section.listing.websites.that.offer.information.on.product.pricing,.shale.gas.development.activity,.and. discount. rates.. Finally,. we. resurrected. a. Journal. paper. from. 1969. by. Granville. Dutton. which. was. a. thought-provoking.discussion.in.its.time.and.which.clearly.shows.that.the.more.things.appear.to.change,.the.more.they.really.stay.the.same.

.

Disclaimer

The Journal of the Society of Petroleum Evaluation Engineers is intended to promote the profession of petroleum evaluation engineering through the dissemination of information that may be of interest and use to members of the profession; and by providing a forum for the discussion of engineering and evaluation issues. Papers, articles, reviews, and references published in the JSPEE, whether peer-reviewed or not, are selected based on the information they provide. Discussion of any paper, article, review or reference published in the JSPEE is invited and encouraged, in written form, as a Comment which, if found appropriate, will be published in a later issue of the JSPEE as space permits. Papers, articles, reviews, and references published in the JSPEE, whether peer-reviewed or not, are not the product of SPEE, are not endorsed by SPEE, and do not necessarily represent the policy of SPEE on any matter which may be discussed or presented in the JSPEE. Any opinions expressed in any paper, article, review, or reference are the opinions of the author(s) and not necessarily those of SPEE.


Characteristics of shales

Shales,.one.of.the.most.common.sedimentary.rocks,.are.fine-grained.rocks.originating.from.clay.minerals.and.muds.. . They. are. characterized. by. thin. laminae. which.break. with. curving,. splintery. fractures. sub-parallel. to.the.bedding.plane.. . If. sufficient.organic.matter. is.pres-ent.in.the.initial.sediments,.hydrocarbons.are.generated.as.a.shale.matures...Shales.are.both.source.and.reservoir.and.can.be.gas.prone,.oil.prone,.or.mixed.. .Liquid.hy-drocarbons,. gas,. and. water. can. be. present. in. the. shale.pore.space.and.gas.can.be.sorbed.on.the.shale.matrix.sur-face...Shale.porosities.are.typically.less.than.ten.percent.and.determination.of.shale.fluid.saturations.by.wireline.logs.is.problematic,.complicating.volumetric.calculation.of.original.gas.in.place.(OGIP).and.original.oil.in.place.(OOIP).. . Shale. matrix. permeabilities. are. very. low,. on.the.order.of.nanodarcies,.and.most.of.the.flow.capacity.of.any.shale.reservoir.is.due.to.natural.fractures...In-place.hydrocarbon.volumes. in. shales. are.pervasive.but. lower.on. a. unit. reservoir. volume. than. conventional. reser-voirs,. making. them. diffuse,. continuous,. heterogeneous.

Well Performance and Economics of Selected U. S. Shales

Leslie S. O’Connor, SPEE Member, and John P. Seidle, SPEE Member MHA Petroleum Consultants

Introduction

Exploitation of oil and gas resources held in shales has been made possible by recent advances in horizontal well drilling and completion technologies. Each shale is unique, no shale play has gone through an entire life cycle, and considerable confusion exists around the economics of shale gas and oil exploitation. Sources of this confusion include unknown well performance, high well costs, and an uncertain U. S. natural gas market. Initial gas production rates of shale wells depend strongly on well completion, and the wells tend to decline sharply. Long term shale well performance remains unknown in most plays and estimated ultimate recoveries (EUR’s) quoted by some independents are being questioned by evaluators. Shale wells are expensive with a good fraction of the cost coming from multiple fracture stimulations of long horizontal laterals. Current U. S. natural gas prices, uncertain as ever, are subject to long term downward pressures as concerns about the strength of the U. S. economic recovery weaken natural gas demand. Rapid expansion of shale gas plays threatens a supply glut and transportation bottlenecks. This paper begins with a brief review the unique characteristics of shale gas reservoirs and the wells which drain them. Next, shale well perfor-mance prediction methods will be briefly discussed. Lastly economic viability of selected domestic gas shale plays will be investigated.

hydrocarbon. resources.. .With.none.of. the.gas-water.or.oil-water.contacts.seen.in.conventional.reservoirs,.shale.reservoirs.are.defined.by.facies.pinchouts,.thermal.matur-ities,.and.stratigraphy.....Shale.plays.are.geologically.com-plex,.not.simple.resource.plays,.and.commercial.shale.gas.and.oil.exploitation.requires.a.blend.of.geosciences.and.engineering.

More.than.30.U..S..shale.basins.(Figure.1).are.cur-rently.experiencing.some.level.of.activity...The.technical-ly.recoverable.shale.gas.resource.in.the.U..S..is.currently.estimated. to.be.862.Tcf. (.EIA,.2011). and. the. fraction.of. this. resource. which. can. be. classified. as. reserves. is. a.source.of.contention.in.the.oil.and.gas.community...With.over.a.decade.of.development,. the.Barnett. is. the.most.mature.shale.gas.play.in.the.U..S..and,.rightly.or.wrongly,.is. often. considered. to. be. an. analog. for. emerging. shale.gas.plays.. .The. shale. condensate. and.oil. resource. (this.paper.considers.only.liquid.oil. in.shale,.so.called.“tight.oil”,. not. oil. produced. by. retorting. shales,. a. liquid. also.described.as.“shale.oil”). is.even.less.well.defined.. .Pro-duction.of.these.liquids.from.shales.is.problematic.when.

This paper was originally presented at the SPEE Annual Meeting, Amelia Island Resort, Florida, June 6, 2011


the. hard. drawdowns. required. for. commercial. produc-tion.from.these.low.permeability.formations.causes.near.wellbore.pressures.to.fall.below.the.dew.point.or.bubble.point.pressures...Assignment.of.such.reserves.is.problem-atic.and.is.not.considered.here...Properties.of.the.shales.considered.here,.the.Haynesville,.Bakken,.and.Marcellus.shales,.are.summarized.in.Table.1.

Shale well completions

Shale.wells.are.typically.completed.with.a.long.lat-eral,.stimulated.with.multiple.transverse.fractures...Com-pletions.vary.little.between.the.various.basins,.regardless.of.the.fluid.being.produced...The.well.is.typically.a.mono-bore,. rather. than. multiple. sidetracks. kicked. off. from. a.vertical.well...Lateral.lengths.have.steadily.increased.to.more. than. 10,000. feet. with. an. optimum. length. yet. to.be.determined...Current.industry.practice.is.to.cement.a.liner.in.the.lateral.followed.by.perforation.in.clusters.and.stimulation.with.thirty.or.more.hydraulic.fracture.stages.(Figure.2)...Lateral.azimuth.is.often.chosen.to.be.perpen-dicular.to.the.major.stress.direction.making.any.induced.fractures.parallel.to.the.major.stress.direction.and.trans-verse.to.the.lateral...The.resulting.completion.is.visual-ized.as.a.rectangular.box.defined.by.the.long.lateral.and.

the.multiple.transverse.fractures...Volume.of.this.box,.the.product.of.lateral.length,.tip-to-tip.fracture.length,.and.fracture.height.is.referred.to.as.the.“stimulated.reservoir.volume”.(SRV).

Shale. well. capital. costs. can. exceed. $10,000,000.with.over.half.the.total.well.costs.being.required.for.stim-ulations...Up.to.thirty.or.more.hydraulic.fracture.stimula-tions. are.placed. in. some.10,000. foot. laterals,. requiring.roughly20,000.barrels.of.water.and2,000,000.lbs.of.sand...Regardless.of.the.shale.formation,.only.about.a.third.of.the.load.water.is.recovered,.leaving.two.thirds.in.the.for-mation...Legitimate.concerns.from.local.residents.about.adequate. water. supplies. and. treatment. or. recycling. of.produced.water.are.growing.in.virtually.every.shale.play...Addressing.such.concerns.will.lead.to.increased.regula-tions,.longer.permitting.times,.and.increased.well.costs.

Shale well performance predictions

With.very. low.reservoir.permeabilities,. shale.wells.often.require.years.to.reach.the.boundaries.of.the.SRV...Several.additional.years.of.production.data.are.required.before.decline.curve.analysis.can.be.confidently.applied.to.such.wells...A.common.strategy.for.estimating.EUR’s.in.other.low.permeability.plays.is.use.of.the.subject.well’s.initial.production.rate.(IP).with.a.correlation.of.IP.and.EUR.developed.from.analogous.wells...With.the.excep-tion.of.perhaps.a.few.Barnett.wells,.no.full.cycle.well.his-tories.are.yet.available.for.shale.plays,.precluding.use.of.this.method.for.estimating.shale.well.recoveries.

Shale. gas. and. oil. wells. typically. show. high. initial.rates.and.dramatic,.hyperbolic.declines...The.gas.produc-tion.decline.of.an.unidentified.gas.well.(Anderson,.2011).shown.in.Figure.3.has.an.initial.rate.of.3.2.MMcfd.and.a.

Table 1. Reservoir properties of selected shales

property Haynesville Bakken Marcellusage U Jurassic Dev-Miss Devonian

fluid type gas oil gasdepth, ft 11,000 9,500-

11,0004,000-8,000

thickness, ft 180-400 160 100-400pressure, psia 9,900 8,500 2,400-4,700temperature, F 300 240 135


first-year.decline.of.22%.per.year...Fitting.a.decline.curve.to.this.early,.transient.production.data.yields.a.hyperbolic.decline.curve.with.a.long.tail...While.this.approach.may.be. useful. for. predicting. production. rates. over. the. next.few.years,.the.long.tail.gives.erroneously.high.estimated.ultimate.recovery...The.two.hyperbolic.declines.shown.in.Figure.3.have.EUR’s.of.49.8.and.85.5.Bcf.

Newly.developed.production.data.analysis.methods,.using.plots.of.a.normalized.rate-pressure.variable.against.the.square.root.of.production.time.and.a.flowing.mate-rial.balance,.provide.estimates.of.the.in.place.gas.or.oil.currently.seen.by.the.well,.providing.a.lower.bound.on.OGIP.and.OOIP...Recovery.factors.for.these.in.place.vol-umes.and,.hence,.EUR’s.are.the.subject.of.debate.but.are.currently.thought.to.be.5.to.10%.of.the.original.fluid.in.place.

Simulation. of. shale. well. performance. for. reserves.

estimation.is.problematic.for.two.reasons...Technically,.history.matching.of.only.transient.production.data.with.a.numerical.model.is.insufficient.for.simulation.of.long.term.well.performance...Economically,.many.regulatory.bodies.prohibit.assigning.reserves.solely.via.simulation...Numerical.models.can.be.part.of.a.suite.of.techniques.for.estimating.reserves.but.cannot.stand.alone.in.determina-tion.of.shale.oil.and.gas.reserves.

The.practical.result.of.applying.several.limited.tech-niques. to. shale. well. production. decline. data. are. non-unique. production. forecasts.. . Production. decline. fore-casts.for.the.unidentified.gas.well.discussed.above,.shown.in.Figure.4,.all.match.the.early.time.data.nicely,.but.es-timated.ultimate.recoveries.vary.from.29.2.to.85.5.Bcf,.a.factor.of.nearly.three...Uncertainty.in.shale.gas.recovery.has. been.documented. in. the.past. (Berman,. 2009),. but.more.recent. is. the.EIA’s.slashing.of. their.Marcellus.gas.estimates.by.nearly.80%.(NYTimes,.8/24/2011)...The.in-ability.to.accurately.estimate.shale.well.EUR’s.will.plague.evaluation.of. shale.oil.and.gas. reserves. for. the. foresee-able.future.and.deserves.additional.research...This.paper.utilizes.public.domain.type.curves.realizing.full.well.that.they.are.probably.erroneous.but.are.nonetheless.widely.used.throughout.the.oil.and.gas.industry.

Haynesville shale well breakeven gas price

The. Haynesville. shale. of. east. Texas. and. western.Louisiana.is.overpressured.(0.7-0.9.psi/ft),.deep.(~11,000.feet). and. produces. primarily. gas.. . Industry. activity. to.date.indicates.a.sweet.spot.centered.in.three.parishes.of.northwest.Louisiana.(Figure.5)...A.type.curve.typical.of.


those.developed.by.independents.(Petrohawk,.2010).for.sweet. spot. wells. is. contrasted. with. that. developed. by.Thompson,.et.al,.(2010).for.the.Haynesville.in.general.in.Figure.6...Mathematical.constants.for.the.hyperbolic.equations.of.the.two.type.curves.are.collected.in.Table.2.. . First. year. decline. for. the. sweet. spot. type. curve. is.82%.while.that.of.the.generic.Haynesville.type.curve.is.89%...A.minimum.decline.of.5%.per.year.was.imposed.on.both.type.curves.here.to.prevent.long.tails.

This.study.employed.public.domain.economic.infor-mation,. augmented. as.necessary. by. reasonable. assump-tions...Haynesville.well.capital.costs.were.9.4.MM$.and.

lease.operating.expenses.were.$2.17/mcf,.which.includes.gathering. and. compression.. . The. Haynesville. produc-tion.had.a.price.differential.of.$1.081/MMBtu.less.than.Henry.Hub.prices...These.and.other.pertinent.economic.parameters.are.presented.in.Table.3...All.economic.cases.considered.in.this.paper.assumed.a.working.interest.(WI).of.100%,.a.net.revenue.interest.(NRI).of.82.5%,.and.an.effective.date.of.January.1,.2012.

Combining. the.SEC.and.NYMEX.Henry.Hub.gas.price.forecasts.(Figure.7).with.the.two.Haynesville.type.curves.gives.four.economic.scenarios.for.this.play...The.resulting.cash.flow.values.based.upon.a.10%.discount.fac-tor,.shown.in.Table.4,.were.all.negative,.prompting.the.

question.of. breakeven.gas.price. for. a.Haynesville.well...Defining. a.breakeven.price. as. that.price.which.gives. a.zero.cash.flow.(discounted.at.10%).value.and.using.the.sweet. spot. type. curve. yields. a. breakeven. gas. price. of.$5.147/MMBtu.. . The. January. 1,. 2012,. NYMEX. price.forecast.reaches.this.level.in.2018.

Table 2. Haynesville type curve parameters

Ref: Petrohawk, 2010, and Thompson, 2010

parameter Petrohawk Thompson

qi, mcfd 18,000 8,911

b 1.05 0.35

Di, yr-1 4.83 3.37

De min, %/yr 5 5

50 yr EUR, bcf 7.874 1.484

sweetspot generic

NYMEX -4,215 -8,561

SEC -3,887 -7,839

Table 4. Haynesville shale well PV10’s m$


Bakken shale well cash flow, discounted at 10% (PV10) sensitivity to initial rate

The.Bakken.play.of.western.North.Dakota,.eastern.Montana,.and.southern.Saskatchewan.is.an.oil.play.pro-ducing.primarily.from.the.middle.member.of.the.Bakken.formation.with.some.newer.wells.testing.the.stratigraphi-cally.lower.Three.Forks.formation...This.study.utilized.an.industry.type.curve,.the.Brigham.type.curve,.developed.for.oil.production.from.the.Bakken.formation.(Darbonne,.2011)..Production.behaviors.and.reservoir.characteristics.vary.across. the.play.and.those.used. for. this. study,. from.western. North. Dakota,. are. not. necessarily. appropriate.for.other.areas.of.the.Bakken.play...

The. two. Bakken. oil. production. type. curves. are.shown. in. Figure. 8. and. the. associated. cumulatives. in.Figure.9...Mathematical.constants.for.both.Bakken.type.curves.are.listed.in.Table.5...Initial.rates.of.both.curves.appear.to.be.similar.but.at. late.times.the.generic.curve.

rate. is.twice.that.of.the.Brigham.curve.. .This.apparent.rate.superiority.vanishes.when.comparing.the.cumulative.oil.production.shown.in.Figure.10...The.slightly.higher.production.rate.of.the.Brigham.curve.leads.to.a.10-year.cumulative. production. a. third. higher. than. that. of. the.generic. curve.. . Cumulative. production. of. the. generic.type. curve. catches. up. to. the.Brigham.cumulative. only.

after.24.years.on.production...Initial.rate.of.the.Brigham.type. curve. is. 906. bpd. and. the. first. year. decline. rate. is.72%.. . Initial. rate.of. the. generic. type. curve. is. 850.bpd.and.the.first.year.decline.rate.is.83%...Economic.value.of.for.these.wells.depends.on.a.good.completion.and.high.initial. rates.. . These. wells. are. typically. completed. with.over.30.hydraulic.fracture.stimulation.stages.and.are.not.without.mechanical.risk...The.question.arose.about.the.sensitivity.of.PV10,.as.a.measure.of.economic.value,.to.initial.oil.production.rate.and.completion.efficiency.

parameter Brigham generic

qi, bpd 906 850b 0.80 1.80

Di, yr-1 2.24 13.04De min, %/yr 5 5

50 yr EUR, mstb 490.3 554.3

Table 5. Bakken type curve parameters

Ref: O&GI, Aug 2010, and pub domain data


Bakken.economic.parameters,. primarily. from.pub-lic.domain.information,.and.augmented.by.prior.experi-ence,.are.collected. in.Table.6.. .Total.well.capital.costs.were.7.1.MM$.and.operating.costs.were.$10,000.for.the.first.two.months.falling.to.$4,000.per.month.thereafter...To.better.understand.the.effect.of.initial.rate.on.PV10,.this.work.utilized.two.scenarios...The.first.scenario.used.the.NYMEX.January.1,.2012,.oil.price.forecast.and.a.2%.cost.escalation.factor...The.second.scenario.employed.the.SEC.December.31,.2011,.price.of.$96.19.per.barrel.and.no.cost.escalation...The.SEC.price.is.compared.with.the.January.1,.2012,.NYMEX.price.forecast.in.Figure.10.

The.resulting.PV10.values.and.the.fraction.of.PV10.realized.in.the.first.10.years.are.summarized.in.Tables.7.and.8,.respectively...The.PV10.values,.all.positive,.ranged.from.10.7. to.12.3.MM$.. .Roughly. three-fourths.of. the.PV10.value.in.all.four.caseswas.captured.during.the.first.decade.of.production.

To.investigate.the.effect.of.completion.efficiency.on.PV10,.additional.economics.were.run.with.the.Brigham.type.curve.initial.rate.reduced.to.three.quarters.then.half.of. the. initial. rate.of.906.bpd.. .The. resulting.deteriora-tion.of.PV10.value.is.illustrated.in.Figure.11...For.both.scenarios,.halving.the.initial.rate.reduced.PV10.by.about.20%.whereas.halving.the.initial.rate.reduced.the.PV10.value.by.a.factor.of.three.

Marcellus shale well sensitivity to drilling delays

The. Marcellus. shale. play. primarily. encompasses.Pennsylvania.and.New.York.and.is.gas.prone.with.some.reports.of.liquids.in.selected.sweet.spots...Very.little.pub-lic.domain.data.exists.for.this.play.yet.public.opposition.

is.mounting.due.to.concerns.about.fracture.stimulation.fluids. possibly. contaminating. shallow. aquifers.. . Such.concerns.have.prompted.a.ban.on.Marcellus.well.com-pletions.in.New.York.State.which.may.not.be.lifted.for.a.number.of. years.. .The. influence.of.drilling.delays.on.Marcellus.well.economics.was.addressed.by.investigating.changes. in.the.PV10.values.and.payout.times.resulting.from.delays.of.one,.two,.and.five.years.

An.industry.type.curve.for.a.Marcellus.well.(Ander-son,.2011).is.depicted.in.Figure.12...The.initial.gas.rate.is.2,600.Mcfd.and.the.first.year.decline.is.67%...These.and.other.hyperbolic.decline.curve.coefficients.are.collected.in.Table.9...Imposition.of.a.5%.per.year.minimum.decline.led.to.a.50-year.cumulative.production.of.4.097.Bcf.

Marcellus. economic. parameters. used. in. this. study.are.listed.in.Table.10.and.include.a.total.well.cost.of.5.MM$.and.monthly.operating.costs.of.$2,000.per.well.per.

Table 7. Bakken PV10 summary, mm$

price

forecast Brigham generic

NYMEX 12.0 10.7

SEC 12.3 11.0

Table 8. Fraction of Bakken PV10 in first 10 years

price


NYMEX 75% 74%

SEC 75% 74%


delay.increases.the.PV10.value.with.the.five-year.delay.case. increasing. PV10. value. about. 30%. over. the. base.case. PV10.. . This. curious. behavior. is. explained. by. the.gas.price,.shown.in.Figure.7,.rising.much.faster.than.well.capital.and.operating.costs,.assumed.to.be.2%.per.year...Drilling. delays. also. affect. time. to. payout.. . As. seen. in.Figure.14,.a.one-year.drilling.delay.does.not.significantly.increase.time.to.payout,.a.two-year.delay.pushes.payout.

back.about.a.year,.and..a.five-year.delay.results.in.a.nine-year. payout,. an. increase. of. just. over. 40%.. Let’s. take. a.look.at.the.economics...Note.this.analysis.does.not.take.account.of.lease.costs.which.could.be.an.important.com-ponent.of.the.economics.of.drilling.delays.

month.. . For. simplicity,. this. case. used. on. the. NYMEX.December.31,.2011,.pricing.shown.in.Figure.7.and.a.cost.escalation.of.2%.per.year.

The. PV10. values. for. a. base. case,. 2012,. Marcellus.well. and. those. associated. with. delays. of. one,. two,. and.five.years.are.shown.in.Figure.13...In.all.cases,.a.drilling.

Table 9. Marcellus type curve parametersRef: Anderson, 2011

parameter valueqi, mcfd 2,600

b 2.50

Di, yr-1 6.04

De min, %/yr 5

50 yr EUR, bcf 4.097

Table 7. Bakken PV10 summary, mm$

price


NYMEX 12.0 10.7

SEC 12.3 11.0

Table 8. Fraction of Bakken PV10 in first 10 years

price


NYMEX 75% 74%

SEC 75% 74%


Conclusions

Exploitation.of.U..S..shales.has.grown.rapidly.over.the.last.few.years.due.to.advances.in.horizontal.well.drill-ing.and.completion.technologies...Projected.oil.and.gas.recoveries. from. shales. are. widely. quoted. in. the. media.as.reasons.for.significantly.increasing.domestic.reserves...However,.a.closer.inspection.of.shale.well.economics.in.three.selected.shale.plays.indicates.modest.to.disappoint-ing. economics.. . Breakeven. gas. pricing. for. Haynesville.wells.was.calculated.to.be.$5.147/MMbtu,.a.price.which.the.current. (January.1,.2012).NYMEX.Henry.Hub.gas.price. forecast. reaches. in. 2021.. . Completion. efficiency.is.critical.for.Bakken.wells.as.halving.the.initial.oil.rate.decreases.PV10.by.a. factor.of.3.. .Drilling.delays. in.the.Marcellus.play.could,.if.current.NYMEX.gas.price.fore-casts.are.accurate,.increase.the.PV10.value.by.a.third.but.could.also.increase.time.to.payout.by.just.over.40%..

Acknowledgements

Use.of.tax.information.provided.by.the.SPEE.web-site.is.gratefully.acknowledged.

ReferencesAnderson, Dave. 2011. Fekete Production Data Analysis Manual.

Berman, A. August 10, 2009. “Lessons from the Barnett Shale suggest caution in other shale plays.” www.aspousa.org/index.php/2009/08/lessons-from-the-barnett-shale-suggest-caution-in-other-shale-plays.Accessed December 12, 2010.

Darbonne, Nissa. 2010. “In Pursuit of Bakken.” Oil and Gas Investor. August, p. 73.

EIA. April 5, 2011. “World Shale Gas Resources: An Initial As-sessment of 14 Regions Outside the United States.” www.eia.gov/analysis/studies/worldshalegas/. Accessed December 12, 2010.

NY Times, August 24, 2011. “Geologists Sharply Cut Estimate of Shale Gas.” www.nytimes.com/2011/08/25/us/25.gas.html. Accessed January 5, 2012.

Petrohawk analyst presentation. May 24, 2010.

Thompson, et al. 2010. “An Overview of Horizontal Well Com-pletions in the Haynesville Shale.” SPE 136875. Presented at the Canadian Society for Unconventional Gas conference, Cal-gary, Alberta, November 29-31, 2010.

BiographyLeslie O’Connor is President of MHA Petroleum Consultants, LLC, with over 30 years of petroleum experience. From 1997 to 2006, Ms. O’Connor headed up the Denver operations for Sproule Associates Inc., another major world-wide consulting firm. Prior to this, she worked for 16 years at other petroleum consultancy and E & P firms, and gained experience in all ba-sins in the U. S., the North Sea, China, Romania, and South America.

John Seidle, a Vice President with MHA Petroleum Consultants in Denver, Colorado, has more than 30 years experience in coalbed methane and shale gas reservoir engineering. Author or co-author of more than 25 technical papers, six patents, and one monograph, he is also an instructor for industry courses in gas reservoir engineering.


Shale Engineering

Rawdon Seager, SPEE Member, Gaffney, Cline & Associates Contributor: George Vassilellis, Gaffney, Cline & Associates

Abstract

With the significant emphasis by many companies on the development of shale gas, a need has arisen for a consis-tent approach to the evaluation of these reservoirs that empirically-based methods cannot accomplish. While undoubt-edly useful, it is recognized that the use of “type curves” may lead to potentially misleading optimistic results especially if they are not constrained by volumetric estimates and an understanding of the physical processes involved. This paper presents an engineering approach (called “shale engineering” to reflect the underlying technical basis) that can be ap-plied when sufficient data are available.

The method involves the numerical treatment of key physical processes that are involved in hydrocarbon extraction from shale by addressing both the natural and the imposed rock attributes that result from massive stimulation. This is achieved by preparing two types of numerical simulation models: one describing the impact of the hydraulic fractur-ing process and creation of the stimulated rock volume (SRV), and another that combines the artificial and natural rock attributes to allow for prediction of flow performance in the long term. In this way, overall computing time can be kept reasonable, while maintaining the necessary level of detail where it is required. The method is concisely explained and an example of its use is presented.

This paper was originally presented at the SPEE Annual Meeting, Amelia Island Resort, Florida, June 6, 2011

Introduction

There.has.been.a.paradigm.shift.in.the.supply.of.natural.gas.in.the.United.States.following.the.boom.in.the.loca-tion,.assessment,.development.and.production.of.shale.gas1..The.EIA2.recently.estimated.that.there.are.a.total.of.862.Tscf.of.technically.recoverable.shale.gas.within.the.US.(Figure.1)..

Figure 1 – North American Shale Gas Plays

.


Similar.formations.are.found.throughout.the.world.(Figure.2),.although.they.are.presently.at.a.much.earlier.stage.of.evaluation..The.highest.potential.is.presently.seen.to.be.in.China,.Argentina.and.Mexico.

Figure 2 – EIA Map of 48 Major Shale Gas Basins in 32 Countries

In.the.last.three.years,.there.has.been.in.excess.of.US$70.billion.of.inward.investment.in.shale.gas.and.shale.oil.transactions.in.the.US.(Figure.3)..

Figure 3 – US Shale Transactions 2008 – 2011

The.very.significant.growth.during.the.past.decade.is.illustrated.in.Figure.4...Note.that.production.from.the.fore-runner.play,.the.Barnett,.is.at.plateau.and.is.expected.to.decline.in.the.future..


Figure 4 – US Historical Shale Gas Production

Figure.5.shows.the.EIA’s.view.of.the.contribution.of.shale.gas.to.the.total.US.supply.for.the.next.25.years...By.2035.it.is.expected.to.provide.nearly.half.of.total.gas.consumed.in.the.US.

Figure 5 – EIA Annual Energy Outlook 2011


All.this.is.presently.taking.place.in.an.environment.of.historically.low.gas.prices.when.considered.in.relation.to.the.price.of.oil...On.an.equivalent.basis,.the.prices.of.oil.and.gas.(as.represented.by.West.Texas.Intermediate.and.Henry.Hub,.respectively).have.been.relatively.close.(Figure.6)..

Figure 6 – Historical US Oil and Gas Prices

.However,.since.around.2006,.there.has.been.a.disconnect.with.the.price.of.gas.falling.far.behind.that.of.oil..In.mid-2011,.gas.was.about.one.fifth.the.price.of.oil.on.an.energy.equivalent.basis...Depending.on.the.price.outlook.that.one.wishes.to.consider.(for.instance,.Figure.7),.this.situation.may.be.predicted.to.continue.into.the.future.for.many.years..It.is.therefore.no.wonder.most.shale.gas.participants.are.moving.their.activity.away.from.relatively.lean.gas.plays.such.as.the.Haynesville.to.richer.plays.such.as.the.Eagle.Ford.and.Marcellus...

Figure 7 – Henry Hub Gas Price Projections


The Challenge of Predicting Shale Well Performance

When.dealing.with.shale. reservoirs,. formation.description.requires. special.attention.. .Resource.concentration.may.follow.regional.trends.over.significant.areas.while.well.performance.is.often.influenced.by.natural.fracturing.(in.addition. to. stimulation.effectiveness). that.may.have.more. localized.attributes.. .The.placement.of.horizontal.wells.becomes.an.intricate.exercise.in.balancing.the.targeting.of.zones.of.rich.hydrocarbon.concentration,.optimum.rock.brittleness.and.the.risk.that.hydraulic.fractures.could.extend.out.of.zone.into.possibly.water-bearing.reservoirs..

This.article.does.not.venture.into.the.aspects.of.sweet-spot.selection,.targeting.and.optimization,.but.rather.fo-cuses.on.key.variables.that.can.describe.the.physical.and.mechanical.processes.that.drive.production.performance...In.this.quest,.the.objective.was.to.provide.a.simple,.practical,.but.yet.relevant.estimation.process.that.is.applicable.to.risk.assessment,.field.development.and.performance.optimization.and.that.can.be.refined.as.more.data.become.available..

In.this.process,.the.gas.and.oil.presence.in.these.rocks.is.quantified.by.the.summation.of.the.volumes.that.occupy.pores.in.the.inorganic.and.organic.matter..The.former.are.similar,.yet.finer,.than.the.pores.in.conventional.reservoirs..The.latter.are.associated.with.organic.matter.that.is.porous.and.also.has.the.ability.to.release.gas.that.is.adsorbed.on.the.rock.surface..The.volumetric.estimation.of.shale.gas.and.shale.oil.in.place.depends.on.specialty.tools.and.core.analysis.that.provide.the.necessary.resolution.to.measure.this.fine.porosity,.fluid.types.and.saturations..The.level.of.petrophysi-cal.sophistication.to.achieve.this.task.requires.the.detailed.lithological.description.and.measurements.of.organic.mat-ter.attributes.such.as.total.organic.content,.kerogen.type.and.maturity..It.is.also.necessary.to.have.a.comprehensive.understanding.of.the.rock.mechanics.and.the.processes.that.lead.to.the.creation.of.the.stimulated.rock.volume.(SRV).and.the.relation.between.its.flow.characteristics.to.the.micro-seismic.surveys.that.are.often.employed.during.the.stimu-lation.process..The.objective.of.shale.engineering.is.to.describe.both.the.mechanism.that.leads.hydrocarbons.from.the.rock.to.the.fractures.and.the.process.that.creates.fractures.to.connect.these.hydrocarbons.to.the.well..

Because.of. these.differences. from.conventional.reservoirs,. traditional.reservoir.engineering.tools.and.concepts.may.not.apply...For.instance:

•. The.relation.to.in-place.volumes.is.questionable•. The.material.balance.approach.does.not.apply•. Flow.is.not.entirely.related.to.pressure.difference•. The.effect.of.natural.fractures.is.often.misunderstood•. As.mentioned.above,.decline.analysis.is.uncertain

One.of.the.methods.frequently.applied.to.derive.the.estimated.ultimate.recovery.(EUR).from.wells.is.that.devel-oped.by.Arps.in.1944..That.approach.is.based.on.the.empirical.observation.that.flow.rate.declines.with.time.from.an.initial.rate,.qi,.based.on.a.decline.rate,.D,.and.a.decline.exponent,.b,.as.shown.in.Equation.1.below.

The.exponent,.b,.can.vary.from.zero.(exponential.decline).through.hyperbolic.decline.(0<b<1).to.a.value.of.b.=.1.(harmon-ic.decline).. .However,.with. shale. reservoirs,.an.early.fit. to. the.production.data.can.frequently.be.made.using.a.b.value.close.to.2.(which.is.equivalent.to.linear.flow)...Under.these.conditions,.use.of.Arps’. equation.can. lead. to. a. significant.over-estimation.of.EUR...In.theory,.if.the.exponent.b.is.equal.to.or.greater.than.unity,. the. rate. decline.becomes. asymptotic,. which,. absent. any.modifying.control,.leads.to.the.impossibility.of.producing.infinite.volumes.from.a.finite.resource...The.issue.is.illustrated.conceptu-ally.in.Figure.8..


Therefore,.any.production.trend.that.can.be.described.with.a.decline.exponent.greater.than.unity.must.be.con-sidered.to.be.transitional.and,.as.the.flow.regime.changes,.the.value.of.b.will.tend.to.decrease.until,.ultimately,.it.is.expected.to.be.less.than.1.(and.perhaps.to.approach.zero)...Unfortunately,.there.is.presently.no.known.method.to.es-tablish.how.the.decline.parameters.will.change.with.time.or.when.it.would.be.appropriate.to.impose.a.terminal.decline.rate.(a.common.method.used.to.try.to.avoid.gross.over-estimation.of.recovery)...Depending.on.rock.and.stimulation.characteristics.it.may.take.many.years.before.boundary-dominated.flow.is.achieved...

Other.researchers.have.proposed.different.decline.schemes.that.appear.in.some.cases.to.fit.shale.wells.better,.but.up.to.this.point.there.is.no.universally.accepted.decline.formulation.that.can.match.short.and.long.term.trends.and.that.is.consistent.with.the.physical.processes.of.production.

As.illustrated.by.Fetkovich.in.1973,.the.conventional.decline.schemes.can.be.supported.by.simple.physical.models.that.relate.to.radial.flow.under.fixed.boundary.conditions.(i.e..constant.drainage.volume,.constant.permeability.and.constant.bottom-hole.pressure)...In.shale.wells.it.will.be.difficult.to.demonstrate.that.all.these.conditions.(except.the.constant.bottomhole.pressure).can.be.sufficiently.maintained.

What.are.some.of.the.other.issues.relating.to.field.development.planning.that.cannot.be.easily.addressed.using.decline.curves?

•. They.do.not.involve.flow-path.constraints.(such.as.surface.operating.pressures)

•. It.is.difficult.to.incorporate.changes.in.well.drilling.and.completion.design.over.time

•. Geo-mechanical.effects.within.the.reservoir.are.ignored

•. The.dual.contribution.of.hydrocarbons.from.inorganic.and.organic.rock.matter.is.not.accounted.for.as.a.dif-ferentiating.factor

In.other.words.when.decline.trends.are.analyzed.and.are.summarized.as.“type.curves”.they.may.not.be.adjusted.for.variations.in.pressure,.organic.material,.brittleness.and.natural.fracture.occurrence.(to.name.just.a.few.key.variables).which.may.be.known.from.regional.studies...In.order.to.capture.the.effect.of.such.parameters.on.production,.a.large.production.dataset.is.required,.which.may.not.be.available.at.the.time.when.development.decisions.need.to.be.made...Even.when.such.studies.have.been.conducted.in.mature.plays.(like.the.Barnett).it.is.recognized.that.such.norms.may.not.and.should.not.be.applied.to.other.shale.formations.unless.they.can.be.shown.to.be.truly.analogous..

As.there.is.no.systematic.way.to.address.these.factors,.long.term.predictions.become.questionable..Despite.these.drawbacks.and.challenges,.the.use.of.decline.analysis.is.prevalent.in.the.industry...Typically,.operators.will.derive.“type-curves”.based.on.the.performance.of.available.production.wells.to.form.the.link.between.the.in-place.resource.and.the.desired.projection.of.production.performance.

There. are. indeed. other. methods. that. can. be. applied,. such. as. more. advanced. decline. analysis. and. analytical.models,. but. this. paper. will. focus. on. an. approach. that. seeks. to. model. the. performance. of. shale. reservoirs. using. a.specially-adapted.numerical.simulation.work.flow.based.on.“shale.engineering”.that.can.replace.the.“type-wells”.with.a.methodology.that. incorporates. known. shale. properties. and. matches. observed.performance...It.seeks.to.provide.more.confidence.in.the.estimates.by.constraining.the.attributes.of.the.stimulated.reservoir.volumes.based.on. information. from. the. fracturing.process,. such.as. treat-ment.pressures.and.rates,.proppant.concentration...

The.shape.of.the.SRV.is.guided.by.the.shape.of.the.micro-seismic.surveys,.recognizing.that.many.of.the.recorded.events.may.not. be. associated. with. the. presence. of. proppant,. or. even. fluid..(Figure.9).and.may.therefore.be.in.parts.of.the.reservoirs.that.is.not.in.communication.with.the.wellbore...


It.is.also.recognized.that.the.induced.permeability.throughout.the.SRV.diminishes.with.distance.and.by.deple-tion.as.dictated.by.a.simplified.geo-mechanical.coupling.between.pressure.and.permeability...This.coupling.is.applied.both.for.pre-existing.natural.fractures.and.for.the.matrix...Variations.in.the.fracture.permeability.with.pressure.are.the.most.critical.in.the.SRV.propagation.process,.while.fracture.and.matrix.variation.with.pressure.is.important.in.the.subsequent. pressure. depletion. process.. . The. starting. point.for. fracture. permeability. is. related. to. the. fracture. density.observed. in. image. logs. and. is. the. main. tuning. parameter.to.match.maximum.pressures.achieved.during.stimulation...This. leads. to. SRV. extensions. that. are. logically. related. to.the.pre-existing.natural.fracture.occurrence.and.this.concept.is. validated. by. the. fact. that. this. SRV. description. is. close.enough.to.match.production.observed.by.different.fracture.stages.through.production.logging...It.also.seems.that.when.a.production.prediction.is.made.for.that.given.SRV,.the.de-cline.shape.matches.closely.the.observed.decline.shape.

Another.feature.of.the.fracturing.process.is.the.creation.of.enhanced.permeability.within.the.reservoir,.even.in.frac-tures.that.are.not.propped...This.may.be.understood.by.refer-ence.to.Figure.10.

During.the.initial.pressuring-up.of.the.well.and.nearby.rock.(“loading”).there.comes.a.point.at.which.a.quantita-tive.change.in.permeability.arises.due.to.rock.slippage.before.the.fracture.pressure.is.reached.(the.blue.lines.in.Figure.10)...Continued.pumping.results.in.fracturing.the.rock.at.the.red.point...Once.pressure.is.released,.the.rock.follows.the.orange.path.to.the.unstressed.state,.which.is.at.a.higher.permeability.that.the.starting.value.(impact.of.hysteresis)...Unfortunately,.there.is.presently.no.established.method.quantitatively.to.derive.the.effect.of.this.hysteresis,.but.the.shapes.proposed.by.Moos.and.Barton.(reference.5).can.be.adopted.to.direct.laboratory.tests.and.“mini-frac”.tests.that.can.measure.these.control.points.at.different.scales...At.this.stage,.the.application.of.such.hysteresis.curves.is.relatively.crude,.more. intuitive. than.absolute,.but. it. is.not. inconsistent.with.certain.observations. like. the.pressure.at.which.shearing.can.initiate,.the.order.of.magnitude.change.in.rock.permeability.that.can.be.achieved.by.cracking.a.rock.in.mini-frac.tests,.the.stiffness.of.the.rock.that.relates.to.aperture.opening.after.tensile.fractures.are.initiated,.and.so.on.

Shale Engineering Models Description

A.typical.shale.reservoir.and.hydraulically-fractured.horizontal.well.drilled.to.drain.it.can.be.conceptually.de-scribed.as.shown.in.Figure.11...The.matrix.is.essentially.tight.and.fluid.movement.is.governed.by.non-Darcy.flow.and.desorption...There.are.probably.natural.fractures.leading.to.a.dual.porosity.and.dual.permeability.system...Immediately.around.the.perforations.will.be.the.induced.major.fracture. that. will. be. propped,. connected. with. an.ill-defined.network.of.smaller.induced.fractures.of.the.entire.SRV.

Several. numerical. methods. have. been. pre-sented. in. the. literature. to.provide. a.basis. to.per-form. numerical. simulation. and. history. matching.as. a. tool. to. provide. production. forecasts.. . These.attempts.are.based.on.a.static.view.of.the.SRV.by.making.a.direct. connection. to.micro-seismic. sur-veys...In.other.words.the.SRV.is.“ring-fenced”.by.the.micro-seismic.events.and.is.equally.attributed.

0.0001

0.001

0.01

0.1

1

- 5,000 10,000 15,000 20,000 25,000

Perm

eabi

lity,

mD

Pore Pressure (psi)

Permeability . vs pressure

Loading pathUnloading pathTheoretical loading curveTheoretical unloading curveCritical Pressure, psiInitial Pressure, psiFrac Pressure, psi

Figure 10 – Permeability Change Due to Fracturing


by. an. enhanced. permeability.. . Previous. methods.often. employ. simplified. flow. formulations. that. do.not. recognize. the. dual. sourcing. of. hydrocarbons.(inorganic.and.organic.pores)...Previous.numerical.methods. commonly. ignore. geo-mechanical. effects.that.lead.to.loss.of.flow.conductivity.with.pressure.depletion.and.somewhat.overstate.the.contribution.from.areas.outside.the.SRV,.leading.to.an.over-esti-mation.of.the.spacing.required.for.optimal.extrac-tion...In.order.to.simulate.this.system.in.an.efficient.manner,.the.shale.engineering.approach.is.to.build.two.separate.geological.and.simulation.models.(Fig-

ure.12)...Both.deal.with.rock.geo-mechanics.through.dilation-compaction.tables.and.fluid.compositional.formulation.(if.required).

The.first.model,.Model.A,.deals.with. the. creation. of. the. SRV. by.modeling. the. fracture. propagation.process. and. provides. the. SRV. per-meability...The.model.is.constructed.with. a. fine. grid. using. as. detailed. a.description.of.the.rock.as.is.available.and. matched. to. the. fracture. stimu-lation.surface.rate.and.pressure.data.(Figure.13),.micro-seismic.data.and.flow-back.behavior.

Model.B.is.intended.to.model.short.and.long.term.performance.of.shale.wells.(whether.vertical.or.horizontal).and.is.constructed.from.a.coarser.grid.to.capture.the.entire.well.drainage.area.incorporating.all.fracture.stages.

In.addition. to.wellbore.hydraulics,. the.model.consists.of. four.components,. each.of.which.contributes. to.well.performance:

1.. Matrix2.. Natural.fractures3.. Minor.induced.fracture.network.(micro-slippage.fractures.with.little.or.no.proppant)4.. Major. induced. fracture. network. (fractures.

with.proppant)

In.a.recent.case.study.for.a.well.completed.in.the.Berea.and.adjacent.Devonian.shale.formations,.two.of.the.fracturing.stages.(#3.and.#7).were.mod-eled.in.detail.and.the.remaining.stages.were.inter-polated...(A.complete.discussion.of.this.evaluation.is. provided. in. Reference. 1.). . The. relevant. perfor-mance.is.shown.in.Figure.14...


The. results. of. the. micro-seismic. surveys.taken.during.each.of.the.nine.fracture.stages.are.shown.in.Figure.15..

It.is.notable.that.most.events.are.close.to.the.packers,.probably.due.to. local. stresses. im-posed. by. packer-setting. causing. weak. points.that.favor.fracture.initiation...The.other.obser-vation.worth.mentioning.is.that.micro-seismic.responses. are. not. confined. to. the. area. of. the.formation.adjacent.to.the.open.frac.sleeve...For.instance,. during. injection. into. stage. 7. (green.dots),.micro-seismic.events.are.seen.also.in.ar-eas.corresponding.to.stages.6.and.4,.but.not.5,.8.or.9...This.confirms.the.theory.that.such.events.are.not.necessarily.associated.with.fluid.place-ment,.but.may.reflect.rock-to-rock.interaction.

Figure.15.also.shows.the.production.rate.contribution.from.each.stage.as.recorded.by.a.production.log.taken.five.months.after.production.started...It.is.observed.that.most.production.originates.from.stages.5.through.9.while.the.most.intense.micro-seismic.activity.appears.around.stages.3.and.4...A.review.of.the.display.of.natural.fractures.based.on.open-hole.logs.prior.to.stimulation.suggests.that.these.features.play.an.important.role.in.identifying.productive.intervals,.perhaps.more.so.than.micro-seismic.events...As.noted.above,.after.modeling.stages.3.and.7.using.model.A,.it.was.possible.to.derive.appropriate.models.for.the.remaining.stages.in.Model.B...Figure.16.shows.the.overall.match.of.the.model.to.the.PLT.rates.and.to.the.total.production.history.of.the.well...

The.goal.is.to.narrow.the.range.of.uncertainty.of.the.projected.performance.of.the.well.(Figure.17)...

Figure 16 – Model B Flow Match

Figure 17 – Model B Prediction Cases


Application of the Model

Once. both. models. are. constructed. and.history-matched. in. this. way,. it. becomes. pos-sible. to. investigate. a. number. of. sensitivities.relating.to.well.performance.and.recovery...For.instance,.variations. in. fracture.design. (fluids,.proppant,.stage.spacing).can.be.tested...In.the.example.given.above,.it.was.possible.to.run.a.number.of.predictive.cases.with.different.well.spacing.assumptions...It.was.shown.(Figure.18).that.reducing.the.well.spacing.from.120.acres.to.90.acres.resulted.in.a.30%.increase.in.cumulative.cash.flow.over.20.years,.but.further.spacing.reduction.to.80.acres.had.a.negligible.economic.impact.

It.is.recognized.that.further.development.of.this.concept.of.“shale.engineering”.is.warranted.by.applying.it.to.a.variety.of.different.situations...In.this.way,.it.is.hoped.that.it.will.be.possible.to.evaluate.alternative.development.op-tions.earlier.in.the.life.of.a.shale.asset.thereby.providing.operators.with.another.tool.to.improve.decision.making...

Conclusions

1.. “Shale.Engineering”.provides.a.new.look.at.shale.performancea.. Includes.rock.mechanics.b.. Models.mass.transfer.through.diffusionc.. Describes.the.induced.reservoir

2.. Transverse.fracture.stages.do.not.perform.similarlya.. Despite.using.similar.design.along.a.relative.uniform.formationb.. Subtle. differences. in. natural. fractures. and. stress. conditions. may. trigger. differences. in. the. induced.

reservoir.(SRV)3.. Micro-seismic.events.may.reflect.rock-to-rock.interaction

a.. Overstate.spacing.assumptionsb.. Un-interpreted.micro-seismic.plots.do.not.relate.to.the.induced.reservoir.(SRV)

Biography

Rawdon Seager is currently Principal – Reservoir Engineering at GCA’s western hemisphere headquarters in Houston, Texas. Rawdon’s main responsibilities include internal quality assurance for technical projects and providing clients with advice regarding reserve and resource evaluation and reporting. He has also provided expert testimony at international arbitrations. Rawdon has spoken at various industry events as well as presenting in-house and public courses to clients on matters relating to reserve estima-tion, classification and reporting.

Rawdon began his career in 1972 as a Petroleum Engineer with Shell International in Malaysia, Brunei, the Netherlands and Austra-lia. In 1980 he joined Roy M. Huffington Inc. in Indonesia where he became Petroleum Engineering Manager, before joining GCA in 1985 with whom he has held senior positions in the United Kingdom, Singapore, Argentina, Venezuela and the USA.

He has a BSc (Honors) in Physics from Bristol University, England and an MSc (Distinction) in Petroleum Reservoir Engineering from Imperial College, London. Rawdon is an active member of the Society of Petroleum Engineers (and current chairman of the Oil and Gas Reserves Committee), Society of Petroleum Evaluation Engineers, American Association of Petroleum Geologists, UK Energy Institute and is a Chartered Petroleum Engineer in the UK. He is also registered as a European Engineer with FEANI.


Footnotes

1. The term “shale gas” refers to gas located within reservoirs that have traditionally been considered to be shales. They have high content of clays, but also important amounts of sand or carbonate lithology.

2. http://www.eia.gov/analysis/studies/worldshalegas/.

References

Vassilellis, G. D., C. Li, V.K. Bust/Gaffney, Cline & Associates; D. Moos, R. Cade/Baker Hughes Incorporated. “Shale Engineering Application: The MAL-145 Project in West Virginia.” SPE146912.

Vassilellis, G., C. Li, R.J.H. Seager/Gaffney, Cline & Associates; D. Moos/Geomechanics International. “Investigating the Expected Long-Term Production Performance of Shale Reservoirs.”

Arps, J.J. “Analysis of Decline Curves” T.P. 1758, Petroleum Technology A.I.M.E. September 1944.

Fetkovich, M.J. “Decline Curve Analysis using Type Curves.” SPE 4629, September 1973, Journal of Petroleum Technology pp 1065-77, June 1980.

Moos, D. and C.A. Barton. “Modeling Uncertainty in the Permeability of Stress-Sensitive Fractures.” 2008. American Rock Mechanics Association (ARMA), San Francisco, CA, July 1-3, 2008.

Acknowledgments

The author wishes to thank his colleagues at Gaffney, Cline & Associates and Geomechanics International for the technical work underlying the concepts portrayed in this paper. In particular, George Vassilellis has been central in promoting a more rigorous approach to shale formation evaluation.

Rawdon Seager, SPEE, SPE, AAPG, Energy Institute, Gaffney, Cline & Associates1300 Post Oak Blvd., Ste 1000, Houston, Texas 77056Tel.: (713) 850-9955Fax: (713) 850-9966Email: [email protected]

Address and contact details as above.Email: [email protected]



Use and Mis-use of the Graphical P/Z Plot

Richard F. Krenek Netherland, Sewell & Associates, Inc.

Issue

One of the more common techniques in reservoir engineering is to attempt to reduce complex equations to simple graphical trends, linear trends where possible. The graphical material balance methodology, known as P/Z analysis, is an example of such a technique. While rigorous material balance work can be complicated and require specialized soft-ware, P/Z analysis is a greatly simplified method for determining gas-in-place and potentially recoverable gas volumes from a volumetric gas reservoir.

Regardless of whether a reservoir is volumetric, valuable information can be derived from the construct of a P/Z plot. For example, a multi-well P/Z plot is very useful in helping to determine whether each of multiple aggregated wells are producing from the same connected reservoir. This plot is also useful in identifying baffles, or restricted-flow boundaries between wells. But the reservoir engineer must make a critical judgment as to whether the simplified P/Z approach to material balance provides valid quantitative answers to the questions of original gas-in-place and recover-able gas volumes, a question that centers on whether the reservoir in question is a volumetric reservoir. A key issue is whether a P/Z plot alone can be reliably used to prove that a reservoir is volumetric.

Discussion

In.order.to..build..a.graphical.P/Z.plot,.a..series.of..shut-in. . (static). . bottom. hole. pressure. measurements.from.the.reservoir.in.question.at.different.points.in.time.are.needed.. .A.minimum.of.two.pressure.points.are.re-quired,. more. points. are. preferable.. For. each. pressure.point,.the.down-hole.Z..(compressibility.factor).is..cal-culated.and.the.static.pressure. is.divided.by.the.associ-ated.Z.yielding.a..P/Z.value...The.various..P/Z.values.are.plotted..on.the.y-axis..of.a..coordinate.graph.as.a.func-tion. of. the. cumulative. production. at. the. date. of. each.P/Z.value...If..multiple.wells.are.included.in.the.plot.(or.if.a.multiple.well.reservoir..is.being.modeled.using..pres-sure.data.from.only.a.single.well),.the.various.P/Z.values.are.plotted.as.a.function.of.the.total.reservoir.cumulative.corresponding.to.each.P/Z.value...In.a.volumetric.reser-voir,.the.relationship..should.plot.as.a.straight.line.with.the.y-axis.intercept.representing.the.initial.P/Z.value.and.the.x-.axis.intercept.representing.the.initial.gas-in-place..The.quality.of.the.result.is.only.as.good.as.the.quality.of.the. input. data.. . Hence,. having. quality. shut-in. bottom.hole.pressure.data.are.important..Lower.permeability.res-ervoirs.require.longer.shut-in.times.to.achieve.accurate.

shut-in. pressures.. The. amount. of. deviation. of. various.points. from. the. established. line. provides. some. indica-tion.of..data.quality.. .Accuracy.issues.can.be.magnified.when.extrapolating.limited.pressure.data.from..immature.reservoirs...

The.mathematical.derivation.of.the.graphical.P/Z.re-lationship. is. based.on. the. assumption. that. the. reservoir.is.volumetric..A.volumetric.gas.reservoir,.sometimes.also.called.a.purely.pressure.depletion.reservoir,.is.defined.as.a.reservoir.that.acts.as.a.tank,.a.closed.system.with.immove-able.boundaries..No.appreciable.amounts.of.liquids.or.gas-ses.enter.or.exit..the.gas-filled.pore.space.of.a.volumetric.reservoir,.except.via.the.well-bore(s)..For.a.volumetric.gas.reservoir,. the.water. influx,.water.production,. and.water/formation.expansion.terms.of.the..generalized..gas.mate-rial.balance.equation.are.deemed..negligible.and.are.elimi-nated...The.remaining.terms.can.be.easily.rearranged.into.a.linear.equation.of.y.=.mx+b.form.where.y.equals.the.P/Z.value.at.a.given.cumulative.production.(the.x-value).and.the.y-intercept.(the.b-value).equals.the.initial.P/Z.value.at.zero.cumulative.production...If.a.reservoir.is.truly.volumet-ric.such.that.no.now.water.influx.or.water.production.oc-curs.and.water/formation.expansion.terms.are..negligible,.then.the.P/Z.relationship.will.plot.as.a.straight.line..


A P/Z vs. Cumulative Production Relationship is Linear for a Volumetric Gas Reservoir

Because.the.above.statement.is.fact.and.because.res-ervoir.engineers.often.look.for.straight.lines.in.historical.data. to.project. future. trends,. it.may.be. tempting. to.as-sume.the.corollary;.that.a.straight.line..P/Z.vs..cumulative.production.relationship.necessarily.proves.that.a.reservoir.is..volumetric....But.that.assumption.has.never.been.prov-en...In.fact,.the.corollary.has.been.disproved.in.a.number.of.reservoirs.around.the.world.. .A.number.of.published.authors.have.commented.on.this.fact:.. .

Gas material balance is supposed to be one of the simplest subjects in the whole of reservoir en-gineering and, indeed, the physics and mathemat-ics are quite trivial. Yet there are great subtleties attached to its application which have perhaps not been stressed sufficiently in the literature and, if unappreciated, can lead the engineer into serious error in assessing the reservoir drive mechanism (water drive or volumetric depletion) and the GIIP [gas initially in place]. Foremost amongst the sources of error is the use of the traditional p/Z versus cumulative production plot in attempting to history match the performance of gas reservoirs. It can lead to a complete misinterpretation of drive mechanism and a serious overestimation of the GIIP. (1)

A common method of predicting gas re-serves is the graphical solution to the gas material balance equation. A special case of the material balance equation is linear in p/z with cumulative gas production (Gp) which predicts the initial in-place gas when p/z is extrapolated to zero. Der-ivation of this form is based on the equation of state, corrected for compressibility (pV = znRT), and, particularly, on the reservoir being closed (no water encroachment). A straight line on the p/z chart results when these conditions hold. Howev-er, an apparent straight line on the chart does not assure that the reservoir is closed.” “This leads to the principal conclusion that it is dangerous to extrapolate p/z charts on a straight line without considering the possibility of water influx. (2)

Analysis of Reservoir D-1 also provides the opportunity to show that straight-line p/z per-formance does not necessarily mean that a gas reservoir has a depletion drive. Theory showing

that depletion-drive gas reservoirs will exhibit a straight-line p/z plot has been developed. The corollary-that a straight line p/z plot proves the ex-istence of a depletion drive-has not been proven, although it is frequently assumed in practice.(3)

Mr..Lloyd.Cason’s.article.describes.observed.pres-sure.response.with.depletion.in.a.weak.water..drive.field.called. Duck. Lake,. located. in. South. Louisiana.. . From.1967. until. depletion. in. 1981,. the. gas. production. rate.decreased. continuously. as. the. reservoir. pressure. de-clined.and.wells.were..lost.because.of.water.production...Cason.presented.a.P/Z.plot. showing. that,.despite. . the..aforementioned. production-based. indications. of. weak.water.drive,.the.P/Z.plot.formed.a.straight..line.through.points.representing.about.45.percent.of.the.true.gas-in-place.. .These. linear.points. .extrapolated. to. . show. .an.apparent.original.gas-in-place.(OGIP).value. that. .was.ultimately.25..percent.too.high...Cason.says,.“Early-time.straight-line.p/z.can.persist.until.40.to.50%.of.the..OGIP.is.produced.and.can.result.in.overestimating.the.reserve.by.25.to.50%”.(pg..1104-1105).. .Bruns.and.Fetkovich.show. that. straight-line. P/Z. response. can. last. virtually.the.entire.life.of.the.reservoir...Through.their.in-depth.analysis.of.simulated.P/Z.curves.for.reservoirs.with.vari-ous..analytical.aquifers,.Bruns.and.Fetkovich..also.pro-vide.interesting.insight.into.the.aquifer..characteristics.that.can.lead.to.straight-line.P/Z.relationships.in.non-volumetric.reservoirs...These.aquifers.generally.tend.to.be.weak.and.of.limited.extent..

A. linear.P/Z.vs..Cumulative.Production. relation-ship.does.NOT.necessarily.prove..the.gas.reservoir.to.be.volumetric.and.does.NOT.necessarily.yield.valid.origi-nal..gas-in-place.or.recoverable.gas.estimates....

. Because. water. encroachment. artificially.supports.reservoir.pressure,.the.graphical.P/Z.approach.will. likely. overestimate. the. correct. original. . gas-in-place.and.recoverable.gas.volume.for.a. . reservoir.with.water. drive. or. water. influx.. And. because. abnormally.pressured. reservoirs. can. experience. appreciable. and.disproportionate. pore. volume. reduction. through.formation. . compressibility. upon. depletion. from. the.initial. abnormal. pressure. state. to. the. normal. pressure..state. (relative. to. pore. volume. reductions. . occurring.after.normal.pressures.are..reached),.the..graphical.P/Z.approach.will.likely.overestimate.the.correct.original.gas-in-place.and.recoverable.gas.volume. in.an.abnormally.pressured.reservoir..


Conclusion

The. graphical. P/Z. plot. can. be. a. valuable. tool. for.determining.the.initial.gas-in-place.and.the.recoverable.gas.volumes.for.a.reservoir.if.it.is.volumetric;.having.no.appreciable. water. influx. or. . water. production. and. no.appreciable. formation. . compressibility. affects.. . Taken.alone,. the.existence.of.a. straight-line.trend.on.the.P/Z.plot.should.not.be.viewed.as.proof.that.the.reservoir..is.volumetric.and.the.resulting.initial.gas-in-place.and.re-coverable. gas. volumes. should. be. viewed. as. uncertain...Uncertainty. rises. if. the. reservoir. is. abnormally. pres-sured..since.abnormally..pressured.reservoirs.are.known.to. exhibit. more. flat. early-time. P/Z. behavior. followed.by. steeper. late-time.behavior.. .Uncertainty.also. rises. if.the.reservoir.is.among.reservoirs.known.to.exhibit..wa-ter.drive.or.water.encroachment,.even.if.weak..A.good.practice.is.to.review.both.production..and.P/Z.behavior.of.nearby-analogous.reservoirs.that.are.already.depleted...If.these.analog.reservoirs.exhibit.predictable.P/Z.behav-ior.through.depletion,.then.the.likelihood.increases.that..the.subject.reservoirs.are.volumetric.

ReferencesDake, L.P. The Practice of Reservoir Engineering, 1994, pg. 470-471.

Bruns, J.R. and M. J. Fetkovich, SPE 898, pg. 287-290, March 1965.

Cason, Jr., Lloyd D. Journal of Petroleum Technology, pg. 1102. October 1989.

BiographyRichard F. Krenek II is Vice President and Team Leader – Res-ervoir Engineer for Netherland, Sewell & Associates, Inc. Rick has a B.S. in Chemical Engineering from the University of Okla-homa, 1986. Rick joined NSAI in 1990 after serving as a Se-nior Project Engineer with Exxon Company, U.S.A. Rick has performed reserve evaluations in all major producing basins in the U.S. and various international basins throughout Europe, Southeast Asia, and the Americas and has led a number of large and complex field studies and equity determinations.



Abstract

Estimates of recoverable hydrocarbon volumes for projects are reported for a variety of reasons. The recipients of recoverable hydrocarbon reports are typically company directors and management, accountants, investors, investment analysts, financiers, media and regulators. The evaluation and veracity of recoverable hydrocarbon volumes is wholly dependent upon the skill and knowledge of experienced petroleum evaluators and supervisors. Due to the technically complex and varied nature of evaluation techniques, this aspect of recoverable hydrocarbon reporting cannot be pre-scriptive or regulated and is outside the scope of this paper.

After a project has been evaluated and the recoverable hydrocarbon volumes estimated, evaluators typically categorise and report recoverable hydrocarbon volumes in terms of existence, maturity and estimate uncertainty. The category termi-nology used by the evaluators to report the volumes of recoverable hydrocarbons should ideally mean the same thing to all evaluators and recipients of the report. Unfortunately, this is frequently not the case - evaluators and recipients can use similar category terminology that has a different meaning, which leads to confusion as to what is actually being reported.

This situation has come about due to the evolution of the SPE reserves standards and needs to be addressed so that the industry can report using terminology that is plainly understood by all.

Prior to about 1980, volumes of recoverable hydrocarbons were mainly estimated using deterministic best estimate techniques. The deterministic reporting definitions at that time mainly considered the existence and maturity of recov-erable hydrocarbons. When probabilistic techniques started to become popular after about 1980, these techniques enabled quantification of the range of estimate uncertainty and solutions were sought to integrate the reporting of these new techniques with the existing deterministic reporting definitions.

To cater for both deterministic and probabilistic estimate reporting, the Society of Petroleum Engineers (SPE), in consultation with other oil and gas societies, introduced probabilistic P90, P50 and P10 terminology and established a relationship between these new terms and the existing deterministic Proved, Probable and Possible terminology. The most recent standard published by SPE is known as the SPE/AAPG/WPC/SPEE Petroleum Resources Management System (SPE PRMS, 2007). However, the current standard has retained a discontinuity between the deterministic and probabilistic definitions, which was introduced when the probabilistic terminology was first equated to the deterministic definitions. The discontinuity has occurred because deterministic techniques were originally focused on the existence and maturity of estimates whereas probabilistic techniques are focused on the uncertainty associated with estimates - two very different concepts. The discontinuity manifests itself in two ways:

1. When deterministic and probabilistic Proved, Probable and Possible estimates are compared they will usually not be equal - both numerically and in physical meaning.

2. Probabilistic estimating techniques have lost the practical use of the deterministic Possible category, which was originally intended to describe recoverable hydrocarbon volumes that were inferred to exist but had not yet been penetrated by a well.

The resolution of these two issues requires stepping back to the original (1955) deterministic definitions and then correctly applying uncertainty techniques to those definitions.

The result is a system that aligns deterministic and probabilistic techniques and enables the deterministic Proved, Probable and Possible terminology to continue in the form that it was originally intended and is still being used today. The most important benefit however would be that all industry stakeholders would once again be aligned in their under-standing of the definitions thereby demonstrating that the industry can effectively regulate itself.

This paper was originally published in The APPEA Journal 2010

The Need For An Inferred Resources Category In Reserves And Resources Reporting In SPE PRMSMichael T. Scott


“reserves”.was.not.specifically.defined,.which.avoids.the.need.for.the.adoption.of.additional.defined.terms.such.as.“resources.“

Fredrick.Lahee.is.undoubtedly.the.father.of.modern.reserves.reporting..Lahee.initially.recognised.the.need.for.a.standard.system.where.recoverable.hydrocarbons.could.be. classified. and. compared. according. to. existence. and.maturity.criteria.and.then,.over.his.professional.lifetime,.developed.and.refined.the.principles.of.such.a.system.

In. 1956. J.J.. Arps. (Arps,. 1956). discussed. the. con-cept.of.uncertainty. in.reserve.estimates.and.noted.that.“it is desirable for the engineer making a reserve estimate to provide his client or his management with the possible spread in estimated ultimate recovery, both high and low, or, if he provides them with a single figure, to point out the probable error in his estimate.”..Later.in.1962,.Arps.also.provided.a.classification.system.that.split.the.earlier.Lahee.classifica-tion.system.into.primary.and.secondary.recovery.catego-ries..This.primary.and.secondary.recovery.reporting.split.never.gained.any.traction.in.the.industry.

In.1974.V.E..McKelvey.(McKelvey,.1974).presented.to.the.U.S..Geological.Survey.a.Total.Resources.classifi-cation.system..This. system.introduced.the.reserves.and.resources. terminology. to. the. industry. –. reserves. being.discovered.and.economic.and.resources.being.undiscov-ered.and/or.uneconomic.(Figure.3).

McKelvey.also.noted.that.the.addition.of.developed.measured. and. undeveloped. measured. categories. would.

A Short Classification History

In. 1944,. at. a. Sun. Oil. divisional. meeting. in. the.USA,.Frederic.H..Lahee.(Lahee,.1944).reported.that.he.had.been.considering.for.several.years “the need for more precise definition of terms used in connection with the statis-tics of wildcatting and crude–oil reserves.” Lahee.recognized.that. comparisons. and. additions. of. reserves. were. being.made.where.the.maturity.and.existence.of.the.volumes.were.substantially.different..At.this.meeting.Lahee.pro-moted. the. idea. of. classifying. recoverable. oil. according.to. several.categories. (Figure.1)..The. system.considered.the.proof.of.existence.and.the.maturity.of.petroleum.re-serves...The.concept.of.uncertainty.in.estimation.was.not.typically.being.considered.in.this.era.due.to.calculations.being.undertaken.manually.

In.1950.Lahee.(Lahee,.1950).again.reported.to.his.peers,.“Too often different persons use the same word with very different meanings,”.and.he.again.proposed.the.defini-tions.that.were.originally.promoted.in.1944.

By.1955.Lahee.(Lahee,.1955).had.refined.his.origi-nal.1944.concept.to.a.system.that.will.trigger.recognition.from.most.readers.(Figure.2)..The.main.update.in.1955.was. that. the.Possible.Discovered. reserves. category.had.evolved. into. the. Probable. reserves. category.. The. 1955.system. cemented. the. terms. Proved,. Probable. and. Pos-sible.into.industry.terminology.

The. 1955. Lahee. system. continued. to. be. a. matu-rity.and.existence.classification.system.and.appeared.to.be. driven. by. the. grid. pattern. drilling. that. is. typically.undertaken.onshore.USA..The.deterministic. system.as.Lahee. proposed. is. still. in. use. today. –. especially. in. the.USA.where.deterministic.(Proved,.Proved.Undeveloped.(PUDs).and.Probable).terminology.are.commonly.used.

An.important.note.is.that.Lahee.used.the.term.“re-serves”.to.simply.mean.recoverable hydrocarbons..The.term.

A. Proved Reserves1. Drilled.2. Undrilled.

B. Probable Reserves1. Undeveloped part of a pool.2. Secondary recovery.3. Behind pipe.

C. Possible Reserves1. In productive areas.

(a) Shallower or deeper pools within fields limited.

(b) Pools outside fields limits.2. Areas not now producing but which are

geologically similar to producing areas in the region.

D. Hypothetical ReservesFrom non-producing regions underlain by sediments that produce in other areas.

Figure 2. Lahee 1955 Classification.


be. a. useful. update. to. the. matrix.. It. is. possible. that.McKelvey. was. trying. to. align. these. terms. with. Proved.Developed. and. Proved. Undeveloped. whilst. also.introducing.an.element.of.maturity.to.a.system.that.only.considers. existence. and. economic.viability.

The.McKelvey.system.appears.to.be.mainly.intended.for.use.in.the.minerals.industry.but.interestingly,.in. the. original. paper,. McKelvey.also.makes.reference.to.petroleum.accumulations. -. possibly. hinting.that.this.system.should.be.adopted.for.that.industry.as.well,.the.terms.measured,. indicated. and. inferred.being. easily. interchangeable. with.Proved,.Probable.and.Possible..It.is.also.worthy.to.note.that.the.McK-elvey. system. devotes. two. thirds.of. the. categories. to. subeconomic.situations,.which.seems.not.overly.useful.

In.2004.the.United.Nations.(UN,.2004).introduced.their.Framework.Classification.(UNFC).for.Energy.and.Mineral. Resources.. The. UNFC. is. a. complex. three. di-mensional. matrix. that. classifies. remaining. resources.according. to. socioeconomic,. feasibility. and. geological.aspects.of.accumulations..The.UNFC.states. that. it. is.a.universally.applicable.scheme.but.the.three.dimension-al. nature. of. the. matrix. and. the. alpha-numeric. coding.makes.it.hard.to.use.and.understand..The.UNFC.greatly.expanded.the.maturity.definitions.with.a.number.of.sub.

classes. that. track. the.phases.of.a.project. from.exploration.through.to.production.

The.Society.of.Petroleum.Engineers.(SPE).through.the.years.has.adopted.various.parts.of.the. prevailing. standards. –. the. terms. Proved,.Probable.and.Possible.as.defined.by.Lahee.be-ing.the.most.well.known..

Around.1980,.as.computer.power.increased.and. became. available. to. the. general. public,.probabilistic.uncertainty.estimating.techniques.were.being.adopted.by.professional.estimators..To.cater.for.these.techniques,.SPE.adopted.the.cumulative.probability.P90,.P50,.P10.terminol-ogy. and. equated. this. to. the. 1P. (Proved),. 2P.(Proved. plus. Probable). and. 3P. (Proved. plus.

Probable.plus.Possible).categories.

SPE.updated. their. standard. several. times.with. the.last.major.update.in.2007.when.the.SPE/AAPG/WPC/

SPEE.Petroleum.Resource.Management.System.(PRMS).was. introduced..This.system.expanded.project.maturity.(as. per. UNFC). and. adopted. an. uneconomic. category.(as.per.McKelvey)..Figure.4.details.the.SPE.PRMS.2007.classification.matrix.

Possibly.in.an.effort.to.include.terminology.covered.by.a.number.of.other.systems,.SPE.PRMS.2007.expanded.its.matrix.to.include.Total.Petroleum.In.Place,.Unrecov-erable.hydrocarbons.and.a.category.for.uneconomic.re-coverable.hydrocarbons.(Contingent.Resources.–.Devel-opment.unviable).

Figure 3. McKelvey 1974 Classification.

Tota

l Pet

role

um In

-Pla

ceD

isco

vere

dU

ndis

cove

red

Com

mer

cial

Unc

omm

erci

al

Production (Produced)

On Production

Development Pending

Unrecoverable

Prospect

Unrecoverable

Approved for development

Justified for development

Development unclarified or on hold

Development unviable

Lead

Play

Reserves

Contingent Resources

Prospective Resources

1PProved

2PProved

+Probable

3PProved

+Probable

+Possible

1C 2C 3C

Low Estimat

e

Best Estimat

e

HighEstimat

e

P9090% cum.

prob.(small

number)

P5050% cum.

prob.(middle number)

P1010% cum.

prob.(large

number)

Non-ProducingDeveloped

Producing

Undeveloped(but expected to be within a

reasonable timeframe)

Figure 4. SPE PRMS 2007.


For.completeness.it.should.be.noted.that,.in.parallel.to. the. systems.noted.above,. the.Former.Soviet.Union,.China,. Norway,. Canada. and. other. countries. have. also.evolved.systems,.which.all.have.positives.and.negatives.when.compared.to.the.various.standards.that.exist.today..In. addition,. in. the. USA. the. Securities. and. Exchange.Commission.(SEC).requires.USA.listed.oil.and.gas.com-panies. to. report. Proved. reserves. to. standards. defined.by.the.SEC,.which.are.different.to.the.SPE.definitions..There.is.no.best.system.

The Nub of the Problem

The.western.world.continues. to.use.Proved,.Prob-able.and.Possible.terminology.but.due.to.the.evolution.of.the.classification.systems.there.are.two.subtle.problems,.which.may.even.be.preventing.the.current.SPE.PRMS.2007.standard.from.gaining.universal.acceptance:

1.. The.deterministic.Proved,.Probable.and.Possible.categories.do.not.mean. the. same.as. the.proba-bilistic.Proven,.Probable.and.Possible.categories.-. even. though. they. appear. to. be. defined. to. be.equivalent.(the.equivalence.discontinuity).

2.. The.probabilistic.Possible.category.has.been.de-fined.as.an. incremental.part.of. the.uncertainty.estimation. range.and. it.no. longer. reflects.what.was.originally.intended.in.the.deterministic.defi-nitions.(the.missing.inferred.category).

The Equivalency Discontinuity

The.easiest.way.to.explain.the.estimating.disconti-nuity.between.deterministic.and.probabilistic.techniques.is.to.go.back.to.the.Lahee.definitions.of.1955.(Figures.2.and.5).

As.can.be.seen.from.Figure.5,. for.a.discovered.ac-cumulation.in.the.original.Lahee.definitions,.Proved.was.defined.as.what.was.in.proximity.to.well.penetrations.and.was.split.into.developed.and.undeveloped.regions..Prob-able.was.defined.as.the.rest.of.the.continuous.accumula-tion.outside.the.Proved.area.

In.the.original.definitions.Possible.was.outside.pen-etrated. areas. –. i.e.. the. accumulation. had. not. yet. been.drilled.but.was.thought.to.have.a.reasonable.chance.of.existing.due.to.its.proximity.to.the.discovered.accumula-tion..In.reality.Possible.is.an.undiscovered.estimate.but.the. accumulation. under. consideration. was. expected. to.have. a. higher. chance. of. existing. than. an. exploration.target.

When.probabilistic.estimating.techniques.started.to.become.commonplace.around.1980,.SPE.adapted. their.prevailing. standard. by. defining. Proved. as. P90,. Proved.plus.Probable.as.P50.and.Proved.plus.Probable.plus.Pos-sible.as.P10.-.for.a.discovered.accumulation..The.impli-cation.being.that,.on.a.cumulative.probability.basis.for.a.discovered.accumulation,.Probable.is.equal.to.P50.minus.P90.and.Possible.is.equal.to.P10.minus.P50..This.was.the.point. when. the. discontinuity. was. introduced. into. the.system.

The. Lahee. (or. deterministic). Proved,. Proved. plus.Probable. and. Proved. plus. Probable. plus. Possible. had.nothing.to.do.with.P90,.P50.and.P10.on.a.cumulative.probability.basis.for.a.discovered.accumulation..In.fact,.Proved.and.Probable.were.the.only.terms.associated.with.a. discovered. accumulation. and. Possible. was. defined. as.being.outside.of.the.discovered.accumulation.

Although. it. could. be. argued. that. there. may. be. a.very.poor.correlation.between.deterministic.Proved.and.

probabilistic.P90.when. an. accumulation. is. pen-etrated.by.a.low.number.of.wells,.as.well.numbers.increase.the.deterministic.Proved.should.start.to.approach.the.probabilistic.P50.

To.explain. this. effect. further:. as.well.num-bers.increase.for.an.accumulation.the.magnitude.of. the. deterministic. Proved. will. increase. and,.correspondingly,. the. magnitude. of. deterministic.Probable. will. decrease.. The. sum. of. determinis-tic. Proved. and. Probable. will. therefore. theoreti-cally.be.held. at. a. steady.value,.which.would.be.equivalent.to.the.probabilistic.P50.value.for.the.whole. accumulation.. When. an. accumulation. is.fully.drilled.the.deterministic.Probable.would.be.

5.


zero.and.the.deterministic.Proved.would.be.at.its.maxi-mum.value.and.would.therefore.be.equal.to.the.probabi-listic.P50.estimate..This.apparent.equivalence.between.the.deterministic.Proved.plus.Probable.estimate.and.the.probabilistic. P50. estimate. for. the. whole. accumulation.may.explain.the.reason.why.the.discontinuity.has.come.about.-.if.this.point.is.viewed.in.isolation.then.the.system.seems.to.work.-.but.unfortunately.this.is.the.only.point.where.it.does.work.

To. reinforce. the. understanding. of. the. differences.between.deterministic.and.probabilistic.techniques.for.a.discovered.accumulation:

•. Deterministic. Proved. will. most. likely. be.a. different. estimate. to. probabilistic. P90..Deterministic. Proved. is. a. well. conformable.estimate. and. probabilistic. P90. is. an. estimate.based.on.a.cumulative.probability.level.for.the.whole.accumulation.

•. Deterministic. Probable. will. most. likely. be. a.different.estimate.to.probabilistic.Probable.(de-fined. as. P50. minus. P90).. Deterministic. Prob-able. is. the.whole. accumulation.volume.minus.the.well.conformable.volume.whereas.probabi-listic.Probable.is.the.P50.cumulative.probability.estimate.minus.the.P90.cumulative.probability.estimate.for.the.whole.accumulation.

•. Deterministic. Possible. is. usually. outside. the.continuous.accumulation.and.will.therefore.not.be.equivalent.to.probabilistic.Possible.(defined.as.the.P10.cumulative.probability.estimate.mi-nus.the.P50.cumulative.probability.estimate.for.the.whole.accumulation).

As.can.be.seen,.differences.in.estimates.using.deter-ministic.and.probabilistic.techniques.are.not.only.due.to.the. different. numerical. techniques. being. used. but. also.because. the. techniques. have. fundamentally. different.meanings.

The. implication.of. this.discontinuity. is. that. there.is.a.potential.situation.for.an.oil.field.where.the.reported.Proved.estimate.for.a.company.using.deterministic.esti-mating.techniques.could.be.substantially.and.materially.different. to. the. reported.P90. (also. called.Proved). esti-mate.for.a.company.that.is.using.probabilistic.estimating.techniques.

The.use.of.the.same.terminology.being.used.for.two.different.techniques.is.an.unacceptable.condition.for.all.

stakeholders..Not.only.will. stakeholders.be.confused.at.the.differences.in.the.magnitude.of.the.estimates.for.the.same.terms.but.it.sends.a.message.to.stakeholders.that.the.industry.has.difficulty.in.regulating.itself.-.or.in.the.worst.case,.the.industry.is.untrustworthy.

The Missing Inferred Category

Lahee.(1955).defined.a.system.with.a.Possible.cate-gory.that.inferred.that.reserves.(or.recoverable.hydrocar-bons.if.you.prefer).could.exist.nearby.to.a.discovered.ac-cumulation..These.inferred.reserves.were.not.considered.to.be.discovered.or.undiscovered.but.were.considered.to.have.a.reasonable.chance.of.existing..It.was.a.grey.area.between.the.two.end-points.of.discovered.and.undiscov-ered..In.most.circumstances.today.the.majority.of.recov-erable.hydrocarbon.estimates.would.simply.be.classified.as.discovered.or.undiscovered.

There.are.some.circumstances,.however,.where.the.application.of.modern.technology.may.drive.the.industry.to. determine. a. need. for. a. deterministic. Possible. or. in-ferred.category..As.an.example.of.where.this.could.be.ap-plied:.consider.a.gas.prospect.that.is.made.up.of.two.fault.blocks.(Figure.6)..Each.of.the.fault.blocks.demonstrate.a.seismic.direct.hydrocarbon. indicator.but. that. indicator.cannot.be.used.to.determine.if.the.gas.is.in.communica-tion.across.the.fault..A.single.well.is.drilled.into.the.first.fault.block.and.gas.is.discovered..

If. the. company. that. discovered. the. accumulation.uses.probabilistic.techniques.then.the.company.will.re-port.P90.(Proved),.P50.(Proved.plus.Probable).and.P10.(Proved. plus. Probable. plus. Possible). estimates. of. the.volumes. that. are. expected. to. be. recovered. from. that.fault-block.

If. the. company. that. discovered. the. accumulation.uses. deterministic. techniques. then. the. company. will.make. a. best. estimate. of. Proved. and. a. best. estimate. of.Probable.for.the.discovered.fault.block,.which.will.most.likely.be.different.to.the.estimates.reported.by.the.com-pany.using.probabilistic.techniques.

The. equivalence. discontinuity. problem. raises. its.head.again. -.one. system,.one. terminology.and.two.dif-ferent. techniques. resulting. in. different. magnitudes. of.estimates. for. the. same. terms. -. and. the. company. using.deterministic.techniques.has.yet.to.define.and.report.the.Possible.recoverable.hydrocarbons.

The.question.now.is:.how.is.the.other.fault.block.to.


be.handled?.The.company.using.probabilistic.techniques.has.three.choices:

1.. The. company. can. assume. that. the. other. fault.block.is.undiscovered.(direct.hydrocarbon.indi-cator.is.not.used.as.positive.proof.of.existence),.thereby. either. correctly. estimating. or. underes-timating. the.estimates.of. recoverable.hydrocar-bons,.or;

2.. The.company.can.assume.that.the.fault.block.is.discovered.(direct.hydrocarbon.indicator.is.used.as.positive.proof.of.existence),.thereby.correctly.estimating.or.over-inflating.the.estimates.of. re-coverable.hydrocarbons,.or;

3.. The.company.can.apply.some.risked.technique,.and.nobody.has.any.idea.what.the.reported.vol-umes.practically.mean.

As. can. be. seen. from. the. choices. above,. there. are.too.many.options.for.handling.of.the.yet.to.be.penetrated.fault.block.

However,. the. company. using. deterministic. tech-niques. places. the. other. fault. block. into. the. Possible..reporting. category. and. reports. a. best. estimate. of. what.it.may.contain..The.deterministic.technique.provides.a.

much.simpler.and.elegant.solution.to.the.problem.than.the.probabilistic.technique.

Figure.6.demonstrates. the.differences.between. the.systems.and.shows.how.the.deterministic.Possible.catego-ry,.as.it.was.originally.intended.to.be.used,.has.effectively.disappeared.from.probabilistic.estimating.techniques.

Solving The Equivalence Discontinuity And Missing Inferred Category

Accepting. that. it.would.be.beneficial. to.have. the.deterministic.and.probabilistic.techniques.aligned,.there.

are.two.practical.ways.to.solve.the.equivalence.disconti-nuity.and.missing.inferred.category.problem:

1.. Go.back.to.the.original.deterministic.definitions.and. apply. the. probabilistic. uncertainty. tech-niques.to.them;.or

2.. Accept. the. current. probabilistic. definitions.and. redefine. the. meaning. of. the. deterministic.Proved,.Probable.and.Possible.definitions.

Due.to.the.evolution.of.the.definitions.and.the.en-trenched. understanding. of. the. deterministic. terminol-ogy. it.would.be.almost. impossible. to.practically. imple-ment. the. redefinition.of. the.deterministic. terminology..The. only. practical. solution. therefore. lies. in. applying.uncertainty. techniques. correctly. to. the. deterministic.definitions.

When.the.estimation.of.uncertainty.(by.cumulative.probability. techniques). started. to. become. commonly.used,.the.designers.of.the.reserves.standards.should.have.applied.uncertainty.to.the.existence.considerations.that.the.prevailing.standards.had.defined..As.an.example,.a.single.well.or.a.number.of.wells.in.an.accumulation.can.measure.(or.prove).a.certain.volume..The.uncertainty.as-sociated.with.the.estimate.of.hydrocarbon.recovery.from.

that.Proved.volume.can.be.reported.as.the.low,.medium.(or.best).and.high.recoverable.hydro-carbon.estimates.

Similarly,. the. volume. that. is. outside.what.is.considered.to.have.been.measured.(or.Proved). is. classified. as. Probable. (as. per. the.original.deterministic.definitions).and.the.low,.medium.(or.best).and.high.recoverable.hydro-carbon.uncertainty.estimates. for.this.category.can.be. reported..Possible. always. remains.out-side. the. continuous. accumulation. that. has.been.penetrated.and.the.low,.medium.(or.best).and.high.recoverable.hydrocarbon.uncertainty.

estimates.for.this.category.can.be.reported.

Applying. uncertainty. to. the. deterministic. exis-tence. categories. immediately. solves. the. discontinuity.between.the.deterministic.and.probabilistic.systems..The.construction.of.this.system.is.shown.in.Figure.7..A.key.change. in. the.definitions. is. that.P90,.P50. and.P10.no.longer. means. Proved,. Proved. plus. Probable. or. Proved.plus.Probable.plus.Possible..Proved,.Probable.and.Possi-ble.revert.back.to.their.original.deterministic.definitions.and.these.categories.have.uncertainty,.which.is.reported.at.the.P90,.P50.and.P10.cumulative.probability.levels.


The.abbreviated.terminology.of.1P.is.still.be.defined.as.Proved,.2P.is.Proved.plus.Probable.and.3P.is.Proved.plus.Probable.plus.Possible.

The Future

To.put. in.place.a.classification. system.that.can.be.practically.understood.and.used.by.all.stakeholders,.three.further.areas.need.to.be.clarified.

1. Maturity Of Hydrocarbons:

Stakeholders.should.be.informed.if.a.recoverable.hy-drocarbon.estimate.is.developed.or.undeveloped.because.this.provides. further. information.on.the.risk.associated.with.the.estimate.and.the.immediacy.of.expenditures.or.revenue..The.UNFC.and.SPE.PRMS.2007.have.split.this.facet.of.classification.into.a.number.of.categories.and.al-though.it.may.be.academically.correct.to.break.down.the.process.into.many.discrete.steps.it.does.not.add.any.prac-tical.value.to.the.system..There.are.only.two.categories.of.interest.to.the.majority.of.stakeholders:.Developed.Pro-ducing.and.Undeveloped..A.company.is.obviously.free.to.elaborate.at.great.lengths.in.its.reports.on.exactly.where.in.the.process.a.project.may.be.but.the.key.question.is: “is it developed and producing or is it yet to be developed?”

2. Permit Life End Consideration And Uncontracted Hydrocarbons:

The. handling. of. recoverable. hydrocarbons. after.contract.life.end.needs.to.be.considered..The.Author.pro-poses.that.unless.a.company.is.in.receipt.of.a.contract.ex-tension.letter.from.the.relevant.authority.then.all.recov-erable.hydrocarbons.post.the.end.of.the.current.contract.period.should.only.be.inferred.at.best.and.therefore.these.should.be.reported.in.the.Possible.category..It.is.mislead-ing. to. report. these. volumes.of.hydrocarbons. as. Proved.or.Probable.reserves.due.to.the.inherent.uncertainty.of.ownership.associated.with.these.volumes.-.especially.in.

areas. where. the. rule. of. law. and.transparency.is.less.than.certain.

Uncontracted. hydrocarbons.are. difficult. to. handle. in. all. sys-tems. due. to. the. uncertainty. of.whether.or.not. the.volumes.will.be.sold.in.the.future.-.oil.less.so,.gas. more. so.. It. is. suggested. that.uncontracted. recoverable. hydro-carbons. are. catered. for. in. either.the. Probable. or. Possible. catego-ries,.depending.on.how.confident.

the. company. is. in. securing. a. future. contract. for. those.volumes.of.hydrocarbons.

3. Uneconomic Recoverable Hydrocarbons:

Stakeholders.will.need.to.decide.if.they.wish.to.in-clude.uneconomic.recoverable.hydrocarbons.in.the.clas-sification. system.. The. Author. proposes. that. for. almost.all.commercial.applications.the.reporting.of.uneconomic.recoverable.hydrocarbons.should.not.be.a.consideration..National.oil.and.gas.companies.however.may.have.a.re-quirement.to.report. technical.ultimate.recovery,.which.lies.beyond.the.economic.cut-off.point..The.Author.sug-gests. that. this.category. lies. to. the. right.of. the.Possible.category.that.was.shown.in.Figure.7.and.is.a.category.that.in.most.instances.should.be.ignored.

4. Exploration:

Exploration,. as. also. catered. for.by.Lahee.as.hypo-thetical. reserves,.needs.to.be.split.out.because. it. is.not.covered.by.the.Proved,.Probable.or.Possible.terminology..Estimates.of.recoverable.hydrocarbon.volumes.for.explo-ration.can.be.sub-divided.into.targeted.(the.discovered.equivalent. of. Proved. plus. Probable). and. adjacent. (the.equivalent.of.Possible)..Splitting.exploration.recoverable.hydrocarbon.volumes.further.into.prospect.and.lead.cat-egories. adds. limited.practical. value..Companies. should.ideally. in. their. reports. however. give. an. indication. of.when.they.expect.to.drill.the.exploration.target.thereby.introducing.a.time.factor.into.the.reported.estimate.

Figure.8.shows.the.simplified.matrix.with.the.above.considerations. included.. The. most. important. category.in.Figure.8. is. the.P50.or.Best.estimate.Proved.Produc-ing.category..This.category.underpins.company.revenue,.firm. future. company.value.and. is.used. for.depreciation.for.accounting.purposes..All.other.categories.have.much.higher.risk.considerations.


Summary

In. the. Author’s. view,. the. reporting. standards. and.definitions. took. a. wrong. turn. around. 1980. when. un-certainty. techniques. were. erroneously. applied. to. the.prevailing. deterministic. definitions.. Not. only. are. the.deterministic. and. probabilistic. definitions. different. in.fundamental.meaning.but.the.deterministic.Possible.cat-egory,.which.allowed.for.the.reporting.of.inferred.recov-erable. hydrocarbons,. was. essentially. removed. from. the.probabilistic.system.

With. the. entrenched. understanding. of. the. deter-ministic.Proved,.Probable.and.Possible.terminology,.the.introduced.misalignment.between.the.deterministic.and.probabilistic.techniques.can.only.practically.be.solved.by.taking. a. step. back. to. the. original. deterministic. defini-tions. and. then.applying.probabilistic.uncertainty. tech-niques.to.those.definitions.

The. aligning. of. the. Proven. and. Probable. catego-ries. so. that. the. deterministic. and. probabilistic. defini-tions.have.the.same.meaning.and.the.re-introduction.of.an.inferred.category.meaning.the.same.as.the.historical.deterministic.Possible.category.would.go.a. long.way. to.securing.a.universally.acceptable.standard.

Due.to.the.current.state.of.the.definitions.it.is.ap-parent.that.the.definitions.are.not.well.understood..All.stakeholders.in.the.industry.need.a.standard.that.is.sim-ple. to. understand. and. is. consistent. in. its. terminology..

It. is. the.Author’s.hope.that.this.paper.takes.us.a.step.closer.

ReferencesArps, J.J. 1956. “Estimation of Primary Oil Reserves.” AIME Petroleum Transactions, Feb 1956.

Lahee, Frederic H. 1944. “Standarization in Compiling Data on Exploratory Drilling And Crude-Oil Reserves.” Presented at Sun Oil Co. spring meeting, Southwestern District, Division of Production, Houston, Texas, June 13-14, 1944, API 44-215.

Lahee, Frederic H. 1950. “Oil and Gas Re-serves: Their Meaning and Limitations.” Frederic H. Lahee, Presented at Sun Oil Co. spring meeting, Southwestern District, Divi-sion of Production, Houston, Texas, March 1950, API 50-312.

Lahee, Frederic H. 1955. “The Terminology of Petroleum Reserves.” 4th World Petroleum

Congress. 1955.

McKelvey, V.E., 1974. “Concepts of Reserves and Resources.” USGS. December 30, 1974.

UN, 2004 - United Nations Framework Classification (UNFC) for Energy and Mineral Resources. 2004.

SPE PRMS, 2007 - Latest Society of Petroleum Engineers Re-serves and Reporting Standard. Available from www.spe.org.

Substantial additional material has been reviewed to develop and refine the concepts and prepare this paper but this material has not been specifically referred to in the text.

BiographyMichael Scott has a Batchelor of Science (First Class Hon-ours) degree in Civil Engineering from Strathclyde University in Glasgow, Scotland, and a Master of Engineering degree in Petroleum Engineering from Heriot-Watt University, Edinburgh, Scotland.

He is a petroleum reservoir engineer by profession and during his 25-year career he has worked for Esso UK, Texaco UK, Esso Australia, Woodside Energy and Cooper Energy. During his ca-reer Mr. Scott has been fortunate to gain experience and knowl-edge in a large number of countries working across new ven-tures, exploration, developments, production and downstream operations.

Michael Scott Cooper Energy Limited Suite 4, Level 4, South Shore Centre 83-85 The Esplanade, South Perth, 6151 Western Australia, Australia [email protected]


Key Issues in Determining Discount Rates for Valuing Real Property

Hal Heaton, PhD Marriott School of Management Brigham Young University

Introduction

Many appraisers are startled when they talk with actual buyers of real properties and determine the discount rates that actual buyers and sellers of real properties use. Buyers and sellers use discount rates that are sometimes sub-stantially higher than those derived using standard weighted average cost of capital (WACC) calculations. When typical WACC calculations are done, appraisers often use data from traded securities such as stocks or bonds to determine the required returns for equity and debt investors. However, when actual transactions are analyzed, the implied discount rates are often dramatically higher than those calculated from stocks and bonds.

Why is there a difference? And which rate is most appropriate?This study will discuss two reasons why the difference may exist. One key concept lies in the subtle, but critical

difference between the definition of “expected” cash flows and what I will refer to as “most likely” cash flows. Another key concept, which has had rising impact in the last few years, is the issue of liquidity.

In this study I will first discuss the logic and usual process for estimating the cost of capital. Next I will define and illustrate the critical difference between ‘most likely’ versus ‘expected’ cash flows. Finally, I will then address the issue of differences between discount rates calculated from stocks and bonds versus those determined from actual property transactions to emphasize the critical difference between required rates of return on highly liquid securities and highly illiquid properties.

Estimating the Weighted Average Cost of Capital

One. of. the. common. approaches. used. to. value. a.property.is.the.income.approach.in.which.the.appraiser.forecasts. the. future.expected.cash.flows. from.the.prop-erty.and.then.discounts.them.to.present.value...The.cash.flows.are.discounted.at.a.rate.which.reflects.the.risk.of.the.cash.flows.and.is.often.referred.to.as.the.cost.of.capital.for.the.property...The.cost.of.capital.reflects.the.return.that.investors. could. obtain. on. other. investments. of. similar.risk.and.characteristics;.a.buyer.of.the.property.must.offer.the.same.return.to.investors.in.order.to.raise.the.capital.to.buy.the.subject.property.

The.standard.textbook.method.to.estimate.a.com-pany’s. cost. of. capital. is. to. find. companies. with. traded.securities. which. are. in. the. same. business. from. which.cost.of.capital.data.can.be.estimated....Fair.market.value.requires. the. rate. that. a. typical. buyer. and. typical. seller.

would.require.for.the.risk.of.the.cash.flows.used.to.value.the.property.

Financing.takes.two.general.forms:.debt.and.equity...Although.there.are.other.types.of.financing.such.as.pre-ferred.stock,.convertible.debt.and.others,.most.of.these.can. be. closely. modeled. as. a. combination. of. common.stock.and.debt...The.appraiser.will.determine.the.appro-priate.mix.of.debt.and.equity.for.financing.the.business.in.the.long.term.and.assume.that.whatever.form.of.security.is.actually.sold,.in.the.long.run.the.mix.will.approximate.the.debt/equity.mix.selected...The.cost.of.capital.will.re-flect.the.weighted.average.of.these.two.sources,.i.e.

Weighted Average Cost of Capital (WACC) = wdkd

(1-T) + weke

(Equation 1)


where.wd. is. the.percent.of.financing.raised.in.the.form.of.debt,.kd.is.the.long.term.cost.of.debt,.T.is.the.tax.rate.paid.by.the.borrower,.we.is.the.percent.of.financing.raised.in.the.form.of.equity,.and.ke.is.the.cost.of.equity.

Hence,.to.estimate.the.cost.of.capital,.an.appraiser.must.look.at.the.amount.and.cost.of.debt.available.to.a.buyer.and.then.the.cost.of.equity,.given.the.level.of.debt.

To.determine.the.cost.of.debt,.appraisers.will.often.estimate.what.credit.rating.the.property.could.obtain.at.the.level.of.debt.assumed.and.then.obtain.average.yields.on. debt. of. that. credit. rating. from. standard. published.sources..This.data.comes.from.the.prices.of.traded.debt.securities.

It.is.important.to.note.that,.when.determining.the.cost.of.capital.for.a.property,.an.appraiser.must.look.sole-ly.at.the.debt.capacity.of.the.property.on.a.stand-alone.basis...The.appraiser.must.not.impute.the.credit.rating.of.a.larger,.more.creditworthy.buyer.who.has.other.assets.to.act.as.collateral.for.the.debt.and.attribute.that.debt.ca-pacity.to.the.acquired.property...The.amount.of.debt.(as.a.percent.of.value).that.a.large,.diversified.company.can.obtain.may.be. substantially.higher. than.the.amount.of.debt.that.a.buyer.could.obtain.using.only.a.single,.stand-alone.property.as.collateral..This.fact.may.explain.part.of.the.difference.between.the.textbook.WACC.calculation.and.the.return.that.actual.buyers.and.sellers.of.a.property.may.require.-.appraisers.may.have.assumed.the.percent.debt. that. an. actual. property. can. obtain. is. the. same. as.the.large,.diversified.companies.from.which.the.data.was.obtained.

To. determine. the. cost. of. equity,. appraisers. often.look.at.the.traded.stock.prices.of.companies.in.the.same.business.as.the.property.being.appraised.and.measure.the.risk.of. those. stocks.. .Perhaps. the.most.commonly.used.approach. is. the.Capital.Asset.Pricing.Model.(CAPM)...The.CAPM.is.developed.from.a.macroeconomic.analy-sis.which.demonstrates.that,.in.efficient.markets,.invest-ments.will.offer.a.return.measured.by.the.equation:

Required Return = Rf + ß(Rm - Rf) (Equation 2)

where.Rf.is.the.risk.free.rate,.Rm.is.the.market.expected.return.and.ß (beta).is.the.measure.of.systematic.risk.and.incorporates. both. the. volatility. of. the. investment. and.the.correlation.of.the.investment.with.the.market..The.

data.used.to.calculate.beta.as.well.as.the.risk.free.rate.and.the.expected.return.on.the.market.in.Equation.2.almost.always.come.from.the.traded.stock.securities.of.the.com-panies.selected.as.comparable.to.the.subject.property..

What Is ‘Expected Cash Flow?’

The.first.explanation.of.why.there.may.be.a.sizable.difference. between. the. standard. WACC. calculated. as.explained.above.and.the.required.return.that.buyers.and.sellers.use.on.an.actual.property.lies.in.the.nature.of.the.cash.flow.being.discounted..Finance.texts.emphasize.that.the. cash. flow. to. be. discounted. is. ‘expected’. cash. flow...However,.many.people.do.not.understand.what.‘expect-ed’.actually.means..‘Expected’.has.a.precise.mathematical.definition:..the.mean.of.the.probability.distribution...In.short,. the. ‘expected’. cash.flow. is. the.average.cash.flow.that. would. be. observed. if. the. investment. could. be. re-peated.many,.many.times.

This. is.often.very.different. than. ‘most. likely’.cash.flow..For. example,. suppose. the. engineers.working.on.a.project,.forecast.that.if.everything.goes.as.planned,.$1000.in.cash.flow.will.result...Say.this.happens.with.90%.prob-ability..However,.10%.of.the.time.something.goes.wrong.and. the.cash.flows.are. zero.. ‘Expected’.cash.flow. is. the.scenario. weighted. average. cash. flow. if. the. investment.could.be.repeated.many,.many.times..For.this.example,.‘expected’.cash.flow.would.be:

. 90% x $1000 + 10% x $0 = $900 ( Equation 3)

The.‘expected’.cash.flow.($900).must.be.discounted.in.the.valuation.process,.not.the.‘most.likely’.cash.flow.($1000)...The.confusion.arises.because.the.owners.of.the.property.often.refer.to.the.$1000.as.the.‘expected’.cash.flow. since. they. are. ignoring. the. low-probability. 10%.event..But.$1000.is.actually.the.‘most.likely’.cash.flow,.not.‘expected’.cash.flow..The.risk.of.shutdown.or.other.factors. affecting. cash. flows. should. be. accounted. for. by.forecasting.all.possible.scenarios,.weighting.the.scenarios.by.their.probability.and.then.computing.the.average.or.‘expected’.cash.flow.as.in.Equation.3...

Unfortunately,.buyers.and.sellers.often.rely.on.a.sin-gle.forecast.of.cash.flows.and.often.this.single.forecast.is.the.‘most.likely’.cash.flows.not.true.‘expected’.cash.flows.that. valuation. requires.. Of. course,. buyers. and. sellers.


know.that.negative.scenarios.can.happen,.but.these.neg-ative. scenarios. may. not. be. specifically. reflected. in. the.cash.flows.since.they.may.not.be.very.likely.to.happen...However,.buyers.and.sellers.adjust.for.this.fact.by.using.higher.discount.rates.than.would.otherwise.be.required.

Adjusting Discount Rates for ‘Most Likely’ Cash Flows

The.best.way.to.deal.with.this.crucial.difference.be-tween.‘expected’.and.‘most.likely’.cash.flows.is.to.forecast.various. scenarios. and. then. weight. each. scenario. by. its.probability.as.in.Equation.3..The.standard.weighted.av-erage.cost.of.calculation.is.only.appropriate.if.this.is.the.case.

However,.most.appraisers.use.only.a.single.cash.flow.forecast.and.ignore.what.the.cash.flows.for.possible.neg-ative. scenarios.. .As.a. result,. the. single. cash.flow.often.reflects.the.error.of.using.‘most.likely’.cash.flows.rather.than.‘expected’.cash.flows...If.such.is.the.case,.then.the.adjustment.to.the.discount.rate.must.reflect.the.magni-tude.of.the.difference.between.‘most.likely’.and.the.truly.‘expected’.cash.flows.

Using.the.example.above,.suppose.the.cash.flow.is.a.perpetuity...To.value.perpetuity.correctly,.the.‘expected’.cash.flow.of.$900.should.be.discounted.at.the.WACC...If.the.WACC.is.10%,.then.the.true.value.is:

. . $900/0.10 = $9,000.......

... However,. if. the.appraiser.makes. the.mistake.of.misusing. $1000. as. the. ‘expected’. cash. flow. then. a. dis-count.rate.of.11.1%.must.be.used.to.obtain.the.correct.value:

. . $1000/0.111 = $9,000

. Experienced.buyers.and.sellers.of.similar.proper-ties.will.often.know.from.prior.experience.that.to.come.out. whole. with. a. portfolio. of. projects,. 11.1%. must. be.used.and.they.will.indeed.use.that.higher.rate.of.11.1%...Appraisers.who.naively.calculate.a.weighted.average.cost.of.capital.of.the.10%.used.in.the.example.are.stunned.to.observe.actual.buyers.and.sellers.using.11.1%.for.valuing.the.$1000.cash.flow...The.failure.to.recognize.the.critical.difference.between.‘expected’.and.‘most.likely’.cash.flows.explains.their.astonishment.

The.necessary.adjustment.to.the.naïve.WACC.gets.larger.as.the.time.horizon.of.the.project.gets.shorter...For.example,.if.the.project.above.with.a.$900.expected.cash.

flow.is.only.a.one.period.project.instead.of.a.perpetuity,.then.the.true.value.is:

$900 / 1.10 = $818

The. appropriate. discount. rate. to. use. if. the. ‘most.likely’.rather.than.the.‘expected’.cash.flow.is.used.is.over.20%!

$1000 / 1.222 = $818

This.is,.needless.to.say,.much.higher.than.the.11.1%.for.an.infinite-lived.project...Most.practitioners.deal.with.projects.that.have.similar.lives.and.so.the.discount.rate.they.use.will.reflect.the.average.life.of.the.project..Unfor-tunately.there.is.no.other.way.to.estimate.the.appropriate.discount.rate.than.to.know.from.experience.how.much.of.an.adjustment.is.required.to.compensate.for.the.use.of.‘most.likely’.and.‘expected’.cash.flows..This.adjustment.may.be.very.different.for.a.refinery.than.it.is,.say,.for.an.oil.drilling.project...

Difference in Required Returns on Securities and Required Returns on Properties

Another.frequent.explanation.of.the.difference.be-tween.discount.rates.calculated.with.the.standard.text-book. procedure. and. the. actual. rates. that. buyers. and.sellers. really. use. stems. from. the. difference. in. security-type.investments.and.physical.properties..Consider.two.investments.with.identical.risk.and.cash.flows..One.can.be.bought.and.sold.simply.by.clicking.on.an.icon.on.your.computer.and.mere.seconds.later.cash.appears.in.your.ac-count.ready.to.be.used.for.any.other.purpose.you.choose...The.second.investment.can.only.be.sold.by.searching.for.a.buyer,.negotiating.a.price,.hiring.lawyers.to.write.up.a.contract,.accountants.to.review.accounting.records,.and.specialists.to.perform.due.diligence.. .Which.would.you.rather.own?..Overwhelmingly.investors.choose.the.easily.traded.investment.

Liquidity. refers. to. the. ease. and. cost. of. buying. or.selling.an.investment...Investors.will.require.a.higher.re-turn.on.assets.of.similar.risk.if.the.assets.are.more.difficult.to.sell,.require.higher.transaction.fees.to.buy.or.sell,.or.cannot.be.bought.or.sold.in.small.pieces.(like.common.shares). as. cash. needs. arise.. Appraisers. who. attempt. to.value.operating.property.such.as.a.refinery,.a.railroad,.a.telecommunications.network.or.other.operating.property.must.obtain.data..Often,. the.data. is.obtained. from.the.traded.securities.(stocks.and.bonds).of.refinery,.railroad.or. telecommunications. companies. which. own. property.


as. similar. to. the. subject.operating.property.as.possible..However. this. data. derived. from. securities. cannot. be.properly.used.without.significant.adjustment...

Securities.will.sell.for.premium.prices.to.the.under-lying.property.for.a.number.of.reasons:

1.. An.investor.can.get.needed.cash.quickly. from.securities..Securities.can.be.normally.sold.with.the.click.of.an.icon.at.very.low.cost.and.the.cash.will.appear.in.the.account.within.seconds..An.operating.property.might.take.weeks.or.months.to. sell. the. property. and. require. large. costs. for.the.legal,.accounting,.negotiation,.and.due.dili-gence.efforts.involved..

2.. An.investor.can.invest.a.little.or.a.lot.in.securi-ties;. a. few. shares. or. many. shares. can. be. sold..A.physical.property.is.typically.sold.in.a.large,.single.block..

3.. An.owner.of.an.actual.operating.property.must.deal.with.the.management.hassle.and.effort.of.hiring.and.firing.employees,.setting.compensa-tion. levels,. marketing. the. product,. building.relationships. with. customers,. developing. ex-tensive. technical. knowledge. about. operating.the.equipment.in.a.property,.meeting.extensive.regulatory. requirements,. developing. extensive.reporting. documents,. and. a. variety. of. other.problems..An.investor.in.a.stock.does.not.need.to.worry.about.any.of.this..

4.. An. investor. in. the. stock. has. absolute. limited.liability;. the. most. the. investor. can. lose. is. the.amount.invested.in.the.stock...In.contrast,.even.if. the. project. is. separately. incorporated,. the.owner.of.a.property.often.does.not.have.limited.liability.. Environmental. issues,. em-ployee.litigation,.or.a.variety.of.other.lawsuits. have. attached. the. owner’s.other.assets.to.pay.damages..Consider.the.huge.amounts.of.legal.liability.that.British. Petroleum. (BP). faced. in. the.oil. spill. near. Louisiana. in. 2010.. The.amount. of. damages. BP. paid. were. a.sizeable.multiple.of.BP’s.investment.in.the.oil.rig..

5.. Stocks. represent. ownership. in. busi-nesses. that. have. substantial. growth.opportunities;. companies. can. build.

new.properties.and.enter.new.businesses..A.sin-gle.property.which. is. the.subject.of.a.property.tax. appraisal. is. limited. to. whatever. the. single.property. can. produce,. e.g.. refinery. companies.can.build.new.refineries;.a.single.refinery.is.lim-ited.to.whatever.it.can.produce...The.potential.growth.of.companies.can.dramatically.affect.the.price.at.which.the.share.is.sold.and.hence.the.equity.rates.as.calculated.in.cost.of.capital.stud-ies..

6.. Stock. prices. capture. future. net. present. value.from. projects. and. assets. which. do. not. even.exist. today.. A. property. value. for. property. tax.purposes. in.most. states. should. reflect.only. the.value.of. the.property.which.exists.on. the. lien.date..

Liquidity,. as. reflected. in. issues. number. 1. and. 2.above,.is.the.focus.of.much.financial.research.on.the.dif-ference.in.required.return.between.liquid.and.illiquid.but.identical-risk.investments...The.issue.of.liquidity.has.ex-ploded.in.importance.in.recent.years.due.to.fundamental.changes. in.capital.markets.and.the.sources.of.available.capital.

. In. the. early. 1980s,. President. Reagan. was. faced.with. a. Social. Security. system. that. was. no. longer. self-sustaining;.he.proposed. significant. changes. including. a.major.increase.in.the.required.contributions..One.of.the.indirect.impacts.of.the.serious.debate.surrounding.social.security.at.the.time.was.a.realization.that.declining.birth.rates.and.longer. lives.would.severely.impact.the.ability.of. Social. Security. to. meet. its. future. obligations.. . As. a.result,.individuals.and.companies.realized.they.could.no.longer. assume. that. Social. Security. would. cover. all. of.

Figure 1


their.retirement.needs.. .Investments.in.retirement.pro-grams.and.personal.savings.rose.dramatically.starting.in.the.early.1980s...As.Figure.1.illustrates,.pension.fund.as-sets.have.risen.from.well.under.a.trillion.dollars.to.over.$15.trillion.since.the.early.1980s:

The.huge.increase.in.the.amount.of.money.in.these.pension.funds.has.had.an.enormous.impact.on.the.value.of.liquidity..These.entities.are.regulated.and.must.regu-larly. report. their. value. to.determine. if. they. are. under-funded...To.have.a.reported.value,.they.must.have.prices...To.have.prices,.they.need.liquidity...As.a.result,.except.for.a.small.portion.of.their.fund.that.may.be.allowed.to.be.relatively.illiquid,.pension.funds.must.invest.primarily.in.liquid.investments.for.which.they.have.available.prices.at.any.given.point.in.time..As.a.result,.these.entities.usu-ally. restrict. their.purchases. so.that. illiquid. investments.can.only.be.a.small.(often.5%.or.less).of.the.portfolio..As.a.result.of.the.increasing.dominance.of.these.investment.vehicles,. the.difference. in.value.between. liquid. invest-ments. and. the.value.of. illiquid. investments.has. grown.wider.and.wider.over.the.years.since.1980.

However,.the.biggest.impact.on.the.value.of.liquid-ity. came. with. the. 2008/2009. downturn.. A. number. of.investments,. especially. mortgage-backed. securities. that.were.thought.to.be.liquid,.suddenly.became.illiquid...In.the.ensuing.drop.in.markets,.even.some.money.market.instruments,.always.thought.to.be.absolutely.liquid,.froze.up...Banks,.corporations,.and.other.entities.that.desper-ately. needed. cash. could. not. obtain. liquidity. (cash). by.selling.investments.that.they.had.always.been.able.to.sell.easily.. . Suddenly,. investment. managers. who. had. never.given.a.great.deal.of.thought.to.the.issue.of.liquidity.be-came.painfully.aware.of.its.importance...

The.need. for. liquidity.became. so. intense. that. the.rate.on.short.term.Treasury.bills.actually.turned.negative!.Why.would.anyone.pay.the.U.S..government.for.the.priv-ilege.of.loaning.it.money?.Because.investors.knew.that.if.they.needed.their.money.back.at.a.moment’s.notice,.they.could.always.sell.Treasury.bills.into.an.enormous,.liquid.market...In.short,.they.were.paying.for.liquidity.

Research. and. empirical. studies. in. the. finance. lit-erature.offer.dramatic.support.for.the.need.to.adjust.for.liquidity.differences:

Liquidity (or marketability) is a key attribute of capital assets, and it strongly affects their pric-ing…investors prefer to commit capital to liquid investments, which can be traded quickly and at

low cost whenever the need arises. Investments with less liquidity must offer higher expected re-turns to attract investors.(1)

…liquidity-increasing financial policies may increase the value of the firm. This was dem-onstrated for our numerical example.… If the spread is reduced to 0.486% [from 3.2%] (as in our low-spread portfolio group), our estimates imply that the value of the asset would increase to $75.8, about a 50% increase.…(2)

Our study contributes to the academic lit-erature since we believe we offer the cleanest and most precise measures of the value of liquidity. Due to the unique experimental design inherent in REITs, especially the precision of underlying asset values, we are able to not only verify a link between liquidity and required returns but we also are able to accurately quantify these gains.… our estimates of wealth creation jump to around 23% when comparing exchange traded claims to non-trading ones.(3)

As.business.students.also.learn.from.the.most.com-monly.used.textbooks,.liquidity.adds.value:

Securities that cannot be converted so quick-ly and cheaply into cash need to offer relatively high yields.(4)

The Appraisal of Real Estate,. perhaps. the. most.powerful.authority.for.many.appraisers,.also.makes.it.very.clear.that.liquidity.must.be.considered:

The rate of return on an investment com-bines a safe rate with a premium to compensate the investor for risk, the illiquidity of invested capital and management involvement.(5)

The.need.to.adjust.for.liquidity.differences.has.long.been.recognized.by.assessors...For.example,.the.California.State.Board.of.Equalization. in. its.Assessors’.Handbook.indicates:

Liquidity Preference. An asset is liquid if it can be readily converted to cash at its current market value. All else being equal, investors pre-fer to hold assets that are liquid. The return for li-quidity preference is the yield component required for holding assets that are not readily convertible into cash. Most financial assets are liquid. Real


estate and most business assets, however, are rel-atively illiquid, and real estate investors must be compensated for this reduced liquidity.(6)

The argument based on lack of liquidity is a much stronger one. There is no question that financial assets are significantly more liquid than real estate assets. Rate of return estimates us-ing the CAPM reflect returns on financial assets; thus, in practice at least, the CAPM assumes that all assets are liquid. An adjustment for lack of liquidity can be made in two ways: (1) consid-er lack of liquidity as an added risk factor and add a premium for it to the cost of equity estimated by the CAPM; or (2) value the real estate asset using the CAPM/WACC without any liquidity adjustment, and then apply a liquidity discount to the estimated value. In both cases it is difficult to arrive at a supportable estimate of the adjust-ment.(7)

Various.studies.have.placed.the.liquidity.premium,.depending.on.the.characteristics.of.the.actual.property,.from.2%.to.over.10%.

Summary

Many.appraisers.rely.on.standard.textbook.approach-es.to.determining.a.weighted.average.cost.of.capital.by.obtaining.data. from.traded. stocks.and.bonds..They.are.often.stunned.at.the.difference.in.required.return.when.they.compare.discount.rates.using.the.standard.method.and.rates.required.by.actual.buyers.and.sellers.of.proper-ties..One.explanation.of. the.difference.may. lie. in.how.the.cash.flows. to.be.discounted.are.determined.. . If. the.appraiser.starts.not.with.‘expected’.cash.flows.but.rather.with. the. ‘most. likely’. cash. flows,. then. the. appropriate.discount.rate.may.be.dramatically.higher.than.the.stan-dard.weighted.average.cost.of.capital..The.second.expla-nation. stems. from. the. fundamental.difference.between.required.returns. -.at. the.same. level.of. risk.as.measured.by.beta.or.other.risk.metric.-.on.stocks.and.bonds.which.are.quickly,.easily.and.inexpensively.traded.as.compared.to.property.which.may.take.weeks.or.months. to. sell.as.well. as. extensive. accounting,. regulatory,. due. diligence.and.legal.costs.

Footnotes1. Amihud, Y. and Mendelson, H., 1991. Liquidity, Asset Pric-es and Financial Policy. Financial Analysts Journal (Nov/Dec): 56.

2. Amihud, Y. and Mendelson, H., 1986. Asset Pricing and the Bid-Ask Spread. Journal of Financial Economics, 17(2): 246.

3. Benveniste, L., Cappozza, D. and Seguin, P., 2001, The Val-ue of Liquidity. Real Estate Economics, vol. 29(4): 656.

4. R. Brealey, R. and Myers, S., 2008. Principles of Corporate Finance, eighth edition, 827. Burr Ridge, Illinois: McGraw Hill.

5. Appraisal Institute, 2001. The Appraisal of Real Estate, thir-teenth edition, 464. Chicago, Illinois: Appraisal Institute.

6. California State Board of Equalization,1998. Assessors’ Handbook, Section 502, “Advanced Appraisal” (December): 63.

7. California State Board of Equalization, 1998. Assessors’ Handbook, Section 502, “Advanced Appraisal: Appendix A” (December): 182-183.

BiographyDr. Heaton is the Denny Brown Professor of Finance, in the Marriott School of Business, Brigham Young University. He holds a PhD. in Finance and an MA in Economics from Stanford University and an MBA and BS in Mathematics from BYU.

Hal Heaton, PhDMarriott School of ManagementBrigham Young UniversityProvo, Utah 84602Phone: (801) 422-2132Fax: (801) 422-0108Email: [email protected]


The Exploration Game Statistical Decision Theory Using Bayes FormulaDr. E.L. Dougherty SPE Distinguished Member & SPE Legion of Honor Recipient of SPE Cedric K Ferguson Medal & J. J. Arps Award Emeritus Professor, University of Southern California

Preface

This paper is a revised extension of the following two papers I submitted to the SPE:1. “The Exploration Game,” SPE 1440, February 1966.2. “The Oilman’s Primer On Statistical Decision Theory,” SPE 3278, August 1970.The SPE informed me that its Editorial Committee found both highly interesting but after extensive debate conclud-

ed that they did not contain sufficient information of interest to SPE members to warrant publication. Both are available via spe.org’s OnePetro. Ironic that less than 20 years later, SPE began publication of a stream of papers on this subject – and SPE Bookstore today offers two books on the subject: Making Good Decisions and Decision Analysis in E&P.

INTRODUCTION

Statistical.decision.theory.–.along.with.its.graphical.counterpart,.the.decision.tree.–.is.a.powerful.and.practical.management.tool..The.method.depicts.and.quantifies.uncertainty,.thus.helping.a.manager.to.make.sounder.decisions..The.technique.provides.an.easily.understandable.framework.that.enforces.a.disciplined.analysis.–.formal.or.conceptual.–.of.the.risks.surrounding.a.decision..As.has.become.the.norm.in.SPE.papers,.we.use.the.acronym.SDT.as.a.convenient.shorthand..

SDT.guides.the.decision.maker.to:

1. think through the decision he is about to make,2. clearly pronounce his objective,3. define the alternative actions available,4. specify the possible outcomes -- physical, political, otherwise -- that could affect results,5. pick quantitative yardsticks to measure costs, benefits, and desirability,6. write down what he believes the probability of each action-outcome pair to be.

SDT’s.decision.tree.traces.the.sequence.of.events.and.outcomes.and.assigns.a.probability-weighted.value.to.each.possibility..Since.computers.perform.required.calculations.almost.instantaneously,.the.impact.of.critical.assumptions.and.data.uncertainties.can.be.thoroughly.tested..Finally,.the.method.provides.a.readily.understandable.–.one.picture.is.worth.a.thousand.words.–.way.of.showing.how.things.stack.up,.thus.allowing.the.judgments.and.experiences.of.others.to.be.called.on.

Technical.articles.explaining.the.concepts.of.SDT.and.recommending.its.use.abound..All.creditable.university.MBA.and.Management.Science.curricula.include.courses.on.it..Shelves.are.full.of.books.on.SDT..The.References.list.the.earliest.and.latest.books.on.oil.and.gas.decisions.–.and.one.in.between.

As.we.have.already.implied,.probabilities.are.the.foundation.of.SDT..We.assume.the.reader.is.familiar.with.the.basic.concept.of.probability.–.p.is.a.number.between.0.&.1.expressing.the.likelihood.of.an.uncertain.or.chance.event..


Exploration Choice

CBA

You.know.that.if.you.toss.a.coin,.a.head.or.a.tail.is.equally.likely.so.p(H).=.p(T).=.0.5..Or.if.you.roll.a.die,.p(1).=.p(2).=.p(3).=.p(4).=.p(5).=.p(6).=.1/6..In.simple.situations.such.as.this,.the.probability.of.each.event.is.well.defined..

In.more.complex.situations.probabilities.are.determined.by.the.following.logical.counting.process:

1.. Define.the.event.whose.probability.you.want.–.for.example,.a.2.turns.up.on.the.die.2.. Count.the.total.number.of.equally.likely.possible.outcomes.–.events.--.of.the.chance.process.–.with.the.die.this.

is.6.3.. Count.the.number.of.equally.likely.ways.the.designated.event.can.occur.–.for.a.2.this.is.1..4.. Divide.the.2nd.number.by.the.1st.and.this.is.your.probability.–.for.‘die.=.2’.this.is.1/6.

Let’s.consider.a.couple.of.more.examples.to.illustrate.the.process..What.is.the.probability.that.someone.I.meet.has.the.same.birthday.as.I?.Ignoring.leap.year.the.person’s.birthday.could.be.any.of.365.days..Only.one.of.those.would.be.the.same.as.mine..Therefore,.the.probability.is.1/365..

What.is.the.probability.of.obtaining.2H.&.2T.when.4.coins.are.thrown?.This.is.the.analog.of.determining.the.probability.of.a.7.when.two.dice.are.tossed.to.be.6/36.=.1/6..With.4.coins.there.are.24.=.16.equally.likely.outcomes..Counting.we.find.5.distinct.outcomes.as.follows:

• 1 – 4H• 1 – 4T• 4 – 3H-1T• 4 – 1H-3T• 6 – 2H-2T

The.desired.probability,.p(2H2T).=.6/16.=.3/8.

What.you.do.not.realize.is.that.things.are.more.uncertain.than.you.think,.as.we.drive.home.in.the.study.of.offshore.bids.later.

This.paper,.which.gives.examples.illustrating.how.to.apply.decision.theory.to.petroleum.situations,.has.two.sec-tions,.The Exploration Game. .and..Exploration Decision Examples.. . In.the.first.the.principles.of.the.method.are.explained.in.a.context.in.which.the.underlying.probabilities.are.known.–.thereby.avoiding.detracting.from.the.expla-nation.by.concern.over.specifying.them.

In.the.second.section,.realistic.example.applications.are.presented..Here,.the.concept.of.subjective.probabilities.is.introduced..These.numbers.are.obtained.by.combining.historical.data.(classical.probabilities.=.long.run.frequency).with.opinions.of.knowledgeable.experts.expressed.as.fractions.between.0.&.1.

THE EXPLORATION GAME

The.Exploration.Game,.a.fascinating.educational.pastime,.pits.an.individual,.or.a.group.of.individuals.playing.col-lectively,.against.an.entity.called.Nature..Individual.players.are.called.Oilmen..A.group.of.Oilmen.playing.collectively,.or.an.individual.playing.alone,.is.called.an.Operator.

The.game.proceeds.as.follows:.The.Oilmen.enter.the.room.in.which.Nature.is.located..Nature.has.a.large.spinner.with.a.calibrated.dial.and.three.bags,.called.Prospect.A,.Prospect.B.and.Prospect.C..

•. Prospect.A.contains.2.white.balls.and.4.black.balls,.•. Prospect.B.contains.3.white.balls.and.3.black.balls,•. Prospect.C.contains.4.white.balls.and.2.black.balls..•. 0.80.of.the.circumference.of.the.dial.is.yellow.(Prospect.A),.•. 0.15.of.the.circumference.is.green.(Prospect.B),•. 0.05.of.the.circumference.is.red.(Prospect.C)..

All.of.this.is.known.to.the.Operator.


Each.play.of.the.game.is.called.an.Exploratory.Play..To.participate.in.an.Exploratory.Play.the.Operator.pays.$5.to.Nature..All.Oilmen.then.don.blindfolds.and.Nature.spins.the.dial..(The.spinner.is.carefully.balanced.so.that.the.final.position.of.the.pointer.is.completely.random.).Nature.indicates.when.the.spinner.has.stopped.but.does.not.reveal.the.color.indicated.by.the.pointer..Nature.does,.however,.make.a.comment.such.as.“Looks like a good shot,”.or.“Could be a real hit!.or.“Many brave hearts lie asleep in the dust.”.Considering.her.capricious.disposition.the.level.of.credence.to.give.to.Nature’s.remarks.is.unknown..(By.observing.her.behavior.over.a.large.number.of.Exploratory.Plays,.some.meaningful.conclusions.might.be.drawn,.but.in.the.absence.of.these.observations.the.Operator.must.decide.for.himself.).At.this.point.the.Operator.has.four.options,.called.Strategies;.these.are:

•. Drill•. Farm.Out•. Explore•. Pull.Out

Drill Strategy

If.the.Operator.elects.to.drill,.the.Oilmen.remove.their.blindfolds.and.inspect.the.dial..Payoffs.are.determined.by.the.dial.readings.as.follows:

When.the.indicated.payoff.has.been.made,.this.Exploratory.Play.is.complete.

Farm Out Strategy

Under.the.Farm.Out.Strategy.the.Operator.takes.in.a.‘Partner’.who.assumes.the.risk.for.a.Dry.Hole.and.in.return.receives.80%.of.the.payoff.for.an.Oilfield.or.a.Bonanza..The.Operator’s.payoff.table.then.looks.like:

When.the.payoff.has.been.made,.this.Exploratory.Play.is.complete.

Pull Out Strategy

If.the.Operator.elects.to.Pull.Out,.this.ends.the.Exploratory.Play..There.is.no.further.exchange.of.money..(The.Operator,.of.course,.does.not.recover.his.initial.$5.outlay.).

Explore Strategy

Under.the.Explore.Strategy.Nature.allows.the.Operator.to.select.one.ball.at.random.from.the.Prospect.indicated.by.the.dial..Of.course,.Nature.does.not.reveal.from.which.Prospect.the.drawing.is.made..Nature.indicates.the.(true).color.of.the.ball.and.replaces.the.ball.in.the.Prospect..For.this.privilege.the.Operator.pays.Nature.an.additional.$2..The.Operator.now.elects.one.of.the.three.remaining.Strategies.and.the.Exploratory.Play.is.completed.as.indicated.

Dial Reading Prospect State of Nature PayoffYellow A Dry Hole Operator pays $35Green B Oil Field Operator collects $100Red C Bonanza Operator collects $500

Dial Reading Prospect State of Nature PayoffYellow A Dry Hole Operator pays $0

Green B Oil Field Operator collects $20

Red C Bonanza Operator collects $100


ANALYSIS OF THE EXPLORATION GAME

The.Expected.Payoff.or.Value.per.Exploratory.Play,.denoted.[EP],.is.simply.the.sum.of.the.payoffs.for.each.pos-sible.State.of.Nature.weighted.by.its.probability.of.occurrence..Similarly,.the.Expected.Net.Gain.per.Exploratory.Play,.denoted.[NG],.is.the.Expected.Payoff.per.Exploratory.Play.less.the.cost.per.play.

Drill Strategy

For.the.Drill.Strategy.these.are:

. [EP]D.=.(.80)(-35).+.(.15)(100).+.(.05)(500).=.$12

. NG]D.=.[EP]D.−.$5.=.$7

Farm Out Strategy

In.this.case.we.have:

. [EP]FO.=.(.80)(0).+.(.15)(20).+.(.05)(100).=.$8

. [NG]FO.=.[EP]FO.−.$5.=.$3

Pull Out Strategy

Under.this.strategy.we.are.certain.to.lose.$5/Play:.

. [EP]FO.=.0

. [NG]PO.=.[EP]FO.−.$5.=.-$5

Peek Strategy

Before.proceeding.to.the.analysis.of.the.Explore.Strategy,.let.us.define.a.hypothetical.(and.unethical).strategy.which.we.will.call.the.Perfect.Insight.or.Peek.Strategy..If.after.the.dial.stops,.we.were.to.peek.before.selecting.our.Strategy,.it.is.clear.that.our.Strategy.would.be.Pull.Out.of.Prospect.A.and.Drill.Prospects.B.and.C..In.this.case.we.would.have:

. [EP]PK.=.(.80)(0).+.(.15)(100).+.(.05)(500).=.$40

. [NG]PK.=.[EP]PK.−.$5.=.$35

Comparing.this.to.our.next.best.Strategy,.Drill,.we.see.that.uncertainty.of.the.true.State.of.Nature.is.costing.us.money..In.fact.we.can.define.the.Expected.Cost.of.Uncertainty.per.Exploratory.Play.to.be:

. [COU].=.[NG]PK.−.[NG]D.=.35.–.7.=.$28

Thus,.uncertainty.about.the.true.State.of.Nature.will,.in.the.long.run,.cause.us.to.leave.four.times.as.much.money.on.the.table.as.we.put.in.our.pockets..This.large.possible,.but.unrealized.gain.causes.us.to.lament.Nature’s.capricious-ness..Most.certainly,.we.would.be.willing.to.pay.her.additional.monies.if.she.would.reveal.some.of.her.secrets.to.us..How.much.we.can.afford.to.pay.depends.upon.how.much.information.we.get.in.return..With.this.in.mind.we.are.now.ready.to.examine.the.Explore.Strategy..(We.could.also.appropriately.call.[COU].the.Expected.Value.of.Perfect.Information.because.it.represents.the.additional.value.we.could.realize.if.we.had.perfect.information.on.the.State.of.Nature.)

Explore Strategy

This.is.actually.a.multiple.strategy,.since,.after.learning.the.color.of.the.ball.drawn,.we.must.then.elect.to.Drill,.Farm.Out.or.Pull.Out..Black.balls.or.white.balls.are.the.only.possible.outcomes.of.the.draw..Intuition.tells.us.that.since.seven.of.the.nine.white.balls.are.in.Prospects.B.and.C,.the.draw.of.a.white.ball.must.be.a.good.omen..On.the.other.


hand,.five.of.the.nine.black.balls.are.also.in.Prospects.B.and.C,.so.is.a.black.ball.also.a.good.omen?.They.can’t.both.be.good..

The.key.to.this.conundrum.lies.in.the.fact.that.80%.of.the.time.we.are.selecting.balls.from.Prospect.A.–.from.which.we.are.twice.as.likely.to.select.a.black.ball.as.a.white.ball..The.remaining.20%.of.the.time.we.are.selecting.balls.from.Prospects.B.or.C.for.which.the.probability.of.obtaining.a.black.ball.is.1/2.or.1/3,.respectively..Viewed.in.this.con-text,.our.intuition.strongly.suggests.that.a.black.ball.is.a.bad.omen.

Thus,.the.draw.of.a.white.ball.bodes.well.for.our.chances,.while.a.black.ball.is.discouraging..But.how.good.or.bad?.Given.the.ball’s.color,.what.should.we.do?.And.what.is.this.information.worth.to.us?.Can.we.quantitatively.determine.the.Explore.Strategy’s.merit?.

The.answer.is.yes..To.do.this.we.must.first.answer.the.question:

Given the color of the ball drawn, what is the probability that it came from Prospect A? Prospect B? Prospect C?

To.answer.this.question.we.use.probabilities.of.multiple.events,.so-called.compound.and.conditional.probabilities,.and.a.remarkable.mathematical.formula.called.Bayes.Theorem.or.Bayes.Formula..Given.probability.estimates.for.the.likelihood.of.occurrence.of.each.and.every.individual.event.of.a.set.of.mutually.exclusive.and.exhaustive.events,.(i..e.,.one.and.only.one.event.can.occur.and.one.must.occur.–.here,.either.Prospect.A.or.B.or.C).and.given.additional.information.relating.to.the.events.(either.a.white.ball.or.a.black.ball.is.drawn).Bayes.Formula.computes.revised.probability.estimates.taking.into.account.the.additional.information..We.show.the.formula.in.a.table.below;.here.we.illustrate.its.use..

In.an.Exploratory.Play.there.are.three.possible.outcomes.of.the.dial.spin,.Prospect.A,.B.or.C..For.each.of.these.outcomes.(events),.if.the.Explore.Strategy.is.employed,.there.are.two.possible.outcomes,.either.the.ball.drawn.is.white.(W).or.the.ball.drawn.is.black.(K)..This.gives.a.total.of.six.possible.results.from.spinning.the.dial.and.drawing.a.ball:

•. Prospect.A.and.White.ball,.•. Prospect.A.and.Black.ball,.•. Prospect.B.and.White.ball,.•. Prospect.B.and.Black.ball,.•. Prospect.C.and.White.ball,.•. Prospect.C.and.Black.ball..

Let.us.denote.these.events.as.AW,.AK,.BW,.BK,.CW,.and.CK,.respectively,.and.adopt.the.following.notation:

•. p(AW).=.probability.Prospect.A.is.selected.&.a.White.ball.is.drawn,.•. p(AK).=.probability.Prospect.A.is.selected.&.a.Black.ball.is.drawn,.•. p(BW).=.probability.Prospect.B.is.selected.&.a.White.ball.is.drawn,.•. p(BK).=.probability.Prospect.B.is.selected.&.a.Black.ball.is.drawn,.•. p(CW).=.probability.Prospect.C.is.selected.&.a.White.ball.is.drawn,.•. p(CK).=.probability.Prospect.C.is.selected.&.a.Black.ball.is.drawn,.

Since.one.of.these.six.possible.compound.events.must.occur,.we.have

p(AW.+.p(AK).+.p(BW).+.p(BK).+.p(CW).+.p(CK).=.1

If.Prospect.A.is.selected,.the.drawing.of.a.ball.is.a.random.selection.of.one.ball.from.six.balls,.two.of.which.are.White.and.four.of.which.are.Black..Since.we.are.as.likely.to.draw.one.ball.as.any.other,.the.probability.of.drawing.a.white.ball.is.2/6.=.1/3..We.call.this.the.conditional.probability.of.drawing.a.White.ball.given.that.Prospect.A.was.selected,.and.denote.this.by.p(W|A).=.1/3.

Similarly,. the. conditional. probability. of. drawing. a. Black. ball. given. that. Prospect. A. was. selected. is. 2/3,. i.e.,.p(K|A).=.2/3..Conditional.probabilities.for.Prospects.B.and.C.are.obtained.similarly..Shown.below.is.a.table.of.con-ditional.probabilities.for.the.Explore.Strategy.


Conditional Probabilitiesp(W|A) = 1/3 p(K|A) = 2/3p(W|B) = 1/2 p(K|B) = 1/2p(W|C) = 2/3 p(K|C) = 1/3

For.the.Exploration.Game.we,.of.course,.have

•. p(A).=..8,.p(B).=..15,.p(C).=..05

where.p(A).denotes.the.probability.of.selecting.Prospect.A,.etc..Given.these.two.lists.of.probabilities.we.can.compute.the.probabilities.of.the.compound.events.AW,.AK,.etc..These.are.given.by.the.formulas:

•. p(AW).=.p(A)*p(W|A).=.(.80)(1/3).=..267.•. p(AK).=..p(A)*p(K|A)..=.(.80)(2/3).=..533.•. p(BW).=.p(B)*p(W|B).=.(.15)(1/2).=..075.•. p(BK).=..p(B)*p(K|B)..=.(.15)(1/2).=..075•. p(CW).=.p(C)*p(W|C).=.(.05)(2/3).=..033•. p(CK).=..p(C)*p(K|C)..=.(.05)(1/3).=..017.

To.interpret.these.results. let.us.consider.a.large.number.of.Exploratory.Plays.in.which.we.employ.the.Explore.Strategy..For.definiteness,.let.us.consider.1,000.such.Plays..With.p(A).=.0.80,.p(B).=.0.15.and.p(C).=.0.05.we.should.expect.in.1,000.Plays.to.be.hit.with.Prospect.A.800.times.and.to.be.presented.with.Prospect.B.150.times..We.should.expect.the.good.fortune.of.encountering.Prospect.C.on.only.50.of.our.1,000.Plays..Out.of.the.800.times.we.draw.a.ball.from.Prospect.A,.on.only.1/3.of.these,.or.267,.should.we.draw.a.White.ball..On.the.remaining.533.draws.a.Black.ball.should.result..Equating.expectation.or.long.run.frequency.with.probability.we.obtain,.as.before,

•. p(AW).=.267/1000.=..267.•. p(AK).=.533/1000..=..533.

The.results.for.B.and.C.shown.above.are.obtained.similarly..Using.the.tabulation.we.conclude.that.on.the.aver-age.in.1,000.Plays.we.will.draw.a.White.ball.from.Prospect.A.267.times,.a.White.ball.from.Prospect.B.75.times.and.a.White.ball.from.Prospect.C.33.times..Thus,.in.1,000.Plays.we.should.expect.to.draw.a.White.ball.267.+.75.+.33.=.375.times..Similarly,.we.should.expect.to.draw.a.Black.ball.625.times;.533.times.from.Prospect.A,.75.times.from.Prospect.B.and.17.times.from.Prospect.C.

In.this.way.we.conclude.that.on.Exploratory.Plays.with.Explore.Strategy.the.probability.of.drawing.a.White.ball,.without.consideration.of.whether.it.came.from.Prospect.A,.B.or.C,.is.375/1000.=..375..We.denote.this.by.p(W),.i.e.,.p(W).=..375..Likewise.p(K).=..625.Observe:

•. ..p(W).=.p(AW).+.p(BW).+.p(CW).=..267.+..075.+..033.=..375•. ..p(K).=..p(AK).+.p(BK).+.p(CK)..=...533.+..075.+..017.=..625

We.are.now.ready.to.answer.our.original.question,.“Given.the.ball.drawn,.what.is.the.probability.it.came.from.Prospect.A?.Prospect.B?.Prospect.C?”.Consider.first.the.375.times.we.drew.a.White.ball..Since.267.times.the.White.ball.came.from.Prospect.A,.75.from.Prospect.B.and.33.from.Prospect.C,.we.can.calculate.that.given.a.White.ball,.the.probability.that.it.came.from:

•. .Prospect.A.is.267/375.=..712.•. .Prospect.B.is.75/375..=..200.•. .Prospect.C.is.33/375...=..088.


Of.the.625.times.a.Black.ball.was.drawn,.on.the.average.533.times.it.came.from.Prospect.A,.75.times.from.Pros-pect.B.and.17.times.from.Prospect.C,.so.we.can.compute.that.given.a.Black.ball,.the.probability.it.came.from:

•. ..Prospect.A.is.533/625.=..853.•. ..Prospect.B.is.75/625..=..120.•. ..Prospect.C.is.17/625..=..027

These.once.again.are.conditional.probabilities,.but.are.inverse.to.the.conditional.probabilities.treated.earlier..Pre-viously,.we.obtained.the.probability.of.drawing.a.White.ball.given.that.the.drawing.was.made.from.Prospect.A..Here,.we.have.the.probability.that.the.drawing.was.made.from.Prospect.A.given.that.the.ball.drawn.was.White..We.denoted.the.former.by.p(W|A);.so.we.denote.the.latter.by.p(A|W),.etc..Summarizing.we.have:

•. p(A|W).=..71..p(A|K).=..85•. p(B|W).=..20..p(B|K).=..12•. p(C|W).=..09..p(C|K).=..03

This.completes.the.example.of.Bayes.Formula..The.calculations.can.be.very.conveniently.carried.out.in.tabular.form.as.shown.in.Table.1..These.quantitative.estimates.of.the.discriminatory.power.of.the.Exploration.Experiment.prove.the.correctness.of.our.intuitive.conclusion.that.a.White.ball.speaks.well.and.a.Black.ball.speaks.poorly.for.our.chances..Since.B.&.C.are.paying.prospects,.before.drawing.a.ball.we.could.say.that.the.chances.for.a.paying.prospect.were.20%..If.we.obtain.a.White.ball.from.the.draw,.the.chances.are.29%.that.we.have.a.paying.prospect,.whereas.if.a.Black.ball.is.drawn.the.chances.are.only.15%.that.we.have.a.paying.prospect.

TABLE I Bayes Formulasapriori Probabilities p(A) = .80 p(B) = .15 p(C) = .05

Experiment Probabilitiesp(W|A) = 1/3 p(K|A) = 2/3 p(W|B) = 1/2 p(K|B) = 1/2 p(W|C) = 2/3 p(K|C) = 1/3

Joint Probabilities p(AW) = p(A)p(W|A) = p(W)p(A|W) = (.80)(1/3) = (.375)(.71) = .267 p(AK) = p(A)p(K|A) = p(K)p(A|K) = (.80)(2/3) = (.625)(.85) = .533 p(BW) = p(B)p(W|B) = p(W)p(B|W) = (.15)(1/2) = (.375)(.20) = .075 p(BK) = p(B)p(K|B) = p(K)p(B|K) = (.15)(1/2) = (.625)(.12) = .075 p(CW) = p(C)p(W|C) = p(W)p(C|W) = (.05)(2/3) = (.375)(.09) = .033 p(CK) = p(C)p(K|C) = p(K)p(C|K) = (.05)(1/3) = (.625)(.03) = .017

aposterior Probabilities p(A|W) = p(AW)/p(W) = p(A)p(W|A)/[p(A)p(W|A)+ p(B)p(W|B)+ p(C)p(W|C)] = .267/.375 = .71 ----------------------------------------------------------------------------------------------------------------------------- p(C|K) = p(CK)/p(K) = p(C)p(K|C)/[p(A)p(K|A)+ p(B)p(K|B)+ p(C)p(K|C)] = .017/.625 = .027

These latter equations are Bayes Formulas


DECISION TREE ANALYSIS OF EXPLORE STRATEGY

Let.us.now.use.a.decision.tree.to.analyze.the.Explore.Strategy..A.partial.decision.tree.for.the.Exploration.Game.with.Explore.Strategy.in.detail.is.shown.in.Figure.1.

The. squares. represent. decision.points.and.the.circles.chance.events..The.branches. in. the. tree.connect.each.deci-sion. point. with. possible. chance. events..Associated. with. each. complete. course.through.the.tree.is.a.payoff.shown.at.the.end.of.the.rightmost.or.terminal.branch.of.the.course..For.example,.if.at.Decision.Box.I,.we.elect.to.Explore,.we.could.draw.a.White.or.Black.ball..If.we.draw.a.White.ball. we. arrive. at. Decision. Box. II;. if. we.draw. a. Black. ball. we. arrive. at. Decision.Box. III.. In. either. case. our. alternatives.are.to.Drill,.Farm.Out.or.Pull.Out..If.we.Pull.Out.we.never.learn.the.true.State.of.Nature,.but.the.payoff.is.zero..If.we.Drill,.we.could.find.A,.B.or.C.and.likewise.for.Farm.Out.

As.shown.above.in.the.Payoff.Tables.and.as.shown.on.the.tree,.each.of.the.lat-ter.Strategies.has.different.payoff.for.A,.B.or.C..To.determine.Expected.Payoff.for.the.Explore.Strategy,.we.start.at.the.right.and.work.backward..First.consider.Decision.Box.II..For.each.decision.alternative.we.compute.expected.payoff..The.probabilities.which.we.use.in.computing.expected.payoff.are.now.the.revised.estimates.corresponding.to.the.draw.of.a.White.ball..For.Décision.Box.II:

•. [EP]D..=.(.71)(-35).+.(.20)(100).+.(.09)(500).=.$40•. [EP]FO.=.(.71)(0).+.(.20)(20).+.(.09)(100).=.$13•. [EP]PO.=.0

These.expected.payoffs.are.shown.on.the.tree.above.the.corresponding.node..Inspection.of.the.expected.payoffs.indicates.that.if.we.reach.Decision.Box.II,.our.decision.should.be.to.Drill..This.is.indicated.on.the.tree.by.x-ing.out.Farm.Out.and.Pull.Out.alternatives.and.recording.[EP]D.=.40.above.Decision.Box.II..

Let.us.now.consider.Decision.Box.III..In.computing.expected.payoff.for.each.decision.alternative.we.now.use.the.probability.estimates.corresponding.to.the.draw.of.a.Black.ball..For.Decision.Box.III:

•. [EP]D..=.(.85)(-35).+.(.12)(100).+.(.03)(500).=.−3•. [EP]FO.=.(.71)(0).+.(.20)(20).+.(.09)(100).=.5•. [EP]PO.=.0

We.see.that.if.a.Black.ball.is.drawn,.we.would.expect.to.lose.money.if.we.Drill.and.if.no.other.alternative.were.available.we.should.Pull.Out..However,.we.can.expect.to.realize.a.small.payout.if.we.elect.to.Farm.Out..This.decision.is.indicated.on.the.tree.by.x-ing.out.Drill.and.Pull.Out.and.recording.payoff.of.5.above.Decision.Box.III.

We.can.now.compute.expected.payoff.for.the.draw.of.a.ball..If.we.reach.this.point.we.expect.to.draw.a.White.ball.37.5%.of.the.time,.following.which.we.would.Drill.with.an.expected.payoff.of.$40..If.we.draw.a.Black.ball.we.would.Farm.Out.with.an.expected.payoff.of.$5;.this.should.occur.about.62.5%.of.the.time..Hence,.the.expected.payoff.for.the.draw.node.is:

I EXPLORE

16 -2

18

II

III

40

5

0

0

A BC .09

40

AB

C

13

AB

CA

B

C

5

- 3

Figure 1 Decision Tree of Explore Strategy


•. [EP]DRAW..=.(.625).(5).+.(.375).(40).=.$18

as.is.shown.on.the.tree..Subtracting.the.$2.which.we.must.pay.to.exercise.the.Explore.Strategy,.we.obtain.the.expected.payoff:

•. [EP]EXPLORE..=.18.−.2.=.$16•. [NG].=.16.–.5.=.$11

Overall Strategy

A.complete.decision.tree.for.the.Exploration.Game.is.shown.in.Figure.2..This.diagram.summarizes.all.relevant.information.about.the.Game..Our.best.strategy.can.be.stated.very.simply:

•. We.should.Explore.on.every.Play.•. If.a.White.ball.is.drawn,.Drill.•. If.a.Black.ball.is.drawn,.Farm.Out.

The.Expected.Payoff.per.Exploratory.Play. is.$16;. the.Expected.Net.Gain.per.Play. is.$11..Use.of. the.Explore.Strategy.increases.our.Expected.Gain.by.$4/Play.($11.vs.$7.for.the.next.best.Strategy,.Drill).over.and.above.the.$2.cost.to.Explore..This.gives.more.than.50%.increase.in.Expected.Net..Because.the.Cost.of.Uncertainty.was.so.large.by.comparison,.this.large.percentage.increase.in.Net.was.obtained.using.a.test.that.is.not.too.discriminatory..The.steps.in.the.analysis.are.encapsulated.in.Table.II.

TABLE II ANALYSIS OF EXPLORE STRATEGYState Of Nature

Prior Probabilities

ConditionalProbabilities

Joint Probabilities

Posterior Probabilities

VALUE DRILL

OPTION

VALUE FARMOUT OPTIONW K W K W K

A .80 1/3 2/3 .267 .533 .71 .85 -35 0B .15 1/2 1/2 .075 .075 .20 .12 100 20

C .05 2/3 1/3 .033 .017 .09 .03 500 100.375 .625 40 -3 [EP]D

13 5 [EP]FO

I EXPLORE

16 -2

18

II

III

40

5

0

0

A BC .09

40

AB

C

13

AB

CA

B

C

5

- 3

Figure 2 Decision Tree of Exploration Game

A BC .09

12

PULL

OUT

0

AB

C

8


EXPLORATION DECISION EXAMPLES

We.will.now.consider. four.cases. to. illustrate.how. statistical.decision. theory,. and. the.graphical. representation.thereof.-.the.decision.tree.-.can.be.used.to.guide.exploration.decisions..These.examples.illustrate.that.the.core.of.the.issue.is.to.estimate.quantitatively.the.probability.of.occurrence.of.each.of.a.set.of.‘States.of.Nature.’

By.the.term.‘States.of.Nature’.we.mean.the.possible.results.of.a.set.of.events.which,.when.known,.will.suffice.to.determine.the.economic.outcome.of.each.decision.alternative..Specifying.what.a.‘State.of.Nature’.consists.of.is.an.essential.first.step.in.the.analysis..In.our.examples,.a.State.of.Nature.is.defined.as.a.reservoir.containing.a.specified.number.of.barrels.of.oil.and.having.a.corresponding.value.in.dollars..

The.set.of.events.may.have.already.occurred,.but.the.corresponding.value.result.is.unknown..This.is.the.case.in.mineral.exploration..Random.physical.events.occurred.eons.ago.which.resulted.in.the.existence.or.nonexistence.of.mineral.deposits.at.each.point.in.Earth..On.the.other.hand,.the.set.of.events.may.not.yet.have.occurred,.and.we.are.estimating.the.outcome.ahead.of.time..This.would.be.the.case,.for.example,.in.marketing.when.estimating.future.sales.of.a.new.or.existing.product..In.either.case,.the.method.is.the.same..

In.most.practical.cases,.an.infinite.number.of.States.of.Nature.are.possible..The.size.of.a.mineral.deposit.may.vary.continuously.from.nothing.to.very.large..Furthermore,.from.the.decision.maker’s.standpoint,.‘size.of.deposit’.is.influenced.by.the.economic.and.physical.environment.of.the.prospect..Ore.below.a.given.grade.or.oil.or.gas.in.a.tight.formation.which.cannot.be.produced.above.a.low.rate.is,.when.evaluating.a.specific.prospect,.the.same.as.no.mineral.at.all..(As.every.mineral.explorer.knows,.when.evaluating.a.region.or.area,.a.“show”.is.not.a.zero.value.result.since.it.helps.to.decide.where.to.look.next..Account.of.this.can.be.taken.using.decision.trees,.but.here.we.limit.ourselves.to.the.simpler.case.of.a.specific.prospect.)

Although.the.analysis.can.be.performed.considering.a.continuous.range.of.reserves,.the.approach.is.much.easier.to.follow.if.only.a.limited.number.of.possible.reservoir.sizes.is.considered..The.latter.approach.is.consistent.with.the.way.most.exploration.decision.makers.tend.to.think.about.prospects..‘Either.the.reservoir.will.be.dry,.small,.middle-sized,.or.big’.constitutes.a.satisfactory.description.of.a.prospect’s.chances.for.most.explorers..In.our.examples,.we.consider.four.possible.States.of.Nature.denoted.E1,.E2,.E3.and.E4.in.Table.III.

The.next.step.in.the.analysis.is.also.made.by.the.decision.maker:.he.must.set.forth.quantitatively,.based.upon.whatever.information.(vast.or.minute).he.has.available,.what.he.thinks.the.chances.are.of.each.possible.State.of.Na-ture.turning.out.to.be.true..These.quantitative.estimates,.when.expressed.as.probabilities,.are.called.the.a-priori.or.prior.probabilities.of.the.States.of.Nature..For.our.examples,.the.prior.probabilities.are.denoted.p1,.p2,.p3.and.p4.in.Table.III.

The Case of No Experiment

At.this.point.we.can.make.a.recommendation.to.the.decision.maker..We.calculate.the.expected.payoff.if.he.pro-ceeds.with.the.exploration..

[EP]PROSPECT.=.(.80)(−1.5).+.(.15)(.8).+.(.04)(8).+.(.01)(30).=.−.46*106.$

Our.recommendation.goes.something.1ike:.“We.cannot.tell.you.exactly.what.will.result.from.this.prospect,.but.we.can.say.that.if.you.were.to.invest.in.a.series.of.prospects.like.this,.over.the.long.pull.you.would.lose.about.a.half.million.per.prospect..We.recommend.you.abandon.the.prospect.because.the.odds.are.against.you.

TABLE III Reserve Size DistributionState of Nature Value of State, $ Prior Probabilities

E1 = Dry Hole − 1.5*106 p1 = .80E2 = 106 Barrels .8*106 p2 = .15

E3 = 5*106 Barrels 8*106 p3 = .04

E4 = 20*106 Barrels 30*106 p4 = .01


However,.we.do.not.have.to.be.entirely.negative.because.we.can.also.say:.“If.you.had.a.series.of.prospects.like.this,.and.you.knew.for.each.one.what.the.true.State.of.Nature.was,.you.would.abandon.the.losers.and.pick.up.the.winners..In.this.case,.your.average.gain.per.prospect.would.be

[EP]P.=.(.80)(0).+.(.15)(.8).+.(.04)(8).+.(.01)(30).=..74*106.$

where.we.use.the.subscript.“P”.to.denote.“perfect.information”.on.each.prospect..Since.the.expected.value.with.your.current.information,.assuming.you.follow.our.recommendation,.is

[EP]PROSPECT.=.0

you.can.afford.to.spend.some.amount.less.than.$740,000.conducting.an.experiment.to.find.out.what.the.State.of.Na-ture.really.is.”.

The.quantity.[EP]P.is.called.“the.value.of.perfect.information.”.It.is.also.called.“the.cost.of.uncertainty”.since.it.is.the.average.amount.of.money.we.do.not.make.that.we.could.make.if.we.had.perfect.information.

The Case of One Experiment

Assume.that.at.this.point.the.decision.maker.asks.us.to.help.him.decide.if.he.should.run.a.seismic.test.on.the.pros-pect.at.a.cost.of.$100,000..To.analyze.this.problem.we.must.know.what.the.possible.outcomes.of.the.test.are,.and.what.the.probability.of.observing.each.test.outcome.is,.given.that.the.State.of.Nature.is.E1,.E2,.E3.or.E4..These.probabilities.are.called.conditional.probabilities.because.their.value.depends.upon,.or.is.conditioned.by,.what.the.State.of.Nature.is..Assume.that.an.experienced.geophysicist.familiar.with.the.area.tells.us.that.the.possible.outcomes.of.the.seismic.test.can.be.characterized.as.falling.into.one.of.four.categories:

•. F1.=.Low.Response•. F2.=.Medium.Response•. F3.=.Large.Response•. F4.=.Very.Large.Response

We.then.obtain.from.our.expert.geophysicist.the.conditional.probability.table.for.the.seismic.test.shown.in.Table.IV.

An.entry.in.Table.IV.is.the.probability.that.the.response.is.Fi.given.that.the.State.of.Nature.is.Ej,.denoted.p(Fi|Ej)..Thus,.the.kind.of.answer.being.given.by.our.geophysicist.is.“If.the.prospect.is.dry,.the.probability.of.a.low.response.is..50.”.or.“If.the.prospect.contains.a.middle-sized.field,.then.the.probability.of.a.high.response.is..25.”.This.result.could.be.derived.from.historical.data.in.the.area.by

1.. Assigning.all.similar.prospects.on.which.seismic.tests.were.run.into.one.of.four.categories:.dry,.small.reservoir,.middle-sized.reservoir,.large.reservoir;

2.. Determining.within.each.category.the.fraction.of.prospects.which.yielded.low,.medium,.high.and.very.high.responses.

This.latter.view.brings.out.clearly.that.in.any.row.in.Table.IV,.the.entries.sum.to.1.0;.for.each.State.of.Nature.some.response.will.be.observed.

TABLE IV Conditional Probabilities for Seismic Test, p(Fi|Ej)

State of Nature Test ResponseF1 F2 F3 F4

E1 .55 .35 .07 .03E2 .30 .40 .20 .10E3 .10 .40 .25 .25E4 .05 .30 .30 .35


Since.we.are.obtaining.conditional.probabilities.before.performing.the.test,.we.are.obviously.not.asking.the.geo-physicist.the.“interpretive”.question,.“What.is.the.probability.that.the.prospect.contains.a.reservoir.of.a.given.size,.given.the.results.of.the.test?”.This.conditional.probability,.denoted.p(Ej|Fi),.is.determined.from.the.analysis.as.we.will.see.momentarily..We.call.p(Ej|Fi).the.a-posteriori.or.posterior.probability..It.is.the.probability.we.will.assign.to.each.State.of.Nature.after.we.have.performed.the.test..However,.we.calculate.the.posterior.probabilities.for.each.possible.test.result.before.performing.the.test,.and.use.these.probabilities.to.determine.if.performing.the.test.is.a.good.bet..The.analysis.is.tabulated.in.Table.V.

The.joint.probabilities.give.the.likelihood.of.the.simultaneous.occurrence.of.a.specified.test.result.and.a.specified.State.of.Nature..Thus.we.have,.for.example,

•. p(F2E2).=.p(E2).p(F2|E2).=.(.15)*(.40).=..06

which.means.that.given.a.series.of.similar.prospects,.we.would.expect.that.for.6%.of.the.prospects.we.would.ob-serve.a.medium.response,.and,.if.developed,.would.find.a.small.reservoir..The.16.joint.probabilities.sum.to.1.0.since.one.and.only.one.combination.can.occur,.and.one.must.occur.for.each.prospect.

The.sum.of.the.joint.probabilities.for.a.specified.test.result,.labeled.p(Fi),.gives.the.probability.of.observing.the.specified.test.result..For.example,.in.testing.a.series.of.such.prospects.we.would.expect.to.observe.a.very.large.response.a.little.more.than.5%.of.the.time:

•. p(F4).=..0525.The.posterior.probabilities.for.each.test.result.are.obtained.from.the.relation

•. p(Ej|Fi).=.p(FiEj)./.p(Fi)

For.example,

•. p(E3|F4).=..01/.0525.=..1905which.is.interpreted.to.mean.that.if.we.observe.a.very.large.response,.the.chances.are.about.19%.or.a.little.over.1.in.6.that.the.prospect.contains.a.middle-sized.reservoir.

The.posterior.probabilities.are.used.to.determine.the.return.we.would.expect.for.each.test.result..These.expected.payoffs.are.labeled.[EP]F.in.Table.V..Thus,.since.[EP]1.=.−1.18,.if.we.run.a.seismic.test.and.obtain.a.low.response,.we.would.expect.to.lose.an.average.of.over.a.million.dollars.if.we.then.developed.the.prospect..This.average.return.is.ob-tained.for.those.prospects.which.give.a.low.response.

Hence,.we.can.at.this.point.recommend.a.decision.rule:.If.the.seismic.test.gives.a.low.(F1).or.medium.response.(F2),.abandon.the.prospect.in.which.case.the.return.will.be.0.(excluding.the.cost.of.the.seismic.test)..If.the.seismic.test.gives.a.medium.(F3).or.a.very.high.(F4).response,.develop.the.prospect.and.obtain.an.expected.return,.respectively.of.$1,100,000.or.$3,070,000..

TABLE V Analysis Of Seismic Test

Stat

e of

Nat

ure

Prio

r p(E

j) Conditional

Probability

p(Fi|Ej)

Joint

Probability

p(FiEj)

Posterior

Probability

p(Ej|Fi)

Valu

e

F1 F2 F3 F4 F1 F2 F3 F4 F1 F2 F3 F4 $e6E1 .80 .55 .35 .07 .03 .44 .28 .056 .024 .8989 .7799 .5657 .4571 -1.5E2 .15 .30 .40 .20 .10 .045 .06 .03 .015 .0919 .1672 .3030 .2857 .8E3 .04 .10 .40 .25 .25 .004 .016 .01 .01 .0082 .0446 .1010 .1905 8E4 .01 .05 .30 .30 .35 .0005 .003 .003 .0035 .0010 .0083 .0303 .0667 30

p(Fi) .4895 .359 .099 .0525 -1.18 -.43 1.11 3.07 [EP]F


We.are.now.in.position.to.advise.the.decision-maker.on.whether.or.not.he.should.undertake.the.seismic.test..The.essential.data.for.formulating.our.recommendation.are.tabulated.in.Table.VI.

The.expected.net.return.given.that.we.run.the.seismic.test.and.then.follow.our.decision.rule.is:

•. [NG].=.(.4895)(0).+.(.359)(0).+.(.099)(1.10).+.(.0525)(3.07).-..100.=.$0.171e6

Hence,.our.recommendation.to.the.decision-maker.is:.“Run.the.seismic.test..If.response.is.low.or.medium,.aban-don..If.response.is.high.or.very.high,.develop..In.the.long.run,.you.will.average.a.net.return.of.$171.,000.”.A.decision.tree.for.this.analysis.is.shown.in.Figure.3.

The Case of Two Alternative Tests

Suppose.that.at.this.point.the.decision-maker.says.that.instead.of.the.seismic.test,.he.could.run.a.gravity.survey.of.the.prospect.at.a.cost.of.$70,000..Can.we.help.him.decide.which.of.these.tests.to.conduct.assuming.that.only.one.test.is.to.be.made?

To.carry.through.the.analysis.for.the.gravity.test,.we.return.to.our.expert.geophysicist..In.this.case.he.can.only.distinguish.three.possible.responses,.low,.medium.and.high.which.we.elect.to.call.G1,.G2.and.G3,.respectively..He.provides.us.with.the.following.conditional.probability.table.for.the.gravity.test.

TABLE VI Seismic Decision AnalysisTest

ResultProbability

p(Fi)Expected

Return, [EP]I, $Cost of

Seismic Test, $

F1 .4895 0 100,000F2 .359 0 100,000F3 .099 1,100,000 100,000F4 .0525 3,070,000 100,000

1

171

2

271

0

Figure 3 Decision Tree of Seismic Test

0

2

2

2

ABANDON

0

0

0

1100

3070

0

0

1100

3070

Decision 1

Decision 2


The.analysis.of.the.gravity.test.is.shown.in.Table.VIII..

From.this.Table.we.obtain.the.following.data.for.formulating.our.recommendation.re.the.gravity.test.

The.expected.net.return.given.we.run.the.gravity.test.and.then.follow.the.decision.rule

is:

•. [EP]G..=.(.6475)(0).+.(.290)(.414).+.(.0625)(1..424).−..07.=.0.139.MM$

Our.recommendation.to.the.decision-maker.runs.like.this:.

•. If.you.run.the.seismic.test,.you.will.average.a.return.of.$171,000.for.an.outlay.of.$100,000,.a.yield.of.$1.71.per.dollar.risked..If.you.run.the.gravity.test,.you.will.average.a.return.of.$139,000.for.an.outlay.of.$70,000,.a.yield.of.$1.99.per.dollar.risked..We.recommend.that.you.carry.out.one.of.the.tests,.but.you.will.have.to.decide.if.you.want.to.go.for.the.higher.return.or.the.higher.yield..

TABLE VII Conditional Probabilities for Gravity Test, p(Gi|Ej)State of Nature Test Response

G1 G2 G3E1 .70 .25 .05E2 .50 .40 .10E3 .30 .60 .10E4 .05 .60 .35

TABLE VIII Analysis Of Gravity Test

Stat

e of

N

atur

e

Prior p[Ej]

Conditional Probability,

p[Gi|Ej]

Joint Probability

p[GiEj]

Posterior Probability

p[Ej|Gi]

Value

G1 G2 G3 G1 G2 G3 G1 G2 G3 $e6E1 .80 .70 .25 .05 .560 .20 .040 .8650 .6897 .640 -1.5E2 .15 .50 .40 .10 .075 .06 .015 .1158 .2069 .240 .8E3 .04 .30 .60 .10 .012 .024 .004 .0185 .0827 .064 8E4 .01 .05 .60 .35 .0005 .006 .0035 .0007 .0207 .056 30

p[Gi] .6475 .290 .0625 -1.31 .414 1.424 [EP]G

TABLE IX Gravity Decision AnalysisTest

ResultProbability p(Gi) Expected

Return, [EP]i, $Cost of

Gravity Test, $G1 .6475 0 70,000G2 .290 .414,000 70,000G3 .0625 1,424,000 70,000

Test Result ActionG1 AbandonG2 DevelopG3 Develop


The.decision.tree.for.the.gravity.test.is.shown.in.Figure.4.

The Case of Sequential Tests

Suppose.that.at.this.point.the.decision-maker.says:.“This.is.very.interesting.indeed!.Perhaps.you.can.help.me.with.yet.another.decision..Suppose.I.first.run.the.gravity.test..Then,.depending.upon.the.outcome,.I.may.or.may.not.run.the.seismic.test.before.making.a.final.decision..Can.your.analysis.help.me.here?”.Our.answer.is:

•. “Yes,.and.this.is.how.we.proceed..We.first.carry.through.the.analysis.for.the.gravity.test.as.we.have.just.done..Then.for.each.possible.outcome.of.the.gravity.test.we.carry.through.an.analysis.of.the.seismic.test.using.the.posterior.probabilities.from.the.gravity.test.as.prior.probabilities.in.analyzing.the.seismic.test.”

The.three.analyses.for.G1,.G2.and.G3,.are.shown.in.Tables.X,.XI.and.XII,.respectively..Figure.5.is.a.decision.tree.portraying.the.results.of.the.analysis..Looking.at.Decision.2.in.Figure.5.we.see.the.following:

1.. Low.gravity,.G1.–.In.this.case,.it.would.pay.to.develop.the.property.only.if.a.very.high.response.to.the.seismic.test.is.observed,.a.response.we.would.expect.to.see.only.about.5%.of.the.time..The.expected.payoff.from.the.seismic.test,.$16,000,. is.not.enough.to.justify.conducting.the.test..Hence,.with.a. low.gravity.response,.the.prospect.should.be.abandoned.

2.. Medium.gravity,.G2.–.In.this.case,.it.would.pay.to.develop.the.property.given.medium,.high.and.very.high.seis-mic.responses..We.would.expect.to.observe.one.of.these.three.responses.about.55%.of.the.time..The.expected.net.return.after.the.seismic.test.is.$731,000..Hence,.with.a.medium.gravity.response.the.seismic.test.should.be.run,.and.the.prospect.developed.if.seismic.response.is.medium,.high.or.very.high.

3.. High.gravity,.G3.–.The.recommended.actions.in.this.case.are.identical.to.medium.gravity..The.expected.net.return.is.higher,.namely.$1,659,000,.because.we.are.testing.more.favorable.prospects.

4.. Looking.at.the.gravity.test.node,.we.see.that.about.65%.of.the.time.we.will.obtain.a.low.gravity.response.and.abandon.the.prospect,. for.a.net.return.of.zero..About.35%.of.the.time.we.will.obtain.one.of.the.favorable.responses,.G2.or.G3..In.these.cases.we.will.proceed.with.the.seismic.test.as.outlined.under.2.and.3..The.payoff.averaged.over.the.three.possible.outcomes.G1,.G2.&.G3.is.$316,000.per.prospect,.which,.after.deducting.cost.of.the.gravity.test,.gives.a.net.return.of.$246,000.per.prospect.

5.. Since.the.expected.net.return.from.the.gravity.test.is.positive,.we.recommend.carrying.out.the.gravity.test.in.lieu.of.abandoning.the.property.at.Decision.1.

1

139

2

209

Figure 4 Decision Tree of Gravity Test

0

2

2

ABANDON

0

0

0

1424

0

414

1424

Decision 1

Decision 2

1

139

2

209

Figure 4 Decision Tree of Gravity Test

0

2

2

ABANDON

0

0

0

1424

0

414

1424

Decision 1

Decision 2


TABLE X Analysis Of Seismic Test – Low Gravity Response

Stat

e of

Nat

ure

Prio

r p(E

j) Conditional Probability

p(Fi|Ej)

Joint Probability

p(FiEj)


p(Ej|Fi) Valu

e

F1 F2 F3 F4 F1 F2 F3 F4 F1 F2 F3 F4 $e6E1 .8685 .55 .35 .07 .03 .4757 .3027 .0606 .0260 .9286 .8493 .6840 .6104 -1.5E2 .1158 .30 .40 .20 .10 .0347 .0462 .0231 .0116 .0677 .1296 .2607 .2723 .8E3 .0185 .10 .40 .25 .25 .0019 .0073 .0047 .0047 .0036 .0205 .0530 .1103 8E4 .0007 .05 .30 .30 .35 4e-5 .00024 .00024 .00028 .0001 .0006 .0023 .0070 30

p(Fi) .5123 .3564 .0886 .0427 -1.31 -.985 -.312 .383 [EP]F

TABLE XI Analysis Of Seismic Test – Medium Gravity Response

Stat

e of

Nat

ure

Prio

r p(E


p(Fi|Ej)

Joint Probability

p(FiEj)


p(Ej|Fi) Valu

e


p(Fi) .4507 .3635 .1166 .0692 -.939 .425 2.678 5.264 [EP]F

1

NG=246

2

Figure 5 Decision Tree of Sequential Gravity & Seismic Tests

0

2

2

0

831

0

414

731

Decision 1

Decision 23

3

3

3

0 p[F2] = .356

Low

Med

High

ABANDON

ABANDON

ABANDON

0

0

0-312

383

16

3

3

3

3

0

0ABANDON

0ABANDON

0ABANDON

0

3

3

3

3

0

0ABANDON

0ABANDON

0ABANDON

14240

1759

1659

316

Decision 3


ReferencesSchlaifer, R. Probability & Statistics for Business Decisions. McGraw Hill, NY (1959).

Chernoff, H. & Moses. L.E. Elementary Decision Theory. Wiley, NY (1959).

Hadley, G. Introduction to Probability and Statistical Decision Theory. Holden-Day, Inc., San Francisco (1967).

Magee, John F. “Decision Trees for Decision Making.” Harvard Business Review (Jul-Aug 1964).

Magee, John F. “How to Use Decision Trees in Capital Investment.” Harvard Business Review (Sept-Oct 1964) 79-96.

Hespos, R. F., & P.A. Strassman. “Stochastic Decision Trees for the Analysis of Investment Decisions.” Management Science (Aug, 1965) 244-259.

Grayson, C.J., Jr. “Decisions Under Uncertainty - Drilling Decisions by Oil and Gas Operators.” Harvard Business School, Division of Research, Boston (1960).

Kaufman, G.M. Statistical Decision & Related Techniques in Oil and Gas Exploration. Prentice-Hall, Englewood Cliffs, N. J. (1963).

Bratvold, R.B. & S. Begg. “Making Good Decisions.” SPE (2010).

BiographyDr. E.L. Dougherty, founder and President of Maraco, Inc. develops and applies software to analyze and optimize oil and gas develop-ment and operation. In addition to Maraco, he founded D2 Computing & Scientific Software.

He has consulted in Australia (Santos), The Netherlands (EBN, TOTAL), Indonesia (TOTAL), Saudi Arabia (Aramco), Kuwait (Kuwait Oil), Libya (Oasis) & Iran (Consortium).

He is Emeritus Professor, USC, (24 years Petroleum and Chemical Engineering). Industrial experience includes Chevron, Esso, Dow Chemical and Union Carbide.

A Distinguished Member of SPE, receiving its J.J. Arps Award, Ferguson Medal & Regional Service Award (Los Angeles), he has coauthored over 50 technical papers.

His BS is from University of Kansas where he was recently inducted into its Chemical/Petroleum Engineering Hall of Fame. His MS and PhD in Chemical Engineering are from University of Illinois.

SPE recently conferred the distinction of Legion of Honor Member to the Professor for career-long service to the petroleum industry and the petroleum engineering profession and for more than 50 years continuous membership in the Society of Petroleum Engineers.

TABLE XII Analysis Of Seismic Test – High Gravity ResponseSt

ate

of N

atur

e

Prio

r p(E


p(Fi|Ej)

Joint Probability

p(FiEj)


p(Ej|Fi) Valu

e


p(Fi) .4332 .3624 .1256 .0788 -.776 1.242 4.801 8.963 [EP]F


Review of SPE 116731

Exponential vs. Hyperbolic Decline in Tight Gas Sands: Understanding the Origin and Implications for Reserve Estimates Using Arps’ Decline Curves

T. Scott Hickman

Abstract of Original PaperWhen tight gas sand reserves are assessed using the Arps’ rate-time equations, the decline behavior is typically

defined in terms of the Arps’ decline exponent, b. The original Arps’ paper indicated that the b-exponent should lie between 0 and 1.0 on a semilog plot. However, in practice we often observe values much greater than 1.0, especially prior to the onset of true boundary-dominated flow. Unfortunately, the correct b-exponent is difficult (if not impossible) to identify during the early decline period — and (obviously) the selection of the wrong b-exponent will have a tremendous impact on reserve estimates, particularly when the b-exponent estimate is too high.

As an exercise to evaluate the b-exponent as a continuous function of time, we have used synthetic and field production profiles. We then compare the computed b-exponent trend graphically to assess the “hyperbolic” nature of each case (recall that the b-exponent should be constant for a given hyperbolic rate decline). The field data cases used in this study were selected from a tight gas reservoir that has been previously evaluated on a per well basis using the production model based on the elliptical flow concept. These cases indicate that only portions of the production history are matched by the hyperbolic rate decline relation — suggesting that using the hyperbolic relation by itself may not be appropriate for reserves extrapolations in tight gas reservoirs, or at least that great care must be used in creating production forecasts based on the hyperbolic rate decline relation.

In addition to the hyperbolic rate decline relation we have also developed and employed a new “power law loss-ratio” rate relation that has more generality than the hyperbolic rate decline relation. This new model tends to match production rate functions much better than the hyperbolic rate decline relation for tight gas and shale gas applications, but we must stress that at this time, the “power law exponential decline” rate relation is empirically derived from only tight gas/shale gas performance cases. We have applied the new model as well as the hyperbolic rate model to two synthetic (simulated) and field (tight gas well) cases for production forecast.

Furthermore, the results of our synthetic performance cases do suggest that layered reservoir behavior can be accurately represented by the hyperbolic rate decline relation. Unfortunately, as other studies have shown, multilayer reservoir performance can be extremely difficult to generalize — particularly when layers in transient and boundary-dominated flow are in communication. Hyperbolic rate decline relation might be considered as an acceptable mecha-nism for estimating reserves in tight gas/shale gas systems, however we urge extreme caution as the hyperbolic relation must be constrained to a relative small duration production forecast.


REVIEW DISCUSSION

Background

The. earliest. literature. on. decline. curve. analysis.goes.back.to.Arnold.in.1923..Arps’.decline.relationships.(1945).were.derived.empirically.from.observation...The.exponential.case.(loss.ratio,.D.=.constant.and.decline.exponential,.b.=.1).can.be.derived.theoretically.for.con-stant-compressibility.fluid.flowing.in.a.boundary-domi-nated.closed.reservoir.with.constant.wellbore.pressure...There.has.never.been.agreement.on.reservoir.conditions.that. cause. hyperbolic. decline.. Fetkovich. thought. that.‘high’. b. values. (0.5-1.0). occurred. in. multi-layer. reser-voirs..The.modern.low.permeability,.extremely.hetero-geneous.gas.producing.formations.with.linear.flow.into.fractures. dominating. the. early. performance. and. tran-sient,. transition. and. boundary-dominated. (B-D). flow.regimes. existing. simultaneously. are. impossible. to. gen-eralize..The.Arps’.hyperbolic.relationship.will.often.fit.this.data.with.b>1,.but.if.not.constrained.in.some.man-ner.results.in.very.optimistic.reserve.projections..Papers.published. to. caution. against. the. applying. hyperbolic.relationship.to.non-hyperbolic.data.(b.≠.constant).usu-ally.suggested.another.more.rigorous.empirically.derived.relationship...SPE.116731.is.a.fairly.recent.addition.to.this.genre..

Objective

The.authors.set.out.to.demonstrate.that.a.conser-vative.hyperbolic. relationship. (b=1).only.fit. a. limited.portion.of.the.performance.data.from.tight.gas/shale.gas.wells.and.projects.excessively.high.reserves.

The. second. objective. was. to. validate. a. decline.relationship. where. D. is. approximated. by. a. decaying.power.law.function.with.constant.behavior.at.large.time.(D∞=0)....This.Power.Law.Loss.Ratio.(PLLR).relation-ship.was.anticipated.to.be.flexible.enough.to.give.a.rea-sonable. match. with. the. transient,. transition. and. B-D.flow.data.and.give.better.reserve.projections.

Approach

Five.data.sets. for.tight.gas.wells.were.used.in.this.study.. .Two.reservoir. simulation.models.were.prepared.including. a. three-layer. model. with. a. very. low. perme-ability. layer.where. transient.flow.would.exist. for. large.

times.. The. other. model. was. single. layer. with. a. finite.conductivity.vertical.fracture...The.remaining.three.data.sets.were.field.performance.data.for.two.small.waterfrac.gas.wells.(SWF1.&.2).and.a.large.waterfrac.well.(LWF)...This.field.data.has.been.analyzed.using.integrated.pro-duction.analysis.in.another.study.(SPE.114947).so.the.EURs.have.been.established.

A.log-log.“q-D-b”.v.time.plot.was.utilized.that.pro-vided.a.unique.diagnostic.insight.as.to.whether.the.data.was. “hyperbolic”. in. nature.. The. flow. rate. (q). and. D-parameter.trend.from.the.hyperbolic.relationship.(b=1).was.curve.fitted.through.the.five.cases..The.q,.D-param-eter.and.b-parameter.trend.from.the.PLLR.relationship.were.also.curve.fitted.through.the.data.sets..

Results

As.anticipated.all.five.data.cases.show.that.that.the.b-parameter.is.not.constant.as.the.flow.regime.advance.from.transient.to.transition.to.B-D...Not.surprisingly.the.hyperbolic.relationship.(b=1).is.only.weakly.correlated.if.at.all.to.the.early.time.performance.and.doesn’t.give.a.reasonable.match.except.in.the.B-D.flow.region...In.all.cases.the.hyperbolic.projection.of.EUR.is.at.least.3.times.too.high,.indicating.that.b<1.at.large.times.

In.contrast.the.new.PLLR.relationship.gives.a.fair.to.good.curve.match.of.q.and. the.D-parameter. for.all.three.flow.regimes...All.the.data.sets.show.some.oscilla-tion.in.the.b-parameter.as.it.advances.through.the.flow.regimes.that.is.not.matched.by.the.power.law.relation-ship...However.the.power.law.does.provide.a.fair.to.good.match.of. the.b-parameter.general. trend. from.the.data.sets...In.spite.of.better.performance.matching,.the.PLLR,.because.large.time.behavior.is.controlled.by.D∞=0,.gives.aggressive...reserve.projections.

By. adjusting. the.D∞. -term. to.obtain. a.best. fit. of.the.D-parameter.trend.(D∞≠.0).a.lower.bound.for.the.reserve. estimate. is. provided. with. out. affecting. the. fit.through.the.performance.data.. .The.adjusted.relation-ship.gives.reserve.estimates.that.closely.match.the.estab-lished.reserves.as.shown.on.the.following.page:


Conclusions

1.. A. log-log. “q-D-b”. v. time. plot. was. developed.that.provides.diagnostic.insight.into.the.hyper-bolic.nature.of.the.data.

2.. An. investigation. of. hyperbolic. decline. rela-tionship.(b=0).in.relation.to.synthetic.and.field.data. shows.poor.correlation.except. in.bound-ary-dominated.flow.and.gives.excessive.reserve.projections.

3.. The.ability.of.the.Power.Law.Loss.Ratio.rela-tionship.to.match.the.data.performance.trend.across.all.three.flow.regime.was.validated.

4.. Calibration. of. the. D∞. by. best. fit. of. the. D-parameter. data. resulted. in. accurate. reserve.projections.

Remarks

The. Sept-Nov. 2011. issue. of. Reservoir. Solutions.published.by.Ryder.Scott.contains.an.excellent.overview.of.the.current.state.of.well.decline.analysis.in.the.era.of.early.time.fracture-dominated.transient.flow.within.the.context.of.the.SEC.concept.of.reasonable certainty.

Comparison of EUR Projections

SPE 116731

-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐EUR (BSCF)-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐-‐

MODEL SIMULATED DATA FIELD DATA

MULTI-‐LAYER SINGLE LAYER SWF1 SWF2 LWF

Advanced Analysis 100.0 2.6 5.4 2.3 3.0

Power Law (D ∞ ≠ 0) 99.6 2.5 5.4 2.3 3.0

Power Law (D ∞ = 0) 230.8 13.9 6.1 3.8 7.4

Hyperbolic (b=1) 3030.0 10.6 26.0 10.0 13.1


Review of SPE 144489-PA

Credit Ratings and Cash-Flow Analysis of Oil and Gas Companies: Competitive Disadvantage in Financing Costs for Smaller Companies in Tight Capital Markets John Davis

SummaryThe author states: “That article concisely presents the results of a cash-flow analysis and the impact of recent cap-

ital-market dynamics on the relative competitive position of bigger [oil majors, public/private-partnership (PPP) oils, and independents] and smaller (unconventionals, small caps, and juniors) oil and gas companies. Upstream energy compa-nies now compete not only for preferred access to the best new hydrocarbon resources but also for credit from capital markets. Although credit ratings of individual companies themselves have mostly remained unaffected by the Great Recession (in 2008 - 2009), the cost of credit and spread tied to the ratings has climbed steeply for most of them. The annual cash-flow statements of 24 representative companies were analyzed over a 5-year performance period (2004 - 2008). The companies involved come from all traditional peer groups: juniors (five), small caps (three), unconvention-als (three), independents (three), PPP oils (four) and majors (six). Oil companies generate cash from the following two main sources of funds: (1) net cash generated from operations and (2) net cash raised from financing activities. In-depth analysis of the cash-flow metrics for each market capitalization category revealed that the operational income of smaller oil and gas companies commonly is insufficient to fund new capital-expenditure (CAPEX) projects. Such companies must resort to external financing resources (debt and equity financing), as follows from this study. The competition for financial resources has heightened since the onset of the recession, and companies need to be entrepreneurial in their search for capital. The pattern that emerged provides a crisp explanation on what drives asset swaps and acquisitions in times of tight capital. This analysis provides useful insight for oil executives as to the range of options and possible outcomes of finance strategies.”

SPEE Comments

The.author.has.a.sense.of.humor..At.the.start.he.says.the.paper.“concisely.presents…”.and.then.he.presents.at.great.length..For.what?..To.state.the.obvious?..Of.course.large.oil.companies.have.better.credit.ratings.and.strategic.flexibility. than. smaller.ones..And. the. strategic. recommendations.offered.are.what. the.companies.already.do..This.is.nothing.new..The.paper.has.some.gee.whiz.value.for.the.information.it.has.pulled.together.but.lacks.new.insights.and.recommendations..Figure.1,.Portfolio.Management.Process,.was.an.interesting.display.of.the.process..The.author.should.define.gearing.ratio.since.the.term.is.not.used.in.the.U.S..It.may.be.implied.in.the.discussion..The.information.on.credit.ratings.and.effect.of.disaster.on.BP’s.credit.is.all.interesting,.but.does.not.lead.to.any.new.strategic.actions..The.normalization.ratios.used.are.not.intuitive..It.might.be.better.to.use.reserves.as.the.normalizing.factor..Finally,.the.paper.would.be.better.if.it.were.about.a.third.the.current.length.


ENGINEERING AND GEOPHYSICS

Assessment of Undiscovered Oil and Gas Resources of the Devonian Marcellus Shale of the Appalachian Basin Province, 2011James L. Coleman, Robert C. Milici, Troy A. Cook, Ronald R. Charpentier, Mark Kirschbaum, Timothy R. Klett, Richard M. Pollastro, and Christopher J. Schenk

Using.a.geology-based.assessment.methodology,.the.U.S..Geological.Survey.(USGS).estimated.a.mean.undis-covered.natural.gas.resource.of.84,198.billion.cubic.feet.and.a.mean.undiscovered.natural.gas.liquids.resource.of.3,379.million.barrels.in.the.Devonian.Marcellus.Shale.within.the.Appalachian.Basin.Province..All.this.resource.occurs.in.continuous.accumulations..

In.2011,.the.USGS.completed.an.assessment.of.the.undiscovered.oil.and.gas.potential.of.the.Devonian.Marcel-lus.Shale.within.the.Appalachian.Basin.Province.of.the.eastern.United.States..The.Appalachian.Basin.Province.in-cludes.parts.of.Alabama,.Georgia,.Kentucky,.Maryland,.New.York,.Ohio,.Pennsylvania,.Tennessee,.Virginia,.and.West.Virginia..The.assessment.of.the.Marcellus.Shale.is.based.on.the.geologic.elements.of.this.formation’s.total.petroleum.system.(TPS).as.recognized.in.the.Appalachian.Basin.Province..These.elements.incorporate.the.characteristics.of.the.TPS.as.a.petroleum.source.rock.(source.rock.richness,.thermal.maturation,.petroleum.generation,.and.migration).as.well.as.a.reservoir.rock.(stratigraphic.position.and.content.and.petrophysical.properties)..

Together,. these.components.confirm.the.Marcellus.Shale.as.a.continuous.petroleum.accumulation..Using.this.geologic.framework,.the.USGS.defined.one.TPS.and.three.assessment.units.(AUs).within.this.TPS.and.quantitatively.estimated.the.undiscovered.oil.and.gas.resources.within.the.three.AUs..For.the.purposes.of.this.assessment,.the.Mar-cellus.Shale.is.considered.to.be.that.Middle.Devonian.interval.that.consists.primarily.of.shale.and.lesser.amounts.of.bentonite,.limestone,.and.siltstone.occurring.between.the.underlying.Middle.Devonian.Onondaga.Limestone.(or.its.stratigraphic.equivalents,.the.Needmore.Shale.and.Huntersville.Chert).and.the.overlying.Middle.Devonian.Mahan-tango.Formation.(or.its.stratigraphic.equivalents,.the.upper.Millboro.Shale.and.middle.Hamilton.Group).

Suggested citation: Coleman, J.L. Milici, R.C. Cook, T.A., Charpentier, R.R., Kirschbaum, Mark, Klett, T.R., Pollastro, R.M., and Schenk, C.J., 2011, Assessment of undiscovered oil and gas resources of the Devonian Marcellus Shale of the Appalachian Basin Province, 2011: U.S. Geological Survey Fact Sheet 2011–3092, 2 p., available at http://pubs.usgs.gov/fs/2011/3092/.

An Overview of Some Key Factors Controlling Well Productivity in Core Areas of the Appalachian Basin Marcellus Shale Play* W. A. Zagorski, Douglas C. Bowman, Martin Emery, and Gregory R. Wrightstone, Search and Discovery Article #110147 (2011)

*Adapted from oral presentation at Session, U.S. Active and Emerging Plays--Paleozoic Basins and Cretaceous of Rockies, AAPG Annual Convention and Exhibition, Houston, Texas, USA, April 10-13, 2011

The.Middle.Devonian.Marcellus.Shale.is.one.of.the.premier.gas.shale.plays.of.North.America.in.terms.of.total.gas.resource,.extent,.production.rates,.and.economic.potential..The.organic-rich.shale.of.the.Marcellus.was.deposited.in.a.foreland.basin.setting.that.was.sediment.starved.and.allowed.for.accumulation.and.preservation.of.the.organic.material..The.Marcellus.Shale.Formation.is.positioned.in.the.lower.portion.of.the.Hamilton.Group,.which.is.bounded.above.by.

Reference and Source ArticlesThe following references are offered as being of possible interest to SPEE Members


the.Middle.Devonian.Tully.Limestone.and.below.by.the.Lower.Devonian.Onondaga.Limestone..The.Upper.and.Lower.Marcellus.Shale.are.divided.by.the.Cherry.Valley/Purcell.Limestone..

Two.major.cores.areas.have.developed.in.the.500-mi.long,.southwest-northeast.trending.Marcellus.Shale.play.fairway..The.two.core.areas.display.unique.combinations.of.controlling.geologic.factors..Thickness,.organic.content,.intra-organic.matter.porosity,.over-pressure,.and.maturity.are.some.of.the.key.Marcellus.gas.productivity.factors..The.Marcellus. thickens. from.approximately.100. ft.average.gross. thickness. in.southwestern.Pennsylvania.to.over.300. ft.average.gross.thickness.in.north-central.Pennsylvania..

High.organic.content.and.the.associated.porosity.and.greater.overpressure.are.key.gas.productivity. factors. for.the.Marcellus.Shale..Organic.content.of.the.Marcellus.can.be.inferred.from.GR-.and.density-log.data.calibrated.with.core.measurements..The.high.organic.content.facies.of.the.Marcellus.is.the.key.reservoir.rock.in.terms.of.hydrocarbon.storage..The.organic.content.varies.from.approximately.2.to.15.wt%.average.in.southwestern.Pennsylvania.to.approxi-mately.4.to.10.wt%.average.in.north-central.Pennsylvania.and.can.be.related.to.greater.organic.maturity.to.the.north..The.over-pressure.mechanism.is.conversion.of.liquid.hydrocarbons.to.gas.with.increased.organic.maturity..

The.key.pore.type.in.the.Marcellus.Shale.is.intra-organic.porosity.identified.by.FIB/SEM.technology..The.intra-organic.porosity.displays.a.degree.of.connectivity.and.is.probably.responsible.for.a.significant.portion.of.the.Marcellus.Shale.productivity.and.gas.in-place..Intra-organic.pores.range.from.<10.to.200+.nm..Other.pore.types.include.inter-particulate,.inter-crystalline,.and.microcracks.

..

Introduction to Aspects of Reserve GrowthJames W. Schmoker, Thaddeus S. Dyman, and Mahendra Verma in.“Geologic,.Engineering,.and.Assessment.Studies.of.Reserve.Growth,”.U.S. Geological Survey Bulletin.2172–A,.pubs.USGS.gov/bul/b2172-A/

Overview

. Since.the.early.1970s,.potential.petroleum-supply.crises.have.been.related.to.political.events.that.disrupt.the.flow.of.imported.oil..Twice.in.the.last.three.decades,.the.routine.of.daily.living.in.the.United.States.has.been.changed.by.politically.induced.reductions.in.the.supply.of.foreign.oil.A.second.but.less.publicized.type.of.potential.petroleum.supply.crisis.relates.to.fundamental.geologic.limitations.on.the.world.supply.of.oil.and.natural.gas..Thus.far,.this.con-cern.has.remained.theoretical..However,.world.demand.for.oil.and.gas.is.predicted.to.continue.to.rise,.and.much.pe-troleum.(especially.oil).has.already.been.produced..Petroleum.is.a.nonrenewable.resource.on.the.time.scale.of.human.activities..Some.people.expect.that.in.as.short.a.time.as.one.or.two.decades,.geologic.constraints.rather.than.political.constraints.on.the.volumes.of.oil.remaining.to.be.discovered.and.on.the.rates.at.which.oil.can.be.produced.will.lead.to.a.more.or.less.permanent.oil-supply.crisis..

. Other.observers.point.out.that.similar.forecasts.of.gloom.and.doom.have.been.with.us.almost.since.the.begin-ning.of.commercial.oil.production..Such.forecasts,.they.say,.have.proved.to.be.poorly.founded.and.will.continue.to.be.poorly.founded.because.of.a.chronic.tendency.to.underestimate.(1).the.abundance.of.oil.in.the.ground,.and.(2).the.pace.and.extent.of.technology.advancement.in.the.petroleum.industry..This.debate.is.complex.and.emotional,.and.it.certainly.cannot.be.resolved.here..However,.we.can.speak.to.one.data.element.that.is.important.to.the.discussion.between.petroleum.supply.optimists.and.pessimists..That.element.is.remaining.petroleum.reserves—the.“inventory”.of.petroleum.that.is.on.hand,.in.the.ground,.waiting.to.be.produced.and.sold..The.remaining.petroleum.reserves.of.a.country.or.of.the.world.depend.upon.the.difference.between.the.volume.of.oil.and.gas.that.has.been.discovered.in.commercial.accumulations.and.the.volume.that.has.been.produced..Volumes.produced.are.in.general.reasonably.well.known,.but.volumes.of.petroleum.that.have.been.discovered.and.can.be.economically.recovered.are.difficult.to.esti-mate,.as.discussed.in.the.following.section..As.a.result,.no.one.really.knows.how.much.petroleum.has.already.been.discovered.but.not.yet.produced..For.the.world,.the.magnitude.of.this.uncertainty.is.on.the.scale.of.many.hundreds.of.billion.barrels.of.oil.or.(for.gas).oil.equivalent.


Assessment of Undiscovered Oil and Gas Resources of the Cook Inlet Region, South-Central Alaska, 2011Richard G. Stanley, Ronald R. Charpentier, Troy A. Cook, David W. Houseknecht, Timothy R. Klett, Kristen A. Lewis, Paul G. Lillis, Philip H. Nelson, Jeffrey D. Phillips, Richard M. Pollastro, Christopher J. Potter, William A. Rouse, Richard W. Saltus, Christopher J. Schenk, Anjana K. Shah, and Zenon C. Valin

The.U.S..Geological.Survey.(USGS).recently.completed.a.new.assessment.of.undiscovered,.technically.recover-able.oil.and.gas.resources.in.the.Cook.Inlet.region.of.south-central.Alaska..Using.a.geology-based.assessment.meth-odology,.the.USGS.estimates.that.mean.undiscovered.volumes.of.nearly.600.million.barrels.of.oil,.about.19.trillion.cubic.feet.of.natural.gas,.and.46.million.barrels.of.natural.gas.liquids.remain.to.be.found.in.this.area..http://pubs.usgs.gov/fs/2011/3068

Review of Emerging Resources: U.S. Shale Gas and Shale Oil PlaysU.S. Energy Information Administration, July, 2011, www.eia.gov

Background

The.use.of.horizontal.drilling.in.conjunction.with.hydraulic.fracturing.has.greatly.expanded.the.ability.of.produc-ers.to.profitably.recover.natural.gas.and.oil.from.low-permeability.geologic.plays—particularly,.shale.plays..Application.of.fracturing.techniques.to.stimulate.oil.and.gas.production.began.to.grow.rapidly.in.the.1950s,.although.experimenta-tion.dates.back.to.the.19th.century..Starting.in.the.mid-1970s,.a.partnership.of.private.operators,.the.U.S..Department.of.Energy.(DOE).and.predecessor.agencies,.and.the.Gas.Research.Institute.(GRI).endeavored.to.develop.technolo-gies.for.the.commercial.production.of.natural.gas.from.the.relatively.shallow.Devonian.(Huron).shale.in.the.eastern.United.States..This.partnership.helped.foster.technologies.that.eventually.became.crucial.to.the.production.of.natural.gas.from.shale.rock,.including.horizontal.wells,.multi-stage.fracturing,.and.slick-water.fracturing..Practical.application.of.horizontal.drilling.to.oil.production.began.in.the.early.1980s,.by.which.time.the.advent.of.improved.down-hole.drilling.motors.and.the.invention.of.other.necessary.supporting.equipment,.materials,.and.technologies.(particularly,.down-hole.telemetry.equipment).had.brought.some.applications.within.the.realm.of.commercial.viability..

The.advent.of.large-scale.shale.gas.production.did.not.occur.until.Mitchell.Energy.and.Development.Corpora-tion.experimented.during.the.1980s.and.1990s.to.make.deep.shale.gas.production.a.commercial.reality.in.the.Barnett.Shale.in.North-Central.Texas..As.the.success.of.Mitchell.Energy.and.Development.became.apparent,.other.companies.aggressively.entered.the.play,.so.that.by.2005,.the.Barnett.Shale.alone.was.producing.nearly.0.5.trillion.cubic.feet.of.natural.gas.per.year..As.producers.gained.confidence.in.the.ability.to.produce.natural.gas.profitably.in.the.Barnett.Shale,.with.confirmation.provided.by.results.from.the.Fayetteville.Shale.in.Arkansas,.they.began.pursuing.other.shale.plays,.including.Haynesville,.Marcellus,.Woodford,.Eagle.Ford,.and.others..

Although.the.U.S..Energy.Information.Administration’s.(EIA).National.Energy.Modeling.System.(NEMS).and.energy.projections.began.representing.shale.gas.resource.development.and.production.in.the.mid-1990s,.only.in.the.past.5.years.has.shale.gas.been.recognized.as.a.“game.changer”.for.the.U.S..natural.gas.market..The.proliferation.of.activity.into.new.shale.plays.has.increased.dry.shale.gas.production.in.the.United.States.from.1.0.trillion.cubic.feet.in.2006.to.4.8.trillion.cubic.feet,.or.23.percent.of.total.U.S..dry.natural.gas.production,.in.2010..Wet.shale.gas.reserves.increased.to.about.60.64.trillion.cubic.feet.by.year-end.2009,.when.they.comprised.about.21.percent.of.overall.U.S..natural.gas.reserves,.now.at.the.highest.level.since.1971..Oil.production.from.shale.plays,.notably.the.Bakken.Shale.in.North.Dakota.and.Montana,.has.also.grown.rapidly.in.recent.years..

. To.gain.a.better.understanding.of.the.potential.U.S..domestic.shale.gas.and.shale.oil.resources,.EIA.commis-sioned.INTEK,.Inc..to.develop.an.assessment.of.onshore.Lower.48.States.technically.recoverable.shale.gas.and.shale.oil.resources..This.paper.briefly.describes.the.scope,.methodology,.and.key.results.of.the.report.and.discusses.the.key.assumptions.that.underlie.the.results..The.full.report.prepared.by.INTEK.is.provided.in.Attachment.A..The.shale.


gas.and.shale.oil.resource.assessment.contained.in.the.INTEK.report.and.summarized.here.was.incorporated.into.the.Onshore.Lower.48.Oil.and.Gas.Supply.Submodule.(OLOGSS).within.the.Oil.and.Gas.Supply.Module.(OGSM).of.NEMS.to.project.oil.and.natural.gas.production.for.the.Annual.Energy.Outlook.2011.(AEO2011).EIA.also.anticipates.using.the.assessment.to.inform.other.analyses.and.to.provide.a.starting.point.for.future.work.

Uncertainty and the Volumetric EquationJim Murtha, Consultant and Jim Ross, Consultant Guest Editorial, JPT, September, 2009

Abstract

What.is.the.correct.mathematical.basis.for.establishing.appropriate.uncertainty.distributions.as.inputs.to.a.proba-bilistic.analysis.of.the.volumetric.equation?..More.specifically:.Should.the.input.distribution.for.each.reservoir.param-eter.be.based.on.either:

1.. The.range.of.values.seen.in.the.well.data.for.that.parameter,.or,

2.. The.range.of.uncertainty.in.the.reservoir.average.for.that.parameter?

ECONOMICS AND FINANCE

The Role of WTI as a Crude Oil BenchmarkK. D. Miller, M. Y. Chevalier, and J. Leavens, Purvin & Gertz, Inc. January, 2010 http://purvingertz.com/content/articles/PurvinGertz_WTI_Benchmark_Study.pdf

Since.2005.the.oil.markets.have.shown.more.short.term.volatility.and.overall.price.range.fluctuation.than.just.about.any.time. in.the.history.of. the.oil. trade.. In.addition.to.absolute.price.volatility,. there.has.also.been.extreme.volatility.in.the.relationships.among.the.crudes,.including.West.Texas.Intermediate.(WTI).and.other.benchmarks.on.the.Gulf.Coast.and.around.the.world..As.a.result.of.the.intensifying.industry.concern.regarding.this.market.volatility,.Purvin.&.Gertz,.Inc.was.engaged.to.prepare.a.report.that.describes.the.Mid-continent.and.U.S..Gulf.Coast.crude.oil.market.physical.infrastructure.and.flow.processes.and.corresponding.commercial.taxonomy..

This.study.will.cover.the.history.and.evolution.of.the.infrastructure.and.flow.processes.from.1970.onward,.with.concentration.on.the.periods.of.most.relevance.for.WTI..It.will.include.as.a.major.focus.the.breakdown.of.crude.flows.by.source.such.as.U.S..Gulf,.Mid-continent.U.S..and.Canada;.the.physical.interaction.of.different.crude.flows;.and.the.resulting.economic.relationships,.including.pricing.conventions.and.benchmark.pricing,.from.the.interactions.of.the.different.crude.flows..This.study.will.explain.the.economic.basis.for.the.evolution.and.development.of.crude.pricing.conventions,.especially.the.role.of.WTI.as.a.crude.oil.pricing.benchmark.

Factors Influencing Oil Prices: A Survey of the Current State of Knowledge in the Context of the 2007-08 Oil Price Volatility Louis H. Ederington, Chitru S. Fernando, Thomas K. Lee, Scott C. Linn, and Anthony D. May www.eia.gov/finance/markets/EFMI_reports_presentations.cfm August 30, 2011 ...

We.document.the.findings.of.a.study.undertaken.to.identify.gaps.in.current.knowledge..pertaining.to.price.forma-tion,.volatility.and.the.role.of.hedging.and.speculation.in.the..global.oil.market..Our.survey.uncovers.considerable.evidence.based.on.several.research..studies.to.suggest.that.fundamental.factors,.namely.stagnant.supply,.unexpected..economic.growth.from.China.and.other.countries.such.as.India,.low.interest.rates,.and.a..weak.U.S..dollar,.were.at.least.


associated.with.and.may.have.contributed.to.the.sharp.oil..price.run-up.and.subsequent.decline.in.the.2007-08.period..There.is.also.some.evidence..to.suggest.that.the.price.run-up.and.decline.may.have.been.exacerbated.by.the.formation..and.collapse.of.an.oil.price.bubble,.perhaps.triggered.by.fundamental.factors.in.both.the..oil.market.and.the.broader.global.economy..Despite.considerable.evidence.pointing.to.a..major.increase.in.oil.derivatives.trading.and.a.significant.change.in.the.composition.of..derivatives.traders.over.the.past.decade,.the.contribution,.if.any,.of.these.traders.and.of..speculation.in.oil.derivatives.to.the.2007-08.oil.market.turbulence.remains.undetermined..for.two.reasons..First,.the.existing.body.of.research.does.not.provide.a.definitive.answer..to.the.question.of.how.oil.inventories.respond.to.the.futures-spot.price.spread,.which..should.be.the.mechanism.connecting.financial.market.speculation.and.physical.oil.prices.if.the.latter.are.determined.by.supply.and.demand..Second,.the.Granger.causality.tests..that.have.been.conducted.to.date.to.test.whether.open.interest.position.changes.by..speculators.lead.or.lag.futures.price.changes.shed.little.light.on.how.speculation.impacts.oil.futures.prices..

Does ‘Paper Oil’ Matter? Energy Markets’ Financialization and Equity-Commodity Co-MovementsBahattin Buyuksahin, International Energy Agency Michel A. Robe, American University July 28, 2011

We.construct.a.uniquely.detailed,.comprehensive.dataset.of.trader.positions.in.U.S..energy.futures.markets..We.find.considerable.changes.in.the.make-up.of.the.open.interest.between.2000.and.2010.and.show.that.these.changes.impact.asset.pricing..Specifically,.dynamic.conditional.correlations.between.the.rates.of.return.on.investable.energy.and.stock.market.indices.increase.significantly.amid.greater.activity.by.speculators.in.general.and.hedge.funds.in.par-ticular.(especially.funds.active.in.both.equity.and.energy.markets)..The.impact.of.hedge.fund.activity.is.markedly.lower.in.periods.of.financial.market.stress..Our.results.support.the.notion.that.the.composition.of.trading.activity.in.futures.markets.helps.explain.an.important.aspect.of.the.distribution.of.energy.returns,.and.have.ramifications.in.the.debate.on.the.financialization.of.energy.markets..

Citation: Buyuksahin, Bahattin and Robe, Michel A., Does ‘Paper Oil’ Matter? Energy Markets’ Financialization and Equity-Commodity Co-Movements (July 28, 2011). Available at SSRN: http://ssrn.com/abstract=1855264 or doi:10.2139/ssrn.1855264

WP-2003-011 Petroleum Property ValuationJames L. Smith June 2003

This.paper.provides.an.overview.of.the.principal.economic.methods.employed.to.assess.the.value.of.petroleum.properties..The.difference.between.wellhead.and.in.situ.resource.values.is.examined,.as.well.as.drawbacks.inherent.in.the.concept.of.“oil.and.gas.equivalents.”.To.be.successful,.any.valuation.method.must.correctly.account.for.uncertainty.-.geologic.as.well.as.economic.-.and.the.value.of.flexible.management.in.pursuit.of.optimal.development.and.use.of.the.resource..Although.the.traditional.discounted.cash.flow.(DCF).technique.is.workable.and.reasonably.accurate.in.many.applications,.it.presumes.the.analyst.can.clearly.distinguish.between.systematic.and.non-systematic.sources.of.risk..The.real.options.approach.may.be.better.suited.for.applications.where.compound.risks.and.managerial.flexiibility.are.likely.to.have.a.significant.impact.on.operations.and.economic.performance..Options-based.approaches.have.been.employed.within.the.industry.for.many.years.to.account.for.the.impact.of.price.volatility.and.cost.fluctuations..Assess-ing.the.value.of.a.collection.(portfolio).of.geologically.interdependent.petroleum.prospects.requires.a.different.form.of.real-options.analysis.since.management.holds.the.option.to.exploit.information.spillovers.by.exploiting.prospects.sequentially..Dependence.among.prospects.gives.value.to.this.option.and.(perhaps.contrary.to.popular.belief).raises.the.value.of.the.whole.above.the.sum.of.its.parts.http://web.mit.edu/ceepr/www/publications/abstracts/WP-2003-011.html


WP-2010-017 The Weak Tie Between Natural Gas and Oil PricesDavid J. Ramberg and John E. Parsons November 2010, revised June 2011

Several.recent.studies.establish.that.crude.oil.and.natural.gas.prices.are.co-integrated..Yet.at.times.in.the.past,.and.very.powerfully.in.the.last.two.years,.many.voices.have.noted.that.the.two.price.series.appear.to.have.“decoupled”..We.explore.the.apparent.contradiction.between.these.two.views..We.find.that.recognition.of.the.statistical.fact.of.co-integration.needs.to.be.tempered.with.two.additional.points..First,.there.is.an.enormous.amount.of.unexplained.vola-tility.in.natural.gas.prices.at.short.horizons..Hence,.any.simple.formulaic.relationship.between.the.prices.will.leave.a.large.portion.of.the.natural.gas.price.unexplained..Second,.the.co-integrating.relationship.does.not.appear.to.be.stable.through.time..The.prices.may.be.tied,.but.the.relationship.can.shift.dramatically.over.time..Therefore,.although.the.two.price.series.may.be.co-integrated,.the.confidence.intervals.for.both.short.and.long.time.horizons.are.large.http://web.mit.edu/ceepr/www/publications/abstracts/WP-2010-017.html

WP-2010-010 On The Portents of Peak Oil (And Other Indicators of Resource Scarcity)James L. Smith August 2010

Although.economists.have.studied.various.indicators.of.resource.scarcity.(e.g.,.unit.cost,.resource.rent,.and.mar-ket.price),.the.phenomenon.of.“peaking”.has.largely.been.ignored.due.to.its.connection.to.non-economic.theories.of.resource.exhaustion.(the.Hubbert.Curve)..I.take.a.somewhat.different.view,.one.that.interprets.peaking.as.a.reflection.of.fundamental.economic.determinants.of.an.intertemporal.equilibrium..From.that.perspective,.it.is.reasonable.to.ask.whether. the.occurrence.and.timing.of. the.peak. reveals.anything.useful. regarding. the. state.of. resource.exhaustion..Accordingly,.I.examine.peaking.as.an.indicator.of.resource.scarcity.and.compare.its.performance.to.the.traditional.economic.indicators..I.find.the.phenomenon.of.peaking.to.be.an.ambiguous.indicator,.at.best..If.someone.announced.that.the.peak.would.arrive.earlier.than.expected,.and.you.believed.them,.you.would.not.know.whether.the.news.was.good.or.bad..Unfortunately,.the.traditional.economic.indicators.fare.no.better..Their.movements.are.driven.partially.by.long-term.trends.unrelated.to.changes.in.scarcity,.and.partially.but.inconsistently.driven.by.actual.changes.in.scarcity..Thus,.the.traditional.indicators.provide.a.signal.that.is.garbled.and.unreliable.Http://web.mit.edu/ceepr/www/publications/abstracts/WP-2010-010.html

On the Relation between Expected Returns and Implied Cost of CapitalJohn Hughes, UCLA Anderson School; Jing Liu, UCLA Anderson School; Jun Liu., Rady School of Management, UCSD April, 2008 http://papers.ssrn.com/abstract=1028882

In.this.study,.we.examine.the.relation.between.implied.cost.of.capital.and.expected.returns.under.an.assumption.that.expected.returns.are.stochastic,.a.property.supported.by.theory.and.empirical.evidence..We.demonstrate.that.im-plied.cost.of.capital.differs.from.expected.return,.on.average,.by.a.function.encompassing.volatilities.of,.as.well.as.cor-relation.between,.expected.returns.and.cash.flows,.growth.in.cash.flows,.and.leverage..These.results.provide.alternative.explanations.for.findings.from.empirical.studies.employing.implied.cost.of.capital.on.the.magnitude.of.the.market.risk.premium;.relations.between.cost.of.capital,.growth,.leverage,.and.idiosyncratic.risks;.predictability.of.future.returns,.and.characteristics.of.the.firm’s.information.environment.


LEGAL AND REGULATORY ISSUES

Expert Testimony: Regression Analysis and Other Systematic Methodologies

Peter F. Colwell, PhD; John A. Heller, JD; and Joseph W. Trefzeger, PhD. The Appraisal Journal, Summer 2009

The.Seventh.Circuit’s.Guardian Pipeline.decision.encourages.wider.use.of.multiple.regression.analysis.in.valuation.proceedings.in.place.of.the.longstanding.matched.pair.comparison.canon..This.article.reviews.applicable.evidentiary.rules,.providing.details.on.cases.appraisers.often.hear.cited.but.may.not.know.well,.such.as.Daubert and Kumho,.and.on.Federal.Rule.of.Evidence.702..A.well-designed.regression.model.would.seem.to.meet.all.requirements.for.admissibility.imposed.by.federal.rules.and.case.law,.and.by.state.rules.favoring.systematic.analysis..Yet.other.techniques.also.might.meet.those.requirements.

Cross-examination Based on Draft Reports is an Uninformative ExerciseBVWire for January, 2012 http://www.bvresources.com/BVWire/January2012Issue112-3.html

Just.last.week.the.Delaware.Court.of.Chancery.published.a.new.set.of.practice.guidelines.to.help.lawyers.and.their.experts..The.non-binding.guidelines.“are not intended to be used as a sword to wound adversaries,” the.court.advises. “To the contrary, they are intended to reduce conflicts among counsel and parties over non-merits issues, and allow them to more efficiently and less contentiously handle their disputes in this court.”.In.a.section.devoted.to.expert.reports,.the.court.recom-mends.that.experts:

•. Do.not.build.rebuttals.into.their.reports;•. Complete.all.of.their.analysis.and.exchange.all.of.their.reports.before.being.deposed;.•. Present.no.new.evidence.at.trial,.“absent extraordinary circumstances.”

The.court.also.prefers.that.parties.“stipulate to limit expert written discovery to the final report and materials relied on or considered by the expert.”.Although.the.court.“understands the degree of involvement counsel typically has in preparing expert reports,”.it.says.that.“cross-examination based on changes in drafts is usually an uninformative exercise.”.Finally,.the.court.will.typically.require.the.parties.to.identify.their.expert.witnesses.and.the.topics.of.their.testimony.in.a.schedul-ing.order,.along.with.the.timing.for.submitting.expert.reports..The.complete.18-page.guidelines.are.available.at:.http://www.delawarelitigation.com/files/2012/01/ChancCtguidelines.pdf

Daubert challenger reaps $4.7M in attorney/expert fees Current.U.S..patent.law.permits.courts.to.award.attorneys’.fees.upon.a.finding.of.“exceptional.litigation.miscon-

duct.”.Although.the.statute.doesn’t.expressly.provide.for.an.award.of.expert.witness.fees,.a.judge’s.“inherent.author-ity”.may..That’s.the.recent.finding.from.the.Federal.Circuit,.which.upheld.an.award.of.$3.9.million.in.legal.fees.and.$800,000.in.expert.witness.fees.for.the.defendant.in.a.patent.suit..“Although we agree … that exclusion of expert testimony under Daubert does not automatically trigger a finding of litigation misconduct,”.the.court.said, “we find that the circumstances of this case were sufficiently egregious,” including.the.defendant’s.having.to.incur.substantial.expense.in.rebutting.“un-tested”.and.unreliable.expert.evidence.

. A.warning.to.BV.experts?.Although.the.case.doesn’t.concern.a.financial.expert.or.evidence,.it.suggests.that.“vulnerability.to.a.Daubert challenge.can.be.a.problem.for.the.client.as.well.as.the.expert,”.says.Dr..Robert.Comment,.in.a.follow-up.to.his.BVR.webinar.last.week.on.the.admissibility.of.DLOM.methods.under.the.federal.standards..Ul-timately,.the.issue.may.come.down.to.whether.“general acceptance can suffice for admissibility when reliability is otherwise questionable, as I claim is the situation with large DLOMs,”.Comment.says..“I believe that many [analysts] in the BV com-munity hold a dangerously inflated opinion of the prophylactic value of ‘general acceptance.’”


Expert’s ‘hyberbole’ comes back to haunt in Daubert hearing. Experienced.litigation.experts.know.that.their.published.articles.and.statements.(even.on.a.blog.or.in.a.profes-

sional.discussion.group).can.be.used.against.them.in.a.courtroom..That’s.what.happened.in.a.recent.bankruptcy.case,.when.the.expert.conducted.an.insolvency.analysis.without.interviewing.management.or.visiting.the.subject.proper-ties,.yet.wrote.in.a.prior.family.law.article.that.“it.was.malpractice”.to.omit.these.steps.when.conducting.a.business.valuation.

. Fortunately,.the.federal.district.court.realized.that.the.expert’s.article.was.directed.specifically.to.divorce.law-yers..Moreover,.the.expert.had.to.value.the.bankrupt.debtor.in.this.case.as.of.a.past.date,.for.which.a.present.site.visit.would.not.have.been.relevant..Likewise,.talking.to.the.owners.wouldn’t.have.been.fruitful,.since.they.were.largely.responsible.for.the.debtor’s.downfall..Nothing.in Daubert excluded.the.expert’s.report.“merely.because.he.made.some.hyperbolic.statements.in.an.article.that.was.exploring.valuation.issues.in.a.context.entirely.different.than.the.present.one,”.the.court.held..It.also.used.the.expert’s.insolvency.analysis,.under.a.balance.sheet.test.and.a.DCF,.to.recover.$2.75.million.as.fraudulent.conveyance,.despite.some.“professional.disagreement”.among.the.experts.as.to.the.reliability.of.the.10b.versus.10a.size.category.data.and.the.calculation.of.company-specific.risk. Nelson v. Walnut Investment Partners, Ltd.,.2011.WL.2711318.(S.D..Ohio)(July.13,.2011).



Our.forefathers.did.not.intend.it.and.our.Constitu-tions.do.not. sanction. it,. but. today.nothing. influences.our. lives. as.much.as. government.. In.our.business. life,.every.aspect.of.providing.a.product.or.a.service.is.sub-ject.to.govern.ment.oversight.so.pervasive.that.it,.rather.than. efficiency,. determines. whether. the. operation. is.profitable.

The.magnitude.of.the.influence.exerted.by.the.Fed-eral.Government.is.well.illustrated.by.the.recent.edict.on.artificial.sweeteners..Here,.as.so.often.where.govern-mental.force.is.applied.to.legitimate.business,.it.was.in.the. role. of. “protector.”. Now. government. should. be. a.protector—a.protector.against.the.use.of.force.or.fraud.to.deprive.a.person.of.his.life.or.property..Such.protec-tion.creates.a.climate.of. free.enterprise. in.which.each.person.is.able.to.profit.according.to.his.ability.to.fulfill.the.needs.and.desires.of.others..In.such.an.atmosphere,.a.person.can.be.of.greatest.help.to.others.by.maximiz-ing.his.own.gain;.in.so.doing,.he.will.be.providing.the.prod.uct.or.service.sought.by.others.at.the.competitively..dictated.lowest.price.

Big Government

Today. government. falls. far. short. .. .. .. or. perhaps.far. overshadows. .. .. .. the. goals. set. for. it. by. those. who.sought.freedom.with.their.lives,.their.fortunes.and.their.sacred. honor.. In. 1964,. twenty-six. million. Americans.made.a.desperate.attempt. to. recapture. liberty—liberty.for.the.individual,.liberty.for.business,.liberty.from.gov-ernment..The.effort.failed.under.a.landslide.of.Pavlov-ian.re.actions;.today.government.reigns.supreme.in.the.school,.in.the.factory,.in.the.market.and.even.......as.the.up.coming.census.will.demonstrate.......in.the.home.

Government. dominates. business—is. that. bad?.Both.are.operated.by.people.having.basically.the.same.

Government Influence On Industry OperationsGranville Dutton Manager of Unitization and Joint Operations Sun Oil Company, Dallas, Texas

in.stincts..Certainly.a.man.does.not.grow.horns.just.be-cause.he.accepts.a.Federal.Position..But.motivations.dif-fer:.in.business,.profit.is.the.criterion.of.success;.in.gov-ernment,.number.of.employees..Where.freedom.reigns,.profits.are.a.function.of.how.well.a.service.or.product.is.supplied;. the. size.of. government.bureaucracies. are.de-termined.by.how.much.power.they.can.obtain..Govern-ment.contributes.nothing.to.the.standard.of.liv.ing;.only.gainfully. employed.private. citizens. and.private. capital.do. this.. Therefore,. the. laborer. as. well. as. the. investor.must.bear.the.burden.of.government.spending.

Levels of Government Supervision

The. first. major. governmental. influence. on. the.petro.leum. production. industry. was. State. regulation..The.goal.was. conservation.and. the. rationale.was.pro-tection.of.the.correlative.rights.of.all.owners.of.a.com-mon.supply..World.War. II.brought.Federal. regulation,.primarily.in.the.areas.of.materials,.allocations.and.price.controls..After.the.war,.Federal.regulation.subsided.until.the.U..S..Supreme.Court.rewrote.the.Natural.Gas.Act.to.bring.gas.producers.under.price.control.of. the.Fed-eral.Power.Commission..As.offshore.production.became.more.sig.nificant.in.the.late.fifties,.Federal.regulation.of.offshore.activities.by.a.host.of.agencies.began.to.expand.to.the.point.where.drilling.operations.in.Santa.Barbara.were.actually.prohibited.by.the.Federal.government.on.leases.for.which.the.industry.had.paid.that.same.govern-ment.600.million.dollars.

The.late.fifties.also.saw.the.mandatory.imports.con-trol. program. instituted. after. a. “voluntary”. limitations.had. failed. to.curb. the. increasing. imports.. In. the.early.sixties,.Attorney-General.Kennedy.initiated.the.attack.on.state.conservation.laws.as.price-fixing.measures..Fed-eral. pressure. has. steadily. mounted. to. the. point. where.

This paper was originally printed in JSPEE Volume II, 1969-70


the.petroleum.industry.is.held.to.be.absolutely.liable.for.pollution.whether.or.not.negligence.is.involved;.where.the.Congress.has.voted.to.decrease.depletion.provisions.in.effect.for.four.decades;.where.the.Administration.has.requested.elimination.of.intangible.expenses;.and.where.a.Cabinet-level.Task.Force.has. recommended.changes.in.the.import.program.admittedly.designed.to.lower.the.price.paid.for.domestic.crude.

Local.regulation.of.the.industry.for.years.involved.little. more. than. drilling. restrictions. within. incorpo-rated.towns.and.cities..More.recently,.aesthetic.regula-tions. calling. for. elaborate. and. expensive. installations.to.dis.guise.drilling.and.production.facilities.have.been.en.acted..In.1969,.both.county.and.city.severance.taxes.were.levied.on.petroleum.production..So.today,.govern-ment. controls. influence. industry. operations. on. the.Fed.eral,.State.and.local.levels.to.an.extent.that.merely.keeping. abreast. of. the. regulations. involves. substantial.expenditures.of.time.and.money;.compliance.with.these.rules.costs.such.staggering.sums.that.only.the.most.inge-nious. technological. advances. have. enabled. petro.leum.to.remain.competitive.

Areas of Government Influence

Government.influence.is.felt.in.three.areas:.direct.regulation,. taxation. and. policy-making.. The. first. two.of. these. are. exerted. by. all. three. governmental. levels.whereas.in.the.policy.field.the.Federal.level.is.dominant.

This.paper.will.discuss.briefly.the.interrelations.be-tween.Federal.and.State.influence.which.seem.to.be.ap-proaching.State.reaction.to.federal.actions..Back.ground.trends.and.the.current.situation.are.discussed.in.order.to.set.the.stage.for.a.prediction.as.to.what.effect.upon.State.production.and.allowables.would.result. from.replacing.the.import.control.program.with.a.tariff.system.

BACKGROUND AND TRENDS

The. past. is. prologue—yet. it. is. our. only. guide. to.the. future.. Trends. based. on. past. performance. can,. of.course,. be. interrupted.by. a. change. in. conditions. such.as.the.Arab-Israeli.conflicts.of.1957.and.1967..Both.of.these.“little.wars”.disrupted.supply.from.the.Middle.East.and.caused.temporarily.high.demands.on.our.domestic.sup.ply..In.1957,.there.was.no.problem.in.filling.this.mar-ket.with.our.excess.producing.capacity;.after.ten.years.of. depressed. prices,. natural. gas. price. regulation. and.

infla.tion,.there.still.was.no.surface.indication.of.a.prob-lem.in.meeting.the.1967.crisis..However,.a.close.study.of.the.allowables.developing.out.of.the.1967.disruption.indi.cates. that. today. the. domestic. industry. would. be.hard.pressed.to.fill.the.additional.demand.resulting.from.a. termination. of. our. overseas. imports.. This. reduction.in.producing.capacity.has.come.about.through.the. in-evitable.effects.on.supply.of.government.policies.affect-ing.petroleum.demand,.prices.and.costs..A.brief.exam-ination.of.the.recent.history.of.these.factors.is.useful.in.understanding.the.current.situation.

Demand

The.demand.for.liquid.petroleum.was.up.60%.dur-ing. the. period. 1950-1963;. during. this. same. time. gas.demand.more. than.doubled..All.qualified.analysts,. in-cluding. those. in. the. Federal. government,. agree. that.by. 1980. demand. for. liquid. hydrocarbons. and. natural.gas.will.increase.at.least.50%..With.such.unanimity.of.my.pre.dictions.one.would.think.the.domestic. industry.would.be.proceeding.full.speed.to.develop.the.produc-ing.capacity.to.meet.the.predicted.high.demand..Under.free. market. conditions. such. an. effort. would. surely. be.forthcoming..However,.several.factors.in.the.feed-back.loop.of.the.law.of.supply.and.demand.have.been.short-circuited.by.government.policies.which.prevent.domes-tic.petroleum.prices. from.providing. the. incentive.and.investment. capi.tal. necessary. to. develop. the. required.supplies.

Supply

The.general.trend.of.domestic.liquid.reserves.add-ed.annually.has.been.downward.since.1950..Not.once.since. that. year. have. discovered. reserves. equalled. the.liquid.hydrocarbons.produced..During.the.period.1950-1967.discovered.reserves.averaged.only.40%.of.the.liq-uids.produced;.worse. still,. during.1960-1967. the. aver-age.was.less.than.20%.and.in.1967.reserves.discovered.were.only.4%.of.production..The.domestic.oil.industry.has.been.surviving.on.upward.revisions.of.known.liquid.reserves.brought.about.primarily.by.advanced.recovery.tech.nology.

Gas. reserves. added. failed. to. equal. production. for.the.first.time.during.1968..Already.signs.of.a.deficiency.are.developing.and.the.long-range.outlook.is.that.alter-nate.fuel.sources.will.have.to.be.used.


New.reserves.are.discovered.only.through.drilling..Yet.domestic.exploratory.drilling.is.barely.holding.a.lev-el.of.9000.wells.a.year.after.reaching.a.peak.of.16,000.in. 1956.. In. view. of. a. guaranteed. increase. in. demand,.why.is.domestic.exploratory.drilling.lagging?.The.reason.involves.producing.costs.and.petroleum.prices.

Costs

One.good.measurement.of.costs.is.the.investment.required.per.dollar.of.lease.revenue..In.the.latest.10-year.period.for.which.figures.are.available.this.value.has.in-creased.from.$1.31.to.$2.30.per.dollar.of.revenue..This.increase.of.75%.is.one.and.a.half.times.the.50%.increase.in.demand.during.the.same.period.

One.big. reason. for. the. increased.costs.of.produc-ing. hydrocarbons. is. inflation.. Inflation,. of. course,. and.in. spite.of. all. the.divisionary.propaganda.about.wages.and.prices,.is.a.direct.result.of.the.federal.government’s.policy.of.monetizing.the.debt..This.process.of.printing.money.to.make.up.the.difference.between.government.expenditures.and.income.causes.the.increase.in.dollars.to.exceed.the.increase.in.goods.and.services..Since.a.siz-able.portion.of.the.Federal.budget.is.spent.specifically.to.depress.the.output.of.goods.(such.as.agricultural.subsidies.in.lieu.of.production).and.services.(such.as.welfare.pay-ments.rather.than.wages.for.productive.labor),.inflation.has.progressed.at.an.alarming.rate..Normally.the.price.of.petroleum.products.would.also.inflate.at.the.same.rate.as.the.general.economy;.the.fact.that.the.investment.per.dollar.of.revenue.has.increased.75%.indicates.revenues.have. fallen. far. behind. in. their. race. with. costs.. Why?.Government.policies.which.have.artificially.restrained.petroleum.prices.

Prices

In.1927.a.million.BTU’s.of.heat.could.be.generated.from.oil.costing.$36.00;.in.1967.this.amount.of.heat.could.be.generated. from.$30.00.worth.of.petroleum—.up.only.$1.00.from.the.low.reached.in.1947..Why.did.fuel.increase.only. 3%. in. 20. years. while. automobiles. tripled. in. price,.housing.and.food.doubled.and.clothing.was.up.75%.

Competition.with.gas.has.held.down.the.price.of.oil.. In. terms. of. energy. production,. gas. is. now. as. im-portant. to. this. country. as. oil.. Since. 1954. the. Federal.Power.Commission.has.been.dictating.the.price.of.gas.and,. by. controlling. the. price. of. its. chief. competition,.

has.man.aged. to.put. a. ceiling.on. the.price.of.oil..Two.years. ago. the. short-range. economists. advocating. gov-ernment.“pro.tection”.of. the.consumer.against. the. law.of.supply.and.demand.were.happily.crowing.about.the.great.fuel.savings.brought.about.by.forcing.one.man.to.sell.his.commodity.to.another.at.a.price.less.than.that.deter.mined. by. a. free. market.. Today. even. the. Federal.Power.Commission.recognizes.that.a.critical.gas.short-age.is.developing.which.can.be.alleviated.only.by.aban-doning.the.fraudulent.fantasy.that.a.few.bureaucrats.can.estab.lish. a. “just. and. reasonable”. price. different. from.that.agreed.upon.by.willing.buyers.and.sellers.in.arms-length.transactions..The.current.commissioners.are.now.groping.about,.with.an.increase.here.and.a.review.there,.in. an.effort. to.find.a.way.out.of. the.bureaucratic.mo-rass.created.by.previous.price-fixing..To.their.plaintive.plea,.“Where.do.we.go.from.here?”,.one.answer.is.surely,.“Don’t. go.protecting. the. consumer. anymore..Another.fifteen.years.of.such.protection.and.all.will.surely.freeze.to.death.”

. Just.at.the.time.the.gas.shortage.has.dented.the.ceiling. which. has. prevented. prices. from. rising. to. the.level.necessary.to.permit.meeting.the.demand,.the.do-mestic.producing.industry.is.accosted.with.a.tax.increase.which. raises. costs. and.a.new. tariff. system.designed. to.depress. prices. as. well.. The. combination. of. rapidly. in-creasing.costs.and.artificially.depressed.prices.raises.this.concern:. Can. the. replacement. costs. of. the. petroleum.reserves.necessary.to.meet.future.demand.be.justified.by.the.anticipated.profit.margin?.The.answer.to.this.ques-tion. will. be. more. influenced. by. government. than. by.purely.economic.considerations.

CURRENT SITUATION

Today.the.petroleum.industry.is.being.handicapped.by.government.influence.exerted.At.various.levels.and.in.various.areas..On.the.municipal.level,.unfair.and.dis-criminatory.taxes.coupled.with.expensive.require.ments.to. abate. even. the. most. remote. dangers. of. air,. water.and. even. noise. pollution. substantially. increase. costs.and.hinder.efficient,.reasonable.operations..The.pollu-tion. spectre.also.poses. a. real.problem.and.expense.on.the. state. level..State.budgets.now.rival. the. skyrocket-ing.Federal.budget. in. their. insatiable.demand. for.new.and.additional.taxes..Yet.the.crucial. influence,.the.in-fluence.which.could.cripple.the.industry.and.the.nation,.remains.at.the.Federal.level.where.the.ultimate.powers.


have.migrated.or.......if.you.believe.that.the.9th.and.10th.Amendments. to. the. U.. S.. Constitution. remain. valid........have.been.usurped.

All. three. branches. of. the. Federal. Government.exer.cises.their.influence.on.the.domestic.petroleum.in-dustry..For.purposes.of.examining.these.influences,.the.areas. in.which. they.operate. can.be. classified. as.direct.regulation,.taxation.and.policy.making.

Direct Regulation

Numerous. federal. agencies. have. issued. orders. di-rectly.regulating.various.aspects.of.the.domestic.produc-ing.industry..From.the.railroad.freight.rates.of.pipe.and.equipment. to. the.navigational. lights.on.offshore.plat-forms. there. is.a.bureau.and.a. regulation.governing.es-sentially.every. facet.of.drilling.and.producing..Federal.proration.of.oil.and.gas.remains.a.threat.and.legislative.authority.for.such.regulation.has.already.been.adopted.

Operating.rules.are.becoming.more.and.more.strin-gent.as.well.as.detailed..Aesthetic.and.ecological.regula-tions.are.becoming.so.prevalent.that.one.observer.has.noted. that. only. the. combination. of. a. landscape. com-pany.and.an.animal. trainer.will.be.able. to.bid.on. the.proposed.Alaskan.pipeline.

Air.and.water.conservation.are.vital.to.this.nation.but.the.current.rash.of.regulations.based.on.emotional.rather. than. factual. . considerations. are. wasting. more.money. than. they. are. conserving. environment.. Con-cerned.and.well-meaning.people.do.not.seem.aware.that.an. energy. deficiency. poses. a. far. greater. and. more. im-mediate.threat.to.the.American.way.of.life.than.does.the.extinction.of.the.Alaskan.moose,.smog.or.water.pollu-tion..With.energy.these.problems.can.be.solved;.without.it.there.is.no.way.to.protect.our.freedom.to.solve.such.problems.

In.spite.of.the.vast.number.of.prolific.agencies.regu-lating.the.producing.industry,.two.continue.to.exercise.more. influence.than.the.combined.effort.of.all.others..These.are.the.Federal.Power.Commission.and.the.De-partment.of.Interior.which.administers.the.Mandatory.Import. Control. Program.. The. Commission. is. now. at.least. considering. abandoning. the. policy. of. “cheap. gas.now”.in.favor.of.policies.that.will.insure.future.supplies.of. gas.at. competitive.and. reasonable.prices..Hopefully.the.relief.will.not.be.too.little.and.too.late.so.that.re-serves.may.yet.be.developed.to.avoid.the.serious.shortage.

which. looms.on.the. immediate.horizon..But.whatever.relief.more.enlightened.Commission.policies.might.pro-vide.could.easily.be.overcome.by.an.unwise.change.in.the.import.program.

Taxation

The. tax. reform. bill. is. now. law. and. the. 2772%.deple.tion.provision.that.was.proper.for.over.40.years.is.now.22%..This.change.will. increase. the. industry’s. tax.bill.nearly.a.half.billion.dollars.a.year—further.reducing.the.capital.needed. to.develop.new.reserves..Since. the.2772%.depletion.has.been.in.effect.for.decades,.its.in-fluence.on.costs.has.been.reflected.in.the.current.price.structure..The.reduction.to.22%.will.inevitably.increase.costs. and. reduce. the. incentive. to. invest. the. capital.neces.sary.to.insure.the.development.of.the.new.supplies.needed.

The.proponents.of.the.reduction.claim.that.the.oil.industry.does.not.pay.its.fair.share.of.taxes..Yet.the.facts.are.that.the.industry,.in.addition.to.collecting.billions.in.gasoline.taxes.without.charge,.was.paying.6%.of.its.gross.revenues.as.taxes.......compared.to.the.5.8%.average.paid.by.all.mining.and.manufacturing..Another.claim.is.that.the.oil.industry.enjoys.excessive.profits..The.facts?.Dur-ing.the.last.fifteen.years.the.industry.has.averaged.11.5%.profit.on.net.worth.com.pared.to.nearly.13%.for.all.man-ufacturing..Even.in.the.good.year.of.1968.the.industry.realized.a.profit.of.only.12.9%.on.net.assets.as.compared.to.13.1%.for.all.manufacturing.

Under. these. facts. how. did. the. reduction. of. the.2772%.depletion.become.synonomous.with.tax.reform?.The.un.fortunate.but. true.answer. is. that. the.oil. indus-try.has. a.poor. reputation..Yet.no. industry.has.made. a.product.available.more.conveniently.or.at.a.lesser.price..There.are.over.220,000.gasoline.outlets.in.this.country.and.it.is.doubtful.if.the.average.buyer.has.ever.found.one.out. of. gas.. Since. 1950. retail. gasoline. prices. exclusive.of.taxes.have.been.increased.from.only.20.to.23.cents,.less.than.a.third.of.the.increase.in.general.cost.of.living..But.unless.such.facts.are.understood.by.the.public.and.their.elected.officials.the.industry.will.continue.to.be.a.scape.goat..Here.then.is.a.challenge.to.all.associated.with.the.industry.and.to.all. fair-minded.and.knowledgeable.Ameri.cans;.a.challenge.to.communicate,.to.educate.and.to.correct.false.impressions..Public.opinion.has.hurt.oil.producers.in.the.past;.in.the.future.it.could.destroy.them.


Policies

Many. governmental. policies. influence. petroleum.pro.duction..The.inflationary.effect.on.production.costs.of.federal.deficit.financing.through.printing.money.has.already. been. described.. Leasing. policies. affect. where.and. how. money. is. spent. and. in. this. area. some. State.policies.exercise.considerable.influence..The.nine.hun-dred.million. dollar.Alaska. sale. and. the. three.offshore.sales.off.Santa.Barbara,.Texas.in.1968.and.Louisiana.in.1967.siphoned.off.nearly.three.billion.dollars.in.in.dustry.funds. that.might.otherwise.have.been.used. to.explore.for.and.develop.new.reserves..The.current.con.fusion.as.to. federal. policies. relating. to. oil. shale. leases. is. delay-ing.development.plans.for.the.domestic.shale.oil.which.will.soon.be.needed.to.augment.conventional.do.mestic.reserves.if.the.United.States.is.to.maintain.its.capability.to.be.self-sufficient.

Numerous. other. federal. policies. harass. the. in-dustry. in. minor. ways.. Government. subsidized. nuclear.power. generators,. government. encouraged. speculation.on.gaso.line. lead.poisoning.and.government. sponsored.develop.ment. of. an. electric. car. are. examples. of. such.policies.whose.constitutional.authority.is.hazy.to.say.the.least.

But.the.policy.currently.at.the.center.of.the.stage.concerns.imports..The.federal.Task.Force.on.imports.has.apparently.proposed.a.policy.of.increasing.the.na.tion’s.reliance.on.foreign.oil.through.manipulation.of.the.cur-rent.import.program.into.a.tariff.system..The.usual.press.leak. which. constitutes. the. trial. balloon. for. such. poli-cy.changes.emphasizes. the.desired. results.of.a. reduced.price. to. the. consumer. and.an. increase. in. gov.ernment.income.with.a.hint.of.possible.individual.tax.reduction..As.for.the.reduced.consumer.prices,.it.would.seem.that.the. long-range. aspects. of. such. a. reduction. should. be.evaluated.in.the.light.of.the.results.of.the.Federal.Power.Commission’s.“cheap-gas-now”.policy.

Another.question.about.price.reduction.that.should.be.asked.is,.if.such.reduction.is.desirable,.why.not.start.with.something.under.direct.government.control,.postal.fees..In.1940,.a.penny-postcard.could.be.sent.from.New.York. to. San. Francisco. for. one. cent;. today. that. same.postcard.may.be.sent.for.five.cents,.or.500%.of.the.1940.price..In.1940.a.long-distance.telephone.call.from.New.York.to.San.Francisco.costs.$3.00;.today.that.call.may.be.made.for.75¢,.or.25%.of.the.1940.price..Yet.the.Federal.government.which.raised.postal.rates.500%.forced.the.

company.which.had.decreased.telephone.rates.75%.to.reduce.their.rates.to.prevent.the.company.from.making.“excess.profits.”

Such.examples.indicate.why.the.future.of.our.gen-eral. economy. and. particularly. that. of. the. oil. industry.will.be.more.influenced.by.government.actions.than.by.purely.economic.developments..The.government.action.cur.rently. under. consideration. which. could. have. the.greatest.effect.upon.both.the.petroleum.industry.and.the.nation’s.defense.capability.is.the.proposed.change.in.the.import.program.

INFLUENCE OF IMPORTS

For.those.committed.to.a.free.economy.there.is.but.one. legitimate. reason. for. import. restrictions:.National.Security..It.is.also.true.that.the.Constitution.authorizes.tariffs.to.provide.such.protection.and.that.the.constitu-tional.method.should.have.been.adopted.instead.of.the.Mandatory. Import. Control. Program.. However,. today.the. reported. tariff. plan. will. not. provide. the. necessary.protection.

The.principal. reason. tariffs.will.not.do. the. job. is.associated. with. the. unstable. political. climate. under.which.the.bulk.of.foreign.operations.are.conducted..The.dangers. of. expropriation. and. confiscatory. contract. re-negotiations. through. legislation.make. it. expedient. for.the.producers.to.bring.in.foreign.crude.at.the.same.price.or.an.even.lower.price.than.domestic.crude..The.result-ing.lower.demand.for.domestic.crude.coupled.with.the.announced.intention.to.set.tariffs.so.as.to.lower.prices.will.drastically.reduce.the.incentive.to.explore.for.and.develop.the.reserves.needed.to.maintain.the.nation’s.pe-troleum.self-sufficiency.

The.effects.of.the.mandatory.import.program,.like.those.of.the.271/2%.depletion.provision,.on.costs.have.been.reflected.in.the.price.structure.during.the.decade.the. program. has. been. in. effect.. A. change. to. the. tar-iff. system. will. add. costs. which. will. reduce. the. antici-pated. profit. margin. of. developing. the. needed. reserves.to.a.level.which.will.not.justify.the.commitment.of.the.re.quired. capital.. In. addition,. the. tariff. itself. will. con-sume.a.billion.dollars.annually.of.the.industry’s.resources.which.could.otherwise.be.used.for.developing.additional.re.serves.. Further. reserve. reductions. in. proved. reserves.will.occur.as.a.result.of.substantial.volumes.of.currently.marginal.production.being.rendered.uneconomical.and.abandoned.


Effects on Domestic Capacity

To.examine.the.effects.of.the.tariff.plan.on.domes-tic.production. it. is.necessary. to.compare. the. resulting.situa.tion.with.that.which.would.exist.under.the.current.pro.gram..Table.1.(page.75). shows. the.predicted. situa-tions. during. the. next. six. years. for. an. increased. crude.demand.of.ap.proximately.4%.per.year.

It. is. estimated. that. removal.of. import. limitations.would.increase.crude.imports.approximately.1.5.million.barrels.per.day..This.would.involve.displacing.the.entire.600,000.BPD.of.domestic.crude.currently.being.refined.on.the.East.Coast,.500,000.BPD.of.Gulf.Coast.crude.and.replacing. 400,000. BPD. of. Midwest. refinery. runs. with.Canadian.supplies.

These. increased. imports. would. necessarily. lower.do.mestic. production.. Under. the. current. program. it. is.esti.mated. that. the. 1975. demand. of. 13.7. million. BPD.would.be.met.by.imports.of.1.8.million;.Texas.produc-tion.of.4.0.million;.Louisiana,.3.3;.California,..9;.Alaska,.1.4;.and.the.other.states.2.3.million.BPD..It.is.estimated.that. the.additional. imports.would. reduce.Texas. to.3.4.mil.lion.BPD,.Louisiana.to.3.0.and.Alaska.to..8.million.BPD.

Table. II. indicates. that. the. Texas. market. demand.factor.would.be.essentially.100%.in.1975.under.a.con-tinuation.of.the.current.program..The.significant.indica-tion.is. that.the.market.demand.factor.would.be.100%.in.1975.under.a. tariff.plan.although.Texas.production.would. be. 600,000. BPD. less.. This. result. would. follow.from.the.abandonment.of.marginal.producing.capacity.and. reduction. in. capacity. occurring. as. a. result. of. de-creased. investments.. The. actual. capacity. reduction. as.shown. by. scheduled. allowables. would. be. in. excess. of.800,000.BPD.

Table. III. shows. a. similar. situation. for. Louisiana..Although.Louisiana.is.not.predicted.to.be.producing.at.capacity.in.1975.under.either.set.of.circumstances,.the.percent.of.depth.bracket.is.estimated.to.be.even.higher.for.the.lower.production.under.the.tariff.plan..Again.the.reason.is.a.reduction.in.producing.capacity.as.indicated.by.the.100%.allowable.being.600,000.BPD.less.

The.total.reduction.in.domestic.producing.capac-ity.would.be.over.2.3.million.BPD..Alaska.is.estimated.to.have.a.capacity.reduction.in.excess.of.600,000.BPD.since. there.would.be. insufficient. incentive. to.develop.the.addi.tional.capacity.at.the.reduced.price..Other.states.

would.suffer.a.smaller.reduction.of.300,000.BPD.primar-ily. as. a. result. of. abandoning. marginal. reserves. which.would.no.longer.be.economical.at.the.lower.price.

Dangers

The. most. serious. danger. resulting. from. the. tariff.plan.would.be. insufficient.producing. capacity. to.meet.a.na.tional.emergency..By.1975.the.United.States.would.have.an.excess.producing.capacity.of.only.700,000.BPD.while. relying.on. foreign. sources. for.3,600,000.BPD.of.crude.and.2,200,000.BPD.of.residual.and.products..Thus.36%.of.the.total.hydrocarbon.demand.would.rely.on.for-eign. supplies. of. which. 4,800,000. BPD. would. be. from.over.seas..A.disruption.of. such.overseas. supplies.would.leave.the.nation.with.a.deficiency.of.four.million.BPD.after.putting.all.excess.capacity.on.production.

The. projected. 1975. total. demand. for. crude,. re-sidual. fuel.and. imported.products. is.15.9.million.BPD.so.such.an.emergency.would.cut.available.oil.by.25%..Such. a. cut. would. exceed. that. which. the. nation. can.withstand. without. disrupting. its. industrial. efficiency..Under. the. tariff. system. this. situation. would. continue.to.become.more.serious.until.foreign.nations.raised.the.price.of.their.crude.to.a.point.where.the.domestic.indus-try.could.again.compete..However,.the.finding,.develop-ing.and.transporting.of.new.oil.reserves.is.a.lengthy.pro-cess.which.would.require.three.to.five.years.to.change.the.trend.after.a.competitive.price.was.established..It.is.doubtful. that. the. Communists. would. give. the. United.States.sufficient.time.to.restore.its.defense.capability.

A.second.danger.is.the.additional.pressure.against.the.nation’s.fiscal.stability.occasioned.by.the.increased.deficit.in.its.balance.of.payments..Today.the.expense.of.the.current.level.of.foreign.imports.is.offset.by.sales.of.equipment.and.supplies..Yet.during.the.first.nine.months.of.1969,.the.overall.trade.balance.deficit.was.2.5.billion.dollars.. An. additional. billion. dollars. annually. for. in-creased.purchases.of.foreign.oil.would.be.a.critical.addi-tion.to.an.already.serious.situation.


NATIONAL OIL POLICY

Concerned.government.officials,. cognizant.of. the.potential.dangers.of.unsecured.petroleum.supplies,.have.initiated.actions.which.will.probably.result.in.negotia-tions. for. continental. and. western. hemisphere. energy.fuels.policies..Yet.the.United.States.does.not.have.a.ra-tional.energy.policy.at.this.time.

The. lack. of. a. clear. national. policy. is. one. of. the.prin.cipal. reasons. the.depletion.provision.has. been. re-duced.and.the.changed.import.policy.is.under.consider-ation..Basically,.the.long-range.effects.of.such.changes.would. be. to. reduce. the. producing. capacity. of. the. do-mestic.petroleum.industry,.to.lower.the.nation’s.defense.capa.bility.and.to.damage.the.country’s.trade.balance.

A.policy.which.could.avoid.such.pitfalls.could.be.simply.stated.as.follows:.the.United.States.Government.will.encourage.the.development.of.adequate,.secure.en-ergy.supplies.which.will.be.available.at.reasonable.costs..The.outlook.of.such.a.policy.would.emphasize.the.prin-ciple.of.the.long.term.good.of.the.nation.rather.than.the.expediency. of. short-lived. savings. accompanied. by. the.expense. of. future. shortages.. Every. knowledgable. citi-zen.interested.in.preserving.freedom.should.inform.his.elected.officials.including.the.President.of.the.neces.sity.of. such.a.policy.and. the. resulting. rejection.of. the.an-nounced.tariff.plan..The.adoption.of.such.a.policy.would.encourage.government.and.industry.to.consolidate.their.efforts.toward.the.joint.goals.of.protecting.the.national.security.and.satisfying.the.needs.of.consumers.

TABLE I

U.S. CRUDE DEMAND AND PRODUCTION (Includes Condensate)

MBPD Total U. S.’ Production

Year Demand Imports Texas2 La. Calif. Alaska Others

1965 9,069 1,238 2,742 1,630 867 31 2,561

1966 9,470 1,225 2,898 1,848 946 39 2,514

1967 9,909 1,128 3,067 2,122 984 80 2,528

1968 10,345 1,265 3,124 2,225 1,027 182 2,522

1969’ 10,745 1,390 3,170 2,300 1,050 200 2,605

Predicted Continuation of Current Import Program

1970 11,220 1,400 3,350 2,450 1,100 220 2,700

1971 11,710 1,470 3,500 2,740 1,050 250 2,700

1972 12,180 1,545 3,650 2,885 1,000 500 2,600

1973 12,670 1,625 3,800 3,045 1,000 700 2,500

1974 13,180 1,710 3,900 3,195 900 1,075 2,400

1975 13,710 1,795 4,000 3,295 900 1,420 2,300

Predicted Imports Restricted Only By Tariff Plan

1970 11,220 2,800 2,750 1,850 1,100 220 2,500

1971 11,710 2,940 2,900 2,170 1,050 250 2,400

1972 12,180 3,090 3,050 2,340 1,000 400 2,300

1973 12,670 3,250 3,150 2,570 1,000 500 2,200

1974 13,180 3,420 3,300 2,860 900 600 2,100

1975 13,710 3,590 3,400 3,020 900 800 2,000

1. U. S. Refinery Runs.2. Includes approximately 150 MBPD of condensate not carried as crude by Texas RRC.

Tables 2 and 3 could not be accurately reproduced. Refer to this paper on the SPEE website under Journal of SPEE .


Sources on the InternetNYMEX Oil and Gas Futures Prices

www.barchart.com/commodityfutures/energies Real.time.futures.prices.on.all.commodities.including.crude.oil.and.natural.gas

Pennsylvania Shale Gas Production and Development Information. http://www.portal.state.pa.us/portal/server.pt/community/office_of_oil_and_gas_management/20291

Information on all Active Shale Development Regions ShaleDaily.com

Documents

The Journal of the Society of Petroleum Evaluation Engineers