Page 211 - Hydrocarbon Exploration and Production Second Edition

198 Cost-Benefit Calculations for Appraisal

medium or low STOIIP. On the branches from the chance node, the estimated
probability of these outcomes is noted (0.33 in each case). The sum of the
probabilities on the branches from a chance node must be 1.0, since the branches
should describe all possible outcomes. The next decision is whether to develop or
not. The development plan in each case will be tailored to the STOIIP, and will
have different costs and production profiles. It can be seen that for the low case
STOIIP, development would result in a negative NPV.
If no appraisal was performed, and the development was started based, say, on
the medium case STOIIP of 48 MMstb, then the actual STOIIP would not be
found until the facilities were built and the early development wells were drilled.
If it turned out that the STOIIP was only 20 MMstb, then the project would lose
$40 million, because the facilities were oversized. If the STOIIP is actually
48 MMstb, then the NPV is assumed to be the same as for the medium case after
appraisal. If the STOIIP was actually 100 MMstb, then the NPV of +$40 million is
lower than for the case after appraisal (+$66 million) since the facilities are too small
to handle the extra production potential.
In the example, development without appraisal leads to an NPV which is the
weighted average of the outcomes: $million ( 40+6+40)/3 ¼ +$2 million. Develop-
ment after appraisal allows the decision not to develop in the case of the low
STOIIP, and the weighted average of the outcomes is $million (0+6+66)/3 ¼ +$24
million.

Value of appraisal information ¼ Value of outcome with appraisal information value of
outcome without appraisal information
¼ $24 million $2million ¼ $22 million

In this example it would therefore be justifiable to spend up to $22 million on
appraisal activity which would distinguish between the high, medium and low
STOIIP cases. If it would cost more than $22 million to determine this, then it
would be better to go ahead without the appraisal. The decision tree has therefore
been used to place a value on the appraisal activity, and to indicate when it is no
longer worthwhile to appraise.
Figure 8.5 shows the same decision tree but now ‘rolled back’ to show the value
of appraisal information – the difference in the EMV with appraisal information,
and the EMV without appraisal information. EMV is the expected monetary value;
the risk weighted outcome of the branch.
The benefit of using the decision tree approach is that it clarifies the decision-
making process. The discipline required to construct a logical decision tree may also
serve to explain the key decisions and to highlight uncertainties.
The fiscal regime (or tax system) in some countries allows the cost of E&A
activity to be offset against existing income as a fiscal allowance before the
taxable income is calculated. For a taxpaying company, the real cost of appraisal is
therefore reduced, and this should be recognised in performing the cost-benefit
calculations.