Drill vs Farmout: The Simplest Case
Posted by D Nathan Meehan January 14, 2011
Category: Production, Reserves, Reservoir   |  Tags: , , , ,

In this example the reservoir engineer is called on to estimate the potentially recoverable resources in an exploration project that is located near a series of small discoveries. The engineer has a map generated (by geologists and geophysicists) from seismic, geological and petrophysical data and has estimated a “most likely” gas-in-place based on analysis of logs from the nearby discoveries, their actual gas-water contacts  and spill points, anticipated pressures, etc. Well costs have been estimated and a success case development plan involving the discovery well and one development well has been made. The company already owns leases for the prospect and has asked the engineer if the exploration prospect should be drilled. This prospect is considered an excellent analog to offset discoveries that have been drilled with very high success rates. There are varying estimates for the likelihood of a discovery ranging from 50 to 90 percent. In the case of an initial dry hole it is anticipated that no further expenditures are likely and the lease and prospect will be abandoned.  Another operator has offered to “farm-in[1]” the acreage, assuming all exploration well costs in return for earning 75% of the block.  After the other operator recovers 150% of their investments, the reservoir engineer’s company share would rise to 40%.   The reservoir engineer must now evaluate retaining all of the future ownership in the field while putting his company’s capital at risk compared to retaining 25% (or ultimately more) of the block but without any risk.

What factors dictate the answer and determine the operator’s decision? While the intrinsic economic attractiveness of the project and the “chance of success” are predominant, the capital situation of the company, its portfolio of investment opportunities, etc., are all important. In a future post, a similar case will be illustrated in more detail to illustrate some of these issues. In the following figure, the Net Present Value at 10% (NPV10) is shown for the “drill” and “farmout” cases as a function of the probability of success. In this case “success” is a single case, viz. the discovery of the gas field with precisely the ultimate recovery and timing estimated pre-drill. The failure case is a single dry hole. In reality, reservoir engineers evaluate numerous alternative cases including a continuum of potential cases and advanced techniques described later are used.

I will be going over how NPV is calculated and alternative (and probably much better) risk analysis techniques in subsequent posts.

Which is preferable, drilling the well or farming out? It is clear that at low chances of success, the farmout case is always superior while as the probability of success approached unity, the drill case becomes increasingly better. But what about a case with 60% probability of success (40% probability of a dry hole)? The NPV10 is slightly greater than farming out. However, there is a reasonably large amount of risk being taken for a small incremental benefit.

NPV of drill and farmout cases vs chance of dry hole

[1] A “farm-in” or “farm-out” represents the assignment from a party (the farmor)  holding the rights to drill on a lease assigns some fraction of these rights to another party (the farmee).  These agreements can include assigning obligations, cash, warrants, information, technology, etc. in addition to the drilling and production rights. Terms range from simple to bewilderingly complex.

4 responses | Add Yours


Marcus Bosworth says:

I appreciate the economics review as applied to Petroleum Engineering. Can you show us a broader outline of what you plan to cover?

Rodolfo Galecio says:

There’s something intriguing about this graph, it only shows the associated probability to a dry-hole event which as we know is a mutually exclusive event that we have to compare with some option, like the proposed farm out which in turn should have its own related probability of occurrence, all of these just in order to allow us to use some decision criteria like the expected value concept.

D Nathan Meehan says:

The “dry hole” event should actually reflect the expected value of the failure case. Perhaps 80% of the time a failure requires one dry hole and 20% requires two dry holes… Similarly, the 100% success case should reflect the EV of the success case. The COS evaluation is a very simple way to then reflect the expected NPV at any COS. Having this for two decisions (farm out and drill) compares the expected NPV at any given COS. There are more sophisticated approaches; however, visual displays like this one are often helpful for managers. Similar graphs are common to illustrate varying bid prices for a property with different levels of (e.g.) expected resources.

Rodolfo Galecio says:

Certainly I agree with you, I have misunderstood the meaning of the graph, indeed it includes the expected value of the choices to be considered and it is an useful way to visualize the relative advantage of each option if we can estimate at least the range of probabilities associated with our project, perhaps this is the most difficult task, getting the right numbers!

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