The application of Monte Carlo simulations is one of the most important tools that reservoir engineers can master in the field of modern risk analysis.
Nearly all business decisions are made under conditions of uncertainty. Decision making under uncertainty implies that adequate information for assuring the right decision is lacking and two or more outcomes are possible as a result of the decision. Petroleum exploration is a classic example of decision making under uncertainty. The following discussion of risk analysis will be phrased in terms of petroleum exploration, although there are applications to manufacturing, marketing and service company decisions that are equally well suited. It is recommended that exploration wells and programs are evaluated using expected value economics which account for the probabilities of realizing various outcomes.
Risk analysis provides a more thorough and comprehensive approach to evaluate and compare the degree of risk and uncertainty in a project than the methods previously discussed. The intended result is to provide the decision maker with more insight into the potential profitability and the likelihood of achieving various levels of profitability than traditional methods of investment analysis.
Conventional methods of analysis usually involve only cash flow and rate of return considerations. The added benefit of risk analysis to the decision maker’s process is the quantitative review of risk and uncertainty and how these factors can be incorporated into the process of developing and implementing investment strategies. Risk and uncertainty cannot be eliminated from the business decision maker by such analysts, or by any other method of investment review. The advantage of decision analysis is its use as a tool to evaluate, quantify and understand risk so that management can devise and implement strategies that will allow the company to minimize its exposure to risk.
Decision analysis is a multidisciplinary science. It involves aspects of many different disciplines, including probability and statistics, economics, engineering, geology, finance, etc. Certain statistical methods of decision analysis provide excellent ways to evaluate the sensitivity of various factors in a risk-based economic analysis.
Several petroleum industry methods for handling risk are briefly described below.
The decision to drill an exploration well can result in a dry hole, discovery of a giant field, or something in between. Each outcome has some likelihood of occurring, yet no outcome is certain to occur. Many take the view because of the inherent subjectivity involved in assigning probability estimates, expected value analysis has little to offer. There is no doubt that assigning probabilities to the possible outcomes of a drilling prospect is difficult. Sometimes is not even possible to define all the possible outcomes. The benefit of expected value analysis, however, is confirmed by its application to repeated trials. If a firm consistently strives to maximize the expected value of many projects over the long run, it can be shown that the firm will do better utilizing risk-weighted value economics.