Expectation of Exploration Cost (EEC)

Exploration decisions are based on the evaluation of possible profits against possible exploration and production expenditure and risk. If all expenditure is certain to be made, a simple calculation is sufficient. However, if the expenditure is made in phases where not all phases are necessarily carried out, a more sophisticated analysis of the expectation of expenditure is required. If this "option planning" element is overlooked, the normal evaluation procedures could turn out to be very pessimistic. The logic of the evaluation in the case of sequential exploration phases with decision points is explored here.

Calculation of Expected Monetary Value (EMV) requires an estimate of the exploration costs (EEC):

Where POS is the probability of success (fraction), the NCS the present value Net Cash Surplus in the case of success. Success is defined as finding more recoverable hydrocarbons than the economic minimum volume ("cutoff").
The failure case is represented in the formula by the complement of the POS, multiplied by the Expectation of PV exploration costs, or "EEC". Another expression for the second term in the above formula is "Expectation of exploration costs in the abortive case"
Exploration costs in the success case are normally included with the development costs in the Net Cash Surplus (NCS) because of fiscal reasons. Here EEC represents the exploration costs regardless of the fiscal treatment of such costs.
In the case of a single well to be drilled on a prospect, all that is required for the EEC is to PV the cost of drilling the well, if the well is not drilled immediately, but say, a year from now or even later.

However, even for a single prospect already defined by seismic work, the EEC may comprise more than the cost of the first well. This is because the EEC should be technically sufficient to reach the decision point where we decide that more than the economic cutoff volume has been proven, or abandon the prospect if less was found. Therefore the EEC may involve the drilling of one, two or more wells, depending on the complexity of the structure. This range of possibilities to "prove up the cutoff" could be expressed as "1.7" wells for instance, representing a judgement on what the average situation would be. If we consider decision points after each well, a more precise analysis can be made, as explained below.

We will now turn to more complex situations, where several investments are envisaged in a given timespan of several years, but with a number of decision points between these exploration phases. At the decision point the company can abort the venture. If such decision points do not exist, for instance because there is a fixed commitment to carry out all the work, regardless of intermediate results, we are back to the one well example, and only discounting is required for the expectation of the total exploration expenses.

Real Options

In exploration as well as in many other business contexts, the evaluation of an uncertain proposition is often done by the Expected Monetary Value based on the discounted cashflow model. If this is applied to a complex program in which decision points are present that allow flexibility in the investment, the discounted cashflow may overestimate the expected investments (e.g. exploration costs) if it is tacitly assumed that all phases will be carried out, regardless of the results along the way. As it seems, there are usually a number of "real options" that allow an explorer to quit at a decision point. Then some of the future investments are not only reduced by PV-ing them, but also by taking into account the uncertainty that the investment will really be made.

In the case of decision points, the procedure requires estimation the "conditional probability of continuation" (POC) after every phase of the exploration program, i.e. at the decision points. This involves imagining that at a given decision point we can choose to continue or quit, but that all previous phases have been done. This estimation is constrained by the results of the prospect appraisal. The probabilistic appraisal is assumed to specify a probability of success (POS) and a mean success volume (MSV) for the end result of the venture, regardless of when (meaning after which phase) it is aborted. To ensure consistency with the appraisal results, the cumulative product of the POC's must be monotone declining sequence that is always higher or equal to POS.
It may be that several phases are anyhow committed. Say, the first three phases are an obligation. Then the is 3. The effect is that the probabilities of continuation for these three phases will be 1.000. The whole PV costs of these phases is added to the pvEEC.

Example (Deterministic demo)