The essential economic evaluation of an exploration opportunity is, amongst others, finding the Expected Monetary Value or EMV. The formula for this is:
EMV=Expected Monetary Value
POS=Probability of success
PVNCS = Present Value Net cash surplus
AEC = Abortive exploration costs, or simply "EEC"
E = Expectation of ...
The PVNCS is the result of the cumulative cash flow calculations. This takes account of the costs of successful exploration. That is because in most cases this is fiscally treated in a different manner from the abortive exploration costs. The latter, AEC should also include the foreseen necessity to drill more than one well to evaluate a structure before it is finally abandoned.
Note that in calculating PVNCS and AEC, the time element plays an important role. All has to be calculated in terms of present value.
Estimating the exploration costs in PV terms becomes difficult in the case of a complete program involving various surveys, several wells, etc. Then actions have to be divided into time intervals with a decision point at the end of each. At the start we are not certain that all the activities will be carried out (if expenditure obligations permit stopping the process). Therefore the notion of "probability of continuation" is introduced. This can be estimated for each decision point subjectively, which is difficult to do, or a probabilistic approach can be used to obtain an expectation of costs of an "uncertain" exploration program. The EEC program has been developed for this purpose.
A positive EMV would suggest a viable prospect. A negative one may suggest a financial disaster, but could still mean that there will be a profit on average for such a case, but not at the discount rate (internal rate of return) that has been applied. Some companies use a set of discount rates and interpolate in a graph of PVNCS versus discount rate to find the "earning power" of the prospect. Spreadsheets have special functions to carry out such an analysis.
Development cost. The calculation of development costs and the other calculations to obtain a net present value cumulative cashflow is usually made by petroleum engineers on the basis of estimates of reserves, such as presented by the MSV. Apart from the MSV the Administration data for the prospect, giving the technical environment, the waterdepth and the location are important data for evaluation. In addition the table of productive areas will help in some cases to estimate numbers of wells.
Another item of great importance is the well initial production rate that we may expect. This affects the number of production/injection wells and hence the capital investment.
Here is an example of the EMV calculation for an exploration prospect:
EMV = POSc * PVNCS - (1-POS)* AEC = 0.13 * 55 - (1 - 0.13) * 7 = 1.06
By setting EMV=0 we can figure out what the minimum POSc should be to make the prospect fly: 0.11. Recently, Peel (2016) made a case for using this minimum POSc as a tool for decision making. Then this minimum is related to the term "Postodds" as used in gambling: the odds neccessary to break even. Alternatively we could calculate the maximum AEC: 8.2.
But the above equation for EMV appears sufficient and is the most explicit way to depict the risk situation.
Note that we write POSc to emphasize that the probability of success should be "economic success".
The EMV is just positive and the prospect accepted.
The EMV is a "point estimate" in time, because the cashflow calculation is dependent on which oil price scenario is considered. This will also influence the cutoff. Moreover, changes in the hurdle rate required by the company would have a large effect through the present value calculation.
As two prospects can have the same EMV, decision making should also look at the capital investment involved in those preospects, if successful. The one with less investment has a greater investment efficiency, or more pv value per pv dollar invested.