The Future Ain't What It Used to Be, Or Is It?

Abstract

Management If a man tells you he knows a thing exactly, then you can be safe in inferring that you are speaking to an inexact man. —Bertrand Russell In “The Difficulty of Assessing Uncertainty” (SPE 5579, 1976) E.C. Capen described how oilfield engineers struggled to quantify variables. Capen asked groups of SPE members to estimate 10 quantities (e.g., dates, distances, times) using ranges with a prescribed confidence level. What he found (and others before and afterward confirm) is that very few people are good at this exercise. Probabilistic methods and in particular Monte Carlo Simulation (MCS) are often thought to solve the problems presented by Capen. However, MCS can make matters worse if a misleading estimate appears to be backed up by a detailed process, voluminous research, and specialized software. All estimates need to be calibrated, that is, substantiated by reference to reality. For clarity, it is worth defining the terms uncertainty and risk. Uncertainty is used here to describe the fact that for any future project a range of outcomes exist. Risk is used to describe less-desirable outcomes; typically risk relates to a project running late and over-budget. The purpose of this article is to suggest that a calibrated estimate of well project duration and cost should be a standard part of the investment decision-making process. A calibrated estimate will substantiate a wide range of possible outcomes and improve the quality of information available prior to allocating capital. Communicating information related to risk is also an area where the E&P industry can learn from others. Rating and Describing Risk Rating systems exist to describe in broad, concise terms the nature of risks associated with particular financial investments. The risk being rated is the less desirable outcome that the borrower defaults on the money invested. Standard and Poor (a credit-rating agency) use the term “AAA” to describe the lowest investment risk to capital. In the Standard and Poor system, 13 basic levels of long-term credit risk are described using a scale from AAA to D. With the potential project costs faced by the E&P industry, it seems strange that standard tools have not been established so that risk can be measured and communicated. The credit-risk system has been through a difficult period and is thought to have contributed to a large number of bad investment decisions. The fact that the risk of collateralized debt obligations (CDOs) was thoroughly underestimated reflects badly on the system. But lessons can be learned from the financial industry. First, although the system was flawed, it has not been abandoned and will be improved. Secondly, so much has been written and published about financial risk that it would be irrational not to use knowledge gained from these expensive lessons. Thirdly, the cost of poorly understood risk is illustrated well by public errors such as the CDO fiasco.