Valuing and Comparing Oil and Gas Opportunities: A Comparison of Decision Tree and Simulation Methodologies

Abstract

Abstract Decision trees have been widely used in the petroleum industry for both economic evaluation and decision analysis. In recent times Monte Carlo simulation has begun to be used to value oil and gas projects and to analyze decisions. In this presentation I will compare and contrast decision tree and simulation methodologies for both economic valuation and decision analysis. As a starting point, I will take a typical Gulf of Mexico project from exploration through to development. The results of a decision tree analysis of the project and a Monte Carlo simulation of the project will be compared. When using decision trees, the expected monetary value (EMV) is usually calculated and used to value the opportunity. Frequently the impact of uncertainties on the EMV is not assessed. In contrast, with the simulation approach the full net present value (NPV) distribution is calculated along with the risk. We will show that, for the Gulf of Mexico project, a relatively complicated decision tree is needed if the EMV of the decision tree is to be close to the mean NPV calculated using the simulation. However, even when the EMV and mean NPV are close, the additional information about the NPV distribution that is part of the simulation output enables risk to be an explicit part of the decision-making process. Although decision tree methods can be extended to include an assessment of risk, since the form of the NPV distribution is not known when using decision trees, a true assessment of project risk is not available.