— as Prospector, you think you've finished your job:
identifying the anomaly and delineating its basic attributes, you've
now completed the requisite geotechnical work refining that promising
with your engineering colleagues, you've developed responsible estimates
for prospect reserves, chance of completion, initial production
rates, per-well recoveries, production schedules and costs for drilling,
completions, facilities and operations. You've gathered necessary
data on contract terms and tax impacts.
time to integrate all this information (together with other assumptions
and parameters) into a cash-flow model for the success-case outcome
of the venture. This will be a discounted cash flow (DCF) analysis
expressing a responsible value for the project, as Net Present Value
(NPV), the fundamental economic measure.
NPV and projected cash-flow profile will be compared against counterpart
data from other projects, in choosing which projects (and in what
share) will be drilled as part of the company's annual E&P portfolio.
the time for you, the Prospector, to be on the lookout for "Hidden
Hurdles" is a term I proposed about 15 years ago for arbitrary economic
requirements that are inserted into the project evaluation process,
ostensibly to help screen out less worthy projects.
- Commonly employed
by well-meaning business people who see their task as guardians
protecting the firm against irresponsible explorationists, even
though they themselves are not actually accountable for exploration
- Insidious, because
their existence is generally not apparent to prospect-generators.
- Dangerous, because
— ironically — they often have impacts on project evaluations
that are different from what was intended. Usually, they select
against growth projects — and successful exploration is mostly
about creating growth.
some examples of "Hidden Hurdles":
Arbitrarily elevated discount rates.
rate selected for the project cash-flow model expresses the time-value
of future production revenues and net cash flows. It is not a useful
proxy for countering perceived risk. Excluding projects independently
financed from foreign banking sources, the same discount rate should
apply to all E&P projects in the corporate portfolio — after
all, it's all the same money!
rate should express the corporation's average weighted cost-of-capital,
which is ordinarily about the same as prevailing corporate loan
rates, or a little higher. Presently, that should be around 8 percent.
Elevated discount rates preferentially penalize longer-term cash
flows, so large-scale projects are undervalued relative to short-term
Arbitrarily depressed oil-price forecasts.
projects whose production revenues don't begin until three-to-six
years after project initiation, use the mean historical oil price
corrected for inflation to production - onset year one, adjusted
for regional market effects and inflated by a realistic inflation
factor. Using much lower projected prices — as a putative "safety
factor" — may allow you to sense how sensitive the project may
be to sustained downward price shifts, but causes the DCF analysis
to lose its value as an objective predictor of project profitability.
that crude oil behaves as an (imperfect) commodity, and has done
so since 1985. Prices will fluctuate throughout field life, so the
mean is the preferred predictive price.
Overly pessimistic drilling-cost estimates.
of completing a drilling project under AFE cost is a lot more pleasant
than an AFE over-run. Consequently, there is often a tendency for
drilling costs to be overly pessimistic, resulting in much higher
front end costs that hammer otherwise worthy projects.
your drilling experts — remember that Unocal's drillers made their
exploration colleagues look very successful in the Gulf of Thailand!
Excessive minimum economic field-size requirements.
play projects where several discoveries may reasonably be contemplated
given venture success, don't insist on recovering all investments
from just one big field. Instead, consider that two or three middle-sized
discoveries may in fact be a more plausible outcome than one very
large discovery. Let lognormality work for you!
Secret minimum prospect-reserves requirements.
everyone accepts the need for corporate efficiency, the notion of
a "headquarters prospect minimum" is often counterproductive, because:
- Such a "Hidden Hurdle"
may be demoralizing to prospectors.
- It presupposes far
more precision in estimating reserves than the facts show.
- It ignores what should
be our primary goal: adding value, not just reserves.
- It prevents consideration
of such ventures from the portfolio point of view.
- It disallows the
efficient monetization of projects not selected for the portfolio,
through farmout or sale.
a conscientious professional prospector, watch out for those "Hidden
Hurdles" — they can incorrectly trip-up your prospect!
reading recommendation: "The Lexus and the Olive Tree: Understanding
Globalization" by Thomas L. Friedman (2000 Anchor Books). An excellent
world overview of the inherent conflict between the evolution of
global business and the preservation of different cultures; superb
insight on the Middle East.
you'll like it!