Risk Optimisation (a "novel" approach for frontier exploration in the oil & gas sector)
Talk to process engineers about risk and they will probably describe it as a form of optimisation because to an engineer, failure is not an option. In frontier exploration, however, we live with the reality that despite all of our hopes for success, there may actually be nothing there. Consequently, risk is viewed as value-destructive, something that needs to be mitigated against but that doesn’t mean that risk itself cannot be managed. In fact, the optimisation of risk is, in itself, a significant value-adding opportunity.
Exploration for minerals or hydrocarbons is fundamentally an evidence-based science. Whether geoscientist or geo-commercial by background, when we are presented with an opportunity to invest our money in, we pull together everything that we know from the available evidence, often allowing prior experience or knowledge to set our cognitive bias, which tends to guide our thinking all the way to discovery or failure. Only then do we find out if our perceptions were really rooted in reality.
This article was written as a companion paper to a presentation on Risk Optimisation presented at the Geological Society 3-day conference on risk (July 10-12th 2017) that spanned both the mining and hydrocarbon sectors of the extractive industries (click here to view an illustrated transcript of that presentation). An attempt was made during the presentation to deconstruct risk before putting it back together in a form that could be recognised by both extractive sectors. Exploration is an intuitive process that uses our knowledge about the way the earth works to help predict occurrences of what it is we hope to find. To aid us along the way, we construct a framework as a coat-hanger for what we know, which helps us identify gaps (“what we know we don't know”). If you remove the uncertainty around what success looks like, risk becomes a matter of chance*. Unfortunately, our framework is incomplete because “we don't know what we don't know”, resulting in us potentially understating risk or, just as importantly, understating the opportunity. To fill those gaps, and to allow us to better assess and thereby mitigate risk, we seek to broaden our evidence base by deepening our knowledge, thereby optimising the convergence of our perceptions with reality.
Exploration as a process, whilst being intuitive at an opportunity level, still follows a business cycle from concept to drilling in both extractive sectors. The ultimate truth machine for both sectors is drilling, sometimes wildcat drilling in frontier areas. Frontier exploration opportunity maturation narrative represented here is adapted from the 1980’s Capital Value Process widely adopted in the Oil & Gas sector summarised in the funnel below:
The narrative is essentially sequential (but not necessarily discrete) and each step should contain an option to drop the opportunity before committing to the next step. Each step means different things to different organisations but all projects begin with a concept and for the purposes of this discussion, the narrative takes you from pre-deal to deal delivery (opportunity selection) before committing to significant expenditure by drilling post-deal. This short article describes Risk Optimisation as a process that can be used to solidify the pre-drilling view of risk, whilst protecting it by ensuring that exposure to failure is minimised.
Risk is much more than just the inverse of PoS, normally seen as something that we should mitigate against to reduce exposure. In fact not all risk is bad (viz. “ignorance is scope”); qualifying risk depends on what you want to do with it to enhance or protect your business and to identify how risk can be value creating. To help explore the dimensions of risk, K2V has mapped out six independent geo-commercial and geo-technical risk components across the exploration business cycle where risk can be applied to enhance exploration success:
1) Risk Harvesting (Geo-technical – Knowledge PinMap™) (S1, S5)
The existence of an initial concept implies access to prior knowledge in the organisation but how broadly spread is that knowledge? Prior knowledge is essential for de-risking, for identifying that any given opportunity has merit before we spend any money on it; before framing. The first step in articulating the value for any opportunity is to establish what you know about it. A new ventures “idea” may be initiated either by an individual or by a panel of individuals who have content knowledge for a given region. Workshops to pool knowledge may follow along with modest research and a list emerges of candidate opportunities. The list tends to be controlled by those on the panel who have drawn on the benefits of their own knowledge only, because a broader college of opinion from knowledge holders assigned or located elsewhere in their organisation was not easily accessible or the means to rapidly process their opinion was not available. Now that the tools to crowd-source opinion are available, the first step to de-risking should be to verify the list of candidate opportunities by harvesting knowledge in the given region and associating that knowledge with the available data. That knowledge is free and helps to enrich the discussion for opportunity selection. K2V Ltd calls this step “Risk Harvesting” but it is effectively prior de-risking, which may increase or decrease the risk of an opportunity, potentially causing the business to choose not to initiate a new venture before committing significant funding. In effect, then, the decision to quit reduces exposure and de-risks the business.
Risk harvesting requires planning foresight, contributing factual information by screening candidate opportunities for new ventures and is the first step in Risk Optimisation through:
· Harvesting knowledge (applying what you know to the business question through crowd-sourcing)
· Data harvesting by reconnecting knowledge with data to establish data richness as a measure of confidence in applying knowledge and to chase down what is out there but not generally known (external knowledge)
· Framing the opportunity supported by knowledge and information, underpinned by real data
2) Risk Polarisation (Geo-technical – GoExplore?) (S1, S2, S4)
Polarising risk is used for quantifying risk in the oil & gas sector to establish the chance that commercial quantities of hydrocarbons exist in any opportunity, whether frontier or near-field. Quantifying the risk of failure is commonly conducted by risk profiling: arithmetically conflating well understood geo-technical and geo-commercial risk factors to derive a deterministic Probability of Success (PoS) or a risk of failure (Risk = 1-PoS). Each organisation has its own methods for combining risk factors but the pre-drill PoS normally comes down to a number that we all recognise as the corporate statement on risk. The number is created by multiplying risk elements based upon evidence that either contributes to success (green) or may result in failure (red). What we know we don't know is expressed by the residual white space. Polarising risk, therefore, is converting subjective segments of white space in to either red or green, contributing to the evidence for a PoS and sets out the work needed to be done to evaluate an opportunity as part of play-based exploration. The value of the work done can be converted in to a dollar amount using simple Value of Information techniques or complicated ones. Just like with risk harvesting, however, risk polarisation can result in an increase as well as a decrease in overall risk. Risk polarisation and its influence on volumetrics and relationship with uncertainty lies at the core of exploration and is science in itself only briefly mentioned here (consult with Rose & Associate, GoExplore or Player (GIS-pax) for complete solutions).
Risk polarisation places the emphasis on technique but technique is not a substitute for hard data. The less we know about an opportunity, the greater the tendency to over-engineer our uncertainty. The trick is to remain honest with what you don’t know and try not to be impressed with your own or someone else's hubris. Trust your risk profiles (white space) and polarises as much as you can in to positive or negative space by evidence alone:
· Applying appropriate technology for polarising risk
· Value of Information (VoI) of applied technology to provide cost benefits
· Limiting expenditure to maximise learning (short of drilling)
3) Risk Spreading (Geo-technical/ Geo-commercial – K2V™) (S3, S4)
Risk Optimisation has so far been more or less sequential through the business life-cycle: we now have enumerated risk (PoS), which is supported by knowledge underpinned by data. Risk spreading now splits between pre-deal and post-deal contexts. Pre-deal risk spreading is dominated by play-based approaches, extrapolating the trends we have observed beyond our data (field of view) in to areas that we don't know but can make a reasonable assumption about following trends that respect geological continuity.
Now is the time to spread risk by examining adjacent areas along identified sweet-spots (play fairways) and balancing risk profiles. Spreading what we know involves quantifying the risk element that is weak in one opportunity (A) but is compensated by the strength in the other (B). Some would say that this is smearing without actually mitigating risk, which may be true. But it does at least force us to identify what our risk tolerances really are and how much they are defined by what we know we don’t know. One of the most damaging biases to exploration business in frontier settings is being seduced in to believing that “what you know” and “what you know you don’t know” is all that matters to quantify risk. It is important that we make provision for what “we don’t know that we don’t know” to complete the framework contributing to a pre-deal "yet-to-find". This is something that most companies have a hard time dealing with because we are told to take the courage of our convictions, only to find post deal that we are sitting at the wrong end of the play fairway – it takes courage to admit at the outset that you may be wrong. This might not be so much an issue for mining because the mining industry drills stratigraphic wells, something the oil & gas sector ceased doing about 30 years ago.
Post deal is completely different now we own acreage and a portfolio of prospects. The temptation in frontier areas post deal is just to drill the biggest bump, because size counts where there is no existing infrastructure. Having constructed a coat-hanger for play-based risk using all the knowledge holders in our organisation, we can establish dependency between prospects but rarely do we have the courage to drill a smaller prospect to maximize the chance of proving a petroleum system that might delay the declaration of a bigger prize. Post deal is where we combine risk dependencies to effectively embark on portfolio creaming.
Opportunities are conventionally displayed on risk vs volume (PoS vs MSV) plots. To properly identify how the level of knowledge and data richness influence the overall PoS, there should be a third axis to the plot to include a component of knowledge. We should routinely be applying what we actually know to business value drivers before we can claim any confidence (and thereby credibility) to economics. This then forms the basis of opportunity ranking, levelling the playing field between depth of knowledge, data richness and breadth of knowledge using the K2V Ltd ranking tool.
Risk spreading, does nothing to change quantification (PoS remains the same) but it does allow the business to acknowledge what it doesn’t know and spread the risk over other areas by:
· Balanced Risk profile (pre-deal) – split play elements out by region and balance risk (above): more of the same = exposure and is not attractive in areas with identical risk profiles
· Risk dependencies (post deal) - avoid bump hunting by selecting the first prospect that proves the play concept (petroleums system or mineral aggregation) before portfolio creaming
· Confidence mapping - 3rd axis in PoS vs MSV domain, underpinning economics
4) Risk Sharing (Geo-commercial) (S4)
A useful mantra for testing the robustness of an opportunity through steps 1-3 is to do economics early and often. A continuous outlook on the geo-commercial consequence of geo-technical uncertainty is the only way to scope and avoid risk unnecessarily. This is nothing more than exploration due diligence common to both extractive sectors. That is as far as the similarities go because the oil & gas sector prefer to trade equity in upstream projects for a share of the risk. The many varieties of mineral species available to the mining sector means that achieving a monopoly is a realistic business aspiration, so risk sharing is less widespread. Nonetheless,the commercial equivalent to risk spreading is risk sharing: if the business cannot carry the chance of being wrong, share the risk with other corporate entities who may have a different view of risk driven by different strengths in their business model or portfolio. Trading equity for risk reduction is only perceptually reducing exposure, the real gain is in getting a promote or even carry. But where it also works for the business is where the prospective partner reduces cost further by bringing a position to bear on acceleration or market privilege. The temptation is to farm-down to the highest bidder because numbers generally speak louder than sense. But the successful partnership is achieved with the right balance of expertise, life-cycle infra-structure, political leverage, gravitas and corporate culture. In the author's experience, geoscientists are very poor at placing themselves in the shoes of the competition. The best commercial minds are much more empathetic, capable of thinking like the competition and finding ways to forge robust partnerships to make their business more resilient.
Risk sharing, therefore, is establish the ideal partner (the highest bidder is not always the best partner) to share opportunity through dilution by:
· External focus - Establishing the partner who will challenge corporate bias and who can unblock the business life-cycle
· Partnering - Study potential partner corporate value propositions with complementary competences and market positions
· Equity swap OR Dilution can be used to share the risk (cost) between operators in areas with complimentary risk profiles, capping exposure back to a level that frees up funding for risk spreading
5) Risk Limitation (Geo-commercial) (S1, S2, S3, S4, S5)
One of the potential consequences of frontier exploration is a new country entry, along with its associated non-technical or above-ground risks. Before you decide to make a bid, you have to undertake to go in to partnership with (become a contractor for) a sovereign state. How will that influence your organisation's reputation? Is the Government (or indeed the regulatory system) stable? Are you potentially altering either a pristine environment or perhaps the lives of communities near your place of operation? Will your activities create boom and bust economies or do you have something longer term planned? How benign is the operating environment for your staff? These are just some of the questions that need answers before you can mature an opportunity and they require vision. Success depends on the three legs of sustainable development being equal: that the business is profitable; that the environment is not compromised; and that the business actively encourages social equity for host communities. Anything less risks compromising the reputation of your business in other countries.
Part of risk sharing is in deal constructs through contracts with Government as resource holders, which becomes risk limitation when reducing liability by negotiating frontier-friendly commercial and fiscal terms in conjunction with a license to operate. Naturally, the negotiation will be completely different in a country where the organisation already holds assets versus a new country entry. Resource holders need to understand the dimensions of frontier risk and the need not to rush to drilling the wrong well, which can damage further exploration by cutting short continued frontier investment. Your ability to negotiate favourable terms rests on the evidence of past success and your ability to apply the experience you have gained from similar positions elsewhere with similar degrees of sub-surface uncertainty. The purpose of risk limitation is to achieve some protection for the business, making the resource holder aware of what you are risking on their behalf and that success needs a measure of give and take. A number of advantageous elements could include tax holidays, a quantifiable minimum work programme and multiple, extendable exploration periods followed by appraisal periods. The minimum work programme for each period should be commensurate with asset maturation (holding, prospect generation, discovery, hydrocarbon maturation) with minimal exposure on failure to complete. Each period should be followed by an option to withdraw or relinquish without penalty. All of this is general house-cleaning if accompanied by enlightened capital constraint which are all fully explained elsewhere. Resource holders are obliged to offer contracts that are fair for all parties, so gaining favour will not be easy.
Risk limitation, therefore, requires vision and aims to minimise exposure (optimise) by looking at the most appropriate commercial constructs for each business opportunity by:
· Obtaining a holding position where possible (options preserved) OR get carry for activities
· Examining cross-cost recovery against production in other licenses in Country OR
· Considering capex vs opex offsets (e.g. leasing vs. buying an FPSO) within operator control
6) Risk Realisation (Geo-technical/Geo-commercial) (S5)
The ultimate truth machine that rewards your treatment of risk through optimisation for both extractive sectors is drilling a frontier opportunity. Risk realisation is not in itself a process but is the natural conclusion of both risk optimisation and exploration opportunity maturation processes. If we are lucky, we discover ore grade deposits or commercial quantities of hydrocarbons and the process begins over again with the risk profile modified to articulate how much has been discovered, are there new business synergies arising from an emerging asset? where is the growth potential? how can we offset the cost of new infrastructure? do we do an outstep? etc. etc. If, however, our worst fears are realised and no commercial accumulations have been found, damage limitation includes switching attention to the real prize, dilution, re-negotiating commitments or liquidating the operating entity to realise tax benefits. What is worse than failure is a teaser. The drill bit makes a technical discovery, requiring additional precarious exploration funding to prove up a commercial case, which ends up a significantly more expensive failure than a straight duster. We tend not to include teasers in our risking despite the fact that up to 40% of outcomes are teasers.
What ever the realisation outcome, having decided to drill and not drop, the time for risking is over – now is the time to execute and revise the risk profile. But does it stop with failure? It may take 10 dry holes to prove that a frontier basin has what is required for commercialisation. Will you stop at the first failure or do you have the resilience to take it all the way to success or to know when enough is enough - stop?
· The success (ca. 10%) = within the range of uncertainty? Commercially viable? = new positions
· The failure (ca. 50%) = Liquidation = repatriate tax benefits but it also means increased knowledge and re-framing for the next value generating activity
· The teaser (ca. 40%) = did you get enough information to make an informed choice? = good decision
The exploration opportunity maturation and Risk Optimisation processes run in parallel but they do not map uniquely on to each other. The former is essentially sequential and linear, the latter contains many iterative loops, which may not be sequential. Both do, however, share a common starting point and end point. Combine both funnels and you get something like the Fibonacci sequenced double nautiloid below:
The double nautiloid is not a model but a guide to optimising risk by moulding together two converging processes that have common starting and end points. As such, it can only be used as a health check at any time in the business process to help guide your thinking and challenge your assumptions. If you follow the tendency of many explorationists by over-engineering your uncertainty and adhering to the double nautiloid literally, you could end up by making the decision making process more complex than it is already. The path to exploration success in both industries is very simple – we take a concept through to discovery and that is all it is – how we manage risk along the way is up to us to balance the exposures thrown up by the business commensurate with that business; resist the temptation to over play it.
Opportunity realisation and risk optimisation don’t stop at success, as each step should be repeated to identify synergies for growing what is, having coevally converged on both processes, a proven viable business. The business model of some small independents use the risk sharing/risk spreading cycle to farm-down every position, using the proceeds to fund new positions under-written by their larger partners. K2V Limited provides tools for organisations with large numbers of potentially geographically spread knowledge holders to de-risk and risk spread exploration opportunities. Risk polarisation tools are provided by a number of excellent other tool providers (e.g. GoExplore) and workflow consultants (eg. Rose & Associates). Geo-commercial risk sharing, risk limitation and risk realisation are tied to organisational best practice and are largely home-grown by most organisations.
There is nothing new in any of this, just common sense which all of us do to a lesser or greater extent. Some of the steps, while they may be idealistic, are made redundant by political, financial or temporal expediency. K2V Ltd. believes that Risk Optimisation during planning increases the resilience of your business by protecting it from downside potential whilst allowing explorers to quantify the upside.