MSc Accounting and Finance

Masters Dissertation
SESSION 2013/14

TITLE

The effect of high risk and uncertainty

on the investment appraisal process of
the upstream oil and gas sector

AUTHOR

Ilinca Vlad
40128310

Supervisor: Donald MacAskill.

1
 The effect of high risk and uncertainty on the
investment appraisal process of the upstream oil
and gas sector

by

Ilinca Vlad

August, 2014

Thesis submitted in partial fulfilment

of the Degree of

Master of Science
In

Accounting and Finance

2
 Declaration

I declare that the work undertaken for this MSc Dissertation has been undertaken by
myself and the final Dissertation produced by me. The work has not been submitted
in part or in whole in regard to any other academic qualification.

Title of Dissertation:

The effect of high risk and uncertainty on the investment appraisal process of

the upstream oil and gas sector

Name (Print): ILINCA VLAD

Signature: _______________

Date: 18/08/2014.

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Abstract

This research aims to observe the appraisal process of the oil and gas firms
operating in the upstream sector. Moreover, it will attempt to diminish the theory-
practice gap by conducting survey type questionnaires distributed to 99 firms
operating within or closely consulting the upstream sector in UK. The research is
mostly concerned with the inherent risks in the sector, raising challenges and what
appraisal tools are used in the face of risk and uncertainties.

The findings show that recent changes in the oil and gas environment have been
affecting the oil and gas sector and particularly the investment process. This was
reflected in declining production rates, declining discovery and falling exploration
rates. It also emerged that the most affected areas were the exploration and
appraisal phase. The vast majority of the respondents were using more than one
appraisal tool at a time in order to get a better picture of the investment. Additionally,
the most preferred appraisal tools seem to be variations of decision analysis trees,
DCFs, NPV, EMV and in certain cases real option valuation. The findings mostly
confirm the results of previous studies such as Macmillan (2000) and also PWC
(2014) and UKOOA (2014) activity reports on the matter of inherent risk and
uncertainty factors. However, the findings relating to the use of real option valuation
and Monte Carlo simulation are in disagreement to some extent with previous
academic studies. The use of these methods was limited in practice and often
disregarded as difficult to understand and time consuming.

From this research it is concluded that the oil and gas industry is at a crucial
moment, where expenses are increasing yet returns of future investments are
decreasing. Great changes will have to be made in the future in order to recover and
to ensure the future profitability of the sector. Even though, the majority of the
respondent firms were aware of the inherent risks in the sector and were using more
than one appraisal tool to account of uncertainty levels, there is little evidence of the
use of sophisticated appraisal tools such as Monte Carlo simulation or real options in
practice. Further research and improvement in the investment process of oil and gas
firms is of upmost importance.

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Acknowledgements

I would like to thank a number of people for their guidance and assistance
throughout my master’s degree and particularly the completion of my dissertation.

Firstly, I would like to thank my dissertation supervisor Donald MacAskill for his
patience, advice and support. Moreover, I especially thank him for his feedback and
constant encouraging during the entire process of writing this dissertation.

Secondly, I would like to thank my lecturers in Edinburgh Napier who have taught
and helped me this year. I can wholeheartedly say that I gained valuable knowledge
during my Master’s studies that will help me in my future career.

Last but not least, I would like to thank my whole family for their belief in me and
never-ending love and support.

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Table of Contents
Declaration 3

Abstract 4

Acknowledgements 5

Content 6

List of figures 8

List of Abbreviations 9

Chapter 1: Introduction

1.1 General introduction 10

1.2 Aim and Objectives

1.2.1. Aim 11

1.2.2 Objectives 11
1.3 Research Approach 12
1.4 Limitations 13
1.5 Structure 13

Chapter 2: Literature review

2.1 Introduction 14

2.2 Definitions 15

2.3 E&P Risks 17

2.4 Current challenge 20

2.4.1 Field discovery 20

2.4.2 Demand and supply in the view of depletion 22

2.4.3 Oil prices and restructuring 24

2.5 The theory-practice gap 26

2.5.1 Monte Carlo Simulation 28

2.5.2 Option Theory 29

Chapter 3: Research Methods 33

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 3.1 Research Philosophy 33

3.2 Research Approach 35

3.3 Research Design 36

3.4 Sample 38

3.5 Data description 39

3.6 Data analysis 40

3.7 Ethics 41

Chapter 4: Findings and Analysis 41

4.1 Introduction 41

4.2 Respondent awareness 42

4.3 Current challenges 45

4.4 The appraisal tools 55

4.5 Summary of findings 68

Chapter 5: Conclusion and Recommendations 69

5.1 Dissertation aim and objectives 69

5.2 Literature review 70

5.3 Research approach 71

5.4 Finding and analysis 72

5.5 Limitations 73

5.6 Recommendations and future research areas 74

References 76

Appendix 80

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List of figures
Figure I. 16

Figure II 18

Figure III 19

Figure IV 21

Figure V 22

Figure VI 24

Figure VII 28

Figure VIII 30

Figure IX 33

Figure X 42

Figure XI 43

Figure XII 46

Figure XIII 47

Figure XIV 48

Figure XV 50

Figure XVI 51

Figure XVII 52

Figure XVIII 53

Figure XIX 56

Figure XX 58

Figure XXI 59

Figure XXII 60

Figure XXIII 61

Figure XXIV 62

Figure XXV 63

Figure XXVI 65

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Figure XXVII 66

Figure XXVIII 67

Table I 54

List of Abbreviations

 Boe barrel of oil equivalent

 DCF discounted cash flow methods

 E&P exploration and production

 EMV expected monetary value

 NPV net present value

 PWC PriceWaterhouseCoopers

 ROA real options approach

 ROV real options valuation

 UKCS United Kingdom Continental Shelf

 UKOOA Oil and Gas UK, known as the UK offshore operators

association.

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Chapter 1: Introduction

1.1 General introduction

One of the quintessential functions of a business is to carefully invest its capital in

order to insure future financial gains and benefits. Thus, the tools employed for
assessing future investments are also very important. Some academics point out
that choosing inappropriate appraisal tools or evaluating the investment erroneously
where the rate of return proves to be smaller than the cost of capital can even harm
the organisation (Arnold and Hatzopoulos 2000).

Moreover, “an appraisal system which leads to failure to apply resources to projects
offering a return greater than the cost of capital results in an opportunity cost and
potential loss of competitive position” (Porter, 1985 in Arnold and Hatzopolus 2000
pp. 603).

However, the problem of investment appraisal is far more critical in the field of
upstream oil and gas companies. It is generally accepted that exploring and drilling
for oil and gas reserves is a very risky business area due to geological, technical and
economic factors (Suslick and Schiozer 2004).

Firstly, the geological aspect is one of the most important and yet difficult to quantify.
Oil and gas resources were formed over the period of millions of years and
accumulated in so called reservoirs provided they are trapped by a “seal” (usually
rocks) (Selley 1998 ) or otherwise travelling upwards to form a “seepage” (Tiratsoo
1984). Exploration phase is when the upstream firms drill to localize a seal/reservoir.
Only if the exploration is successful (anything is found) and field is trapped then can
it be used for exploitation purposes (Robellius 2007).

Secondly, economic evaluation of possible findings is also challenging. Costs of

exploration, probability of finding, future oil price and quality/quantity of oil/gas are
intertwined and difficult to estimate (Suslick and Schiozer 2004). The quantity of the
trap (reservoir) is initially estimated by geophysical tools with varying rates of

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success. However, more information becomes available after the drilling and in the
production stage (which can be very late) (Dake 2004).

The literature surrounding this topic presents limited information on the current
investment appraisal process of the oil and gas firms. The underlying studies mostly
focus on the increasing challenges that the industry faces in the 21st century and on
what appraisal tools could be more useful to adapt the level of risks and
uncertainties involved in the sector. Additionally, very few of the journals contain
practical evidence from within the oil and gas operating firms; but mostly focus on
theoretical and computer-generated algorithms. In general there are two big issues
facing the research in this sector. Firstly, the level of difficulty of the appraisal
process as it involves geological, technical and economic considerations that vary
with the investment project. Secondly appraisal information from the upstream oil
and gas firms is highly confidential and difficult to come across.

1.2 Aims and objectives

1.2.1. The aim

The aim of this research is to observe the investment appraisal process of the
upstream oil and gas firms under the impact of high risk and uncertainties and
emerging challenges characteristic to the industry.

1.2.2. The objectives

The aim will be achieved through the following specific objectives:

1) To critically analyse the existing literature surrounding the oil and gas
appraisal process including the main culprits for risk and uncertainty and what
techniques are recommended by the academics to alleviate these.

2) To carry out a questionnaire type survey in order to collect primary data from
practice by targeting the oil and gas firms operating in the UK.

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 3) To discuss the results of the survey, but also compare and contrast with
existing theories and previous studies relating the topic.

4) To draw conclusions of current practice in the appraisal process and offer

recommendations for future areas of research based on findings and
limitations of this study.

This research is important as it is attempting to observe one of the most important

industries for the global economy (Hall et al 2008) and how it ensures future growth
and profitability through its appraisal process under ever increasing risk and
uncertainty.

Understanding what appraisal tools to use in a complex environment such as oil and
gas can be useful for other high risk industries such as pharmaceuticals, high tech or
R&D projects.

The author wishes to pinpoint the distinctive risk and uncertainty factors that appear
when evaluating oil and gas exploration and production projects such as geological,
technical and economic valuation factors. Moreover, this study draws attention to
recent changes in the oil and gas environment that are very likely to negatively
impact on the investment process in the future.

Previous studies of the appraisal process in the industry are often difficult to access
(conference journals/meetings) or have little practical evidence from realistic oil and
gas investment projects. Consequently, this research endeavours to interpret in an
accessible manner, what investment appraisal techniques are being used in practice.

1.3 Research Approach

This dissertation sets out to examine the investment appraisal process of upstream
oil and gas firms. In order to do so, primary research will be conducted with the help
of self-completion questionnaires. The survey will be distributed to 99 firms that are
either upstream oil and gas firms operating in the UK (or with exploration rights in the

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oil fields in UK) and also to contractor firms which are employed by the former to
appraise investments or to manage the investment process.

The survey will mostly revolve around the inherent risks in the oil and gas sector and
raising challenges that could affect the investment process. Respondents will be
asked question in order to understand if these challenges are perceived in practice
and what areas of the E&P process are affected the most. Additionally, the
questionnaire will also attempt to shed light on the investment appraisal techniques
that are currently being used in practice.

1.4 Limitations

This dissertation has several potential limitations in its research approach and
methods. Due to the limited availability of time, information and limited access to
primary research only 99 firms (in UK) implicated in the appraisal process of E&P
were targeted. Amongst this number approximately 67 firms were independent oil
and gas firms operating in exploration and production, while a number of 32 firms
were directly involved in advising these firms on such matters. Although, the target
group was either directly involved or with good knowledge of the investment
appraisal process, the sample might not be significant to generalise the results for
the whole oil and gas sector.

Additionally, the use of self-completion questionnaires has its own limitations. The
most important limitation is that the research cannot verify if the information was
correctly answered by the targeted respondents. Moreover, the survey was required
to use mostly closed-end questions in order to maximise the time-efficiency and
maintain the interest of the respondents. Thus another limitation of the study would
be that the research cannot fully grasp the reasoning behind the close-end answers.

1.5 Structure

This dissertation is comprised of five chapters. The first part of the dissertation will
expose the reasoning behind choosing this topic through general introduction
section. Additionally, the aims and objectives and also the structure of the research
will be presented.

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The second chapter of the dissertation will focus on the existing literature on the
topic. This will mainly revolve around explaining the actual challenges and culprits of
high risk and uncertainties in the oil and gas sector, but also on developing changes
in the current oil and gas environment and how these can impair future investments.
Moreover, previous studies based on observed practice or theories will also be
presented to highlight what appraisal tools are recommended to be used in practice.

In the third chapter of dissertation, the methodology of the research will be justified
by presenting underlying research philosophy reasoning and consequently the
research approach and design.

The results of the primary research will be then presented in the chapter four of the
dissertation. Additionally, the findings will be discussed and contrasted with existing
figures in order to draw conclusions from the study.

Last but not least, chapter five will summarise the overall findings of the dissertation
and offer recommendations for future research on the topic based on the limitations
of this study and existing literature.

Chapter 2: Literature review

2.1 Introduction

Suslick and Schiozer(2004) describe the oil and gas upstream sector as one of the
classical examples of decision making under uncertainty. Making the appropriate
investment decision is particularly difficult due to geological, financial risk and
uncertainty. Additionally, the exploration and drilling of commercial oil entails longer
time scale, higher investments, considering numerous outcomes and higher risks
than other sectors.

It has also been suggested that the oil and gas industry is at the forefront of the fast
paced global changes. Macmillan (2000) argues that four factors are directly
enhancing the risk and uncertainty in the sector: field size, finite resources, demand
and restructuring. Moreover, the factors seem to also impact on the investment

14
process in the industry. For instance, many of the major oil and gas producers
benefit from “giant fields” previously discovered. However, the discovery of giant
fields has considerably decreased and the discovery of smaller fields does not cover
the profit need (Macmillan 2000).

Furthermore, upstream oil and gas firms are very influenced by oil prices, which are
notorious for their volatility. It is also argued that oil prices for instance, can directly
affect the strategic investment process and that while it is clearly a very important
factor today, it is more than likely to become even more important in the future
(Henriques and Sadorsky 2011).

Moreover, the end of the 20th century has brought oil prices to a new low, causing a
major restructuring in the sector where “the changes unleashed by the mergers look
unstoppable and a great deal of capital and a matching appetite for risk to succeed”
(The Economist, 1998 pp 74 in Macmillan 2000).

2.2 Definitions

Petroleum or crude oil is a perishable resource formed over millions of years in

certain key conditions and is found today in the subsurface of the earth in the form of
reservoirs. If more than two reservoirs are found together it is called an oil field.
Exploration is the activity of attempting to discover fields of reservoirs of crude oil; if
this is successful the next step is to produce the crude oil meaning bringing it to the
surface and producing it for commercial purposes (Rubelius 2007).

Geologically speaking there are certain conditions that must be met for the crude oil
to be “commercially exploitable”. Hydrocarbons form and accumulate in reservoirs,
but they also “migrate” and can reach the surface through a process named
seepage. In order for the exploration to be successful, the reservoirs must be
“trapped” to prevent the migration (Tiratsoo, 1984). For example a seal or a trap is
“any geometric arrangement of rock…that permits significant accumulation of oil or
gas or both in the subsurface” (Biddle and Wielchowsky in Rubelius 2007).

15
To sum up, oil fields must have an active rock, a migration path through which the
hydrocarbons can move and eventually accumulate when entrapped by the “seal”
(as illustrated in figure I below).

Figure I

(Rubelius, 2007 pp.27)

After a possible trap or oil field has been identified, but before the drilling has begun,
geological and technical investigations are carried out to determine if the volume of
oil in the subsurface outweighs the costs of drilling it. Although there are some
techniques such as seismic tests to determine the feasibility, much remains
uncertain until the actual drilling beginnings.

Estimating the subsurface reserves and appraising this information can be done with
geological, engineering/technical and economic data and it can be either
deterministic or probabilistic. For instance, the evaluation can be deterministic if it is
based on only one estimate or it can be probabilistic if it accounts for a larger range
of estimates and their chance of occurring. Either one of these approaches will result
in classifying the subsurface hydrocarbons (if any are discovered) in proven,
probable or possible recoverable resources, in which case the first category would
be preferred (Rubelius 2007). Then, if the initial appraisal (pre-drilling) is
satisfactory, the next decision is to invest in exploratory drilling to gain more
information and to allow further tests (Finch el al 2002).

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During the exploration drilling, samples of rocks are collected and they are tested for
the type of rock (the less permeable the better the chances of an oil reservoir) and if
there are any hydrocarbons present. However, multiple other tests must have
favourable results including a production test as it is too early to determine if the
level of hydrocarbons is in satisfactory volume. If all the criteria are met, appraisal
drilling can begin and only after this stage a decision can be made for the
development phase, which is known as production (Dake 2004).

2.3 E&P RISKS

The two most important factors that are raising the uncertainty in the upstream
sector are geological issues such as structure, reservoir seal and amount of
petrol/gas resources and also the economic evaluations of the costs, estimating
probabilities of findings and level of commercial oil (Suslick and Schiozer 2004).

The same view is shared by Walls (1996) in an attempt to discover the main risks
facing a petroleum company. He considers that exploration project risks are based
on two important risk estimates. The first would be estimating the probability of the
success rate (discovering an oil reservoir) and hence including consideration of the
geological risk factors. While the latter, requires estimating the quality and quantity of
the proven resources (economic evaluation). Also, Hvozdyk and Mercer-Blackman
(2010) divide the main risks in two categories: “below the ground” and “above the
ground” risks consistent with the previous authors.

The upstream oil and gas firms mainly deal with the exploration and production of
proven reserves. Robelius (2007) explains that exploration is the activity led out to
find areas with commercially exploitable deposits, while production refers to both
drilling and extraction of the subsequent deposit discovery. Both comprise multiple
uncertain outcomes that can impair the investment appraisal.

However before any exploration activities are carried about, the firm will have to
purchase a license from the “resource owner” (usually government) in order to
assess if petroleum is present. Geological and geophysical studies are then carried
out with sound energy/seismic surveys to develop an underground image. Even at
this stage, promising results do not guarantee oil presence until “exploration drilling”

17
when the so-called wildcat drill begins. Intriguingly, even if sufficient hydrocarbon
levels are discovered at the target depth, it is too early to know if the oil is
commercially exploitable or if the exploration should cease. Further drilling must be
done (“appraisal drilling”) and additional tests in order to determine if there is a
proven profitable source of oil and if the size of the oil field would satisfy the needs.
At this stage, if the size is profitable the upstream firm must then apply for a
production license (Robelius 2007). The process is illustrated by the author of this
dissertation in figure II below.

Figure II.

Acquire exploration license

Exploration
estimates

es
Abandon/Delay
Exploration e
De
Drilling

Sample rocks Production test

Appraisal Abandon/Delay

Drilling De

Production license Actual production

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Furthermore, economic evaluations are of utmost importance and must be carried
out throughout the project life (Simpson et all 2000 in Macmillan 2000). This is
because the initial geological investigations can give a mere estimation of the
potential oil find, but the accuracy of the estimates will progressively improve with the
drilling tests and finally production stages (Robelius 2007).

Macmillan (2000) also illustrates how important these uncertainties are in the
investment process of an upstream firm (Figure III). All the six stages show the main
points in time where investment appraisal must be considered in order to continue
the project. In other words, based on the above geological uncertainties and the
economic evaluation (costs incurred, future possible costs, and future possible
benefits) the firm must decide whether to continue investing in exploration phases or
to abandon the investment all together. Nonetheless, it seems that at least until the
very end of the exploration phase (when the wildcat drill proves to be a discovery drill
and the analysis and estimates of the oil field are completed) the outcome of the
process is uncertain, the decision of abandonment is still premature (could lead to
opportunity loss) and all this while costs are accumulating.

Figure III.

(Macmillan 2000 pp.93)

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To make matters worse, even when the investment decision proves to be
successful (and a satisfactory oil field to cover to outweigh the costs) the payback
period in which the financial benefits from the discovery would cover the incurred
costs is usually between ten to fifteen years. When applied to the case of North
Sea oil discovery, there is a time gap of seven years between the exploration
phase and deciding to enter the production stage and another three to four years
until oil is actually produced. Finally oil fields can produce for a maximum of
twenty years (until complete abandonment). The major costs of the project are
experienced in the first stages (until the production begins), while the benefits can
be ripped over the production life of the project. Consequently, the economic
valuation/analysis (at each stage of the investment process) is even more difficult
to estimate and prone to errors due to the extensive time gap between the project
stages and influences of volatile factors (also difficult to predict) such as oil
prices/inflation/exchange rates (Macmillan 2000).

2.4 Current challenges

The fast-paced changing global industry has had a strong impact on the
development of the upstream oil and gas industry and ultimately on their strategic
investment process. Macmillan (2000) classifies the trends in four categories
each bearing important consequences on the industry: field discovery size,
depletion rate, demand and finally restructuring. Similar studies also classified
the recent trends as: “supply-constrained environment” (Hvozdyk and Mercer-
Blackman 2010), “the new era beyond easy oil” (Jojarth 2008) or “the peak of the
oil age” (Aleklett et al 2009).

2.4.1 Fields discovery

It seems that the largest upstream oil and gas companies are still relying in large
proportion on “giant oil fields “, investment and discoveries that have been made
decades ago. The overall production from giant fields has been constantly
declining, firstly because some giant fields were discovered a good twenty to fifty

20
years ago (Macmillan 2000, Rubelius 2007, Hook et al 2009) and secondly
because the discovery of new giants has constantly decreases ever since the
1960s (illustrated in figure IV from Hook et al 2009).

Figure IV.

(Hook et al. 2009 pp. 2264)

This is particularly important because giant oil fields, as their name suggests are
the world’s largest source of commercially exploitable oil based on the amount of
recoverable oil resources and on maximum oil production level. Figure V. (Hook
et al 2009) shows just how important giant oil fields are to the total oil production.

21
Figure V.

(Hook et al. 2009 pp. 2264)

With fewer giant field discoveries post 1960s-1980s, the total discovery has not
ceased but many smaller fields have been found although they are not merely as
profitable (The Economist 1996 in Macmillan 2000). The production rate has
experienced an average decline rate of 9.1% or 6.4% (when firm invests in more
techniques). Moreover, consistent strategic investment will have to be made in
the following years (2007-2030) to offset the declining resources and discovery of
giant oil fields (Hvozdyk and Mercer-Blackman 2010).

2.4.2 Demand and Supply in the view of depletion

As petroleum is a finite resource and it has been confirmed numerous times that
the supply will soon end, the proportion of supply and demand for its uses is also
very important for the future investments of the upstream companies (Gowdy and
Julia 2007).

On one hand, Adelman 2002 (in Jojarth 2008) pursues the view that demand for
oil and gas will end abruptly even before the supply has ceased due to raising
demand and supply for alternative energies. Jojarth (2008) and Hall et al (2008)

22
confirm that investing in alternative energy has been a growing industry due to
the increasing risks and costs of the oil and gas sector. On the other hand,
Macmillan (2000) and Jojarth (2008) imply that demand can rise due to the
emerging markets (e.g China). Moreover sources such as Alkett et al (2009)
Fantazinni (et al 2011) and Hall el al (2008) argue that it is questionable whether
future oil production (supply) can match the future demand levels.

Hvozdyk and Mercer-Blackman (2010) consider that in the situation of restricted

supply possibilities and strong need for more investment in exploration of oil
fields (which will subsequently lead to new discoveries), it is of utmost importance
that economic valuation of costs involved are carefully accounted for. However,
the current geological challenges are increasing the investment costs and
causing delays in the investment process.

On a similar note, Jojarth (2008) analyses the overall technical costs (“box” of
costs rather than separate) including exploration, development (drilling of
production wells, installation of platforms, subsea equipment pipelines etc.), lifting
costs (operating and maintaining production equipment) and finally capital
expenditure costs (major pipelines, processing plants etc.) over the entire life
time of the active oil field. The study shows that variable such as field specifics,
depletion rate, and location but also environmental and political hazards can
cause up to 70% variation in the production costs and ultimately reflect on the oil
prices.

Hvozdyk and Mercer-Blackman (2010) empirically compare which factors

(“above” or “below ground”) have a greater impact on the strategic investment of
the upstream companies. Not surprisingly, evidence inclined towards the below
ground factors, meaning that geological factors and high technical risks are
negatively influencing the investment of the companies and also delaying the
process. Hence, the two studies complement each other. Enhanced geological
and technical risks will increase technical costs (more has to be invested) yet
investment will be either delay (due to higher costs and risks) or even completely
deter some investments.

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Henriques, and Sadorsky (2011) also confirm that increased production costs
(caused by input prices) or even uncertainty surrounding these can affect the
strategic investment decisions of the firms and negatively impact on the profits.
Additionally, they point out that the volatility of oil prices could be a main culprit in
this process.

2.4.3 Oil price and restructuring

Another very popular trend in the literature emphasises on the great increase in
oil prices as a major cause for underinvestment in the oil and gas upstream
sector. The end of the 20th century and beginning of the 21st has marked an
unprecedented level of rise in the oil prices. For instance, oil levels have risen
from nearly 20-30% (early ‘90s) to a 40-50% (1998-2002) (Mohn and Misund
2009) or as illustrated in figure VI from $12/barrel (in 1999) to $80/barrel in 2006
and to an astonishing $100/barrel in 2007 (Tsoskounoglou et al 2008).

Figure VI.

(Tsoskounoglou et al 2008)

24
Henriques, P. Sadorsky (2011) and Mohn and Misund (2009) analysed the effect
of oil price volatility on companies’ strategic investment decisions and both found
empirical proof that the former affects the latter.

Henriques and Sadorsky (2011) argue that the relationship between investment
and oil price volatility is a U-shaped type relationship. In other words, in times of
increased uncertainty (when the oil prices increase consistently) the option of
waiting to invest increases until the uncertainty is resolved. Simultaneously, after
consistent increases in uncertainty in investment the option value will increase
and ultimately it will cause an increase in investment. While the volatility of the oil
prices is below a certain point, strategic investment of the firms will decrease;
however, when the “inflection point” is surpassed the level of strategic investment
will increase.

Also, Mohn and Misund (2009) found that uncertainty will negatively influence the
investment of the oil and gas companies in the long term, while oil price can
increase strategic investment level in the long term.

Macmillan (2000) and Casertano (2012) argue that oil companies have taken
defensive action against the volatility of prices and have been focusing on a
massive restructuring of the industry through large mergers and acquisitions.
Substantial backlash was attributed to the upstream firms for the focus on
inorganic growth rather than investing on “organic development” i.e. investing in
exploration to enhance their proven reserves (Casertano 2012).

However, Casertano (2012) suggests that focusing on mergers and acquisitions

was the right decision (rather than exploration investment) at the time due to the
oil price volatility. He also highlights that other waves of mergers and acquisitions
took place in the upstream sector in different decades and all had an impact on
the investment of the sector. Firstly, between 1977 and 1985, the upstream firms
have attempted to limit the impact of “swinging oil prices” through acquisitions
(aimed to increase reserves). This seems to have increased investment in
production and exploration (North Sea and Alaska). The second wave was
25
characterized by increased exploration costs, high volatility in prices and demand
and diminishing profitability. Similarly, upstream firms had to involve in mergers in
acquisitions (vertical integration with downstream firms to control the volatility of
price and demand) and the level of investment in exploration of new reserves has
increase even more than in the first wave.

After 1990s, the wave of acquisitions has change in nature: while the volatility of
prices (particularly in between 2003-2008) increased, investment in exploration
has decreased. Casertano (2012) claims that this was due to the changing nature
of the oil and gas sector, which is now negatively influenced by political,
geological and technical risks.

2.5 The theory-practice gap

As it was discussed in the previous section, the literature suggests that both
exploration and production decisions of the oil and gas firms involve very high
risks and uncertainties. Another emerging trend in the literature advocates that
very little is known of the actual investment appraisal techniques used to make
these decisions (Macmillan 2000, Schiozer et al. 2004, Ligero et al 2005).

Schiozer et al (2004) attribute this to the occurring uncertainties and risks

throughout the investment project at different stages. Geological aspects cause
uncertainty in regards to the location of traps containing hydrocarbons, if the
reservoir is sealed and it the hydrocarbon level in the trap is sufficient to outweigh
the costs. Hence, this will reflect on the engineering estimates and ultimately
economic valuation which must predict what is to be found underneath the
surface.

Quite often, the uncertainty revolving the geological aspects is not solved until the
decision to explore further or even to produce is made, which can be very costly
(Dake 2004, Macmillan 2000). The investment projects that start with the
exploration stage require a large initial capital investment (for instance a wildcat
well requires nearly $15million to drill offshore but only 1 out 10 prove to be
successful in discovering hydrocarbons) and if and only if the exploration is a

26
success and the hydrocarbons can successfully be exploited, it takes nearly 10-
15 years to claim the revenue (Macmillan 2000).

Additionally, Litero et al (2005) identify three types or risk that occur and must be
considered in the development stage of the investment project. Firstly, the risk of
opportunity loss that can occur if a field is estimated to be unfeasible before it is
developed and proven to be successful. Secondly, there is also the risk that a
field was estimated to be optimal for development but it proves to be
uneconomical after the production. Lastly, there is the possibility of suboptimal
development, where the field is abandoned before it is exploited to its maximum
capacity.

Therefore, Macmillan (2000) notes that due to the characteristic risks and
uncertainties of an investment in the oil and gas firms and also the different
nature of every single field to be explored or developed, more and more decision
makers are taking a step away from traditional appraisal methods and take an
active interest in appraisal tools that can capture the risks and uncertainties in the
industry.

Macmillan’s (2000) findings reveal that decision analysis trees are common
practice amongst the oil and gas decision makers. Also, EMV (expected
monetary value) and decision analysis tree tend to be used in combination to
incorporate the risk and uncertainties in the investment project at certain stages
(as shown in figure VII). Nonetheless, it is argued that each decision point has to
calculate decades ahead and must account for inflation and future oil prices,
which can seriously impair the estimates. Other methods such as Monte Carlo
simulation and option theory were often disregarded due to their complexity.

The sample of interviewees used for in the Macmillan study also displayed a high
preference for DCF methods and especially NPV. Although several faults of the
NPV method were pointed out such as the use of variables that cannot be
accurately predicted such as future cash flows from the not yet developed field or
the future oil prices the findings do not reveal if or how the interviewees adjust the
NPV rate accordingly.

27
Figure VII.

(Macmillan 2000 pp.93)

Likewise, Arora (2012) claims that some of the most used techniques for the
investment under risks and uncertainty (particularly applied to upstream oil and
gas firms) are: expected monetary value (especially the decision tree analysis),
payback period, discounted cash flows, sensitivity analysis, option theory and
portfolio theory etc. However, there is little empirical evidence to shed light on the
matter and to understand how their decision process works.

2.5.1 Monte Carlo Simulation

Finch et al (2002) investigate whether the risk analysis via the Monte Carlo
simulation is a technique often used in practice. The Monte Carlo simulation is
reputed to be a sophisticated and formal approach to investment appraisal and
the basis for decision-making in the upstream oil and gas industry (Murtha,
1997). This technique allows for risk, uncertainty and success scenarios to be
accounted for using probability distributions and provide the decision maker with
a full view that shows numerous outcomes and expected returns (Macmillan,
2000). Additionally, it allows for technological, geological, engineering and

28
economic knowledge from professional service firms to be incorporated for a
better estimation (Finch et al, 2002).

Finch et al (2002) argue that Monte Carlo simulation is constrained by obtaining

the initial geological data, based on which probabilities of hydrocarbons volume
are drawn, NPC or DCF methods are applied for the possible revenue and only
then a decision tree combined with EMV is drawn. Finch et al (2002) observe that
15 out of 20 oil companies included in their study have attempted to use this
technique but with very little success. Only a very small percentage of the
companies in the study have been partially implementing the simulation model
and rarely for the economics prospects only.

Likewise, Macmillan (2000) exposed from a series of interviews that very few
respondents choose to use Monte Carlo because of the amount of analysis and
work needed to acquire the figures.

Similar studies that analyse the application of risk analysis in industry practice are
rare and while the Macmillan study is based on 27 (20 interviews), Finch et al
(2002) base their findings on the same data with only a few additional inputs from
informal contact with two other major oil firms.

2.5.2 Option theory

It was also argued on numerous occasions that option theory approach is one of
the most suitable tools for the investment appraisal process of oil and gas firms
because it can incorporate the risk and uncertainties involved.

Dias (2004) discusses how companies in the industry can maximize their value
by correctly adapting the real options in their investment process as illustrated in
the figure below.

29
 Figure VIII.

(Dias 2004, pp.94)

Dias (2004) advocates that the real options approach allows adjusting for
“managerial flexibility” or responding accordingly to the uncertainty scenarios that will
be changing with time, without substituting the discount cash flow methods but
complementing them for a better picture of the investment. Thus, he proposes that
NPV should be maximised subject to the managerial flexibilities, market uncertainties
such as oil price and also technical uncertainties such as field discovery or its
volume and quality.

Dias (2004) demonstrated how real options should be introduced in practice with
simple examples. For instance, in the exploration phase of the project, managers will
have to make a decision in regards to the further investigation/appraisal of volume
and quality of the reserves in order to continue with the wildcat drilling.

Consequently, when the uncertainty is resolved the firm is faced with the decision of
developing the reserves or wait until a certain date or more information becomes
available. In other words, the ROA allows the company to incorporate real life
options such as the option to expand the available information, to delay or to
abandon the project (Dias 2004).

30
Moreover, Dias (2004) claims that EMV and other traditional methods can
underestimate certain decisions and this is where using real options approach can
pay off. For example, if the initial investment of drilling is $30 million and the chance
of a successful drill is 30% and the positive NPV is $95 million, the EMV will be -1.5$
million. Whereas, if the option approach is used the process goes as follows the first
decision to drill occurs and only if the first drilling is positive the second decision of
drilling can be made. In the calculation example this will change the value of the
investment from -1.5$m to +3.75$m.

On the contrary, Smith and Mccardle (1998) claim that investment appraisal
examples with the options approach have been “oversimplifying the kinds of projects
encountered in practice” and provide a tutorial on how options should be applied in
practice by offering real oil and gas investment examples through a collaboration of
the two authors with six analysts from different operating companies. In this
approach only real scenarios from practice were used for a realistic result.

According to Smith and Mccardle (1998), applying the real options approach can be
made in two ways: firstly it can model the managerial flexibilities (wait, abandon etc.)
and then value the risk approach by using the adjusted discount rate to determine
the present value of future cash flows or option valuation (with Black-Scholes
formula) or secondly do not model the managerial flexibility and just value the risk
approach through either one of the two methods above.

Smith and Mccardle (1998) have identified in their findings, great problems with both
approaches at different stages of the computation process. Using the real example
of a large undeveloped offshore field with consistent uncertainty, it was discovered
that accounting for the managerial flexibilities can be done in three different ways.
Each and one of the alternatives was extremely difficult and time consuming to
calculate, with extensive use of computer programing and sophisticated models.

Additionally, when considering different managerial options will also need to take into
account the information available at that point in time for instance the current oil
prices or inflation. These figures are unknown at the time of the appraisal and are
usually calculated using the geometric Brownian motion, which according to the
study is not consistent with real practice and instead mean reversion can be used

31
although this method significantly decreases the value of the option to wait (makes
NPV or present values lower than the other method).

Although the authors also point out a few benefits of using real option approach, the
main outline is that the method is often overlooked in practice particularly because of
the complexity of the actual calculation and that if used they should be used in
combination with decision analysis and discounted cash flows for a better result.

Even though in literature real options are often mentioned for petroleum appraisal,
there are very few studies that should be the real practice of it. For instance, Bailey
et al. (2003-2004) claim that large companies such as BP, ChevronTexaco,
Anadarko and El Paso are very enthusiastic about using real options valuation and
demonstrate by presenting examples of only one occasion of ROV use of each firm.

Nonetheless, the examples date back to the early 90s, when oil and gas firms where
undergoing serious changes due to the rising oil prices and new methods of
valuations very tested rather than fully adopted at the time. Triantis (2001) also
points out that Texaco was using at the time a mix of appraisal techniques including
DCFs, Monte Carlo simulation and decision analysis. Real options were also
discusses to be adopted but rather in a more holistic way to serve for risk
management and strategic position purposes not for economic evaluation.

Another issues is that some studies such as the one conducted by Bailey’s (2003-
2004) contrasts real option valuation to DCF methods alone, while in fact it should be
compared with equivalent techniques that can account for uncertainty and risks
specific to the industry.

This section of the study has contrasted the existing studies in the field in regards to
the appraisal techniques used by the oil and gas firms. Very few studies have
presented empirical evidence to support their findings. The vast majority of studies
are arguing what methods should be used in practice and offer examples and tests
of the calculations.

The risk and uncertainty levels caused by the very high geological features,
difficulties in the economic valuation and amplified by decreasing oil discoveries,
unequal demand and supply and high volatility of oil prices followed by massive
restructuring are unprecedented. Much can be learned by better understanding the

32
decision process of insuring future gains of an industry that is now at “the end of its
conventional era” (Tsoskounoglou et al 2008).

Chapter 3. Research Methods

3.1 Research Philosophy

Saunders et al. (2012) compares the research process with an onion that has
multiple layers that must be properly understood and explained before reaching
the centre. As shown in the figure IX, we can see that collecting the research
data is at the heart of the “research onion” and the research philosophy and
approach must be taken into consideration first, in order to choose the
appropriate methodology choice and techniques.

Figure IX.

(Saunders 2012)

33
Also, Johnson and Clark (in Saunders pp 128) argue that awareness and
understanding of main philosophies are vital for the business and management
researchers and illustrate this with a simple example. Between a researcher
concerned with the resources needed in a manufacturing process and a
researcher concerned with the workers attitude in the same manufacturing firm
there will be significant differences in opinion. Not only will these reflect on the
methods and resources used but it will also impact on the final views and
conclusions drawn from the study.

Consequently, it is relevant to mention that this study is adopting a pragmatic

philosophy as it considers that the research area is very vague and opaque. Very
little is known about the actual techniques that oil and gas firms use in their
appraisal process whether it is exploration or development phase. Moreover the
existent studies construct models of appraisal techniques based on oversimplified
models of reality and tend to generalize the empirical results but with limited to no
practical evidence. Thus, this study admits that there are multiple ways of
interpreting the research question and it is impossible to grasp a holistic view of
the appraisal process of such an uncertain and prone to risk industry. All
research methods with no exception have their own limitations in explaining the
research questions and this study will attempt to acquire multiple views through
the use of mixed research methods for a fuller view.

Additionally, the epistemology of pragmatism allows both subjective and objective

views to be taken into consideration provided that they can offer important
information on the research question (Saunders 2012). This research will employ
to some extent notions of naïve or empirical realism thorough the use of
questionnaires and drawing conclusions about what appraisal techniques are
used based on the data received. However, it will also make use of interpretation
elements. The research accepts that some of these results may vary from one
firm to another and there are subjective factors to account for these results such
as the increasing uncertainty in the field due to rising oil prices, decreasing giant
field discovery, restructuring etc.

34
3.2 Research approach

One of the objectives of this study is to analyse with the use of quantitative
methods what investment appraisal tools are used in the oil and gas industry for
appraising strategic investments. Therefore, the type of research carried out in
this work will be an inductive approach with regards to the relationship between
the theory and the nature of the research. The reason behind this is that inductive
approach is “especially strong in terms of generating theories out of data” (Glaser
and Strauss 1967 in Bryman and Bell 2007 pp. 14).

As it was highlighted in the previous chapter, few studies have actual information
of the appraisal techniques that oil and gas firms use to account for risks and
uncertainties. Previous studies mostly examine what methods should be used for
this purpose. Thus, a deductive approach would be most inappropriate in this
situation. The existing studies and theories do not necessarily point out direct
observations or findings that should be tested. Instead, this paper aims to gather
information about the appraisal process from multiple views and only then
attempt to generalise the information and “induce” a theory/conclusion.

First and foremost, secondary data was collected from published from published
journal articles, conference papers, and company reports in order to gain an
understanding of the existent theories and research on the topic.

Subsequently after carefully analysing the existing theories and studies, an

informed opinion was made and the primary data could be collected. This was
done with the use of quantitative methods such as questionnaires.

Last but not least, the analysis of the primary data accounting for interpretation
and empirical realism allowed new findings and ideas to emerge and generalise
the results for the target firms.

35
3.3 Research Design

It is also very important to distinguish between qualitative and quantitative

research. According to Saunders (2012) there are a few ways to do so. The most
simplistic way is to discern between numerical data and non-numerical data the
first being quantitative research while the latter is considered qualitative.
However, it can also classify data collection techniques such as questionnaires to
be quantitative and data analysis techniques such as interviews to be fully
qualitative.

In reality, it appears that the research design can and in fact does include a
mixture of both types of research. As Saunders (2012) points out there could be
questionnaires that not only account for data collection and numerical data but
can also include questions that may require a qualitative or a word formulated
response and it is described as embedded mixed methods research (Saunders et
al 2012 pp 168).

According to Bryman and Bell (2011), the term of quantitative research is often
associated with a deductive approach by elaborating hypothesis from existing
theories and testing them with the help of collected data. Nevertheless there are
also substantial cases in which, this type of research does not flow deductively
and is not testing for hypothesis, but instead “theory acts loosely as a set of
concerns in relation to which the business researcher collects data” (Bryman and
Bell 2011 pp 151).

This study will be using embedded mixed research methods as described above
and will be using self-completion questionnaires that will involve both numerical
data and qualitative data. Although, questionnaires and structured interviews are
quite similar in nature (Bryman and Bell 2011), there are a few advantages that
were suitable and determined their use in this study.

Using self-completion questionnaires distributed via email and LinkedIn can

reach a “geographically widely dispersed sample” in a much more efficient way.
The oil and gas industry has undergone drastic restructuring in the past decades
and hence the business environment is dominated by very large companies that
merged or acquired many smaller firms in the past. Although all oil and gas

36
companies have an appraisal system, the point of interest mainly targets the
large companies that heavily invest in exploitation and production. In the case of
structured face-to-face interviews or even skype interviews, it would be very
difficult, time-consuming and costly to reach the desired sample within the
specified time-frame of the project.

Additionally, the data will not be affected by the interviewer effector interviewer
variability and can be completed at the respondent’s convenience (Bryman and
Bell 2011). On the other hand there are a few disadvantages and limitations to
using of questionnaires in favour of structured interviews. The questions must be
less in number, shorter and with an easy to follow design to avoid losing
respondents. However, “respondents cannot be trained in the way interviewers
can be; nor do they know their way around a research instrument in the way a
‘lone researcher’ might” (Bryman and Bell 2011 pp 232) and respondents cannot
be given any guidance through the process nor they can be prompted to answer
all questions or expand on an answer.

A similar study was undertaken by Macmillan (2000), however the approach of

the study was deductive in nature and was conducted through structured
interviews. Although there was a large response rate and extensive information
was obtained, the results mostly detailed on what the respondents felt about
certain appraisal techniques but did not shed light on what techniques are
actually used in the investment process.

The author of this study strongly believes that targeting the right sample of
individuals responsible or aware of the appraisal procedures in the respective
firm with self-completion questionnaires would serve the aim of this study. The
respondents will no longer face the interviewer effect bias or long, salient
questions and could offer valuable information in regards to the appraisal
techniques used.

37
3.4 Sample

A vital element of this study is selecting the representative population that is

suited for the research topic or in other words determining the sample of
population that the self-completion questionnaires will be presented to (Bryman
and Bell 2011).

The majority of the case studies discussed in Chapter 2 with a few exceptions are
referring to the oil and gas firms that operate in both exploration and production in
the UK and hence extract from UKCS (UK continental shelf). Hence, this
dissertation will also focus on this sample of population for the following reasons.

Firstly, the oil and gas sector in UK it is one of the most important industrial
players nationally that has a huge potential economic benefit and also equally
high taxes to pay (UKOOA, 2014). Secondly, the challenges discussed in
Chapter 2 are also much more accentuated in this particular sample of
population.

According to the official Oil and Gas survey activity (2014), exploration is “at its
biggest challenge in 50 years” and especially “the last three years have seen the
lowest rate of exploration in the history of UKCS” (pp1). Additionally, drilling
activity is also facing challenges. While nearly £1.6 billion was invested in
exploration and appraisal activity in 2013, the discovery rates were low (£80
million of recoverable resources) and nearly 50% of the exploration and appraisal
wells that were supposed to be drilled in 2013 were either postponed or cancelled
due to financial difficulties. At the same time, investment levels have increased
and it was reported to have been the highest rate of investment for more than
three decades and new fields and brownfield developments were commissioned.
Last but not least, operating expenditures for the sector have increased
unexpectedly to £8.9 billion in 2013 and are expected to rise even higher in the
following years (Oil and Gas Activity Survey 2014).

Thirdly, there is a large availability of information relating the UKCS operating oil
and gas firms due to associations such as UKOOA (UK Offshore Operators
Association) or PILOT that was originally named as Oil and Gas Taskforce.

38
Last but not least, the UKOOA contains the names and contacts for all the
members of the association. This will serve as the sample of population that will
be contacted and the self-completion questionnaires will be distributed to.

3.5 Data description

As it was discussed in the previous section of this chapter, the sample for the
primary research was identified in oil and gas exploration and production
operating firms in the UK. In order to obtain a satisfactory rate of responses, the
author of the dissertation has identified 99 firms to be contacted for the survey.
The target group concerns firms that are either upstream oil and gas firms
operating in the UK (or with fields in the UK) but also contractor firms that are
employed by the first category to appraise or to manage the investment process
(found through the UKOOA membership status).

The survey type questionnaire is comprised of fifteen questions, as illustrated in

the appendix. The primary research is to be conducted during the July-August
2014 period in the following manner. Firstly, 67 oil and gas E&P operating firms
were targeted and initially contacted through general contact email or LinkedIn.
After obtaining the relevant accounting, finance and appraisal departments
contact details the questionnaire was sent to the desired respondents.

Secondly, an additional 32 contract firms were identified. This group was carefully
selected from the UKOOA member firms on the basis of practical experience and
collaboration in project appraisal of the upstream oil and gas firms. The process
of distributing the survey was similar to the first target group and was conducted
shortly after the questionnaires were distributed to the first group.

The response rate to the survey was approximately 43%, which is satisfactory
considering the difficulty of reaching such a narrow group of respondents. The
majority of the oil and gas upstream firms are easily identified, however
accessing the individuals that are aware or responsible of the investment process
within the firms is challenging. Several attempts to contact employees within
each and one of the firms were made, until the right contact details were provided
and the survey was distributed. Additionally, the vast majority of the operating

39
firms that were contacted are major or at least very large oil and gas firms and
thus their investment process is of utmost interest as the capital expenditure
capabilities are higher and so are the inherent risks.

The data will be discussed by contrasting the results from the two target groups
in order to highlight similarities or differences in the responses of the two groups.
Additionally, the results will be compared with previous qualitative research
gathered from the literature to complement the understanding of the study. Last
but not least, conclusions will also be drawn by contrasting the existing studies on
what appraisal tools are recommended by the academics (theoretical) and what
is observed from the practice-based primary research.

3.6 Data analysis

The most common types of quantitative data analysis are the univariate, bivariate
and multivariate analysis depending on the number of variables involved. The
analysis of the data will be a univariate analysis which is its name suggests the
analysis of one variable at the time (Bryman and Bell 2011).

Bivariate and multivariate analysis are concerned with the analysis of two or more
variables at the same time and are mostly concerned to determine the
relationship between these two with various techniques such as Contingency
tables, Pearson’s R or testing for statistical significance etc. (Bryman and Bell
2011). For this particular study, the research as discussed before is inductive, it is
not testing any hypothesis nor it is looking to determine causality between two or
three variables. The study will analyse and compare specific values, highest and
lowest values, proportions and will attempt to generalize trends over time or
sector trends.

Thus, the data analysis will merely focus on simple techniques such as frequency
tables, diagrams and medians etc. in order to gather new findings and ideas.

40
3.7 Ethics

With regards to ethical issues, given the nature of the research undertaken there
are not likely to be any ethical issues. Through the primary research, self-
completion questionnaires will be used and the questions will be mostly closed-
ended questions where, personal or private information are not asked. Thus, the
questionnaires will maintain the anonymity and confidentiality standards.

Last but not least, when previous research and work is used in this paper it will be
carefully quoted and referenced according to the Harvard referencing system to
avoid all forms of plagiarism.

Chapter 4. Survey findings and Discussion

4.1 Introduction

In this part of the dissertation, the main focus will be to present the results
obtained from the conducted questionnaire. Subsequently, the results will be
analysed with the use of simple techniques such as tables and diagrams and
discussed in the light of previous research to draw conclusions around the
majority or highlighting new trends in the appraisal process.

4.2 Respondent awareness

Due to the difficulty to approach the research sample of large upstream oil and
gas employees that were in charge or aware of the appraisal process of the
exploration and production projects, contractor companies were also used in this
study. Nonetheless, both target groups can present biases due to the nature of
the research method. Subsequently, the first two questions of the survey will help
distinguish if the responders are aware or in charge of the appraisal process.

In the first question of the survey, the respondents were asked to classify how
risky or uncertain they consider the oil and gas sector to be. The reasoning
behind this question, is to test if respondents are part of the target group of not.

41
The findings are shown in figure X. illustrated below.

Figure X.

45%
39%
40%
35%
30% 27% 28%

25%
20%
15%
10% 6%
5%
0%
Very risky Risky and Fairly risky Merely uncertain
uncertain

As we can see, the majority of the individuals or 66% rated the oil and gas
industry as either very risky or risky and uncertain. The question purposely did
not imply what part/department/action of the oil and gas industry is risky/uncertain
in order to contrast the results with the second question.

There seems to be general consensus in the existing literature that oil and gas
appraisal of E&P is a very risky business. For instance, Suslick and Schiozer
(2004) attribute this high risk to geological factors such as uncertainty in regards
to hydrocarbon charge or reservoir seal. But also to the economic valuation that
has to model these uncertainties and compute them over a long period of time.
Last but not least technological risk is also a great concern in the sector as
unexpected and costly changes can occur throughout the life of the project. On a
similar note, Tarhan et al (2009) add that through all the four stages of the
exploration and production projects, the uncertainties persist and many crucial
decisions must be made before uncertainties are resolved.

The findings seem consistent with the literature in the sense that only individuals
with some knowledge of the oil and gas sector would know how risky oil and gas
sector could be. This can imply that the correct group of target individuals was
reached. However, the percentage of individuals that considered the sector to be

42
 only fairly risky or merely uncertain or 34% is higher than expected. A reason for
this could be that some of the replying individuals are not directly involved in the
oil and gas decision making process. Or alternatively, they could be operating in
other departments than accounting, financing or project management
consultancy.

The second question in the survey was more straightforward in asking if the
individuals are aware or even responsible of investment appraisal procedures.

The findings and explanations are illustrated below:

Figure. XI

E, 10%
A, 23%

D, 16%

C, 17%

B, 39%

Where A, B, C, D, E represents the following groups:

 Group A represents the employees that chose the option “I am aware and directly
involved in the appraisal process”.
 Group B represents the employees that opted for the choice “I have good
awareness of the process within the form and am involved to some extent”.
 Group C represents the employees that “have some knowledge of investment
appraisal for certain small scale investments”.
 Group D represents the proportion that “have some awareness of the process but
I do not directly deal with the appraisal itself”.

43
 Group E is the proportion of respondents that opted for “I have limited to very little
or no implication in investment appraisal projects”.

The proportions of the results help draw some conclusions together with the first
question. Firstly, only 10% of the respondents answered that they have limited to
very little information about the appraisal process, leaving a very high 90% that
does have knowledge about it.

Group A or employees with good awareness and involvement in the appraisal is

a moderate number or 18% almost the same level with group C or D. If this
percentage was too high it could have been concluded that the survey response
is affected by biases. Although the biases or answer errors cannot be entirely
avoided, this comes to show that the bias is not very high.

Group B has the highest percentile and it highlights that most respondents have
good knowledge of the process and are involved to some extent. This is probably
the most important category in the study as it reflects the views of the target
group.

In major or large oil and gas firms or alternatively consultancy firms that work
directly with the upstream sector it is very rare that individuals are in charge of
making the decisions. In most of the cases, the employees act as participants to
the process; for instance experts, accountants, consultants or advisors compute
the economic valuations, interpret the presented data (geological surveys,
technical proposals, economic forecasts) or advise what the suitable course of
action is. Because the main focus of this research is to cast light on the appraisal
process and what appraisal tools used to alleviate the risk and uncertainty of the
sector rather than the whole decision making process are group B is most likely
to do that.

Additionally, the percentile of workers that choose some knowledge and

implication in small projects of the sector (or group C in 17%) is also very
important and part of the desired target group. During the sampling of this
research the author of the study considered that smaller investment projects are
also important. In the past two decades, trends of mergers and acquisitions have

44
changed the E&P sector and most of the giant fields and revenue itself comes
from the giant oil and gas firms such as BP plc, Chevron, Exxon, Shell, Total and
ConocoPhillips etc. Even between the giants of oil and gas there are
considerable differences in the amount invested in E&P. Casertano (2013)
argues that Shell, Exxon, Total and BP were spending $1.30-$1.60 dollars per
barrel in terms of exploration costs, whereas ConocoPhillips, Eni and Chevron
were much more aggressive and investing $2.80 per barrel. Additionally, the
exploration and production sector and particularly in the UK is still filled with
smaller-sized independent firms that have considerably lower capital
expenditures when compared to the majors.

The respondents that are included in group D and E form a percentile of 26%. It
can be implied that these two groups are not entirely aware of the appraisal
process but could have some knowledge. These two groups could also include
answers from individuals that are not necessarily targeted or placed outside the
relevant departments. However, it seems more plausible that the answers come
from informed individuals possibly from different departments or business areas.

Nonetheless, there is little discrepancy between the less informed groups (D&E –
26%) and the 34% that described the oil and gas sector as being slightly risky
and merely uncertain, which shows that the bias or error of the survey is limited.

4.3 Current challenges

The next part of the survey was concerned with current challenges in the oil and
gas sector as identified in the literature review. Question 3 is fashioned in such a
way so that it allows the researcher to infer if these challenges are perceived in
practice or not.

Q3. Do you believe that recent concerns in regards to resource maturation, rising
oil prices and increasing operating expenditure are founded and have a negative
impact on the oil and gas sector?

The findings are illustrated and discussed below.

45
Figure XII.

37%
33%

15%
13%

2%

Strongly Agree Neutral Disagree Strongly

agree disagree

The challenges that were named here were: resource maturation, rising oil prices
and increasing operating expenditure. Not surprisingly, the vast majority of the
answers (approximately 70%) were of the opinion that these changes are
seriously impacting the oil and gas sector.

Additionally, question 4 served to narrow down the answers and allow the
respondents to directly point out a few of the effects of the recent uncertainty and
risk levels.

Q4) If so, which of the following to you consider being the most crucial effect of
these changes?

The choices of answer that the respondents were given are as follows:

A) Declining production rates

B) Declining oil discoveries
C) Volatile oil prices
D) Increasing expenditure costs

46
Figure XIII.

D
23% A
35%

C
13%

B
29%

These two questions and their results complement each other and thus it can be
implied that the vast majority of the focus group believes that oil and gas sector is
strongly affected by recent challenges.

The most predominant effect of risk and uncertainty as pictured by the results
was reflected in the declining production rates (35%). This is in accordance with
several up to date studies such as the one conducted by PWC (2014) which
stresses on how much the business environment has changed the industry and
the need for a change to overcome to challenges. The recent uncertainty as they
name it, is attributed to declining production levels, decommissioning and rising
costs which in turn are causing delays in future E&P projects or even
postponements and severely affecting the exploration activity as well (PWC-
Northern Lights).

Moreover, UKOOA described the 2011-2014 three-year period as being a

crossroad, where the exploration activity is at its lowest rate in the last fifty years
and even if all the drilling wells are given the green light the rate of drilling will still
be too low to recover satisfactory level of resources.

Hook et al (2009) also argues that global oil production from the vast majority of
oil fields stopped expanding in 2004 and has started declining ever since (Figure

47
XIV). However, it implies that declining global production is mainly due to
depletion of giant oil fields (figure IV & V) that were discovered nearly half a
century ago and the fact that not enough fields or giant fields being discovered to
counteract the effect.

Figure XIV.

(Hook et al 2009)

The results of the survey tend to be in accordance with this view as a very high
percentile (29%) considers declining oil discoveries to be a very important factor
in the recent uncertainty in the sector.

The same view is reflected in Macmillan (2000) which provides the example of
BP which until 1996, 80% of its oil and gas production was from a very few giant
fields in America and UK.

Alternatively, this percentile of 29% can be explained by the resource maturation

and depletion and not just the declining discovery of giant oil fields. The UKOOA,
activity report of 2014 shows that in 2012 a total of 11.4 billion boe of oil and gas
was under either production, under development or considered for investment.
However, in 2013 the number abruptly dropped to 10.7 billion boe available of

48
resources. Moreover, proven resources decreased from 7.1 billion boe to 6.6
billion boe in 2014 and 9.4 billion boe of oil and gas have been forecasted to
have a 50% chance of recovery rate.

The third most important culprit according to the percentages is the increasing
expenditure costs that the oil and gas sector has to deal with. Although not as
imperative as the previous two causes (23% as opposed to 29% and 35%), it is
generally accepted and discussed that expenditure levels have been increasing
and straining the future exploration and production investments.

The activity survey of oil and gas industry in the UK (UKOOA 2014) shows that
total expenditure levels have reached a high of £26 billion in 2013 summing up
both large capital investments and rising operating costs. Operating costs per
barrel of oil equivalent have increased from £13.5 to £17 in the past year.
Furthermore, nearly £1.6 billion was invested in exploration and appraisal
expenditure and even so, the number of drilled E&A wells has significantly
decreased. Also the decommissioning activity became an important expense
and for the first time it represents nearly 3.5% out of the total expenditure.

Last but not least, oil prices are notorious for being volatile and having a direct
effect on the global economy and the businesses operating within (Henrique and
S 2001). In the past waves of changes in oil prices has impacted greatly on the
oil and gas sector. However, at the moment oil and gas prices are at a steady
level and thus not being a major cause of concern, which could explain why only
13% of the focus group has opted for this answer.

Question 5, has attempted to find out if the previously identified upstream

challenges have/had an effect on the future investments projects in exploration
and production of either new or existing fields.

Q5) Do you consider that recent changes in the oil and gas environment (e.g. the
ones mentioned above) to have affected the investment process of the firm’s
exploration or production in new or existing fields?

49
The results are illustrated below:

Figure XV.

35%
31%
30%

25% 23%
20% 21%
20%

15%

10%
5%
5%

0%
Strongly agree Agree Neutral Disagree Strongly
disagree

According to the findings, the opinion with regards to the investment in

exploration and production sector is mixed. A total of 51% of the focus group
agrees that the above mentioned causes have had a negative effect on future
E&P investments, while a very high 44% disagree with this view.

The findings could reflect the fact that the capital that is invested in exploration
and production is still very high and still growing on a yearly basis. However, due
to the declining rate of production or exploration, the profits made from the
investments are significantly reduced. These mixed opinions could reflect the
contradictory views of a financial perspective, where solid capital investments are
made in large numbers even in the face of recent challenges and an accounting
or economic perspective, where it is observed that these investments can merely
justify the costs.

The capital investment in the UK oil and gas sector has increased in the past
years at a higher pace than previous survey activities predicted. The oil and gas
UK association has registered that £14.4 billion was invested in 2013 and the

50
capital investment is predicted to remain above £10 billion yearly until at least
2016 (shown in figure below).

Figure XVI.

(UK Oil and Gas activity survey 2014)

UKOOA (2014) points out that this increase in investment was registered due to
the following factors: the sanctioning of large projects that are now under
development, brownfield allowances, necessary upgrades on offshore facilities
and stable oil prices. However, since there is a considerable delay between a
discovery and its development, it is expected that the recent declining exploration
activity will seriously impact the investment activity in the next 5-6 years.

Additionally, the capital expenditure efficiency has been constantly decreasing

over the years (illustrated in figure XVII). This could once again support the
research findings, by showing that the capital expenditure is very high while the
efficiency is very low causing the contradictory views.

51
Figure XVII.

(UK Oil and Gas activity survey 2014)

Another important aspect was brought to light by question number 6, which was
asking which area of the strategic investment process was affected the most. The
choices of answers and findings are presented below.

Q6) If so, what area of the strategic investment process has been most affected
in your opinion?

A) Acquiring exploration rights

B) Carrying out exploration and appraisal drilling
C) Deciding production drilling
D) Deciding production extraction

52
Figure XVIII.

A
D 8%
21%

C
19%
B
52%

The findings show that exploration and appraisal drilling are by far the most
affected by recent uncertainties and risk in the sector. Acquiring exploration rights
was the least voted answer only in proportion of 8%, which might reflect that
significant allowances by the government were made in 2013 in order for
investments such as brownfields to become more accessible and convenient for
the upstream sector to invest in.

Additionally, production drilling and extraction together form a high 40% and
entails the fact that production is also seriously affected and in a way closely
connected with the success of exploration and appraisal activities (PWC 2014).

It was noted that despite the increase in expenditure in exploration and appraisal
(£1.6 billion) the performance of the E&A was very poor in 2013. UKOOA (2014),
notes that nearly 50% of the expected E&A drills were postponed or cancelled
due to technical issues or lack of finance.

Studies confirm that exploration and appraisal drilling have been critically affected
by the financial crisis, when oil prices have collapsed (UKOOA, 2014). This has
particularly affected the UKCS or the North Sea oil and gas investments as
exploration was previously being founded through raising equity. Yet, the
financial crisis made investor more risk adverse and exploration financing is now
relying on the production generated income.

53
Exploration and production are hence directly influencing each other. If
exploration has poor discovery or recovery rates, it will ultimately negatively
impact on the production income which will then have to be reinvested in new
exploration causing a continuous loop of predicament.

Finally, question 7 is the last one in the survey concerning the current challenges
in the upstream sector. These findings are very important to determine if the
current focus in the investment of upstream oil and gas is placed on geological,
technological or economical risk factors.

Q7) Which factors are in your opinion the most important causes of risks or
uncertainties affecting the process at this stage?

The participants were asked to rate each one of the risk factors from a scale of 1
to 5, where 1 is least important and 5 is the most important.

The results are illustrated in the table below:

Table I.

1 2 3 4 5

Geological risk 1% 4% 14% 47% 34%

Economic risk 15% 24% 39% 19% 3%
Technological 3% 11% 25% 31% 32%
risk

As it was previously mentioned Hvozdyk and Mercer-Blackman (2010) divide the

oil and gas investment appraisal risks in two categories: below the ground (which
could be consistent with the geological risk and technological risk in certain
situations) and above the ground risks such as the accuracy of the economic
valuations.

From the findings it emerges that geological risk and technological risk are
usually described as important or very important in the appraisal process. The

54
economic valuation however, comes in as the last risk factor with considerably
smaller ratings.

As we can recall from figure III, the investment appraisal process of the oil and
gas firms has different nodes, where actions and decisions must be taken. These
decisions are usually under the pressure of high uncertainty and risks caused by
the below the ground risk factors or technological and geological factors. The
economic valuation is projected by taking into consideration these geological and
technological factors. Subsequently, the accuracy of the economic valuation
relies on solving the uncertainties caused by the other factors.

At present, in the light of depletion and decreasing production rates great efforts
are being made with the help of new technology to increase the recovery rate of
oil from existing fields. However, this is enhancing the technological risk and
geological risk as it’s becoming increasingly expensive to do so and less
profitable (PWC, 2014).

On a different note, UK initiatives are being put in place so that future challenges
will be met. PWC’s Aberdeen based centre of excellence for Oil and Gas
suggests that the key is to implement a strategy for a longer-term rather than the
next five years, which will enhance collaboration and innovation in order to
encourage new investments, improve asset management and cost reduction etc.
Which is why, this research is interested in finding out what appraisal techniques
are being used at this crossroad in the oil and gas industry.

4.4 Appraisal Tools

In order to understand what investment appraisal tools are actually used in the
investment appraisal of E&P projects, this section will discuss the rest of the
questions included in the survey.

First of all, question 8 is a general question that concentrates on the main

techniques used in general for all types of projects in E&P, without mentioning if it
would be appraisal, production or it involves new or existing fields.

Q8) Which are the main appraisal technique/s universally used in the company
for all types of exploration and production decisions?

55
The results are shown in the figure below:

Figure XIX.

4%
5%

DCF/NPV
36% Payback
21%
Decision analysis tree
EMV
Option theory
Monte Carlo Simulation
21%
13%

From the findings above, we can infer that DCF methods and particularly NPV is
amongst the most used methods (36%). This could be because all the other
methods tend to incorporate discounting future cash flows one way or another.
For instance, the cash flows should be discounted at the different nodes of a
decision analysis tree for a more realistic view. This should also be the case for
expected monetary value, or EMV combined with a decision analysis tree. Monte
Carlo simulation and Option theory as discussed previously are difficult to
implement methods and usually use computer software. In the vast majority of
these cases the numbers are modified to reflect the discounted value of future
incomes.

Payback method has been selected in a proportion of 13%, which is a high

number considering that oil and gas is well recognised for having extremely long
payback periods. Moreover, traditional appraisal methods are not well viewed by
academics especially since they are not meant to be used in fast paced
environment as they can lead to calculation errors ( Boston, 2002, Adler, 2000).
However, in practice payback is often still used for smaller sized projects and in
combination with other methods to give an indicative view of how long the funds

56
will be tied up in certain investments. Because the question is a general one and
doesn’t infer which type of investments are appraise, it might be fair to assume
that the payback method or variations of it is being used in an indicative manner
for smaller investments in existing fields or upgrading of existing fields or
machinery.

Additionally, the findings illustrate that variations of decision analysis trees and
expected monetary value or the combination of the two are used quite
extensively in practice summing up to a percentage of 42%. This is consistent
with the interview-based results of Macmillan (2000) that shows mixed views on
when EMV is used but does point out that EMV is very used in practice. It
emerges that EMV can be used in exploration decisions but also on “to drill or not
to drill” decisions where risks and uncertainties are quite high.

Finally, Monte Carlo simulation models and option theory have the least positive
response rate, with the first one being 5% and 4% respectively.

The next question or question number 9 is interested in finding out of the same
proportions or the same techniques would be used in case of riskier decisions
such the initial exploration or appraisal drilling.

Q9) Which is/are the main appraisal technique/s used in the company for initial
exploration or appraisal drilling decisions?

The answers from this question are summarised in the figure illustrated below.

57
Figure XX.

5%
9%
DCF/NPV
38% Payback
Decision analysis tree
25% EMV
Option theory
Monte Carlo Simulation

20% 3%

Although, the changes in percentages of tools used are not significantly different
when altering the question from overall oil and gas investment appraisal to just
exploration and appraisal phase, several conclusions can be drawn.

Firstly, a small increase in the use of DCF can be noticed or the NPV method.
These results are similar to the explanations obtained by Macmillan (2000),
where several interviewees mention that NPV is almost always used in all project
evaluations to give an idea of the size of the projects.

Additionally, we observe an increase in the use of expected monetary value. In

other words when decisions have a higher grade of uncertainty the EMV seems
to give a better idea of accepting or rejecting a certain investment.

The result of this survey, however presents a slightly contrary view with Diaz’s
(2004) findings on the expected monetary value, which suggested that this
method could easily underestimate certain outcomes, and that valuation would be
positively appreciated with the use of real options. Although, we observe a slight
increase in the use of real options when evaluating exploration and appraisal
investments (from 5% to 9%) it does not appear to be a preferred method for
decision making in the sector.

The results also agree with Smith and McCardle (1999) to some extent, when
arguing that although real options are inherent and perfectly capable of modelling

58
high risks ventures there seems to be very little evidence of their use in real
practice, which could be explained by the difficulty to compute and comprehend
the results.

Also the use of the decision analysis trees is approximately constant at 20% and
it seems that this type of appraisal tool is equally preferred by investors when
making a risky decision.

On the other hand, Smith and MCCardle (1999) attempt to compute a decision
tree for a large, risky and underdeveloped oil field. In order to reach their
findings, complicated and very time consuming programs were used and the
outcomes at every node of the decision tree was considered and calculated. The
decision tree that they obtained were also very difficult to interpret (figure XXI ).
Yet the decision tree that they wanted to obtain is illustrated in figure XXII which
is a much simpler and easier to interpret version.

Figure XXI

(Smith and MCCardle 1999, pp.4)

59
Figure XXII.

(Smith and MCCardle 1999, pp.2)

In order to clarify if the respondents tend to use overly complicated decision

analysis trees or if they simplify their results to a more standard tree question 10
presents the respondents with the image of a simple decision analysis tree
(illustrated above), where the nodes are calculate with NPV and asks if this type
of appraisal tool would be used on an undeveloped project.

Q10) Suppose the firm is considering the decision to invest in a very large
undeveloped field name Y. Would the company find it useful to use a decision
analysis tree as illustrated below (figure XXII was used)?

The findings are summarised in the figure below:

60
Figure XXIII.

40% 38%

35%

30%

25%
19% 20%
20%
14%
15%
9%
10%

5%

0%
Strongly Agree Agree Neutral Disagree Strongly
Disagree

Surprisingly, the majority (38%) seems to be indifferent to using the decision

analysis tree for an undeveloped oil field. However, a close percentile of 33%
seems to agree with the idea of using a simple decision for such a difficult
decision, while 29% of the respondents tend to disagree with the idea.

The difference in the answers could also be explained by the size of the
investment and also the risk preferences of the managing team in charge of
these decisions. It is generally accepted that the upstream sector is mostly
dominated by a few major companies. The amount of capital available would
obviously vary with the size of the upstream firm and so will the possibility of E&P
investments. On that note, larger companies with more access to financing or
capital funds would feel more at ease with using a decision analysis tree,
whereas smaller firms could prefer a more complicated tool.

However, question 11 follows the same principle only it illustrates figure , in which
each node is calculated with EMV.

Q11) Alternatively, would you prefer a decision analysis tree that accounts for
EMV at each node of the tree as illustrated in the figure below?

61
Where, figure VII previously illustrated in chapter 2 was utilised.

(Macmillan 2000)

The findings in this section are as follows:

Figure XXIV.

30%
27%
26%
25%
21%
20%
17%

15%

10% 9%

5%

0%
Strongly agree Agree Neutral Disagree Strongly
disagree

In this case, the findings tend to be more positive in the favour of using a simple
decision analysis tree but with the improvement of EMV and especially in the
case of an undeveloped field. The majority agrees with the use of this tool in

62
proportion of 47%. The percentile of neutral opinions and also disapproving
opinions has considerably and changed in favour of approving this appraisal
technique. Hence it can be suggested that, the combination of decision analysis
and EMV can be a popular tool in practice.

The following two questions tackle the issue of Monte Carlo simulation and real
option to see what percentage of the focus group would prefer using these
techniques when appraising for high uncertainty.

Q12) For the same example, would the firm use option theory concepts such as
incorporating the real business options (wait, abandon, delay) or option valuation
(Black-Scholes formulae) to appraise the investment?

The findings are illustrated in the figure below:

Figure XXV.

60%

49%
50%

40%

30% 28%

19%
20%

10%
4%

0%
Very likely To some extent Only in certain Improbable
cases

According to the results of the survey the vast majority of the respondents
answered that they would use real option valuation only in certain cases (49%) or
to a little extent (28%). However, an improvement can be seen in the sense that

63
an approximate 23% would use real options valuation for investment appraisal at
least to some extent or in certain project evaluations.

This result somehow contrasts with the general findings in the literature. Firstly,
Macmillan (2000) points out that the majority of her interviewees were not aware
of the real options approach or if it was used for appraisal purposes in the
particular upstream sector at all. Secondly, Galli (1999) also argues that when
extending the real options model to natural resources, the implication of the
necessary assumptions such as no arbitrage, risk free rate or risk probabilities
would modify the probabilities of having fields of different sizes. Additionally, this
would imply that the real option model is less practical than other appraisal tools
and this issue is more difficult to be noticed in practice than in academic
examples.

On the other hand, the results seem to be in accordance with the findings of
Triantis (2001) and Bailey et al (2003/2004). Both studies argue that real options
are being used in practice and particularly by oil majors such as Texaco,
Chevron, Amoco and a few others. Moreover, it is implied that real option
valuation was almost always used together with other appraisal tools such as
DCFs or decision analysis trees to offer a better picture of a risky investment.

From the previous questions, we observed that the use of real options is limited
in the universal decision making of the oil and gas firms. However, the
percentage of usage steadily increased from 4% to 9%, when mentioning a very
risk and uncertain undeveloped field prospect. Finally, the fact that the majority
(49%) of the answers show that real options are used to a certain extent can
imply that real options are more and more used when there are high amounts of
risk and uncertainty.

As question number 8 and question number 9 both showed that Monte Carlo
analysis is rarely a preferred method of investment appraisal, the next question
aims find out if the method is used at least to certain extent.

64
Q13) Alternatively, would you prefer using risk analysis techniques or Monte
Carlo simulation in particular to appraise a high risk E&P investment?

The findings are illustrated in the figure below.

Figure XXVI.

60% 57%

50%

40%

30% 26%

20% 15%

10%
2%
0%
Very likely To some extent Only in certain Improbable
cases

According to the survey findings, the vast majority of the respondents responded
that the use of Monte Carlo risk analysis is improbable (57%) and a contrastingly
low 26% would only use it in certain cases.

On the same note, Galli et al (1999) infers that although Monte Carlo analysis is a
good tool to be used for incorporating risk and uncertainties, it has little followers
in practice due to mathematical, technical and financial difficulties. Monte Carlo
analysis is a statistical tool that relies exceedingly on statistical probabilities and
distributions to account for varying parameters (due to risk and uncertainty) and
not allowing any managerial flexibility. Additionally, the computation of this risk
analysis tool is very difficult even with the help of advanced software programs
because most of the input variables are unknown.

Nevertheless, 26% of the respondents answered that Monte Carlo analysis is

used in certain situations, which is in accordance with Murtha’s (1997) findings.

65
His research shows that although the use of this tool is limited for investment
appraisal purposes of exploration and production Monte Carlo is used especially
for cost engineers for technical purposes such as estimating costs of pipelines
and platforms (Murtha 1997).

Additionally, Macmillan (2000) also points out that Monte Carlo is a well-known
technique to the interviewees of her research but that it was not used in the
investment appraisal process of the exploration and production and described it
as a “mathematical black box”.

The findings from question 14 tend to portray the same idea.

Q14) Do you believe decision analysis tools such as real options or Monte Carlo
analysis are time-consuming and require extensive resources to compute them?

Figure XXVII

40%
36%
35%

30% 27%
25%

20%
14%
15% 12% 11%
10%

5%

0%
Strongly Agree Agree Neutral Disagree Strongly
Disagree

When respondents were asked if real option valuation and Monte Carlo analysis
are time-consuming and resourceful appraisal tools, the majority answered that
they either strongly agree (36%) or agree (27%), summing up to a 63%
percentile. Additionally, a comparatively smaller number of respondents were

66
either neutral (12%) to the volume of calculation and time requirements or in
disagreement (11%).

Question 15 was the last one in the survey directly concerned with the state of
practice of appraisal techniques used for upstream E&P decisions. The reasoning
behind this last question was to attempt and find out if the individuals in the focus
group rely on more than one appraisal techniques to make an investment
decision.

Q15) Academics argue that combining these techniques or using more than one
at the same time can give a better picture of the investment appraisal decision.
Do you agree?

The results are illustrated in the figure below:

Figure XXVIII.

50%
45%
45%
40% 42%
35%
30%
25%
20%
15%
10%
5% 8%
3% 2%
0%
Strongly Agree Agree Neutral Disagree Strongly
Disagree

It seems that almost all respondents have answered that multiple appraisal
techniques and tools are used to evaluate an investment project. The findings
from question 15 also validate the answers from the previous questions 8-14,
where the focus group showed mixed preferences for techniques such as DCF,

67
NPV, decision analysis trees, EMV, option valuation and finally Monte Carlo
analysis.

The overall findings hence suggest that in the decision making process of the
upstream oil and gas firms, more than one technique is used depending on the
underlying risks and uncertainties. For instance, undeveloped oil fields and
exploration and appraisal decisions are heavily influenced by geological,
technological risk factors and the use of multiple techniques can alleviate the
uncertainties and offer a more holistic picture of future investment projects based
on which better and more informed decisions can be made.

4.5 Summary of findings

The primary research conducted through a questionnaire type survey has

highlighted to some extent, current views in the oil and gas upstream sector with
regards to the inherent risks and uncertainties in the industry, current challenges
in the sector and preferred appraisal tools.

In the first part of the survey, respondents were asked about their views on the
inherent risk in the oil and gas industry and their overall awareness and
involvement in the investment appraisal process of the firm. A high percentile of
66% responded and categorised the oil and gas sector as being either risky or
very risky. Additionally, the findings suggest that the desired target group of the
survey was reached as the participants answered that they were either aware or
involved in appraisal to at least some extent.

The second part of the survey was mostly concerned with the current challenges
in the sector and whether if these affect the investment process in the view of the
respondents. According to the results, the most important factors of risk and
uncertainty were caused by technical and geological issues. Additionally,
resource maturation/depletion, volatile oil prices and increasing operating
expenditures are growing factors of risk and uncertainty that negatively impact on
the upstream sector.

68
 Furthermore, it can also be inferred that the majority of the answers implied that
the oil and gas sector’s future investment process is strongly affected by
declining production and new discovery rates.

Finally, the third part of the survey revolved around what investment appraisal
tools are used in practice. It emerged from the findings that multiple appraisal
techniques are employed for the same project for a fuller view of the investment
costs. The most used tools according to the survey were DCFs, NPV and
variations of decision analysis trees and EMV. It also seems that preference for
Monte Carlo technique and real option valuation in practice is quite low, although
an increase in the use of ROV tool is observed in the case of undeveloped oil
fields.

Chapter 5. Conclusion and Recommendations

5.1 Dissertation aim and objectives

The aim of this dissertation, which was previously identified in the first part of the
research, was to observe the investment appraisal process of the upstream oil
and gas sector under the impact of risk and uncertainties specific to the sector.

Thus the objectives of the dissertation were as follows:

1) To critically analyse the existing literature surrounding the oil and gas appraisal
process including the main culprits for risk and uncertainty and what techniques
are recommended by the academics to alleviate these.

2) To carry out questionnaire type survey in order to collect primary data from
practice by targeting the oil and gas upstream firms operating in the UK.

3) To discuss the results of the survey, but also compare and contrast with existing
theories and previous studies relating the topic.

69
4) To draw conclusions of current practice in the appraisal process and offer
recommendations for future areas of research based on findings and limitations
of this study.

As discussed in the previous chapters of the dissertation, the oil and gas sector
was affected on numerous occasions by oil price shocks which in turn affected
supply and production. Over the years, the sectors had retaliated and
continuously improved their decision making process and in particular the
investment process of exploration and production.

Consequently, this dissertation wishes to observe one of the most important yet
risky and uncertain industries in the global economy and how it appraises its
future investments in exploration and production stages. The oil and gas
appraisal process has specific risks and uncertainties steaming from geological,
technical and economical valuation factors and is constantly challenged by
emerging concerns in these areas. Thus, understanding the investment process
can be useful not only for future developments in the upstream sector but also
other high risk industries such as pharmaceuticals, high tech or R&D
investments.

5.2 Literature review

The first objective of the dissertation was to critically assess the existing literature
on the oil and gas sector. The dissertation firstly describes the main terms and
definitions and then goes on to evaluate the main risks in exploration and
production of hydrocarbons.

The majority of the academics seem to agree that that oil and gas risks are
divided into two categories: above and below ground risks. It was also implied
that these risks are directly influenced by geological, technical and economic
valuation factors. Additionally, the majority of the studies also identify additional
developing challenges in the oil and gas environment. The most discussed ones
were field discoveries, depletion, and oil pricing, restructuring and economic
valuation. Finally, the literature suggests that in the face of such risk factors

70
sophisticated tools such as Monte Carlo analysis and real options should be
used.

The previous studies presented in the literature review have little evidence from
real scenarios in practice with one or two exceptions. The vast majority of the
studies discuss which appraisal tools should be used or how uncertainties impact
on the oil and gas sector, with theoretical or computer generated tests and
solutions. Thus, the second objective of the dissertation was to collect primary
research and draw conclusions on the state of practice in the upstream sector.

5.3 Research Approach

This dissertation has followed a pragmatic philosophy as it was discussed in

chapter 3. The research area is vague and opaque and little real practical
evidence was identified in previous studies on the actual techniques or views of
upstream oil and gas firms. Thus, this research adopts the view that there are
multiple ways of interpreting the research topic and very difficult to gain a
complete picture of the appraisal process.

As a result, mixed research methods were used in order to gain a more complex
view of the process. The data collection technique used was self-completion
questionnaires which although quantitative in nature they served to collect both
qualitative and quantitative information. The sample that was targeted summed
up a total of 99 firms that were directly involved in the oil and gas upstream
sector in the UK. Out of this number, 67 firms were independent exploration and
production firms, including major oil companies with extraction rights in UK.
Additionally, 32 consulting firms and members of UKOOA that have worked in
direct collaboration with upstream firms for investment consulting and advisory
were targeted.

71
5.4 Findings and Analysis

As it was discussed in the data description section of the dissertation, 99 firms

where targeted for the questionnaire and an approximate 43% response rate was
achieved.

The first section of the findings was concerned with whether if the questionnaires
have been correctly answered by the desired group of respondents i.e. the
employees of the firms that would be directly involved in the appraisal process or
good knowledge of it. The findings suggest that the vast majority (sum of 62%)
were directly involved in the appraisal process either directly or to some extent.

Additionally, the respondents were asked in a generalised manner if they

consider the oil and gas environment as a whole to be a risky venture or not. The
results of the survey have shown that more than 66% believe that the sector is
very risky to operate in. Thus it can be implied that the wanted group of
respondents was correctly targeted.

The second part of the findings was concerned with the raising challenges in the
upstream sector emerging from the literature and particularly if they are noticed in
practice. The challenges were described in the questions as resource maturation,
volatile oil prices and increasing operating expenditure. The answers show that a
high majority of 70% believes these factors directly affect the sector. More
importantly, the answers pinpointed that effects of these challenges are straining
the production rates (35%), discovery rates (29%) and finally the operating costs
(23%). Most of the results, as discussed in chapter 4 are in agreement with
previously conducted studies such as PWC (2014), Hook et al (2009) and
UKOOA (2014).

The findings also revealed that the most affected areas of the investment process
were exploration and appraisal drilling (52%) and production drilling to some
extent (19%). The UK oil and gas activity report (2014) also shows that
exploration and appraisal have been considerably strained and exploration and
production are now linked more than ever. After the financial crisis, the majority of
the oil and gas firms were require to fund their exploration activities with the

72
profits gained from production. Hence, if production levels fall it will also impact
on exploration and vice versa.

Moreover, the most inherent causes of uncertainty in the upstream sector were
classified as technological and geological risks, where the economic valuation
risk was considerably lower. It emerges from the findings that technical and
geological risks are high in the initial stages of the process and they indirectly
affect the economic valuations at each point of the decision making by either
solving or complicating the uncertainties.

Finally, the third part of the survey was interested in finding out what appraisal
tools are used by the respondents when appraising upstream projects. The main
findings suggest that the most used techniques in general are: DCFs/NPV,
decision analysis trees and EMV and occasionally payback method. However,
the results showed an increase in the use of real option valuation and expected
monetary value, when it was clearly mentioned that the investment project would
concern an undeveloped field with high risk and uncertainty levels. Moreover, a
high majority of 87% answered that more than one investment technique are
used at all times. The results are similar with the ones obtained by Macmillan
(2000), however there are some contrasts with studies carried out by Bailey
(2003) and Triantis (2001) who believe that real options are extensively used in
practice. The results show that a very small percentage of respondents use either
real options of Monte Carlo simulation.

The dissertation has thus achieved its second and third objective in the fourth
chapter. The results of the conducted survey were presented, discussed and
compared with existing academic studies.

5.5 Limitations

This research has several limitations. Due to the limited amount of time and
available information, only 99 firms were targeted for the questionnaires. Even
though the response rate of 43% was satisfactory and the results were in
agreement with previous studies in the literature, the sample might not be large

73
enough to be considered a representative group of all the operating E&P firms in
the oil and gas sector.

Additionally, due to limited access to information and access to such a dispersed

sample the self-completion questionnaire method was used. Although this
technique has several advantages such as maintaining anonymity of the
respondents and a fairly quicker response time it also has its limitations. The
most concerning issue is the risk of obtaining inaccurate information. The author
of the research cannot control or verify if the initially targeted group correctly
answered the survey.

5.6 Recommendations and Future Research Areas

The author believes that there is a significant gap between the available theory
and known state of practice in the oil and gas upstream industry. Most of the
conducted studies are based on theoretical or computer generated examples with
very little real state of practice examples. It would be beneficial for the future of oil
and gas industry if more studies with access to primary information would be
undertaken.

It seems that the exploration and production sector is at a crucial crossroad,

where calls for innovation and collaboration from academics, the industry itself
and the public sector are being made (PWC, 2014). It is predicted that the
declining exploration and production rates on one hand and the increasing capital
and operating expenditure on the other hand will be strongly impacting on the
future of the oil and gas sector.

This research has attempted to narrow down the theory-gap practice in the
upstream oil and gas sector. Although, the findings are in general agreement with
previously conducted studies, there is still much work to be done. It seems that
practitioners mostly rely on traditional techniques such as decision analysis trees,
EMV and DCFs for the vast majority of their projects. However, more advanced
techniques such as Monte Carlo analysis or Real options valuations are often
disregarded due to the difficulty of computing them. Thus, a valuable area of
future research would be applying real option valuation and/or Monte Carlo

74
analysis to real E&P scenarios in order to raise awareness of these methods in
practice or alternatively improve the existent available appraisal tools.

In conclusion, this dissertation has met all its aims and objectives that were set
out in the first chapter. The findings show that the oil and gas industry is affected
by growing challenges in the environment such as resource maturation and
depletion, fields’ discovery, volatile oil prices that in turn are directly affecting the
investment process of the upstream firms, particularly in the exploration and
appraisal phases. It is also concluded that the majority of the respondents use
appraisal techniques or variations of DCFs, NPV, decision analysis trees and
EMV with little use of real option valuation. However, there is a strong demand for
future research and development in this topic.

75
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Appendix

As mentioned in the previous chapters, the appendix will present all the questions
and choices of answers used in the survey.

Question 1.

1) How would you describe the strategic investment appraisal process in the oil and
gas sector?

(Please tick the appropriate response)

Very risky
Risky and uncertain
Fairly risky
Merely uncertain

Question 2.

2) How would you describe your awareness or involvement in the decision making
process of the firm’s investment appraisal process?

(Please tick the appropriate response)

I am aware and directly involved in the

appraisal process
I have good awareness of the process
within the form and am involved to
some extent.
I have some knowledge of investment
appraisal for certain small scale
investments
I have some awareness of the process
but I do not directly deal with the
appraisal itself.

Question 3.

3) Do you believe that recent concerns in regards to resource maturation, rising oil
prices and increasing operating expenditure are founded and have a negative
impact on the oil and gas sector?

(Please tick the appropriate response)

80
 Strongly agree
Agree
Disagree
Strongly disagree

Question 4.

4) If so, which of the following to you consider being the most effect of these
changes?

(Please tick the appropriate response)

A- Declining production rates

B- Declining oil discoveries
C- Volatile oil prices
D- Increasing expenditure costs

Question 5.

5) Do you consider that recent changes in the oil and gas environment (e.g. the
ones mentioned above) to have affected the investment process of the firm’s
exploration or production in new or existing fields?

(Please tick the appropriate response)

Strongly agree
Agree
Neutral
Disagree
Strongly disagree

Question 6.

6) If so, what area of the strategic investment process has been most affected in
your opinion?

(Please tick the appropriate response)

E) Acquiring exploration rights

F) Carrying out exploration and appraisal drilling
G) Deciding production drilling
H) Deciding production extraction

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 Question 7.

7) Which factors are in your opinion the most important causes of risks or
uncertainties affecting the process at this stage?

(Please rate the answer from 1 to 5, where 1 is least important)

Geological risk 1 _______ 2_______ 3________ 4_______5_______

Economic valuation risk 1________ 2_______ 3_________ 4______ 5_______

Technological risk 1________2_______3__________4________5______

* Where geological risk refers to estimating chances of reservoir discovery

* Economic valuation refers to estimating the future revenues
* Technological risk refers to health, safety and hazardous machinery.

Question 8.

8) Which is/are the main appraisal technique/s universally used in the company for
all types of exploration and production decisions?

(Please tick to appropriate answer/s)

DCF/ NPV _______

Payback _______

Decision analysis trees ______

Expected monetary value (EMV) _______

Option theory ________

Risk analysis/Monte Carlo Simulation __________

Question 9.

9) Which is/are the main appraisal technique/s used in the company for initial
exploration or appraisal drilling decisions?

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(Please tick to appropriate answer/s)

DCF/ NPV _______

Payback _______

Decision analysis trees ______

Expected monetary value (EMV) _______

Option theory ________

Risk analysis/Monte Carlo Simulation __________

Question 10.

10) Suppose the firm is considering to decision to invest in a very large undeveloped
field name Y. Would the company find it useful to use a decision analysis tree as
illustrated below?

(Please tick the appropriate response)

Strongly agree
Agree
Neutral
Disagree
Strongly Disagree

83
Question 11.

11) Alternatively would the firm a decision analysis tree that accounts for EMV at
each node of the tree?

(Please tick the appropriate response)

Strongly agree
Agree
Neutral
Disagree
Strongly Disagree

Question 12.

12) For the same example, would the firm use option theory concepts such as
incorporating the real business options (wait, abandon, delay) or option valuation
(Black-Scholes formulae) to appraise the investment?

(Please tick the appropriate response)

Very likely

To some extent

84
 Only in certain cases

Improbable

Question 13.

13) Alternatively, would you prefer using risk analysis techniques or Monte Carlo
simulation in particular to appraise a high risk E&P investment?

(Please tick the appropriate response)

Very likely

To some extent

Only in certain cases

Improbable

Question 14.

14) Do you believe decision analysis tools such as real options or Monte Carlo
analysis are time-consuming and require extensive resources to compute them?

(Please tick the appropriate response)

Strongly agree
Agree
Neutral
Disagree
Strongly Disagree

Question 15.

15) Academics argue that combining these techniques or using more than one at the
same time can give a better picture of the investment appraisal decision. Do you
agree?

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(Please tick the appropriate response)
Strongly agree
Agree
Neutral
Disagree
Strongly Disagree

86