Jackson Black our man in Havana!

This is a fantastic article that kicks off the much vaunted Spotlight feature.

The feature was written by a well-respected individual whose company are currently involved in European Exploration/Production.

In the spotlight today;  Risk in oil and gas exploration.


Risk in Oil and Gas Exploration

There are two ways of looking at the hypothetical corporate brochure of “Slick Oil plc” and their kind, with their confident assessments of low risk exploration prospects; You can either assume that they know what they are doing and invest straight away, or you can ask “what do they mean “low risk” and why do they think they know that?”

If you are the latter type of investor, the place to start unpicking their claims is to understand a little about the fundamentals of how risks in exploration are calculated.

Let’s get “Risk” and “Uncertainty” clear first.  Exploration Risk asks “What is the chance of an undrilled prospect having Oil or Gas or nothing at all?”  The concept is that of a light switch; On or Off.  Once a discovery is made our attention gets drawn to estimating the size of the discovery – and the range of possible reserves. That is “Uncertainty” – the concept is like a light’s dimmer switch. Bright – Dim.

To give a rough guide to Exploration Risk – “Low Risk” prospects have 25-50% chance of success (one in two to one in four), “Medium Risk”: 15-25% (one in four to one in six) and “High Risk”: 8-15% (one in six to one in twelve).  Anything higher risk than that is a dry hole but just doesn’t know it yet.

Note that nothing in exploration is ever really low risk in the sense that you would actually bet your life on it.  A “low risk” prospect these days might have a one in four (25%) chance of success.  Sounds like good odds until you turn it around – there is a three in four chance that it just will not work. If there was a three in four chance of you dying in a medical procedure you would probably think twice about having it (I’m thinking 95% is medium risk in that regard).  So what the oil company is really saying is that the “Low Risk” exploration is relatively low risk compared to OTHER exploration!

I don’t want to scare you but a high risk prospect with a chance of success of one in ten (10%) or less – well they almost never work (and no, you don’t need to just drill ten of them to be sure of success – even if you can afford to).  This type of exploration only makes sense to drill as part of a portfolio where other prospects have a good chance of working, as the exploration business model only works because the value of success generally greatly exceeds the value of failure – so when success comes (and you need a portfolio where it surely will work) this covers the costs of the failed efforts to that point.   If it is one in ten – the reward had better be super massive or it’s just not worth it.

However, this is indeed the explorationists lot in life; they know that even the best prospects are more likely to fail than not, but there is no substitute to drilling for finding oil.  It’s not shipbuilding – if it were we’d expect most ships would sink (we have to just hope it was other people’s ships that did the sinking!).  As technology improves, the easy prospects are quickly hoovered up, and the next set of technical problems to solve are just as difficult as ever.  When the exploration wells do come in though – the rewards are worth the pain.

Evaluating Exploration Risk

So let’s unpick the risk estimate.  A scrupulous operator will always base the risk or chance of success estimate on a technical basis, and should be able to explain this – if pressed – to the investor.

Chance of success for an oil or gas prospect is calculated by the myriad oil companies in many different ways (every company thinks it has the perfect way of doing it) but it all boils down to the same thing – assessing probability of three chance factors all coming together favourably.  The three chance factors are Charge, Trap and Reservoir.

The “Charge” chance factor is the chance of the generation of oil or gas (you need to cook “source rocks” (organic mudstone or coals) to get oil or gas formation in the earth) AND that those hydrocarbons have seeped along bedding planes and faults into a trap, AND this needs to have happened at a time when the trap (see below) is already formed (if it gets there too early the oil is just lost!).   Look at the company’s presentation material – if the prospect is near proven discoveries and fields charge is probably not a big risk but if it lies at the edge of a basin or an untested basin – this is the risk element to focus on. If there’s no Charge – there’s no-anything!

The “Reservoir” Chance Factor is the chance of finding some rock with connected holes in it that the oil or gas can fill up.  Oil does not stay underground in vast lakes or caverns like in “Journey to the centre of the earth”.  Actually oil and gas sits in tiny holes or pores between grains of rock.  Think of the spaces between the sugar grains in a sugar lump and you’ll get the idea. Put a lump on some spilt tea and see the where the tea moves to.  Most reservoirs like this are either sandstone (like solid sandy beach material) or limestone (like buried barrier reefs), but there are many different ways to make pores or space for oil underground – having natural fractures for example.  The most important thing is that the reservoir must also allow the oil and gas to get in – and when we need it to – it must be able to flow out of the reservoir too – this is called being permeable.  Look for discussion of how close the prospect is to the same geological type and age of reservoir and how well that offset reservoir produced oil.

The “Trap” Chance Factor is the chance of this oil or gas having got getting stuck underground.  Both oil and gas float on the water that fills up most holes underground, so if left unhindered the oil and gas will just rise up, or permeate from the depths to the surface where they are lost (there are some of these today making tar pits or rarely eternal flames). However, if there is a geological structure with a sealing layer above it, the oil and gas can get stuck – like the air in a U-bend under a sink.  There are a gazillion ways that the earth can have got deformed during its history to make a “structure”, but it boils down to squashing or stretching the earth as tectonic plates shuffle about. It’s not really that important to the job in hand here so long as there is a structure to catch the oil, and it hasn’t tilted or ruptured subsequently. Seismic is used to define the shape and formation history of underground structures. Seismic sections are echo sounding profiles that give you the ability to estimate what the earth looks like –often in some detail – up to 5km below the surface. The more of this stuff you have, and the more recent it is, the better.  2D (single lines) seismic is notorious for defining structures inadequately, but 3D is usually much better both in definition of the structure and reliability. Compare 2D platform games from the 80’s with 3D computer graphics games like Call Of  Duty and you’ll get a feel for what that extra depth of data means to our ability to predict and understand what’s beneath our feet.  Look for lots of seismic data, good well control, and high relief, unsubtle structures.  Unsubtle is good-by the way! I’ve been a bit glib about this here but look for evidence or discussion of regional sealing layers – being next to similar successful structures is usually a good sign.

The oil company will look at each of these three factors, investigate them, analyze the concepts, collect more data, re-analyze etc until they are blue in the face, and then assign a percentage chance of success to each factor based on their own in-house system or rules.  As an investor you won’t have all the data, nor time to duplicate the studies but there is a really simple way to simulate the oil company approach and ball-park these numbers. For each of the three factors think a) “unproven or unaddressed or just plain nonsense”, then the Chance Factor is 0.3. or b) “the story sounds good but they admit there is not enough data to be conclusive”: Chance Factor 0.5, or c) “the explanation sounds reasonable, encouraging and supported by evidence”, 0.8.

The prospect chance of success is the multiple of these three factors Chance of Success (COS) = Charge * Trap * Reservoir. It’s like a traffic light – if ANY of these elements don’t work then nor will the prospect. If they are all good – then there’s a good chance the prospect will work.

A simple example.  Hypothetical “Slick Oil Plc “have a prospect well next to an existing field at similar depth, where they have a quite well-defined structure (they’ve only got 2D seismic but have many near-by wells). However their prospect has a sandstone reservoir that isn’t seen in nearby wells and is only predicted by a geological model.

So, Charge (providing the play is similar to the adjacent field and shallower than the source rock) = 0.8.  Trap – 2D seismic & wells is OK but not proven though and there may be complications on sealing units = 0.5.  Reservoir – whoa! Are they desperate or visionary? – you choose but if there’s no evidence yet then assume = 0.3.  Chance of success 0.8 x 0.5 x 0.3 = 0.12 or 12%. This is a one in eight shot and somewhat high risk.

The method here of course is crude and simplistic but if you keep asking “what makes them think they know that?” for each factor, it should let you spot a high, medium or low risk prospect in a consistent way. Remember “Low Risk” prospects have 25-50% chance of success (one in two to one in four), “Medium Risk”: 15-25% (one in four to one in six) and “High Risk”: 8-15% (one in six to one in twelve). If the hypothetical “Slick Oil Plc” claims its low risk – phone them up and make them justify it!

By applying this type of logic (with a bit of experience around the different types of play being pursued) you should be able to QC the risk assessments of an oil company from their published materials, or at least assemble a coherent set of questions to ask.

So back to the “one in ten” chance of success prospects. They don’t tend to work as there will be either one very poor risk factor, or three moderately poor risk factors.  The only time they come in really is in the former case – where you have estimated the one “very poor” factor incorrectly. Often this is due to lack of data – and “cup half empty” analysis – and is something to be cautious of.

By the way, just to finish off: – there is a relatively new, specific type of exploration prospect that defies the methodology above. That type of prospect has a Direct Hydrocarbon Indicator (DHI). That usually means that the seismic appears to show some independent evidence of the presence of hydrocarbons. This breaks the rules because you don’t need to know what the source rock is, or what the seal to the trap might be or even what the reservoir might be as you believe you can actually see the oil (or more usually gas) on the seismic.  Unfortunately there are many examples where DHI’s are not as good as they appear and they are just artefacts of the technology used or features that simulate the effects of hydrocarbons. They are also better at finding gas than oil which isn’t always what you need to do. For this reason the estimate of chance of success for such a prospect is more an estimate of how reliable the DHI is for finding the fluid (oil/gas) that you need to find for commercial success, i.e. how difficult it is for nature to fool the technology. Yet with a good technical story, supported by near-by analogue success, it is valid in some cases to have an exploration chance of success over 50%.

This simple method of exploration risk analysis simulates what oil companies do and allows you to challenge their claims or take some of the journey in understanding what they are trying to do. Use the data the companies provide as clues to how they have assigned risk – and understand the risks you are thinking of investing in.

Remember the method discussed here is just a guide – its not a guarantee of success. Most exploration wells (even the “low risk” ones) will not work, and on the other hand, occasionally a one in ten chance will come-in!

If nothing else you can consistently compare the stories of various companies, and pick the plays with the risk profile that suits you. If the oil company cannot satisfy you about one of these critical elements it may be that the risks are not all that they seem.

Jackson Black

The information contained in this Feature has been written for www.guerillainvesting.co.uk Under pseudonym. Copyright rests wholly and exclusively with the Author.The Feature has been written for RESEARCH purposes only and in no way should be taken as investment advice.Private Investors are advised to always seek professional investment advice before investing.

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No Responses

  1. Barney says:

    Phew! That took some time reading Dan.
    Who is it this Jackson Black?
    Certainly know there onions i’ve copied it and printed it off hope you don’t mind.


  2. investorjestor says:

    Good read. Much to much to take in at one go .
    Like the charge ,trap res info’ so what Jackson is saying is that its a combination of these 3 factors that dictate the Chance of success?

  3. Aidy says:

    IF YOU WANT this to be taken seriously who is this character Jackson Black? its all abit cloak an dagger for me.
    is Jackson related to the jackson five
    come on who is it?

  4. miopus says:

    Really good article, and easy to understand and apply.

    • bellycose says:

      Enjoyed the read took some of the mystery out of how these chaps asess their licences.
      Full marks 10 out of 10 for the effort Jackson.


  5. Doug says:

    Good article, thanks

  6. 13thMonkey says:

    Thanks Dan and Jackson. I like the back-of-an-envelope risk calculation method in particular.

  7. theAIMboy says:

    Nice post Dan – but who is Jackson Black? I would also like to point out there is more to investing in these types of plays than purely geological predetermination. Look at the people running the company, can you believe what they say and have they got they got a credible exploration team. In addition what does the modern imaging techniques tell us?


  8. elise says:

    hey dan you have made me so much money by pointing me in the right direction.


    whats your take on enquest?

    they own the thistle platform now and have started a drilling campaign there first in maybe 15 years, they are doing flow tests just now…a friend of a friend tells me they are getting close to 8000bpd………they have just taken over Stratic Energy Corp


    any rumours or thoughts on this company

    many thanks Elise

  9. stevejones says:

    The Havannna title is this guy based in Cuba
    Or europe Dan? whats his full job description is he a rigger, director, manager, office worker, analyst ceo?
    good read though must be on the ball ‘@his company.


  10. amanda says:

    Can’t understand the part about the sugar lump and the oil how can there be oil in such a tight structure i always thought of the oil in a kind of lake or pool so when its pumped to the surface does it come out mixed with rock sand etc?

    • Barnston pickle says:

      I still dont understand the COS thingy if theres a 25% chance of success on the drill then surely if you just drill 4 times you’ll hit some thing?
      Or am i missing some thing here Jackson.
      Jackson what do you think of Sterling energys chances they said a 1 in 10 so realistically is it pants?


      • TheBrain says:

        Barnston, it might be worth you googling probabilities and doing some research as, if you don’t know why four 25% chance drills doesn’t guarantee you’ll hit oil, you’re likely to end up broke.

  11. Rocky says:

    hi dan,
    i am just a small investor.but i am great fan of yours.i read ur every post.i have been following ur post for more than six months now.any updates on encore oil. when is that going to move.

  12. Aj says:

    Hi Dan,

    I remember you mentioned Bowleven PLC a little while back and wondered what you were hearing from within the city walls so to speak.

    The company have just made two highly significant discoveries at their Sapele-1 exploration well, offshore Cameroon. With estimates of the combined size of the discoveries ranging from 95 million barrels oil equivalent (boe) to 670 million boe, Mr Kevin Hart CEO (previously Finance Director at Cairn Energy PLC for over eight years) said they were “potentially transformational” for the company.

    The well is around 40 days from reaching the deepest point that it will target in the Douala Basin. This is the location of a prospect that Bowleven believes may contain as much as 3.7 billion boe. YES potentially 3.7 Billion Barrels of OIL.

    Fox Davies Capital estimate a risked NAV of 317p based on net risked resources of 77MMboe, with unrisked values of 1,807p and 500MMboe respectively.

    I would love to hear what your thoughts are here Dan.

    The potential over the next few weeks is enormous for investors



  13. Forest fred says:

    Nice article, and i don’t care if its written by Glenda Jackson or jack black. Anything that boosts my knowledge in an easily understandable way is welcomed.

    I’ve also noted bowleven. Seems to fit the BMD criteria of HAVING oil rather than sniffing for oil. Thoughts?

  14. Apur says:

    What is happening with VOG and MTA? Both are coming down.

    Invested yesterday in it after the great rise.

    What do you think how long will it take to go up again.


  15. TheBrain says:

    Makes XEL attractive with it’s COS of minimum 70%!

  1. 16 November, 2010

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