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When do I Need a CIO?

22 Jan 2017 Leave a Comment Written by Albert M. Passy
When do I Need a CIO?

For most companies, the “IT guy” is more than sufficient – someone to take care of the technology “plumbing”, while the owner occassionally makes the decisions on the big things – the CRM system, email, website, inventory/sales management systems, etc.  But you’ll get to a size where you’re spending more time managing your systems than managing your business.  If you stop and think about, you know you need help. Running the company, maximizing revenue, building new or deeper sales channels – these things ought to be your focus everyday.

But you are spending too much time trying to track down a customer’s orders on the spreadsheet you use.  Or your IT guy says you need a bigger file server, but you don’t know how much to spend.  Or you can’t get your inventory costs nailed down because your purchasing and inventory systems can’t talk to each other.  Or a customer’s order goes out wrong because someone confused the emails with the order spreadsheet on them.

All of these are signs that you need someone to be paying attention to your technology and systems, and how they integrate with your business operations.  You need a Chief Information Officer.

What we offer is a part-time, or contract CIO.  Either on an hourly or retainer basis, we look at your business, it operations and how all of your technology supports your goals and your bottom line.

Contact us to see how we can help.

Are My PUDs Worth Anything?

22 Feb 2016 Leave a Comment Written by Albert M. Passy
Are My PUDs Worth Anything?
Idle Drilling Rigs

Idle Drilling Rigs (photo credit: AP Photo/Reporter-Telegram, James Durbin)

Many of you are looking at groups of undeveloped wells, either yours or someone else’s, and the numbers are telling you that they have a negative value – technically the seller should have to pay to get rid of them. But we all know that’s not the case. They have some value – maybe small, but something. How do you put a number on that value?

Traditional Methods are No Help

Right now, you’re probably using Net Present Value to evaluate those undeveloped properties. There’s nothing inherently wrong with NPV, but it has several weaknesses that just don’t help in today’s price environment.

First and foremost is that most NPVs use one price through the future. Some test with a few different future prices, but all that reveals is the range of exposure – not the likelihood and therefore, not the value. Some will test a range of subsurface outcomes – but not as often. Some will test a range of cost estimates. But rarely. If the NPVs are coming from Aries, or PhdWin, then it’s definitively just averages. Everyone understands that’s inadequate, so there are several techniques to “risk-adjust” the NPVs.

Discount rates

According to the SPEE1, the most common method used to risk adjust the NPV is discount rates. NPVs for projects that are perceived as “riskier” are discounted at a higher rate. This has the effect of making the capital costs, which are usually up-front, appear larger than the revenue, which usually comes later, for many years. However, this doesn’t help in the current situation (or ever, really, but that’s a story for a different essay). It doesn’t matter how you discount, these current wells can’t be profitable. If you drill them now, prices are too low now to support the well. This just can’t reveal the value of that undeveloped project – it can just tell you that it’s not profitable now.

Scenario Analysis

The second most popular method is “scenario” analysis. A few scenarios are run, with different price decks, maybe with different subsurface results. Then someone subjectively approximates the probability that each scenario could occur, the different NPVs are weighted by the risk estimate, and voila! a risk-adjusted NPV results. The biggest problem with this is that we are terrible at estimating the likelihood of anything happening (see Macando), so we end up with a bigger mess than we started with.

Financial Options

(A)n option is a contract which gives the buyer … the right, but not the obligation, to buy or sell an underlying asset … at a specified … price on or before a specified date.

At a high level, that sounds an awful lot like a drilling lease – the lease holder has “the right, but not the obligation” to drill on the owner’s land, for a certain period of time. For many years, the financial community struggled with how to price options. It was well understood that it was a probability issue – that prices could wander in the future, and that some of them would result in the option expiring “in the money,” i.e. worth something, and some would not. It wasn’t until the pioneering work of Black and Scholes in the early 70’s that the issue was finally settled.

But it wasn’t. Though the Black-Scholes formula is well-suited to pricing options that can be exercised only at their expiration dates (“European” options), most interesting options are “American” – they can be exercised “on or before a specified date.” (Sounds like a lease again.) Black-Scholes cannot price American options2. There are some valuation practitioners out there who claim to be using Black-Scholes for undeveloped properties. If they are, avoid them.

A whole host of methods have been developed to price more complex options, with exotic names like Binomial Tree, or Monte Carlo Simulation. Their details aren’t really pertinent to this discussion, but they address almost all of the shortcomings of Black-Sholes at pricing complex options – and real petroleum projects.

Real Options

The applicability of financial option valuation techniques to non-financial projects is not a recent development. The academic literature is rich with papers that explore this concept. A review of these articles reveals that “real” projects differed from financial projects in one significant way – there was flexibility embedded in the real projects, that wasn’t in the financial “projects.” This field was dubbed “real options.”

Every petroleum project has these embedded options that conventional techniques ignore. Drilling can be delayed if the current price environment is unfavorable. (Sound familiar?) The field can be shut-in, or abandoned if unprofitable. If the subsurface results are favorable, the field can be down-spaced (expanded). If they are unfavorable, the entire field abandoned. Conventional techniques just aren’t up to the task of properly valuing any real petroleum project.

The Simulation Approach

Almost every other approach developed to value options came about because the most suitable approach, simulation, was impossible to do in a reasonable period of time . Now that computer power has caught up with simulation needs, simplified methods aren’t required. We understand how to simulate what prices can look like in the future, and simulate the decisions that would be made along the way to drill, or to abandon, etc.
The key is that we don’t forecast prices. Simulation approaches generate many future price paths that move up and down just like real prices do, with random movements. Though in the real world, real events generate those movements, statistically, they look random – and that allows us to simulate them.

Each of those thousands of futures has a value – positive and negative. By averaging the positive values, we can estimate how much (or little) that project’s value is.

Applicability to Petroleum Properties

It should be clear by now that we believe that the techniques pioneered in the financial industry can and should be applied to the oil and gas business. Only with a sophisticated approach can all of the real options be included. Only with a sophisticated approach can biases in price estimates be avoided, allowing the statistics to express themselves in value. Only with a sophisticated approach can the valuation be truly customized for your company’s value proposition.

 

 

To answer the question: Yes, they are worth something. But you won’t figure that out with a simple NPV.

 

 

  1. http://comptroller.texas.gov/taxinfo/proptax/pdf/96-1166.pdf ↩
  2. Geske, Robert, and Richard Roll. “On Valuing American Call Options with the Black‐Scholes European Formula.” The Journal of Finance 39, no. 2 (1984): 443-455.  http://dx.doi.org/10.1111/j.1540-6261.1984.tb02319.x ↩

New Year’s Forecasts

2 Jan 2016 Leave a Comment Written by Albert M. Passy
New Year’s Forecasts

2016_Happy_New_Year_ClipArtIt’s that time of year, when pundits are reviewing their previous predictions and renewing them for new year.  It appears that I am no different.  Last week, I was asked to appear on a local news broadcast talking about what’s in store for the Houston economy in 2016.  Being an oil and gas guy, I focused on that part of the economy.  From the fifteen minute interview, they pulled 3 sentences 1   (including one on the local real-estate market which I very reluctantly gave):

I almost hear the comments now:

But, Marc, you said you don’t “do” forecasts.

I don’t, and certainly not professionally. But I do have opinions, like everyone else, and I will share them when asked.  (Especially in exchange for a little free publicity for my business.)   That doesn’t change our fundamental belief that you can’t make business decisions on opinions.  Everyone has a different one.  We must remember, however, that opinions are not information.

Do we remember a certain investment bank’s $200 oil price forecast from a few years ago?  The same one now calling for $20 oil?  Though a certain belief in a general trend for prices is necessary for long-term planning, detailed forecasts, especially in the short term, are worse than useless.  Business like that are making bets on specific price directions, instead of minimizing their risk.  They turn themselves into speculators, betting on the next rise or delay in a decline.

I spent several years as an officer on nuclear submarine.  One of the many things you learn in that job is how to make decisions.  And one of the first principles is to know the very last minute that you must make a decision – and spend every minute up until then gathering information.  Business decisions should follow the same principles: gather as much information as possible, and make your decisions at the last minute.

Unfortunately, if you’re using traditional valuation techniques, you’re not gathering all the information possible.  You’re not minimizing your chances of making a poor decision. You’re making a bet on the world being average – and we all know it’s not.

It’s our business to help you make information from data, to make clear the risks to your plans.   Contact us to discuss how we can help you make better decisions.

 

 

 

 

 

  1. I am “cautiously optimistic” – but thanks to the magic of TV editing, the “relative to some of the fears out there” got lost. ↩

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