Project Economics and Decision Analysis, Volume 2 - Probabilistic Models

439 Pages·2002·6.178 MB·English

by  Mian, M. A.

Project Economics
Decision Analysis
and
Volume 2 Probabilistic Models
Disclaimer: The recommendations, advice, descriptions, and the
methods in this book are presented solely for educational purposes.
The author and publisher assume no liability whatsoever for any loss
or damage that results from the use of any of the material in this book.
Use of the material in this book is solely at the risk of the user.
Copyright© 2002 by
PennWell Corporation
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Library of Congress Cataloging-in-Publication Data Available on Request
Mian, M. A.
Project Economics and Decision Analysis, Volume II: Probabilistic Models
ISBN 978-0-87814-855-4
All rights reserved. No part of this book may be reproduced, stored in a
retrieval system, or transcribed in any form or by any means, electronic
or mechanical, including photocopying and recording, without the prior
written permission of the publisher.
Printed in the United States of America
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PREFACE
The international oil and gas industry remains one of the most
important, highly capital-intensive and risky industries at global,
regional, and local levels. Capital and exploration spending in this sector
average in excess of some $40 billion/year (Oil & Gas Journal {OGJ}:
June 10, 1996). Our profit margins are under real pressure from many
factors, including the higher costs of developing new reserves, less oil
found per foot drilled, rising inflationary costs of doing business, over-
supply of crude, crude oil price volatility, competition for oil company
investments, competition for acreage/concessions, competition for funds,
and the overall business risk and uncertainty put our profit margins under
real pressure.
Therefore, it is very crucial to carry out prudent economic evaluations
of any capital investment’s commitment before resources are committed.
This, of course, requires a thorough understanding of the techniques
available and their application by all those involved in decision-making. To
assist with in achieving this goal, the industry deserves a comprehensive
guide that will provide all the necessary concepts of capital investment
evaluation, capital budgeting, and decision analysis. This two-book series,
Project Economics and Decision Analysis, Volumes I and II, hopefully
meets this requirement.
Objective
One goal in writing this book has been to provide the students,
practicing engineers, geologists, economists, planners, and managers
with a solid foundation in the dynamic and growing field of capital
investment evaluation with emphasis on the uncertainty aspect. It
describes how investment decisions are currently made under different
stages of uncertainty, and prescribes techniques that will assist in making
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Project Economics and Decision Analysis
Volume II: Probabilistic Models
rational decisions. Therefore, the book is a compilation of knowledge
about the prescriptive styled application of the paradigm of decision
analysis to capital investment problems. This two-volume set describes
the philosophy, process, and methods of capital investment evaluation and
decision analysis.
In summary, the main objectives of these books are to:
• Explain the ever-expanding role of economics in prudent capital
investment decision-making.
• Assist readers in developing a knowledgeable vocabulary of the
terms associated with economic analysis.
• Review the procedures used in preparing capital investment eval-
uations and decision analysis.
• Relate the new vocabulary and knowledge to some specific problems.
• Provide ways of interpreting estimates that include uncertainty (i.e.,
converting probabilistic description into a measure of profitability).
• Assist in achieving solid hands-on experience with capital invest-
ment evaluation and decision analysis.
Emphasis and Style
The book presents a balanced blend of theoretical concepts and their
practical utility. I prefer to focus less (compared to other books) on
providing extensive theoretical discussions. Theory, I feel, distracts the
reader from the most important concepts and their practical application.
Moreover, theory will seem sterile and pointless unless its usefulness is
made clear. Therefore, I have focused more on the practical application.
The underlying concepts are stressed, and made concrete with liberal use
of illustrations, many of them taken from actual real-life capital investment
evaluations. Algebraic formulations and spreadsheets are used side-by-
side to help readers develop conceptual thinking skills. Emphasis is placed
on model formulation and interpretation rather than algorithms.
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Preface
The technical materials have been developed with considerable
patience—assuming very little foreknowledge and proceeding in a step-
by-step manner in order to minimize the possibility of the reader
getting lost along the way. Moreover, I have resorted to a greater degree
of informality in the presentation in the belief that readability should be
an overriding consideration. Toward the same goal, intuitive and eco-
nomic explanations are frequently provided to clarify the whyof a partic-
ular concept/technique.
This book is primarily intended for use by economists, earth scientists,
engineers, and students. It also is intended to serve as a refresher, and
perhaps as a self-study textbook. The problem-solving approach is instruc-
tive in nature, but the foundational principles show the practical application
of the material. Its chief purpose is two-fold: (1) to render a systematic
exposition of certain basic deterministic investment evaluation methods,
and (2) to relate these to the decision analysis so the mutual relevance of the
two is clearly brought out.
Therefore, the book is literally divided into two separate, yet
complementary, volumes. This book, Volume II deals with the concepts of
decision analysis (incorporating risk and uncertainty as applied to capital
investments). Generally, each topic is introduced by a practical or conceptual
overview, followed by a brief discussion related to its application in practice
and a solved example.
Volume I is essentially introductory and deals with the deterministic
evaluation tools used for capital investment evaluations. These concepts
are seldom covered, as broadly or from the same viewpoints in economics
and other courses, yet they are fundamental to the proper understanding
of all evaluation work.
For optimum benefit, it is recommended readers explore both vol-
umes and benefit from their integrated instruction. Additionally, a CD is
included with this volume and provides helpful software, spreadsheets,
and tables to enhance the practical application of this material.
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Project Economics and Decision Analysis
Volume II: Probabilistic Models
Examples and Assignment Problems
Included in these two volumes are an abundance of solved real-life
examples (some 100+) and end-of-chapter assignment material (some
200+ questions and problems) are included in the book. Examples are
presented to reinforce the reader’s learning process. Each solved
example is straightforward, fully explained, and avoids sudden leaps to
conclusions that might confuse the reader. The assignment material is
divided into questions and problems. The questions primarily address
key concepts and terms in the chapter. The problems either consolidate
a number of chapter topics or else focus on a comprehensive analysis of
a single topic.
As always, careful choices among the wide variety of assignment
material will offer practical knowledge since the assignments include
various combinations of breadth and depth, theory and procedures,
simplicity and complexity. For maximum benefit, the reader should work
out as many of these problems as possible, if indeed not all of them.
Spreadsheet Applications
An additional unique feature of this book is embedded application
of computers in solving investment evaluation and decision analysis
problems. Rapid advancements in computer hardware and software are
revolutionizing our working environment. Powerful computers are now
available at affordable prices, and new state-of-the-art software makes it
easy to do things much faster and more efficiently. Much of this was not
feasible several years ago. Today, most of us are using spreadsheet
programs to build models of the decision problems we face as a regular
part of our daily work activities. Because of this, it makes sense to use
spreadsheets as the vehicle for introducing undergraduate and graduate
students, dealing with investment evaluation and decision analysis, to
the concepts and tools covered in this area. Spreadsheets also capture
users’ interest and add a new relevance to investment evaluation and
decision analysis.
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Preface
Examples are provided to show how computers can be used to help
make better evaluations and, hence, better decisions. The Microsoft Excel
spreadsheet is making it increasingly easy and practical to do sensitivity and
scenario analyses. Its use has gained acceptance in the industry and makes it
feasible to do a variety of analysis of with a multitude of problems. The latest
version of DecisionTools™ Suite (an Excel add-in) by Palisade Corp.,
including the award winning @RISK, PrecisionTree, BestFit, TopRank, and
RISKView is used where applicable. Screen captures of the various menus
of DecisionTools Suite are used. A copy of the software is included on the
CD-ROM accompanying this volume. The CD-ROM also includes all the
tables and spreadsheets incorporated in the book. This greatly enhances the
utility of the book and permits the quantification of project evaluation and
risk analysis in a practical manner.
Request for Suggestions
Considerable amount of dedication and investment (time and capital)
goes into writing and publishing such a book. PennWell Books and I have
made every effort to introduce this two-volume book as the most compre-
hensive stand-alone desk reference. However, we sincerely welcome your
thoughts as an end-user to help us further improve the contents, presenta-
tion, and utility of this book so as to make it a standard for the new gener-
ation of petroleum industry personnel. The author and publisher believe
this book to be substantially error-free. For any errors remaining, I will
always be very grateful for your comments, suggestions, or corrections
sent to me directly or through PennWell books.
Acknowledgements
Many people are involved in the successful publication of a book. I wish
to thank the following for making significant contributions to this book.
Without their assistance, this project could not have been possible.
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Project Economics and Decision Analysis
Volume II: Probabilistic Models
• All the people at PennWell who contributed their efforts to the
production of this book, especially Editorial Manager Marla
Patterson, and the production, and editing staff, as well as Sue
Rhodes Dodd, my editor and president of Amethyst Enterprises in
Tulsa, Oklahoma.
• Mr. Randy Heffernan of Palisade Corporation for sending me a
copy of the latest version of their DecisionTools™ Suite and allow-
ing me to include this tool on the CD-ROM accompanying this
volume. This has significantly enhanced the utility of this book.
• I would like to thank James A. MacKay of Texaco, Houston, Texas,
and Dr. Roger Eraj Ertefai (Petrochemical and Refining Group
Leader) at Qatar Petroleum for reviewing some parts of the man-
uscript. Their comments were very valuable.
• I would like to thank my wife, three daughters, and son for their
continued patience, support, encouragement, love, and back rubs
throughout this project. They contributed to this effort in ways
that I probably will never know or understand. Special thanks to
my daughters at the University of Colorado at Boulder for being
on the Dean’s list; this has contributed a lot to my enthusiasm.
• Last but not least, I thank my parents for their continued support
and inspiration and for being together for more than 50 years.
M. A. Mian, P.E
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CONTENTS
PREFACE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .xiii
1. INTRODUCTION
Handling Uncertainty in Capital Investments . . . . . . . . . 4
Industry Practice Over the Years . . . . . . . . . . . . . . . . . . . 6
Classification of Decision Situations . . . . . . . . . . . . . . . . . 7
Terminology Used in Decision Analysis . . . . . . . . . . . . . . . 8
The Decision Analysis Cycle . . . . . . . . . . . . . . . . . . . . . . . 11
Advantages of Decision Analysis . . . . . . . . . . . . . . . . . . . 16
Misconceptions Regarding Decision Analysis . . . . . . . . . 17
Applications of Decision Analysis . . . . . . . . . . . . . . . . . . 19
Typical Industry Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Questions and Problems . . . . . . . . . . . . . . . . . . . . . . . . . . 24
2. STATISTICS AND PROBABILITY CONCEPTS
Descriptive Statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
Measures of Central Tendency . . . . . . . . . . . . . . . . . . . 30
Mean, Median, and Mode . . . . . . . . . . . . . . . . . . . 31
Geometric, Harmonic, and Quadratic Mean . . . . . . 35
Weighted Average . . . . . . . . . . . . . . . . . . . . . . . . . 39
Choice of a Suitable Average . . . . . . . . . . . . . . . . . . . . 42
Measures of Variability . . . . . . . . . . . . . . . . . . . . . . . . 44
Range, Variance, and Standard Deviation . . . . . . . . 45
Mean Absolute Deviation . . . . . . . . . . . . . . . . . . . . 46
Coefficient of Variation . . . . . . . . . . . . . . . . . . . . . 47
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Descriptive Statistics from Grouped Data . . . . . . . . . . . 50
Mean, Median, and Mode . . . . . . . . . . . . . . . . . . . 52
Geometric and Harmonic Mean . . . . . . . . . . . . . . . 53
Variance and Standard Deviation . . . . . . . . . . . . . . 53
Graphical Presentation of Data . . . . . . . . . . . . . . . . . . . 56
Other Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
Quartiles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
Dociles and Percentiles . . . . . . . . . . . . . . . . . . . . . 64
Coefficient of Peakedness and Skewness . . . . . . . . 66
Spreadsheet Application . . . . . . . . . . . . . . . . . . . . . . . . 66
Understanding Probability Concepts . . . . . . . . . . . . . . . . 70
Objective Probability . . . . . . . . . . . . . . . . . . . . . . . . . . 72
Classical Approach . . . . . . . . . . . . . . . . . . . . . . . . 72
Empirical Approach . . . . . . . . . . . . . . . . . . . . . . . . 75
Subjective Probability . . . . . . . . . . . . . . . . . . . . . . . . . 77
Modern Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
Operations on Event Sets . . . . . . . . . . . . . . . . . . . . 81
Characteristics of Events . . . . . . . . . . . . . . . . . . . . 82
Rules of Probability . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
Complementation Rule . . . . . . . . . . . . . . . . . . . . . 85
Addition Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
Multiplication Rule . . . . . . . . . . . . . . . . . . . . . . . . 87
Probability Table and Probability Tree . . . . . . . . . . . . . 92
Baye’s Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
Theoretical Probability Distributions . . . . . . . . . . . . . . . 99
Discrete Probability Distributions . . . . . . . . . . . . . . . . 101
Binomial Probability Distribution . . . . . . . . . . . . 101
Multinomial Probability Distribution . . . . . . . . . . 105
Hypergeometric Probability Distribution . . . . . . . 107
Poisson Probability Distribution . . . . . . . . . . . . . . 110
Continuous Probability Distributions . . . . . . . . . . . . . 113
Normal Probability Distribution . . . . . . . . . . . . . . 114
Lognormal Probability Distribution . . . . . . . . . . . 122
Uniform Probability Distribution . . . . . . . . . . . . . 126
Triangular Probability Distribution . . . . . . . . . . . 128
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