Merak V&R Notes

Decision & Risk Analysis
Schlumberger Private
Outline
Introduction
Basic tornado Concepts
Basic decision tree concepts
Basic Monte Carlo concepts
Monte Carlo vs. decision trees
Independence, dependence, correlation
More Monte Carlo topics
Portfolio theory
Introduction
Three loose categories of analysis:
Sensitivity Analysis
Decision Analysis
Risk Analysis
The underlying theme is uncertainty:
How important is it?
How can it affect decisions?
What is the impact of it?
Each of these categories can make use of different
tools.
The questions asked in each stage of analysis tend to
be different.
Sensitivity Analysis
How much is the
value of a project
affected by
uncertainties?
Is the range of
possible outcomes
acceptable?
Which uncertainties
are the most
significant?
Is it worth trying to
refine the estimates of
the most significant
variables?
Decision Analysis
Should we drill, sell, or run seismic?
Is the cost of adding a compressor likely to be
recouped?
Which development strategy will pay out most quickly?
Should any decisions change if we change our
measure of value?
How much is seismic information worth, if anything?
Risk Analysis
What does the risk
profile for the project
look like?
What is the
likelihood of losing
money?
Should we be
surprised by the
outcome of this
project?
What is the most
meaningful measure
of risk for us?
Basic Tornado Concepts
Uncertainty
Everything has uncertainty at some level
Understanding it has two components:
How uncertain is it?
How much does it matter?
High, Base, Low
When specifying how uncertain something is,
we often give high, base, and low estimates.
What does this mean?
The base estimate is generally the estimate for the
most likely value.
High and low are more tricky: the range should be
wide enough to capture most possibilities, but it
should not be so wide that the estimate has no
meaning.
Some terminology:
Variable: an uncertain parameter affecting the result of a
calculation. E.g., oil price, operating costs, net pay, etc.
Value Measure: a measure of value; the result of a
calculation. E.g., NPV, ROR, recoverable reserves, etc.
Basically, these are inputs and outputs, respectively.

Tornado Diagrams
To create a tornado diagram...
calculate the VM using the base estimate of all the variables
calculate the VM using the low and high estimate of each variable
calculate the change in VM between low and high for each
variable
plot each change as a horizontal bar with the largest at the top
Spider Diagrams
A spider diagram is another sensitivity analysis tool:
calculate the VM using a range of values for each
uncertain variable
plot the VM vs. the percent change in the base
estimate for each variable
steeper slopes indicate the VM is more sensitive to
changes in that variable
negative slopes indicate an inverse relationship
Basic Decision Tree Concepts
Probability
Everyone is familiar with the concept of
probability:
When you flip a coin, there is a 50% chance of
getting heads.
When you roll a die, there is a 1 in 6 chance
(16.6667%) of rolling a 4.
All of decision analysis relies heavily this concept.
Decision Tree Nodes
There are three types of nodes in a standard decision tree.
Decision nodes represent decisions that need
to be made.
Uncertainty nodes represent uncontrolled

uncertainties.
End nodes represent outcomes or states of

events that can be realized.
Expected Value
Expected value (EV) is the weighted average of all
the possible outcomes.
It is generally not possible to achieve the EV in a
single trial.
If the identical project could be done many many
times, the average outcome should be close to the
expected value.
High, Base, and Low Revisited
A common element of a decision tree is the three-
branch uncertainty node.
Recall that EV is the probability-weighted
average of all the outcomes.
For the calculated EV to be meaningful, care
must be taken in the selection of the
probabilities.
A three-branch uncertainty node is usually used to represent a

continuous variable in a simplified form.
More High, Base, and Low
A continuous variable needs both its average value and its range
of possible values to be roughly captured by the three-branch
representation.
Probability-value pairs need to be carefully selected.
The selection of low, base, and high

values is closely related to the
probabilities used, and vice versa.
Cumulative Probability Graphs
A cumulative probability plot is a useful tool for understanding
the results of a decision tree.
To create a CP graph:
Sort all possible outcomes from
lowest to highest.
Plot the probability of the lowest
outcome against its value.
For the next outcome, plot its prob. plus the previous prob.
against the its value.
Repeat for all points.
CP Graphs and Risk Tolerance
Two decision trees can have the same expected value but
different cumulative probability graphs.
Two coin flip games:
Heads: win $10, Tails: win $0
Heads: win $1, Tails: win $0, play ten times
If it cost $4 to play these games,
would you?
What if the stakes were measured
in thousands of dollars?
In Class Example
Using the ProCalc5 Spreadsheet:
Plot a tornado diagram
Create a decision tree with top three variables
Calculate expected value
Plot a cumulative probability plot
Basic Monte Carlo Concepts
The Calculation Engine
Recall the discussion of variables and value measures.
They are the inputs and outputs of a calculation engine.
A calculation engine could be Merak Peep, MS Excel, or
any other application that has inputs and outputs.
The Calculation Engine
For a Monte Carlo simulation, inputs are described as PDFs
Random values are drawn for each input and outputs are
calculated.
Repeating this builds up a histogram of possible output
values.
Probability Distributions
A probability distribution is a means of expressing the
range of possible values for an uncertain variable, and the
likelihood of those values.
The most common means of

expressing this is a
probability density function.
The probability of the variable
being in the range x to x+dx is
P(x) * dx
Random Sampling
During a Monte Carlo simulation, numbers are drawn at
random from each variables PDF.
The sampling is done such that areas of high probability
density are chosen more frequently than areas of low
probability density.
If region A has twice the probability density of region B,
there should be twice as many sample values drawn from A
as from B.
Measures of Central Tendency
There are many kinds of averages.
The most common

are mean, median
and mode.
For an asymmetric
PDF, these three
measures will not be
the same.
Continuous vs. Discrete Distributions
One important property to note about a probability
distributions is whether it is continuous or discrete.
Continuous distributions apply to
variables such as porosity or price.
Discrete distributions apply to

variables such as the number of
dry holes or success vs. failure.
Cumulative Probability Revisited
A cumulative probability graph is obtained by integrating
the probability density function.
This is an alternate view of the same information, but it can
be easier to interpret, depending on the insight sought.
Percentiles
It is easy to illustrate percentiles using the cumulative probability
graph.
There is a 10% chance of the true value being less than the P10
estimate of that value.
It is also possible to easily determine the likelihood of the variable
falling within any given range of values.
Correlation
It is possible for variables to be random but not
independent of each other.
If, when the values of one variable are high, the values of
the other variable also tend to be high, then they are
positively correlated.
When the opposite is true, they are negatively correlated.
Correlation does not necessarily imply a causal
relationship between two variables.
Correlation continued
The degree of correlation is measured by the correlation
coefficient, which runs from -1 to +1.
Plotting the values
of one variable vs.
the corresponding
values of the other
variable is a good
way to visually
inspect correlation.
Decision Trees vs. Monte Carlo
There is considerable overlap between

decision trees and Monte Carlo simulation.
both model uncertainty

both calculate expected value
both consider ranges of outcomes
What are the differences?
As we have discussed,
uncertainty nodes commonly
have three branches to represent
an uncertain variable.
An alternative
representation of the same
information in the form of a
discrete probability
distribution:
Decision Tree vs. Monte Carlo
Is the 3-spike graph really

accurate?
Are there really only three
possible prices?
Should all prices around
the base price be equally
likely?
Instead of a few discrete values, Monte Carlo can
use a continuous distributions to represent
uncertain variables
Both decision trees and Monte Carlo use a
calculation engine to provide data.
The key difference is how this output data is
used.
Decision trees use the values of the outcomes
and their associated probabilities to
determine a weighted average. This is the
expected value of the tree.
EV = (P(1) V(1)) + (P(2) V(2)) + (P(3) V(3))
In Monte Carlo analysis, expected value is
calculated by taking the mean of all the
outcomes.
There is no weighting by probability because
the sampling from the input distributions
accomplishes this.
Sampling is more
frequent in regions of
high probability density.
EV = (V1 + V2 + V3 +)/N
Sample size important.
Pros and Cons of Monte Carlo
Pro: For situations where precision is important,
MC modeling is more sophisticated than decision
trees.
Con: More sophistication requires more data and
effort. A three-branch uncertainty node may be
just as good for rough calculations.
Pro: For large numbers of uncertain input
variables, the number of calculations required
for MC analysis can be smaller.
Con: Decision trees are faster to calculate
when relatively few uncertainties are involved.
Pro: Monte Carlo is a good risk profiling tool.
What are the P10 and P90 values?
What is the chance of losing money?
How does this project fit into the
portfolio?
Con: Monte Carlo alone is not a decision

analysis tool.
Cannot determine value of information.
Cannot determine optimal strategies.
Insights are more difficult.
Dependence and Correlation
The distinction between correlation and dependence

is not always clear.
Dependence implies a relationship between
events (if this, then that).
Correlation implies a relationship between
variables (if A is high, then B is low).
Both can manifest themselves similarly,
depending on the application.
Tornado Dependence
Recall the previous discussion of tornado diagrams
Each variable is adjusted one at a time to observe the
effect on the value measure.
This implicitly assumes that the variables are
independent of one another.
Correlation and dependence can be expressed to a
limited degree by associating more than one variable
with a sensitivity bar.
Use the high estimate for A with the high estimate for B
to represent a positive relationship
Use a low estimate in conjunction with a high estimate to
represent a negative relationship.
Decision Tree Independence
By default, variables in decision trees are independent
The shorthand notation
mentioned earlier shows
the same uncertainty node
following each branch of
the previous node.
This implies that the value
of the second variable is
independent of the first
variable.
Decision Tree Dependence
Both correlation and dependence can be defined in a
decision tree.
Both are specified in the
same way.
Here, the values used in
each uncertainty node in
the second level are
different.
Could also have different
probabilities.
Bayesian Revision
An unintuitive aspect of probability theory.
Imagine that from analogy you have been able to

determine the probabilities of hitting a good,
moderate, or poor well.
Also, from past
performance you
know the likelihood of
good or poor seismic
results given different
qualities of wells in
the region.
Bayesian Revision
Unfortunately, the probabilities you

have are in this format.
But you need them in this
format.
Bayesian revision is the
technique of converting
the probabilities from one
representation to the
other.
Bayesian Revision
The results of the Bayesian revision in this example
are shown in the tree below.
Note that the
resulting probabilities
are not obvious.
Bayesian revision is
very closely tied to
the concept of Value
of Information
Value of Information
The question that might occur to you after looking at
the previous example is whether the seismic
information was worth obtaining what is the value
of that information?
Because of the unintuitive nature of Bayesian
revision, value of information calculations are often
surprising.
Sometime information turns out to be extremely
valuable at other times it has no value at all.
In order for information to have any value, it must in
some way affect the decision you make.
A Simple Card Game
Youre walking through a dirty, run-down casino on the
edge of town. A surly looking man stands at a table with a
deck of freshly shuffled cards. You ask him what game he
is dealing and he explains:
The rules are very simple my friend. It costs $100 to play
this game. After you hand over the money, he will turn
over the top card of the deck. If the card is a face card,
you win. If not, you will lose. How much do you win? If the
card is a Jack, you win $150. If the card is a Queen, you
win $250. If the card is a King, you win $350. So you see,
its really a very easy game. Let us play.
Do you want to play this game?

A Simple Card Game
You hesitate, trying to work out whether you should play
the game. The man sees you pause and leans toward you
with a wink. You can smell his warm breath as he
whispers to you:
I see you are an intelligent person. Perhaps I can suggest
a way we both can profit. If you tip me $50, I will signal
you with a tap of my foot whether the next card is a face
card. You can then decide if you want to play.
Is his offer a good one?

A Simple Card Game
A thin waif of a woman is watching you from off to the
side. She signals for you to come over to her. Against
your better judgment, you go over to hear what she has to
say.
I know the offer this man has given you. I will make you a
better offer. For only $25 dollars, I will consult my poor
dead mother and tell you whether the card will be a face
card. She is hardly ever wrong no more often than two
heads in two coin tosses.
Is her offer a good one?

Random Number Generators
Random number generators do not actually
generate truly random numbers.
They use an algorithm to create a string of pseudo-
random numbers.
The algorithm requires a seed number that is used
as the starting point for the string of numbers.
If the same seed is used, the same string of
numbers will be generated.
This feature of random number generators can be
exploited in some applications.
Random Walks
One method of modeling price is with a random walk.
A distribution is used to model the month-to-month
changes in price.
For each iteration of the MC simulation, one sample
value is drawn for each time period of the economic
evaluation.
The goal is to reproduce the
statistical properties of real price
charts by carefully selecting the
parameters describing the random
walk.
Convergence
How many iterations are required for a MC simulation?
Tracking the changes in statistical measures as the
simulation proceeds is a method of addressing this
question.
The speed of convergence depends on the setup of the
MC model and the desired level of accuracy.
The more iterations, the more accurate the results.
Combining Distributions
Care must be taken when combining the results of
separate MC simulations.
Adding the P10 results of two projects does not give
the P10 result for the combination of those projects.
The results must be added iteration by iteration.
If the results of the projects are correlated (because
of a common price forecast for example), the order
of the iterations is crucial.
Portfolio Theory
The Problem in a nutshell:
You have N projects that you could pursue
You have enough money to do n projects
n<N
Extra complications usually arise in the form of

additional constraints:
minimum production quota
drilling rig availability
contractual obligations...
Portfolio Theory
Three important ideas:
The rational investor:
value is good
risk is bad
Project value dependent on portfolio:
value is portfolio-contribution dependent
portfolio is more (or less) than the sum of its parts
More than one optimal portfolio:
more value gained by accepting more risk
less risk achieved by accepting less value
Portfolio Space
Imagine that you plotted every feasible portfolio
on a graph of value vs. risk
An upper boundary

would be apparent
Only the points represent
valid portfolios - the
space is typically not
continuous
How can portfolios be compared and selected?

Dominance
A portfolio can be said to dominate others when it
has as much or more value for the same or less
risk
Portfolio A is dominated
by portfolios in quadrant II
Portfolio A dominates all

portfolios in quadrant IV
Cannot definitively
compare portfolio A to
portfolios in quadrants I
and III
A portfolio is efficient if it is not dominated

The Efficient Frontier
The collection of all efficient portfolios can be
called the efficient frontier
Collection of points, not a
continuous line
Have not yet defined value
and risk
How can value and risk be quantified?

Risk Profiles
The histogram of possible outcomes is called a
risk profile.
From it, many statistical
measures can be derived:
expected value = mean
uncertainty = standard deviation
(Traditional Markowitz definitions)
downside uncertainty = semi-
standard deviation
equals standard deviation for
symmetrical risk profiles
Low, high, and median estimates
Probability of losing money or
missing quota
The Definition of Risk
Throughout all of this discussion the definition of risk
(and value) has not been discussed.
There is no correct definition of risk.
Exploring different definitions can lead to
valuable insights.
This is most easily illustrated through an
example.
The following slides show efficient frontier graphs
for a selection of portfolios produced from
fictional projects.
Risk Definition
Most common EF
graph: mean vs.
semi-std. dev.
56 most efficient
portfolios marked
Must trade off value
and risk to select
No obvious choice
Interpretation of
risk not intuitive
Risk Definition
Risk = P10 AT Cash
(low estimate)
Now 8 efficient
portfolios
Some points stand
out with new view
Data mining gives
new insight
Risk Definition
Risk = prob. of not
being $200 million
company
Now 3 efficient
portfolios
Look for portfolios
with less risk than
neighbors
Lowest chance of
missing target with
highest value
portfolios
Risk Definition
Risk = variability
(normalized risk)
Now 9 efficient
portfolios
Note low-risk
portfolios
Note poor portfolios
for further insight
Projects can be
liabilities
Risk Definition
Risk = standard
deviation of ATCash
(Markowitz)
Similar set of
efficient portfolios
Diversification leads
to lognormal risk
profiles
Risk Definition
Risk = prob. of
exceeding first-year
spending limit
Risk no longer
based on same
indicator as value
Note elbow in curve
Tradeoff more
obviously beneficial
with this view
Risk Definition
Risk = prob. of
missing first-year
BOE target
Risk again related to
portfolio constraints
Dramatic change in
picture again
Risk Definition
Value & risk based
on discounted
ATCash (NPV)
Shift in relative
positions highlights
time value of money
Process can be
repeated with each
new indicator
The End!!!
Thats all folks!

Merak V&amp;R Notes

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Merak V&amp;R Notes

Uploaded by

Copyright:

Available Formats

Decision & Risk Analysis

Basically, these are inputs and outputs, respectively.

Uncertainty nodes represent uncontrolled

End nodes represent outcomes or states of

A three-branch uncertainty node is usually used to represent a

The selection of low, base, and high

The most common means of

The most common

Discrete distributions apply to

There is considerable overlap between

Is the 3-spike graph really

Con: Monte Carlo alone is not a decision

The distinction between correlation and dependence

The shorthand notation

Both are specified in the

Imagine that from analogy you have been able to

Unfortunately, the probabilities you

Note that the

Do you want to play this game?

Is his offer a good one?

Is her offer a good one?

Extra complications usually arise in the form of

How can portfolios be compared and selected?

Portfolio A dominates all

A portfolio is efficient if it is not dominated

How can value and risk be quantified?

From it, many statistical

You might also like

Merak V&R Notes

Merak V&R Notes