HGS General Lunch- The Perfect Unconventional Resource Portfolio
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Tuesday, October 15, 2019
The Petroleum Club of Houston
1201 Louisiana Street, 35th floor, Houston, TX
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Social 11:15 AM, Luncheon 11:30 AM- 1:00 PM
Cost: $35 pre-registered members; $40 for non-members/ALL walk-ups;
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Speaker: Bill Fairhurst, Riverford Exploration
The Perfect Unconventional Resource Portfolio
Having all industry knowledge and experiences to date in U.S. unconventional resource plays & traveling back to time=zero(T0=prior to drilling, completing & producing from the first unconventional resource horizontal well, onshore United States); what investment choices should one make, which unconventional resources plays should be selected & which should be avoided? Given industry knowledge & experiences how can we construct The Perfect Unconventional Resource Portfolio if the unconventional resource revelation started today with today’s product prices & costs?
Construction of the Portfolio Model.
Most economic optimization models, developed for O&G Industry project selection during the 1970s–1990s, focused on the optimum level or percentage to acquire for each project. Alternatively, Portfolio Optimization modeling determines the percentage of a firm’s total CapEx that should be invested in each project or similar class of multiple projects.
Using the Tight Oil Resource Assessment Industrial Consortia (TORA) research at the BEG, Jackson School of Geosciences, UT– Austin, previous Bureau Sloan Foundation & DOE funded research evaluations (now part of the TORA Consortium), & some additional play information, Estimated Ultimate Recoveries (EURs) for every unconventional resource well in 10 resource plays. These are plotted by play in Fig. 1 as log-probability plot distributions for 5 gas resource plays (Barnett, Fayetteville, Haynesville-Bossier, Marcellus, & Utica) & 5 oil resource plays (Bakken, Eagle Ford, Midland, Delaware, & Niobrara).
Since Markowitz’s 1990 Nobel Prize-winning work on portfolio construction for equities (Markowitz, 1952 & 1957) & most significantly since the late 1990s; sophisticated financial software & Monte Carlo simulations have been developed to accomplish portfolio construction for investment choices. Previous experience evaluating thousands of individual investment options in hundreds of models has shown statistically significant confidence & correlation with these financial evaluation packages using paper, pencil, & straight-edge methodologies versus more sophisticated, expensive Monte Carlo simulations, & which can achieve a similar sophistication of a solution & are used in this report.
Given that play EURs are log-normally distributed, the Expected Value (EV), mean, of a log-normal distribution can be determined graphically without having to compute the EV from each value (individual well) in a distribution. Plotting the known p90, p50, & p10 reserves on log-probability paper & drawing a straight line provides an accurate representation of the reserve distribution for each play.
The EV of a log normal distribution is determined using the p10/p50 ratio. In this study, p90 represents the lower 10% of values & p10 represents the higher 10%. Using the p10/p50 ratio & graphs the EV is defined along with the Cumulative Probability distribution (Rose et. al, 1994). Knowing the EV cumulative probability percentage, on the x-axis of the log-probability graph & intersecting point with the reserve distribution determines the EV EUR for each unconventional resource play is defined. The EV is verified using Swanson’s Mean ((p90*.3)+(p50*.4)+(p10*.3)) (Capen, 1992).
Economic models only need to be run for 3 EUR values (p50, EV, p10) to represent the entire distribution of potential economic outcomes. The EV economic model is used as the measure of Central Tendency, most likely outcome for investors. Companies or investors having fewer than 30 investment options should make financial decisions on p50 economic results, the most likely outcome of small samples. In constructing The Perfect Unconventional Resource Portfolio in this study sample sizes for each investment option are greater than 30 & the mean, EV, figures are used.
An Optimal Portfolio is constructed on a single economic metric. Several economic/financial metrics are typically reported in the output of economic runs for investment options and may be used as screening criteria. The Perfect Unconventional Resource Portfolio model develop here uses Investment Efficiency (IE), Discounted Return on Investment (D(ROI)) also referred to as the Profitability Index (PI). Either term may be used interchangeably.
Economic runs were made using current Product Prices, CapEx, LOE for each p50, EV, p10 EURs for each play. Product Prices & costs were escalated at 3%. Depending on actual production and EUR 5 products were included: oil, condensate, plant tail-gate gas volumes for liquid-rich gas or wellhead gas volumes for drier-gas wells, natural gas liquids (NGLs), & water.
The first comparison of investment options is ranked from highest IE to lowest (Figure 2). Using that comparison only, CapEx would be deployed in descending order after investment options are exhausted for the preceding investment.
Two observations on Investment Efficiency, Profitability Index, models are worthy of note. First, a general guideline is that IE should be greater than 2 & undiscounted ROI (Cash-on-Cash) should be greater than 3. The fact that none of the EV investment options in this model has an IE >=2 nor undiscounted ROI >=3 at current product prices, investments in any of these options would be considered only if no other better investment options were available.
As the industry is experiencing, the high CapEx exposure of these plays is one of the most significant financial issues with unconventional resource plays. These investments are so capital intensive per the reserves recovered & economic returns that the EV reserves of each unconventional resource play might not be a good investment. The fact that the industry has spent so much Capital on these plays without impressive returns may be destroying wealth. This is an increasing concern over the last several years & reason additional investment funding has been difficult to obtain for unconventional resource E&P firms.
Second, discounted CF models in the upstream O&G industry are almost universally discounted at 10% or PV10. The argument for using a standard discount rate is that it is a standard way to compare different investment options regardless of a company’s capital structure. PV10 is used because that is the expected market return for equities. Using an industry-standard PV is, financially, incorrect. The correct PV is each firm’s or investor’s Cost of Capital (COC). This is because the investment option being evaluated is compared to the cost or benefit of keeping money where it is or investing in other financial options for each firm.
If a firm is 100% financed by public equity & public equity expects a 10% return, then all individual investments should be discounted at PV10. If a firm is selecting O&G investment opportunities from cash being held in a saving account, that firm discount rate should be 1–2.5%. Their alternative is to keep the funds at the bank or make the O&G investment. If that firm used a PV10 CF model, they would underbid or under select the O&G investment opportunities.
Similarly, firms using Mezzanine or Private Equity (PE) should use an 8-18% discount factor, their cost of capital. The risk firms with higher than a 10% expected return create using a PV10 is overestimating the value of opportunities relative to their COC. If they make an investment choice at or close to PV10 & their actual COC is closer to 14.5%, they may never meet the requirements or obligations for investors. Most evaluations in the O&G industry are likely making these errors in some way.
Another common O&G industry error is to increase PV discounting to account for technical risk or increased reserve category (e.g. PUD vs PDP). Technical risk should be evaluated in the CF portion of the model not by discounting. When risked twice (once technically & again using a higher discount factor than COC) higher-risk, further-out, or less developed reserve category projects are not evaluated equally to properly discounted evaluations. So, let’s visit the risk.
Risk. Three risk factors are reviewed: technical risk, individual investment option (project) risk & portfolio risk. Economic risk (product price and costs) may also be considered at these stages & are usually run as sensitivity cases. The proper way to do this in constructing a Portfolio is to use similar economic factors & construct Portfolios for each sensitivity case. All risk factors need to be separated & treated properly.
Technical Risk. Technical Risk is the risk or variability of various production outcomes & factors affecting these potential outcomes (geologic/reservoir characterization). A quick-look measure of the unconventional resource plays risk (variability) is the slope of the potential production outcomes on the log-probability chart (Fig 1). Most of the O&G plays have similar slopes or similar technical risk of various production outcomes. The uniform slopes in 4/5 plays for each O&G is somewhat surprising. Each O&G has one similarly higher technical risk option or risk of production outcomes. For oil that is the Delaware Basin & for gas it is the Utica play. Higher technical risk projects have higher variable outcome distributions so the EV is farther from the p50. The standard deviation can be derived from just 2 figures, p50 and p10. SD=((p10-p50)/p50)/1.28167. The denominator is the z value between p50 & p10 in a standard normal distribution.
Project Risk. Project Risk is the risk or variability of financial outcomes of a single project or investment option. It may or may not be similar to technical risk but must be evaluated separately. The standard deviation of the project risk can be calculated in the same method used for technical risk but on the appropriate project financial outcome metric being evaluated.
Portfolio Risk. Portfolio Risk is the risk or variability of selection among various investment options (projects). This is the magic of portfolio construction & selection. The Risk or Standard Deviation is the Square Root of the sum of the individual options weight percent squared times the standard deviation squared of that option.
This creates a hyperbolic change in risk reduction among 2+ investment choices. This non-linear, greater risk reduction is the reason 2+ investment choices are less risky than individual investment choices or a straight average between investment options.
Returns. Returns are the EV of the Financial Metric used for each investment option or the weighted average of more than one option, a straight-weighted average.
The Perfect Unconventional Resource Portfolio Defined
The Perfect Unconventional Resource Portfolio includes all investment options & all combinations among those options (Fig 3). An envelope is defined as the maximum & minimum return for each level of risk or maximum & minimum risk for each level of return. There are a limitless number of selections within the envelope.
The Efficient Frontier, Efficient Set, “consists of those portfolios that offer the highest return for each & every level of risk, or the lowest risk for each & every level of return” (Jacob & Pettit, 1988). The Efficient Set is from the Minimum Standard Deviation Portfolio (MSDP) point along the envelope with the highest return at any given level of risk.
A straight line can be drawn from the y-axis. This point is the Risk-Free investment opportunity, usually T-Bills. This model has been modified using Investment Efficiency so an Investment Efficiency of 1.0 was used as the firms Cost of Capital or required minimum return for a public company. The intersection or tangent of that line & the Efficient Set, is the Perfect Unconventional Resource Portfolio.
At time=zero, To, with all research, info, & results known to date at today’s Product Prices & Costs; the Perfect Portfolio is the following percentages regardless of company size or aversions to risk (technical, project, or portfolio risk):
29% Midland Basin
9% Delaware Basin
8% Eagle Ford
The solution assumes independence among investments, team or company area expertise, efficient markets for prices, transportation, & all investors COC is 10%.
There are alternatives to increase return or decrease risk. That is not to move up or down the Efficient Set but to move along the risk-free borrowing line. Increased return with the least amount of increased risk would be to borrow to invest more in p*, the portfolio percentages presented. To decrease risk & maximize return, the investor would invest in p* but not the entire CapEx & lend at 10% to others.
The Bakken was first in both the ranking of Investment Efficiency & the percentage of CapEx in the budget defined by The Perfect Unconventional Resource Portfolio. The Midland Basin unconventional resource play moved from fifth in the ranking of Investment Efficiency to second-highest percentage (29%) of CapEx in the Portfolio. The Delaware Basin moved from second to third. Why? The Delaware EV Investment Efficiency is 8% higher than the Midland Basin but the lower variability (risk) of the Investment Efficiency makes the Midland Basin a better risk: return option in the portfolio. Similar but to a smaller drop in order also occurs for the Marcellus because of the higher variability of outcomes.
Macro-financial to Micro-financial
Individual firm (microeconomic scale) solutions will fall within the industry (macroeconomic) scale. The current reserve estimation includes actual results, current & applied technologies, economic, & financial advancements at the time each well was drilled. However, an individual firm may have reason to use a different distribution of outcomes versus the industry outcomes (timing, technology, opportunity differences).
Four such cases are shown (Fig 4): an original Elm Coulee distribution (shown but not used in constructing the portfolio), Elm Coulee in-fill well expectations, using the current technology to drill & complete 1mi long Delaware horizontal wells, & current technology to drill and complete 2mi long Delaware horizontal wells. The new p90 to p10 distributions fall within the original distributions but generally above the play-wide p50 values.
The new Perfect Portfolio is shown with the previously constructed portfolio in Fig 4.
Investment Efficiency Undiscounted ROI
Elm Coulee Original wells 3.07 4.58
Delaware Basin new 2-Mile Hrz wells 2.89 4.01
Elm Coulee new in-fill wells 1.73 2.73
Delaware Basin new 1-Mile Hrz wells 1.70 2.59
Several of these options are above the hurdle of 2.0 for Investment Efficiency & 3.0 for undiscounted ROI or closer to these metrics than the previous options.
These are possible & were investment opportunities available to an individual firm, Company X. Company X’s decisions (investment selections & percentages of total CapEx, Portfolio) & performance can be evaluated using these analyses.
The Perfect Unconventional Resource Portfolio for XEx given these new investment options are:
All Choices Available (excluding original Elm Coulee): 3-New Choices Only:
36% 2-Mile Delaware Horizontals 54% 2-Mile Delaware Hrz.
26% 1-Mile Delaware Horizontals 38% 1-Mile Delaware Hrz.
14% Bakken 8% Elm Coulee Infill
5% Elm Coulee Infill
3% Eagle Ford
Given the small size of the firm, it's unlikely that Company X could place itself in a position to invest in each of the investment choices defined by All Choices Available. However, Company X came close to combining the 2 portfolios defined.
What investment decisions did Company X make or what could other firms do to capitalize on the newly defined & existing resource play opportunities (Fig 5)?
- Existing positions in the Delaware Basin allowed for participation in drilling new 2mi & 1mi horizontal wells in the Delaware Basin.
- An existing PDP position in the Elm Coulee Field allowed for participation in the Elm Coulee in-fill drilling.
- Additional Bakken PDP was acquired for less risk than drilling & completing new Bakken wells.
Performance Comparison to The Perfect Unconventional Resource Portfolio:
- All Delaware new 2mi (69% of CapEx) & 1mi horizontal wells (21% of CapEx) production & economic returns came in as modeled representing 90% of Company X’s CapEx. The Perfect Portfolio with all 14 investment options indicated a mix of 61% of CapEx. The model using the 3-new options only was 92% of CapEx for this investment option.
- All Elm Coulee in-fill drilling EURs came in the top one-half of originally estimated production profile representing 6% of Company X’s CapEx including acquisition costs compared to 5% & 8% of the 2 Perfect Portfolio models. Having more positive results than modeled may be from limited sample size or shift in the lower portion of the projected reserve distribution similar to the original Elm Coulee EUR distribution. More research or in-fill production results are needed to determine which of those factors most likely resulted in better than expected outcomes.
- The Company purchased Bakken PDP positions using 4% of CapEx.
Are better than expected outcomes good? The first answer is obvious; they are good financially because of the superior results. They are not good solution for the technical & financial team that built the models. Why? If management & investors had better pre-drill estimates & known of the better than expected returns, the Portfolio selection, & investment choices would likely have been more heavily weighted & more of these better returns would have been selected.
Company X came very close to matching The Perfect Unconventional Resource Portfolio investment choices and percentages. The outcome was slightly better than the predicted investment options due to better than expected results of the Elm Coulee in-fill well program. The Delaware Basin investments results were exactly what the technical and financial team had predicted. These observations assist in identifying technical and financial evaluations that need improvement and those that should be rewarded as most accurate in developing The Perfect Unconventional Resource Portfolio. The focus of the firm on Investment Efficiency and its investment selection has assisted in the firm obtaining a Return on Capital Employed (ROCE) of over 80% for sixteen years and 71.75% since January, 2017.
More good news! Figure 5 (Ikonnikova et. al., 2018) shows an increase in the distribution of Investment Efficiencies for all Midland Basin Wolfcamp A & B wells by year (2012-2017). The distribution has a mode and averages just over one (1) during 2012-2013; increasing to one and half (1.5) during 2014-2016; and over two (2) in 2017. The increase in Investment Efficiencies is likely attributed to the higher production rates at lower marginal cost as the result of increased horizontal distance in zone per well; tighter stage, cluster, and perforation spacing; higher proppant and fracture stimulation concentrations per linear foot; and the change to slick water proppant fluids. Such improvements have also been observed in other unconventional resource reservoir plays.
1. This paper has demonstrated construction of Perfect Unconventional Resource Portfolio, the optimum drilling, completions, production, & economic results by basin/play/project investment choices in time=zero (To) using today’s information & knowledge of all drilling, completion, & production results.
2. The Perfect Unconventional Resource Portfolio for all resource plays (Macroeconomic Model) can be modified and used by individual firms (Microeconomic Model) to make better investment choices & beat the Macroeconomic, Industry Model.
3. Increases in Investment Efficiencies by year have been improving.
Bill Fairhurst, President, Riverford Exploration, LLC, Manager, Industry Engagement BEG, Jackson School of Geosciences University of Texas – Austin
Riverford Exploration, LLC is a privately held Expl., Production & Consulting business with an interest in over 12,000 gross HBP acres & 70 wells producing 10,000 BOE/day in MT, ND, OK, north TX, & the Delaware Basin.
As Manager, Industry Engagement for the BEG, Bill serves as a contact for Bureau research consortia & operating O&G E&P companies. Bill has been involved in the majority of U.S. resource plays prior to the resource revolution & is credited with economic discovery of the WolfBone play in the Delaware Basin. Previously, he placed his company in Elm Coulee Bakken Field prior to its discovery, the largest onshore U.S. discovery in 56yrs. He & his teams have also discovered dozens of new fields in traditional plays in the Williston, Rocky Mountains, Permian, mid-Continent, Gulf Coast Mesozoic basins, offshore U.S. & has worked & led expl. programs on 6 continents with the former President of Shell, Arco & other E&P firms.
Bill recently turned around mid-size, private equity (PE) financed E&P firm from a $70 mil loss to a $600 mil gain in 2yrs. Previously he was a key Exec & Technical leader at well-known, private E&P firm driving growth, strategically advancing a $200 mil firm into a billion-dollar organization in 6yrs, adding 2 new regional offices & hundreds of new investment opportunities. He has successfully led A&D teams in technical & general mgmt positions & assisted with equity & debt financing for several organizations.
Bill graduated from OH Wesleyan University in Geology & Economics-Management; the University of Missouri-Columbia with M.S. Geology; & from the C.T. Bauer College of Business at UH with MBA in Finance. He has provided Expert Legal testimony involving geology, engineering, & economic evaluation; provided & managed professional testimony before 8 state Industrial Commissions; published & spoken nationally & internationally in technical, business & policy forums. Bill is a Certified Petroleum Geologist by the AAPG; a licensed PG in the state of Texas; a Qualified Reserve Evaluator by the Canadian Securities Administrators, & member of HGS.
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