Petroleum Economics – Uncertainty and Risk

Introduction

*Explain the difference between uncertainty and risk, in the context of investment

Uncertainty relates to a lack of knowledge about future events. There’s a quote from one of the US presidents that goes “there’s things we know we know, there’s things we know that we don’t know, but there’s also things we don’t know that we don’t know”. It’s a pretty thick quote but illustrates a point in the final section. That’s where uncertainty is born from.

Risk infers that there is some material implication in the outcome. Risk and uncertainty can be related at times, however sometimes uncertainty carries no material risk.

Our main concern is the impact uncertainty has on petroleum investment.

*Describe a simple system of classification for factors, giving rise to investment risk

We can classify risk into several difference sections:

· Geological Risk

· Facilities Risk

· Political Risk

· Economic Risk

· Partner Risk

Geological Risk

Geological risk is the uncertainty due to incomplete data sets that are an intrinsic part of exploiting unseen reserves subsurface. We must make our best estimations and predictions about formations and pay areas. These predictions involve uncertainties that relate to material risk.

Facilities Risk

The materials used to transport and house the migration of petroleum products from reservoir to refining facilities must tolerate corrosive fluids and harsh environments. There is risk that these facilities may be damaged through a project life cycle resulting in loss of produced materials and loss of money.

Political Risk

Political risk arises from uncertainty in nations with regards to their rules, laws or legislation. If there is a change to a contract this can have a significant impact on the projected profitability of a project.

Economic Risk

Oil and gas as a commodity is incredibly volatile – and I mean that in a financial sense. In the past 10 years 2005 – 2015 we have seen the price of a barrel of oil rise from $50 to $150 down to $40 in 2009 back up to $120 and most recently down to $45 in 2015. This increases risk as with any financial instrument: the greater the volatility, the greater the uncertainty. Companies are also exposed to inflation and exchange rate fluctuations.

Partner Risk

Finally, partner risk arises from operations where two companies are involved, typically from joint ventures. Two companies may choose to work together to exploit a reservoir because of complimentary services or economies of scale.