Risk: dealing with risk aversion

Development Geology Reference Manual
Series	Methods in Exploration
Part	Economics and risk asseement
Chapter	Dealing with risk aversion
Author	Peter R. Rose
Link	Web page
Store	AAPG Store

There is a subtle, variable, but powerful human attribute called risk aversion. It is the proportion by which the expected value (EV) of a venture is discounted by the investor. Stated simply, risk aversion expresses the common human reaction to risk propositions, that the displeasure associated with losing a certain amount of money exceeds the pleasure associated with winning the same amount, that is, “it hurts worse to lose than it feels good to win.” Although many psychological forces influence risk aversion, the most important ones have to do with the size of the bankroll (or budget), the magnitude of potential gain (or loss), and the chance of success or failure. Risk aversion makes small and large firms respond differently to the same venture.

People are usually inconsistent when making risk decisions, and their inconsistencies can affect development decisions as well as exploration decisions. Table 1 lists the more common risk biases. For example, some production departments in major companies are so risk averse that they transfer development wells deemed to have less than a 90% chance of success to the exploration department as so-called in-field wildcats! The result is to retard reserve development significantly because such wells must then compete with legitimate large-reserve exploratory projects, and the margins of developing oil fields do not receive timely evaluation.

Table 1 Biases affecting risk decisions

Type of Bias	Common Example
Framing effects	Decision makers will take a greater gamble to avoid a loss than to make an equal gain
Existence of prior account	Decision makers are more inclined to take a risk at the beginning of a project than later in the project's life
Maintaining a consistent frame of reference	Decision makers are more likely to invest during a run of good fortune and less likely to invest during a run of bad fortune
Probability of success	A venture having a perceived high chance of success is preferred over a second venture having a low chance of success, even though the expected value of the second venture is clearly superior
Wrong action versus inaction	Managers avoid criticism by not making a decision rather than taking action that could result in the same loss
Number of people making the decision	Groups are more prone to take risks than are individuals
Workload and venture size	Large volume ventures are preferred over smaller ones, especially when decision makers are busy
Personal familiarity	The “comfort bias”: decision makers are more risk prone in deals or environments with which they have had past good experience

Development versus exploration risk aversion

In contrast to exploration ventures, which are commonly perceived to be high risk propositions, development and enhanced oil recovery (EOR) projects are sometimes seen as low risk ventures by management. Since all projects— exploration and development—are competing for limited funds, the risk assessment needs to be consistent and reliable for all projects so a fair comparison can be made. Often development (including EOR) projects require significant capital expenditures in relation to anticipated revenues. In these cases especially, it is important to assess the uncertainties involved correctly. For example, the uncertainties in process efficiency, development time and costs, and future prices are commonly greater than we care to admit, and they may negatively impact project profitability and the chance of commercial success. The geologist and the engineer must team up to improve the characterization of the reservoir and the assessment of the uncertainty in development and EOR projects. Geologists likely have more experience in estimating uncertainty, whereas the engineer is likely better at quantifying a process. The strengths of the two disciplines must be combined. This will hopefully minimize any bias that may exist in assessing the riskiness of development and EOR projects compared to exploration projects.

Properly done, all projects should be put on the same playing field by good, unbiased risk analysis. If this is done, then all project cash flows can be discounted at the same discount rate (the real rate of return) and projects can be compared on the basis of the expected net present value. We are probably a long way away from achieving this goal, but we need to head in this direction. The problem is simply that for EOR and development projects, the risks are different, and non-geological risks often go unrecognized and/or underestimated.

Common industry measures to reduce risk

Equations are available to quantify the risk-adjusted value (RAV) of any given venture to a given firm, if the firm's risk aversion (or preference function) is known. Cozzolino, Grayson, and Walls provide methods for determining it. The risk-adjusted value (RAV) is calculated as follows:

${\mbox{RAV}}={\frac {-1}{r}}\ln {\big [}p\times e^{-r(R-C)}+(1-p)\times e^{-rC}{\big ]}$

where

• R = gross reward (in millions of dollars)
• C = cost (in millions of dollars)
• p = probability of success
• r = risk-aversion function (in millionths)

Note that this equation combines both expected value and risk aversion (after ). This equation is especially useful to small companies seeking the proper investment share among several ventures in a program.

Arps and Arps provided a graphical method for determining whether the risk of a given exploration venture is acceptable, if the cost, reward, and chance of success are known and if the firm has chosen a probabilistic safety factor (that is, 95%) for its overall program. The Arps and Arps method is not applicable to most development projects, except for very small firms.

However, the petroleum industry has traditionally dealt with risk aversion through more pragmatic business methods, including the following:

• Farming-out leased acreage in exchange for a drilling commitment
• Making bottom-hole or dry-hole contributions on nearby competitor acreage
• Obtaining a share of a given venture at an especially favorable price
• Acquiring a legal option allowing subsequent enlargement of interest in the event of early success
• Promoting one's partners as a result of obtaining an early favorable lease position, having unique technical capabilities, or their legal or financial disadvantage
• Reducing one's share in the venture
• Going non-consent, which means not participating in an early part of a venture only to come back in later under a penalty, usually severe

Risk aversion: practical considerations

Risk aversion is a universal—but not uniform—attribute of human beings. Although the phenomenon is rooted in concern for safety, its cost—in keeping the firm out of high-risk, high potential ventures—is not generally acknowledged or even recognized. 'Companies that are strongly risk averse pay a high price for their conservatism. Here are some points to remember:

• Geotechnical personnel must operate using the risk preferences of the management or client, not their own personal risk preferences. For example, if a firm is seeking only near-certain development well opportunities, the development geologist should be cautious in generating risky edge wells or new zone ventures.
• Constant use of the expected value concept as a benchmark is of considerable help. Usage of thesis help can also be advantageous when you entrust professionals execution of your documentation and assets.
• Risk aversion commonly operates when decision makers fear criticism or loss of position. Here the most common consequence is that the firm will not participate in highly imaginative or controversial projects, many of which have substantial reserve potential, preferring instead those that are orthodox in concept and execution—and commonly mediocre in results!
• Hidden hurdles—overly conservative parameters within the economic evaluation process and ordinarily not readily perceived by geotechnical professionals—tend to screen out many projects from consideration, often for the wrong reasons and often counterproductively. Good examples of hidden hurdles include (a) unrealistically high DCFROR or corporate discount rates, (b) overly cautious cost estimates, and (c) overly pessimistic wellhead price forecasts.
• Remember the common biases that cause decision makers to behave inconsistently.

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discounted cash flow rate of return