Casinos make money. Lots of money and it is simple to understand why. Players under all possible outcomes vs the House are at a disadvantage. The probability that they will lose is greater than the probability that they will win. Always. There is no way (legally) to change the probability of the outcome in the players favor; to increase the player’s probability of winning greater than 50% of the time. If there was, players would find it and they would exploit, and the casinos would go bankrupt.
The probability of outcomes for casino games are well documented and are dependent on the behaviors of the player. The behavior of the player is the main input in determining how many times a player will win. If the player executes a consistent well disciplined strategy, they can increase their probability of winning. Never over 50%, but players can get close to 50% in some games.
Casino games and investments opportunities are different in one key aspect. Unlike the casino Player, the Investor should have the probabilities in their favor. The Investor can become the House by repeatedly investing in cases with =>50% of success. The key is to understand and know the REAL probability of the opportunities, to understand the inputs that you are in control and to make decisions that enable to win repeatedly.
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What is Probability?
Probability is a measurement of a particular outcome occurring. A P90 value, common term in Oil & Gas, simply means that a particular result has a 90% probability of occurring greater than the P90 value. If the situation is repeated 100x, 9/10 times the result will be above the prediction. 1/10 times the result will be below. If an investor wants to achieve a specific outcome, let’s assume 2x money invested, this outcome has an associated probability. If the probability is low, then the outcome is unlikely to be achieved.
P50, another common term, is the median outcome. If done correctly, 50% of the time a result will exceed this prediction and 50% it will fall below. This is a true P50.
You can never eliminate a poor or conversely an exceptional result from occurring, and only achieve a specific outcome. There will always be a variance associated with results. However, the aggregate of repeated results, can achieve a P50. The key is to understand the probability of the investment by incorporating as many meaningful variables into a prediction as possible. This may sound simple, but this is anything but straightforward.
How to become the House?
All investments have a range of outcomes that balance returns and risk. Like the casino, gain and loss swing widely over the short term. More reward comes with more risk. The market demonstrates this every day. However, reaching investment goals is an understanding in whether the outcome (ie. the goal) has a probability greater than 50% of occurring. In this case, the investment strategy, repeated consistently overtime, will deliver OVER its goal. If this is known, the investor is the House which has > 50% chance of winning (always). The investor will will reach and likely exceed their objective. If the probability of the investment strategy is less than 50%, the investor is the Player, and will always be disappointed. They will always fall short of expectations over time.
E+Ps that exploit shale reservoirs have an advantage in that they drill multiples of wells in similar fashion. There is nothing simplistic about shale reservoirs, they are intensely complex. However, it’s the repeated nature of the investing via drilling that can normalize the long term results.
The extensive data (ie. volume of wells already drilled) is the advantage of shale drilling evaluation. Wells are essentially multiple data points that can be incorporated to assess inputs and the input’s impact on the outcome. Its unique to unconventional oil and gas drilling to have thousands upon thousands of data points across all variables in a specific basin. The advent of data platforms, machine learning and advanced predictive models in combination with this immense data set from 10 plus years of repeated drilling has changed the paradigm for oil and gas evaluation and understanding.
It should be noted that the sheer amount of data creates the potential for Simpson’s Paradox. Lurking variables may ‘flip’ the analyses. Therefore, it is crucial to understand what data is missing, that can’t be quantified and incorporated that may produce this phenomenon.
The success of a drilling program is built on the probability of the inputs
Success is achieving what was projected to be achieved. It’s meeting guidance, meeting cashflow projections that were promised to make the investment decision. In that regard, to become The House, you need MORE than a great investment plan that is attractive. You need more than a large resource in place. You need more than good funding and execution (see previous article here). The past decade of shale drilling has taught one thing – the absence of geologic risk via large resource-in-place does nothing to create value. It’s a starting point, not an end to reach investment goals. Many plans were pursued with a great plan to high growth and FCF within a few years. However, the probability of these plans to reach these goals was not understood, and sometimes very low.
One common oversight of Oil & Gas investing in shales is not understanding the probability of the plan fully. The well forecast may be a P50, but that does mean the CF projection of the plan is a P50, as the cashflow has many other inputs besides the well forecast.
In addition, the variance of the plan is of importance. This allows you to anticipate the range of outcomes for successive cycles. Understanding the highs and lows of an 80% confidence interval (ie. meaning the outcome has an 80% probability to be within the range) is very important. This allows the investor to understand if the lows are within means to absorb and sets realistic expectations over time.
Maybe most importantly, the variance demonstrates the timeframe and sample points (ie. wells) that are required to achieve the median. This is key, because it allows the E+P to understand the capital and time required for the entire program to obtain the expected results consistently.
Of course, all of this, the range and the probability, is dependent on understanding the inputs…….
Working backwards from Cashflow
Understanding the probability of the outcomes, is first addressed in understanding the variability of the inputs. In oil and gas investing, the major output is the cashflow projection of the well. This is of most importance. The major inputs include the well forecast, price forecast, and the capital cost estimates. All these inputs will have a range. The key leverage for the investor (ie. E+P company) is understanding the probability of inputs (Forecast, Price, Capital) and the resultant probability of the output (Cashflow).
Unfortunately, this understanding is more difficult than it sounds for E&P’s and drilling wells.
Take for example the Well Forecast, a key input in the projection of Cashflow. This input is actually an output derived from many other sub-inputs including rock quality, subsurface pressure, targeted drilling, and completion design. Of course, analogs provide numerous data points to correlate these production drivers to a well forecast. In addition, many of these sub-inputs are also derived from other variables and could also be considered an output. As you work backwards from the Cashflow projection or even the Well Forecast, the number of variables expand exponentially.
Secondly, understanding the importance of each variable (ie. the impact on the forecast) must be done. Some variables have no impact, some are very impactful, and some are redundant. To add to the complexity, variable importance must be done not at a point in time (ie. 6 month on-production), but through time to assess the impact on near and long term well forecast, and the resulting cashflow. Impact must also be understood for all well streams (gas, oil, water). Production drivers will have a different impact on the various streams, and these need to be understood independently if the well forecast is to be accurately predicted.
As you can see this is no small task. The complexity can be overwhelming, and often leads to shortcuts which take the form of unsubstantiated assumptions. The most common example is overlooking the applicability of an analog or set of analogs. Humans are tuned to correlate a trend and to make a determination on what is primarily responsible. We naturally overweight what fits in with our heuristics and bias. For example, a common determination has been to link production with length or with tonnage. Others include orientation, presence of structure, organic content, pore pressure, etc. The commonality is the focus and overweighting of one variable to others in response to an output at one point in time. (ie. 6-month Cumulative Gas). The reality is far more complex. The one variable may have a large impact, but it is not the only impact. Shortcutting to the easy conclusion is aided by theory-induced blindness as well.
The result of shortcutting is the construction of a ‘P50’ forecast that is no longer reliable, and the real probability remains opaque with potentially devastating consequences. There are all sorts of motivations for a team or an engineer to present a forecast with inherent assumptions as a P50. (This was explored in a previous article on Forecasting bias)
As assumptions, bias, theories and other forces work into a forecast, it is pushed off its true P50. The can happen in cost estimates, shrink estimates, downtime estimates and price forecast as well. The resultant cashflow that is presented with “certainty” may have a very low REAL probability of achieving its goals. In this case, the investor is now ‘blind’ and no longer knows the probability of the projection; they no longer know if they are The Player or The House. Remember – To become The House, the projected cashflow must have a probability of equal or greater than 50% with certainty. If you don’t know probability, it’s likely you are below; likely you are the Player.
Is it possible to be ‘The House’ While drilling?
Of course it is possible. Remember The House has a greater than 50% chance of winning. Your plan, your well expectation, your cashflow estimate can have a FAR greater probability than 50%. Your plan or well estimate could have a 90% probability, albeit likely lower return. Setting the objective and probability is up to you.
It is also up to the company to employee means to account for all data available to assess the probability of the well estimates. Utilizing the ever present and growing data storage and processing power available, we can now determine, with statistical confidence, the P50 (or any probability) of an estimate and variance (ex. P10/P90 Ratio). We have the tools to determine the impact through time on all streams of every production driver independently. If done consistently, you will be The House which knows all behaviors of every game and every outcome. You will know the probability and the variance of your well forecast.
Lastly, much has been discussed about the merits of data approaches vs physic based approaches. This will be explored in the next post. However, they are not mutually exclusive, they can and must be used together. Data models are blind to physics, which can provide intuition and direction. The leverage and scalability of data models, including the utilization of all available data to calibrate outputs, is very powerful. Together they are a sum greater than the parts and should be employed together highlighting the strengths of each technique. They are not adversaries, but rather allies in determining accurate projections.