Monte Carlo Simulation: Its Status and Future
- James A. Murtha (Consultant)
- Document ID
- Society of Petroleum Engineers
- Journal of Petroleum Technology
- Publication Date
- April 1997
- Document Type
- Journal Paper
- 361 - 373
- 1997. Society of Petroleum Engineers
- 5.6.3 Deterministic Methods, 4.2 Pipelines, Flowlines and Risers, 5.7 Reserves Evaluation, 7.2.3 Decision-making Processes, 7.1.5 Portfolio Analysis, Management and Optimization, 5.1.5 Geologic Modeling, 4.6 Natural Gas, 1.1.2 Authority for expenditures (AFE), 5.6.9 Production Forecasting, 5.7.2 Recovery Factors, 7.2.1 Risk, Uncertainty and Risk Assessment, 2 Well Completion, 7.3.3 Project Management, 1.6 Drilling Operations
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Distinguished Author Series articles are general, descriptiverepresentations that summarize the state of the art in an area of technology bydescribing recent developments for readers who are not specialists in thetopics discussed. Written by individuals recognized as experts in the area,these articles provide key references to more definitive work and presentspecific details only to illustrate the technology. Purpose: to informthe general readership of recent advances in various areas of petroleumengineering.
Monte Carlo simulation is a statistics-based analysis tool that yieldsprobability-vs.-value relationships for key parameters, including oil and gasreserves, capital exposure, and various economic yardsticks, such as netpresent value (NPV) and return on investment (ROI). These probabilityrelationships help the user answer such questions as "What is the probabilitythat the NPV of this prospect will exceed the target of $1,500,000?" or "Howlikely is it that the reserves added from this year's exploration program willfall short of our planned production? " Monte Carlo simulation is a part ofrisk analysis and is sometimes performed in conjunction with or as analternative to decision [tree] analysis.
Putting aside for the moment a description of Monte Carlo simulation, themethod has attracted its share of critics over the years. Their commentsinclude "I did this in FORTRAN in 1964, It just never caught on. "; "Why notjust add or subtract 10% to the base case?"; "The answer is whatever you wantit to be. "; "The answer depends on who is doing the simulation. "; "Garbagein, garbage out. "; "You never have enough data"; "A black box, hocus-pocus,that's all it is, "; and "It takes too long to run enough cases. " To somedegree, the critics have been silenced by the evolution of virtually universalspreadsheet programs, much faster computers, and relatively simple software torun simulation and process data. Nonetheless, we will address some of theunderlying concerns, but it is necessary to lay some foundation first.
Our objectives are (1) to define Monte Carlo simulation in a more generalcontext of risk and decision analysis; (2) to provide some specificapplications, which can be interrelated; (3) to respond to some of thecriticisms; (4) to offer some cautions about abuses of the method and recommendhow to avoid the pitfalls; and (5) to predict what the future has in store.
What Is Risk Analysis?
Although the word "risk" occurs with great regularity these days in thepetroleum literature, it has not always been fashionable. In its 60-pageSubject Index, the 1989 printing of the 1,727-page Petroleum EngineeringHandbook contains just one reference to "risk [factor]" in an article aboutproperty evaluation.
Among the numerous words and phrases associated with risk analysis aredecision analysis, risk assessment, risk management, portfolio management andoptimization, and strategic planning. In some contexts, these words are usedonly in a qualitative sense, but our focus is quantitative.
Decision analysis, in its broadest form, includes problem identification,specification of objectives and constraints, modeling, uncertainty analysis,sensitivity analysis, and rules that lead to a decision. Generally speaking,risk analysis and assessment refer to the quantification of uncertainty, almostalways in the context of possible investments. In the oil and gas business,although much of the analysis might pertain to reserve size, capital cost,production forecasting, and the like, the bottom line universally is monetaryvalue.
Risk management connotes a second stage, where the investors seek protectionfrom unfavorable situations; i.e., they work to mitigate the risks. Thus,turnkey contracts, guarantees, insurance, locked-in prices, and hedges areinstruments of risk management.
A portfolio is an aggregation of investments. Portfolio managers mix theirprospects to reduce collective risk and enhance ROI. Optimization is oftentaken as maximizing some measure of reward, such as NPV or profit-to-investmentratio, subject to constraints on risk. Strategic planning involves portfoliomanagement but may include more intangible aspects of investments, such as theadvantage of having a presence in a country.
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