Risk Measurement for Oil and Gas Exploration: The Marriage of Geological and Financial Techniques

Abstract

A method is presented for fully risking projects, such as exploration ventures or the acquisition of undeveloped reserves. The expected value of an exploration project overstates the 'value', because it does not reflect the uncertainty in the project, as measured by its variance or standard deviation. If the expected value is calculable, then the risk-adjusted value (RAV) can also be calculated. The RAV depends additionally upon the size of the exploration budget, compared with the project, and also upon the 'price of risk'. That price is incorporated from the finance literature. The technique permits answering three related questions: 1) the risk-adjusted rate of return for a given project; 2) the risk-adjusted value of that project; or 3) the risk premium appropriate for a particular project, given the size of the firm's exploration budget.