October 2010 SPE Economics & Management 99

Thirteen years have passed since this article and 23 years since my
first paper on the subject. How has this methodology evolved?
I was a list-maven in the 1997 paper, providing guidelines,
predictions, and aspects of the perfect world31 items in all. Let
me address a few.
Probabilistic portfolio and cashflow (full cycle) models have
appeared and some of them endure, but their use seems dominated
by deterministic counterparts
Cost models are among the easiest to formulate probabilistically.
Yet engineering and contracting companies are slow to embrace
statistical methods. Their reason is simple: clients dont demand it.
We see steady growth in courses on uncertainty analysis, con-
sultant/trainers, technical papers, specialty commercial software,
and Monte Carlo software licenses. But I fear that quality of mod-
eling (ask any expert or peer reviewer), proper use of data (see the
September 2009 SPE J Pet Technol editorial), and use of language
(consider the confusion between mean and P50, the ambiguous
P10 production forecast, and the nonsensical Pmean) have
not kept pace.
I am encouraged by peer reviews and best practices. Professional
societies have been supportive. Publication of the Petroleum Reserves
Management System is a step in the right direction as is Moderniza-
tion of Oil and Gas Reporting from the US Securities and Exchange
Commission. Hopefully, implementation of these guidelines will be
based on extensive dialog rather than narrow agendas.
While experimental design is more common, we miss opportu-
nities to identify ranges of petrophysical parameters with the geo-
logic model before building the reservoir simulator. For instance,
to estimate a range of average porosity or average net pay over an
area, one can modify the average contour gradient for that param-
eter in Z-map or change the gridding algorithm in GeoGraphix. I
get glassy-eyed stares when I suggest such methods.
Integration remains a serious weakness. To my knowledge, no
company does systematic, comprehensive risk analysis, fully sup-
ported by top management. Instead we find silos where the artful
science is practiced: exploration, reserve estimation, new ventures,
cost estimating. I know of two corporations who introduced sys-
tematic procedures only to have a new manager or corporate execu-
tive revert to deterministic methods after hundreds of employees
were trained. Many companies allow engineers or geoscientists
to do uncertainty analysis on some component only to have them
report to the next level (in unison now, the mantra) P10, P50,
and P90 cases, where those values might be treated injudiciously.
Making decisions based solely on a weighted average of three
percentiles is, finally, a deterministic method.
A common ingredient of many of these shortcomings is high
level management buy-in to probabilistic methods. Perhaps there are
too few incentives for executives to learn the language, know how to
ask the right questions, and make more complex decisions.
So, progress has been grudging and slow. There are bright signs
and a growing group of adherents. Eventually, faulty methods
will be exposed and corrected, language will be improved, and a
critical mass of disciples will find their way into top management.
I remain hopeful.
Jim Murtha
Jim Murtha, a registered petroleum engineer, presents seminars
and training courses and advises clients in building probabilistic
models in risk analysis and decision making. He is an industry-
recognized expert on risk and decision analysis; he was elected to
Distinguished Membership in SPE in 1999, the recipient of the
1998 SPE Award in Economics and Evaluation, and was 19967
SPE Distinguished Lecturer in Risk and Decision Analysis. Since
1992, over 5000 professionals have taken his classes. Murtha has
published Decisions Involving UncertaintyAn @RISK Tutorial
for the Petroleum Industry, and he is the principal author of the
chapter on Risk Analysis and Decision Making for the new SPE
Petroleum Engineering Handbook. In 25 years of academic experi-
ence, he chaired a math department, taught petroleum engineering,
served as academic dean of a college, and co-authored two texts
in mathematics and statistics. Murtha has a PhD in mathematics
from the University of Wisconsin, an MS in petroleum and natural
gas engineering from Penn State, and a BS in mathematics from
Marietta College.
What follows is a reprint of an SPE paper from 1997.
The correct citation for the paper would be:
Murtha, Jim. 1997. Monte Carlo Simulation: Its Status and Future.
J Pet Technol 49 (4): 361373. SPE-37932-MS. doi: 10.2118/
37932-MS.
100 October 2010 SPE Economics & Management
Introduction
Monte Carlo simulation is a statistics-based analysis tool that yields
probability-vs.-value relationships for key parameters, including
oil and gas reserves, capital exposure, and various economic yard-
sticks, such as net present value (NPV) and return on investment
(ROI). These probability relationships help the user answer such
questions as What is the probability that the NPV of this prospect
will exceed the target of $1,500,000? or How likely is it that the
reserves added from this years exploration program will fall short
of our planned production? Monte Carlo simulation is a part of
risk analysis and is sometimes performed in conjunction with or
as an alternative to decision [tree] analysis.
Putting aside for the moment a description of Monte Carlo
simula tion, the method has attracted its share of critics over the
years. Their comments include I did this in FORTRAN in 1964.
It just never caught on.; Why not just add or subtract 10% to the
base case?; The an swer is whatever you want it to be.; The
answer depends on who is doing the simulation.; Garbage in,
garbage out.; You never have enough data.; A black box, hocus-
pocus, thats all it is.; and It takes too long to run enough cases.
To some degree, the critics have been silenced by the evolution of
virtually universal spreadsheet programs, much faster computers,
and relatively simple software to run simula tion and process data.
Nonetheless, we will address some of the under lying concerns, but
it is necessary to lay some foundation first.
Our objectives are (1) to define Monte Carlo simulation in a
more general context of risk and decision analysis; (2) to pro-
vide some specific applications, which can be interrelated; (3) to
respond to some of the criticisms; (4) to offer some cautions about
abuses of the method and recommend how 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 the petroleum literature, it has not always been fashionable. In
its 60-page Subject Index, the 1989 printing of the 1,727-page
Petro leum Engineering Handbook
1
contains just one reference to
risk [factor] in an article about property evaluation.
Among the numerous words and phrases associated with risk
anal ysis are decision analysis, risk assessment, risk management,
portfo lio management and optimization, and strategic planning. In
some contexts, these words are used only in a qualitative sense,
but our fo cus is quantitative.
Decision analysis, in its broadest form, includes problem identifi-
cation, specification of objectives and constraints, modeling, uncer-
tainty analysis, sensitivity analysis, and rules that lead to a decision.
Generally speaking, risk analysis and assessment refer to the quanti-
fication of uncertainty, almost always in the context of possible
in vestments. In the oil and gas business, although much of the analy-
sis might pertain to reserve size, capital cost, production forecasting,
and the like, the bottom line universally is monetary value.
Risk management connotes a second stage, where the inves-
tors seek protection from unfavorable situations; i.e., they work to
miti gate the risks. Thus, turnkey contracts, guarantees, insurance,
locked-in prices, and hedges are instruments of risk management.
A portfolio is an aggregation of investments. Portfolio man-
agers mix their prospects to reduce collective risk and enhance
ROI. Opti mization is often taken as maximizing some measure of
reward, such as NPV or profit-to-investment ratio, subject to con-
straints on risk. Strategic planning involves portfolio management
but may in clude more intangible aspects of investments, such as
the advantage of having a presence in a country.
For purposes of this paper, risk analysis is any form of analysis
that studies and hence attempts to quantify risks associated with
an invest ment. So that we do not beg the question, we need to
define risk. By risk, we mean a potential loss, and, more generally,
loss or gain (i.e., a change in assets associated with some chance
occurrences). To use the term analysis, we surely suggest that the
risk is quantifiable. The risks in drilling a well include the direct
costs of the rig and of other goods and services, the possibilities
of unscheduled events and the as sessment of their consequences,
the possibility of failure (i.e., a dry hole, a missed target, or an
unsuccessful completion), the range of possibilities of success, and
the chance of a serious mishap. Risks associated with building a
gas-fired electric-power generating plant include the forecasts of
gas price (on the cost side) and electric price (on the revenue side)
as well as capital and operating costs, downtime, and demand. Risk
associated with estimating reserves for an explora tion prospect
include estimation of the geological chance factors.
Simple Risk Estimates by Use of Probability
Suppose you have drilled 56 wells in a field-development pro-
gram, 14 of which were deemed dry holes. What is the chance
that the next well will be dry? Perhaps 14/56 is a good answer. It
depends on whether there has been a trend to have fewer or more
dry holes over time. In other words, is the success of one well in
some way depen dent on the success of others? Whatever the case,
providing an esti mate for the probability of a dry hole is a form
of risk analysis.
As a more complicated example, consider the estimate for geo-
logical success based on chance factors where the probability of
success is the product of the probabilities of having a structure, a
seal, a reservoir, a source, and timing. Estimating the factors and
ob taining the product is a form of risk analysis.
As the subsequent examples illustrate, however, the specific
risk- analysis technique called Monte Carlo simulation offers a
flexible and powerful tool to study complex problems. Monte
Carlo analysis serves as the focal point for the remainder of this
discussion.
Probability Distributions and Random Variables
Much of risk analysis consists of estimating something with a
range of values rather than with a single value. We report that the
wildcat well will require between 56 and 87 days to drill instead
of saying it will take exactly 65 days and that the total cost will
be between U.S. $4.3 million and U.S. $7.2 million, not exactly
U.S. $5.2 mil lion. Instead of the single-point estimate of U.S. $34
million, we say the waterflood prospects NPV is a normal distri-
bution with a mean of U.S. $34 million and a standard deviation
of U.S. $1.7 million.
Thus, as we move toward risk analysis, it becomes necessary
to de velop some familiarity with the rudiments of probability and
statis tics. For our purposes, we need the paired ideas of probability
dis tributions and random variables. A random variable is a variable
or parameter that can be described by a probability distribution,
which in turn is an xy plot relating probability to value. There are
Monte Carlo Simulation: Its Status and Future
J.A. Murtha, SPE, Consultant
Copyright 1997 Society of Petroleum Engineers
This paper is SPE 37932. Distinguished Author Series articles are general, descriptive rep-
resentations that summarize the state of the art in an area of technology by describing
recent developments for readers who are not specialists in the topics discussed. Written by
individu als recognized as experts in the area, these articles provide key references to more
definitive work and present specific details only to illustrate the technology. Purpose: to
inform the gen eral readership of recent advances in various areas of petroleum engineering.
A softbound anthology, SPE Distinguished Author Series: Dec. 1981-Dec. 1983, is available
from SPEs Book Order Dept.
October 2010 SPE Economics & Management 101
two com mon formats for probability distributions: a cumulative
distribution function (CDF), which is a nondecreasing (or nonin-
creasing, depend ing on preference) function whose y values range
from 0 to I. It is sim plest to think of a random variable as a graph
of cumulative probabili ty (on the y axis) vs. value. The compan-
ion plot, called a probability density function (PDF) is simply the
derivative of the CDF. Fig. 1 shows both these plots for a normal
distribution. Although the CDF presentation is ultimately more
useful, the PDF may be more familiar.
Once a variable, X, is described by its CDF, we can obtain a
Monte Carlo sample (Fig. 1) by first generating a random value, Y,
uniform ly distributed between 0 and 1, then by taking the inverse
function of that value from the CDF curve to get X. Simulation
software
2,3
does all this behind the scenes; the users job is to
specify appropri ate probability distributions.
Percentiles
Common use of a CDF is to specify certain values of a variable,
X. The expression, P
10
, meaning the 10th percentile, is the value
of X corre sponding to 0.10 on the cumulative-probability axis.
Experienced users often describe distributions by specifying two
or three percentiles. Of particular interest is P
50
, which is called the
median and is one of the common measures of central tendency,
like the mode (most popular range; most likely category) and mean
(arithmetic average value).
Risk Analysis in the Form of Monte
Carlo Simulation
Monte Carlo simulation is an alternative to both single-point
(determin istic) estimation and the scenario approach that presents
worst-, most -likely-, and best-case scenarios. The term Monte
Carlo dates back to the Manhattan Project in the 1940s, where it
was used as a code name. The inference is to the gambling mecca,
where chance rules. For an ear ly historical review, see Ref. 4. The
following paragraph, drawn largely from Ref. 5, offers a brief
description of the Monte Carlo process.
A Monte Carlo simulation begins with a model (i.e., one or
more equations, together with assumptions and logic relating the
parame ters in the equations). For purposes of illustration, we select
one form of a volumetric model for oil in place, N, in terms of
area, A; net pay, h; porosity, ; water saturation, S
w
; and formation
volume factor, B
o
.
N = 7, 758Ah (1S
w
)/B
o
. . . . . . . . . . . . . . . . . . . . . . . . . . . (1)
Think of A, h, , S
w
, and B
o
as input parameters and N as the out-
put. Once we specify values for each input, we can calculate an
output val ue. Each parameter is viewed as a random variable; it
satisfies some probability vs. cumulative-value relationship. Thus,
we may assume that the area, A, can be described by a lognormal
distribution with a mean of 2,000 acres and a standard deviation of
800 acres, having a practical range of approximately 600 to 5,000
acres. Fig. 2 identifies and shows similar distributions for each of
the other input parameters.
A trial consists of randomly selecting one value for each input
and calculating the output. Thus, we might select A = 3,127 acres,
h = 48 ft, = 18%, S
w
= 43%, and B
o
= 1.42. This combination
of values would represent a particular realization of the prospect
yield ing 63.5 million bbl of oil. A simulation is a succession of
hundreds or thousands of repeated trials, during which the output
values are stored in a file in the computer memory. Afterward, the
output val ues are diagnosed and usually grouped into a histogram
or cumula tive distribution function. Fig. 3 shows the output and
the sensitivity chart for this model.
Selecting Input Distributions. Lognormal distributions are often
used for many of the volumetric model inputs, although net-to-
gross ratio and hydrocarbon saturation are seldom skewed right and
al ways sharply truncated. Triangles are also fairly common and are
easy to adapt because they can be symmetric or skewed either left
or right.
6
Sometimes, the distributions are truncated to account for
natural limits (porosity cutoffs, well spacing). When all the inputs
are assumed to be lognormal, with no truncation, and independent
of one another, the product can be obtained analytically.
Shape of Outputs. In this example, regardless of the distribution
types of the inputs, the output is approximately lognormal. That
is, the reserves distribution is always skewed right and looks
lognor mal. In fact, a product of any kind of distributions, even
with skewed-left factors, has the approximate shape of a lognor-
mal dis tribution. Fig. 3 displays the best-tting lognormal curve
overlaying the output histogram for our rst example.
Sensitivity Analysis. One of the byproducts of the simulation is a
sensitivity chart (Fig 3). A measure of signicance toward a given
output variable is calculated for each input variable, namely the
(rank- order) correlation coefcient between the two parameters.
When the correlation coefcient is close to 0 (as in the case of B
o
),
the output (reserves) can achieve a value near the upper limit of its
range with a small B
o
and vice versa. The fact that it is negative
here is trivial; there is essentially no correlation between B
o
and
N. These coef cients can range from 1.0 to 1.0. Area is identi-
ed as the most sig nicant parameter, and the others are ranked
accordingly. As models become more complex, sensitivity analysis
identies the driving variables that merit additional scrutiny
and, by contrast, helps reduce effort wasted on worrying about
the wrong things. Unlike the tradi tional tornado chart or spider
diagrams obtained by tracking the changes in an output caused by
allowing exactly one model input to vary while holding the others
xed, this sensitivity analysis from Monte Carlo simulation is far
more versatile because it permits func tional or correlation-type
relationships among the inputs.
Correlations Among Inputs (Dependency). Unless otherwise
spe cied, the samples of the various input distributions are taken
inde pendent of one another. Thus, on a particular trial, a very large
value of S
w
may be paired with a very large value of or a small
value of A could be chosen along with a large net pay. If there is
a geological argument (or empirical data) to justify a correlation
between a pair of parameters, then the simulation software can
honor that relationship.
Correlation among inputs, in this particular example (not in gen-
eral) causes the resulting output to become more dispersed. Thus,
when area and pay (often) or porosity and water saturation (nearly
Normal CDF
PDFNormal Distribution
P
r
o
b
a
b
i
l
i
t
y
C
u
m
u
l
a
t
i
v
e

P
r
o
b
a
b
i
l
i
t
y
x
x
1.00
0.80
0.60
0.40
0.20
0.00
0 200 400 600 800
0.004
0.003
0.002
0.001
0
0 200 400 600 800 1000
Fig. 1CDF and PDF for normal distribution having mean of
450 and a standard deviation of 117 (P
10
= 300, P
90
= 600). Also
shown is a Monte Carlo sample.
102 October 2010 SPE Economics & Management
Lognormal, mean 2000, STD 800 acres
P
r
o
b
a
b
i
l
i
t
y
584.60 1,913.08 3,241.55 4,570.02 5,898.49
500 1,500 2,500 3,500 4500
Area
Normal, mean 45, STD 3 ft
P
r
o
b
a
b
i
l
i
t
y
36.00 40.50 45.00 49.50 54.00
Pay
Normal, mean 0.14, STD 0.02
P
r
o
b
a
b
i
l
i
t
y
P
r
o
b
a
b
i
l
i
t
y
F
r
e
q
u
e
n
c
y
0.08 0.11 0.14 0.17 0.20
Porosity
Forecast: Area
Normal, mean 1.34, STD 0.06
P
r
o
b
a
b
i
l
i
t
y
1.16 1.25 1.34 1.43 1.52
Bo
Triangular, 0.20 0.30, 0.45 fraction
P
r
o
b
a
b
i
l
i
t
y
0.20 0.26 0.33 0.39 0.45
Sw
1.000
.750
.500
.250
.000
1000
750
500
250
0
11 Outliers
1,000 Trials
Cumulative Chart
Mean = 2,000
Fig. 2Five input distributions, with area shown in both CDF and PDF formats; STD = standard deviation.
Sensitivity Chart
Target Forecast: Reserves
Overlay Chart
Reserves
Area .84
.35
.30
.15
.05
.105
P
r
o
b
a
b
i
l
i
t
y
.078
.052
.026
.000
-1 -0.5 0
0 14 28 41 55
1
Measured by Rank Correlation
Lognormal Distribution
Mean = 23
Sid Dev = 11
Reserves
0.5
Sw
Porosity
Pay
Bo
Fig. 3Output distribution (histogram) with fitted lognormal curve.
always) are correlated, the prospect appears to be riskier and the
mean value of the estimate increases somewhat when the correla-
tions are incorporated in the model. Sometimes, the difference is
slight, but the modeler should be prepared to describe at what level
the correlations make a difference.
5
Imposing correlations among
inputs can also reorder the list of sensitive variables.
Model Shortcomings. There is a widespread practice of extract-
ing one or a few numbers from the reserve distribution to run
econom ics, treating well productivity and capital costs as deter-
ministic and thereby reducing the effectiveness of the uncertainty
analysis. The eld-development model that follows picks up where
the reserves ex ample leaves off. As engineers and geoscientists
October 2010 SPE Economics & Management 103
become more accus tomed to integrating risk-analysis components,
the exploration-pros pect model will include scoping estimates
for production forecasts and both capital and operating expenses.
Without this integration, identifying the relative importance of the
various risks is difcult. How does eld-size uncertainty compare
with the uncertainty of the capital costs or the productivity of the
wells? Where should we invest additional resources to acquire
information? What are the key issues when negotiating with part-
ners or forming alliances? These questions are not easily answered,
yet they should be acknowledged.
Why Do Monte Carlo Simulation?
We do risk analysis because there is uncertainty in our estimates of
capital, reserves, and such economic yardsticks as NPV. Quantify-
ing that uncertainty with ranges of possible values and associated
probabilities (i.e., with probability distributions) helps everyone
un derstand the risks involved. There is always an underlying model,
such as a volumetric reserves estimate, a production forecast, a cost
estimate, or a production-sharing-economics analysis. As we inves-
tigate the model parameters and assign probability distributions and
correlations, we are forced to examine the logic of the model.
The language of risk analysis is precise; it aids communication,
reveals assumptions, and reduces mushy phrases and buzz words.
This language requires study and most engineers have little expo-
sure to probability and statistics in undergraduate programs.
Monte Carlo Simulation-Typical Problems
In addition to the widely used volumetric-reserves model, the
fol lowing three problems serve to illustrate the breadth of Monte
Carlo simulation. Taken as a whole, they also suggest a process of
integra tion or consolidation.
Problem 1Drilling Authorization for Expenditure (AFE):
Esti mate Total Costs and Times. Drilling AFE estimators are
prime can didates for Monte Carlo simulation, being conceptually
simple, ubiqui tous, and essential to the overall prospect evaluation
process.
79
Fig. 4 shows a simple format for the AFE model, with
categories of activity times and costs of goods and services. One
task for the user is to esti mate durations for various activities,
such as drilling the hole sections, completing, and testing. Another
task is to estimate line-item costs. In this model, the drilling
expert provides two values for each estimate: a low and a high
estimate. A preliminary calculation in the worksheet solves some
simple equations
10
to obtain the mean and standard devi ation for
a lognormal distribution for that cost or time category. These high
and low estimates are treated as P
10
and P
90
: the actual value has
a 10% chance of being less than the low value and a 10% chance
of exceeding the high value. One could treat the low estimate as
a P
5
and the high estimate as a P
95
, or variations thereof. Because
the input pa rameters represent times and costs, they are generally
regarded as skewed right; there are more extreme values to the
right of the mode than to the left, causing a tail of large values
having low probability of occurrence. Alternative distributions
include beta, gamma, and triangu lar (which would require three
user estimates).
Acknowledging Historical Data. When data are available from
analogous projects, one can t particular distributions to specic
input parameters. There is a tendency for engineers to want to lean
heavily on data, sometimes at the risk of including inappropriate
data. Certainly, in time, more and better data may be available.
One must often settle for carefully designed sensitivity analysis
to quantify the drivers and the impact of changing distribution
types and ranges.
Warning. Do not report partial results. Too often, the results of a
sim ulation are reduced to a mean value or a P
50
. Sometimes two or
three values, such as P
10
, mode, and P
90
, are passed along to the
next level, where they are used to run economics. Such practices
are not in the spirit of Monte Carlo simulation. As described later,
the economics itself must be a simulation that samples from the
full distributions for the drilling cost as well as from distributions


Generic AFE Model File: AFEGEN.XLS
J. Murtha, 1994
Rig Day Rate, $M 110
Cost Estimates
Item P10 P90 Est Cost Intangible Tangible
Location 450 770 602 602
Bits 110 270 183 183
Power, fuel, water 170 260 213 213
Wellhead 243 412 323 323
Casing liners 625 750 686 686
Cement 280 320 300 300
Mud 360 500 428 428
Logging 450 750 593 593
Coring 0 0
Labor 1 220 280 249 249
Labor 2 160 260 208 208
Time Estimates
Rig Time Description P10 P90 Est Time
Job/Demob 0.5 2.1 1.20 132 132
Stage 1 30 in. 2 2.5 2.24 247 247
Stage 2 20 in. 4 7 5.42 596 596
Stage 3 13
3
/8 in. 9 12 10.46 1150 1150
Stage 4 9
5
/8 in. 12 25 18.05 1985 1985
Stage 5 7 in. 7 13 9.82 1080 1080
Stage 6 0.00 0 0
Test 7 14 10.27 1130 1130
Complete 2 5.3 3.50 385 385
P&A 1 2.4 1.64 181 181
TOTALS 62.6 $10,671 $9,662 $1,010
Fig. 4Drilling AFE estimator template.
104 October 2010 SPE Economics & Management
for prices, expenses, and production forecasts. One cannot cap-
ture P
10
-case economics run by splicing together P
10
cases for the
numerous ingredients.
The proper role for the drilling AFE is a preliminary step to
more comprehensive models. The outputs (total time and costs) can
be re ported as a distribution or a series of distributions over time or
for each of several wells. In cases where there are multiple wells
or drill ing costs along with facilities costs, care must be taken to
transmit the correlations between the relevant distributions.
Other Cost-Estimation Models. Aside from the utility of the AFE
model in its own right, it serves as a paradigm for other cost-estima-
tion models. Many cost engineers use Monte Carlo techniques for
pipelines, platforms, and other facilities. Even the notions of contin-
gency can be described in useful terms. For purposes of including
them in the Monte Carlo economics model, simple spreadsheet
line -item models, similar to the drilling AFE, are adequate. When
sched ule details are paramount, a project-scheduling model is nec-
essary. In recent years, Monte Carlo versions of the most popular
schedul ing programs have become available.
Problem 2Field-Development Program: Estimate Production
and Revenue Streams. Start with a deterministic forecast of oil pro-
duction, possibly generated by an exponential-decline model,
q = q
i
exp( at), . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2)
where q
i
= initial rate, stock-tank barrels per year; a = fractional
de cline per year; and t = time in years. Think of both q
i
and a as
proba bi1ity distributions. We do not know exactly how much oil
will be produced in the first year or how sharply the production will
decline from one year to the next. Likewise, assume some distribution
for the capital cost of drilling and completing the well. Note that
this distribution should come from the drilling engineers who
model the AFE simulators. Further assume that operating costs
can be de scribed in terms of probability distributions. We might
want to break cost into fixed and variable components and to treat
variable costs as being proportional to oil production or water pro-
duction. Alternatively, we could correlate operating expense and
oil production. Generate the forecast of production and discounted
cash flow for some time horizon (e.g., 20 years). Calculate NPV
at 10% interest. So far, we have a single-well exponential-decline
forecast for a single production stream.
This model generalizes to any number of wells. The underlying
deterministic production forecast need not be exponential decline.
Fig. 5 illustrates a more complicated production profile with a
delay and ramp-up followed by two declines. Wells can be linked
by cor relations or other relationships. More than one zone in a well
can be modeled, and associated gas production can be accounted
for in the model. Workovers, waterfloods (i.e., capital investments,
with un certainty and future changes in production streams) are
possible. Anything that can be handled deterministically can be
included in the stochastic model.
The output distributions of this model are the requisite input
dis tributions for portfolio-optimization models. Namely, these are
fore casts (1) of aggregate field production by type, which sum
to re serves; (2) of cash flows, one of whose sums is NPV, and
ROI; and (3) of capital and operating expense, providing a measure
of expo sure. The usefulness of this model is obvious. One can
estimate the probability of achieving some hurdle rate for ROI or
of failing to meet a target NPV. The sensitivity analysis highlights
the input parameters that drive the model and alerts investors to
opportunities to mitigate the risks. ROI is a parameter that needs
special attention when doing a simulation because it relies on an
iterative process to converge and may occasionally fail. The result-
ing ROI output distribution then has some missing data. There are
several ways to avoid this pitfall.
Problem 3Strategic Plan: Estimate Reserve Increases, NPV,
and Capital Exposure. The strategic-plan model can be rather sim-
ple. The objective is to aggregate various capital investments (let
us call them ventures) making up a portfolio. In the upstream side
of the petroleum industry, these ventures might represent countries.
Each investment is represented by distributions for capital, reserves,
and NPV. Restricting the portfolio further to an exploration portfolio
might add the number of wells planned and success rates, along
with the associated estimates for reserves, cost (both exploration
and de velopment), and NPV. Figs. 6 and 7 show the spreadsheet
template and typical inputs and outputs for such a model.
Trend Chart
Time
Rate
4.5
3.4
2.3
1.1
0.0
90%
50%
Fig. 5Production forecast with uncertain ramp-up, peak rate,
and two decline segments.

Strategic Plan Exploration Program File: CBMULTP2.XLS
(C) Jim Murtha, 1995
Inputs
P(S) Wells Dry Hole Cost Reserves/Discov NPV/Discov
fraction number $MM MMBOE $MM
Venture P10 P90 P10 P90 P10 P90
Pacific Rim 0.5 10 1.6 3 80 210 275 550
Latin America 0.33 5 2.1 5.5 88 320 180 362
North Sea 0.2 5 3.9 7.7 90 430 245 520
West Africa 0.1 5 4.4 9 200 600 390 850
Simulation Results
Success Capital Reserves NPV
$MM MMBOE $MM
Pacific Rim 3 2.19 194 334
Latin America 0 3.29 108 342
North Sea 1 6.70 160 301
West Africa 0 6.56 221 396
Totals 4 18.74 742 1304
Fig. 6Spreadsheet template for exploration portfolio.
October 2010 SPE Economics & Management 105
On each trial of the simulation, samples are taken from number
of discoveries for each venture, along with corresponding reserves,
NPVs, and capital exposures (both exploration and development).
Outputs are the aggregations of these parameters. Aggregation mod-
els rely on good input distributions and any correlations between
them. These input distributions are themselves outputs from an
explo ration-economics model. Correlations arise from technology
changes (high productivity in several wells might depend on state-of-
the-art drilling or completion), economic factors (changes in prices
of prod ucts and in costs of goods and services affect all projects), and
estima tor biases (capital costs estimates on various projects might be
made by the same team, which tends to underestimate certain line
items). Estimating the coefficients of these correlations may be dif-
ficult. One can (and indeed should) run the various economic models
using common price and cost forecasts. The resulting simulation
results would yield the desired correlations.
Scenario Errors
Deterministic reserves estimates are often described in terms of
low-, medium-, and high-side possibilities. Some people think in
terms of extremes: worst and best cases together with some base
case (mean, mode, or median). Others report P
10
, P
50
, and P
90

val ues. Sometimes, these cases are linked to such categories as
proved, proved plus probable, and proved plus probable plus pos-
sible. While there is nothing wrong with any of these notions, the
logic of obtaining the cases is often flawed.
Do Not Multiply or Add P
10
Values. When volumetric products
are used to obtain reserve estimates, there is a temptation to build
the low-side reserve estimate by taking the product of low esti-
mates for the various factors. This is a dangerous business at best.
The product of P
10
estimates for area, pay, and recovery factor, for
example, is approximately P
1
. For special cases (all distributions
lognormal, no correlations), one can nd an exact answer. But
if you use a different distribution type, include any correlations
between inputs (larger area tends to be associated with thicker
pay), or change the number of factors (breaking out recovery factor
into porosity, saturation, formation volume factor, and efciency),
there are no simple rules of thumb to predict just how extreme the
product of P
10
values is.
Do Not Multiply P
50
Values or Modes. Less obvious is the fact
that the P
50
value or the modes for the inputs do not yield P
50
or
mode, respectively, for the output, except in very special cases.
The mean values of inputs will yield the mean of the product dis-
tribution, pro vided there is no correlation among inputs. In other
Fig. 7Outputs for exploration-portfolio model.
0 0 5 0 0 0 . 1
375
250
125
0
Forecast: Wells
Forecast: Capital
Forecast: NPV
$MM
$MM
MMBOE
Forecast: Reserves
P
r
o
b
a
b
i
l
i
t
y
F
r
e
q
u
e
n
c
y
.750
.500
.250
.000
0
0 1375 2750 4125 5500
$7.5 $14.4 $21.3 $28.1 $36.8
$0 $1,750 $3,500 $6,250 $7,000
4 8 11 16
1.000 500
375
250
125
0
P
r
o
b
a
b
i
l
i
t
y
F
r
e
q
u
e
n
c
y
.750
.500
.250
.000
1.000 500
375
250
125
0
P
r
o
b
a
b
i
l
i
t
y
F
r
e
q
u
e
n
c
y
.750
.500
.250
.000
1.000 500
375
250
125
0
P
r
o
b
a
b
i
l
i
t
y
F
r
e
q
u
e
n
c
y
.750
.500
.250
.000
words, even the base-case reserve estimate generally should not
be obtained from a product of base-case inputs except in very
special cases.
Similar arguments apply to cost models, such as a drilling
AFE model, where the principal output is a sum of inputs. One
cannot simply add the low and high estimates for the line items
and hope to obtain realistic low and high estimates for the total.
Typical sums of P
10
values might be P
1
or P
2
, and could be much
less likely (see Fig. 8). Again the exact value of the sum of P
10

values depends on distribution types, relative sizes of inputs, and
correlations. It is im prudent to try to generalize. Fig. 8 illustrates
a postsimulation graph of the P
5
and P
95
curves for depth vs. time.
The obviously incorrect curves representing the sum of the best
and worst values for the in puts are included. This is the analogy
of obtaining low and high esti mates of reserves by taking products
of P
10
and P
90
values.
Do Not Add P
50
Values or Modes. Worse yet, one cannot simply
add modes or P
50
values from individual cost models to obtain the
mode or P
50
, respectively, of an aggregation. Only means add to
means. Yet, it is a common practice to estimate the base cost of a
drilling program by adding the base estimates for individual wells.
Similarly, total capital cost is often estimated by adding the base
costs for the various line items.
A simple exercise shows how far off the total cost can be. Take
10 identical triangular distributions, each having 100, 200, and 350
for low, most-likely, and high values, respectively. While the mode
of each is 200, the mean is 216.7. The sum of these distributions is
approximately normal with a mean of 2,167 and a standard deviation
of approximately 18. The sum of modes, 2,000, is well outside the 3 -
standard-deviation range. In other words, 10 independent line items,
each ranging in cost from 100 to 350 with most likely of 200, would
have an aggregate cost in the range 2,113 to 2,221. Do not even con-
sider adding the high or low estimates. The modes themselves sum
to values outside the range of practical consideration.
What Monte Carlo Simulation Does Not Do
In spite of its power and applicability, Monte Carlo simulation
does not do the following.
1. It does not make decisions; it prepares for decision making.
2. It does not analyze data; there is companion software for
that purpose.
3. It does not optimize functions; the output distributions serve
as ingredients for optimization.
4. It does not provide ready-made models; everyone builds
their own.
106 October 2010 SPE Economics & Management
Who Does Risk Analysis in the Oil and
Gas Industry?
Virtually all segments of the industry-operating companies, large
and small; service companies; consulting firms; and financial insti-
tutionsare engaged in some form of risk analysis. Thousands of
geoscientists and engineers have attended classes in probabilistic
reserve estimation, general principles, or hands-on Monte Carlo sim-
ulation; and the pace of that training is accelerating. Several ma jors
have organized some sort of process to do risk or decision analysis
on a systematic basis. They have created task forces, organized
procedures, held in-house training, molded internal specialists, and
designated champions. Seldom, however, has this been attempted at
a corporate level. Rather, it may be done in the exploration group or
within the planning department or by the drilling engineers.
At this time, it appears that no oil and gas operating company
has a fully implemented, unified program to do probabilistic esti-
mates of their key operating parameters: reserves, capital exposure,
and NPV. A few have made efforts in this direction; there always
seems to have been pockets of resistance. These efforts sometimes
date back to the 1970s, some even further. Since Hertzs
11
widely
read article, there have been the sporadic articles
l228
and books
2934
on Monte Carlo simulation and related topics in the petroleum lit-
erature. The attention given to risk analysis in recent years should
begin to generate more research and broader literature.
Responses to Criticisms of Monte
Carlo Simulation
Many of the criticisms of Monte Carlo simulation fall into the
fol lowing categories.
1. It didnt work 20 years ago.
2. There are no adequate data.
3. Outputs depend on people running the models.
In response, one can cite the development of spreadsheets and
fast computers. Instant graphics and statistical analysis, simple
pro gramming, row and column structure, hundreds of canned func-
tions, and an estimated 30 million official users make Excel and
Lo tus 1-2-3 natural vehicles to do Monte Carlo simulation.
Data can be a problem; but either you have them and can easily
ob tain statistical curve fits or you dont (often the case) and you
learn how to do sensitivity testing to find out the key parameters
and how they affect results when the distribution type and ranges
are altered. Then, you make a concerted effort to acquire data in the
future. The point is this. If you can make a deterministic estimate
for some param eter, then you can make an estimate for its possible
range (e.g., from P
10
to P
90
). Many people feel more comfortable
presenting the range.
Item 3 is addressed in the guidelines in the next section. Suffice
it to say, there are many abuses of Monte Carlo simulation (and of
decision trees). One example is multiple models within a company
to estimate the same thing. There should be exactly one model for
charge assessment, one for reserves estimating, one for drilling AFE
model, and one standard facilities cost model. Like any other soft-
ware tool, they should be designed carefully with input from the key
users, maintained over the long term, and reviewed periodically.
Some Guidelines for Monte Carlo Simulation
1. Establish comprehensive objectives: scope, deadlines, process.
2. Hold awareness seminars on the language concepts of risk
analysis.
3. Design and conduct training in Monte Carlo software.
4. Decide which models to build or buy.
5. Designate teams or individuals to design and acquire the
models.
6. Establish reporting procedures: forms, timing, and people.
7. Keep reports of results to a few pages and 30 minutes.
However, insist that they include (1) sensitivity analysis with 10
or fewer driving input parameters, (2) the basis of selection of
all key inputs, (3) identi cal-format output distributions, and (4)
signatures of reviewers.
8. Avoid duplication or modification of models; use periodic
re view to suggest changes.
9. For each model, identify two people who will be responsible
for explanations, assistance in running, review, and collection of
re usable examples and who will, in general, assume responsibility
for the integrity of the model and its use.
10. Set firm guidelines for documenting all models and applica-
tions religiously and thoroughly.
11. Establish look-back procedures that focus on improvement of
estimations and of the model logic, not on reward or punishment.
12. Always ask whether there is another model doing essen-
tially the same thing and offer an incentive to one of the model
builders to join your company.
13. Periodically have a disinterested third-party review the
ap plications.
Future of Monte Carlo Simulation
Is there a rebirth of simulation, and will it persevere? Here are
some predictions.
Fig. 8Time-vs.-depth forecast with actual P
5
and P
95
vs. sums of P
10
and P
90
inputs.
Drilling Performance:
D
e
p
t
h
,

f
t
Time, day
0 -2000
-6000
-10000
-14000
-18000
-22000
sum P10
sum P90
Sampled
P95
P5
50 100 200 150
October 2010 SPE Economics & Management 107
Near-Term Developments.
1. Field testing of two commercial economics packages inter-
faced to Monte Carlo spreadsheets.
2. Testing of at least two stand-alone comprehensive Monte
Carlo economics-evaluation models.
3. Some form of geostatistics interface to Monte Carlo simulation.
4. Formalized agreements for sharing data and model description.
5. Renewed attempts at systematic integration of risk and deci-
sion analysis into companies.
Future Developments.
1. Commercial Monte Carlo templates for economics, drilling/
facilities costs, and production forecasts.
2. Seamless links between components, with empirical data.
3. Several corporations embracing the method.
4. Several portfolio and planning models; at least two commer-
cial models already exist.
5. User groups for Monte Carlo software.
6. Look-backs; companies will formalize this process.
7. Catalogs of distribution types.
8. Steady growth of technical papers.
The Perfect World. The following would be present in an ideal
en vironment for engineers and scientists
1. The language of basic statistics would be as common as lan-
guage of engineering economics.
2. Appropriate databases would be generated, properly main-
tained, and used to guide parameter modeling.
3. Everyone would know the significance of their analyses and
how their results plugged into the next level of model.
4. All estimates would be ranges; single-number requests would
be refused.
5. Budgets would be built on distributions. Aggregation, prop-
erly done, results in estimates with relatively less dispersion than
the in dividual components. We too often fool ourselves with single
num bers and then either force spending or create reasons for miss-
ing the target. There would be no penalty for coming in over
budget. Per formance measures would be probabilistic.
Can this happen? Of course! We must assume that everyone
can be educated.
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SI Metric Conversion Factors
acre 4.046 873 E01 = ha
bbl 1.589 873 E01 = m
3
ft 3.048* E01 = m
in. 2.54* E+00 = cm
*Conversion factor is exact.
James A. Murtha is an independent consultant specializing in
risk analysis and decision-mak ing. He holds a BA degree from
Marietta C. and MS and PhD degrees from the U. of Wisconsin,
all in mathematics, and an MS degree in petroleum and
natural gas engineering from Pennsyl vania State U. Murtha is
an SPE Short Course instructor and a member of the Forum
Series in Asia Pacific Steering Committee. He was a 199596
Distin guished Lecturer and a 1994 Speakers Bureau speaker.
He chaired the 1994 SPE Petroleum Computer Conference Pro-
gram Committee and has served on the Electronic Publishing,
Computer Applications, and Editorial Review committees.