For exploration, and particularly for frontier exploration, it is useful to know how likely exploration may open up further discoveries in the block. We try to quantify how exploration discoveries may lead to further success – and how these results should affect company valuation
Companies exploring in frontier basins frequently include maps and tables with all the prospects and leads in the acreage in marketing information, often adding the prospects’ sizes to give an unrisked block resources estimate. There is a risk that these representations are misunderstood by investors.
We agree that managements are right to give investors an idea of the depth of prospectivity in their assets/acreage – more, larger and lower risk prospects give exploration teams the luxury to choose the best chance of drilling a valuable well especially in the case where exploration is mandated by licence commitments. You can therefore understand that a company would want to demonstrate it is drilling from a position of strength.
However, we continue to see dangers in this approach for investors who do not appreciate the complexities in oil exploration. The modern reality is that investors should not use this apparently large resource base as a metric to value the block/company. Companies rarely drill a second wildcat well if the first is a failure. Using Norwegian Petroleum Directorate data (of 1,100 exploration wells spanning 48 years) companies have only drilled a licence/block a second time 10% of the time if the first was dry in the last five years or so (see chart below).
But is this data indicative of other, more frontier, areas? Frontier exploration failures with no follow-ups are common (just looking at West Africa in the last five years throws up many wells in Morocco, Namibia and elsewhere). From 2011-2015, West African dry wells had a follow up in the same block only 7% of the time.
We have therefore long been advocates of only valuing the first well in a block (unless a campaign is already committed to and more wells are definitely going to be drilled). Managements should be more clear to reduce the possibility that (less informed) investors will attribute value to the cumulative gross block resource estimates.
What about the play opening argument?
Investors and managements have made the argument that if a discovery is made, it significantly de-risks further prospects. This would mean that we should include some value for this de-risking before the first well.
We again look at the NPD for some quantification, but with many caveats. The North Sea was de-risked by UK drilling before widespread exploration/development occurred in Norway and explorers in the basin had higher levels of confidence in the various elements (source, migration etc) before drilling. Commercial quantities of oil are typically much lower in Norway that they may be for more frontier areas offshore (perhaps 50mmbboe for Norway vs 200mmboe for offshore Africa). Every basin is different, so we give this analysis with a pinch or more of salt.
However, looking at blocks in Norway, the chances of a block containing two or more fields given that it already has one is around 40% (where a block is of type 1/3 or 10/11) – see chart below. These blocks are much smaller than those typically seen in Africa. Scaling up to a collection of blocks which are roughly equivalent to Cairn’s Deep Offshore block (containing the SNE field) in area, this chance increases to over 55%.
This is for Norwegian blocks, that are substantially smaller than typically frontier offshore blocks
Resulting probability tree
And assuming a 30% CoS (roughly the commercial chance of success for a wildcat in Norway), we can produce a rough interpretation routes to success/failure. Here we also use the observation that if the first well is unsuccessful, the chance of success for the second well falls to 15-20%. For information, if two are unsuccessful, the chance of a third being a success has been 13% (and 6% for a fourth well). Given only 10% of initial unsuccessful wells are followed up, the impact of these CoS on subsequent wells is vanishing small.
Note: We use a 50% chance after a first success here as a simplification of the 40-55% chance of finding more than one field given one has already been discovered (where 40% is over a block in Norway and 55% is for a collection of Norwegian blocks roughly the size of the SNE block in Senegal).
Overall, going from NPD data, the chance of two (or more) successes is 15%, the chance of a first well being successful with no further successes is 15%. The chances of a failed campaign (either because a second well is not drilled or a second is unsuccessful) is 69%. The chance of a first failure is followed up by a success is 1%.
Going from this data, there is therefore a case for including value for play-opening discoveries. For every discovery, further discoveries are have a c.50% chance of occurring, though many more wells may need to be drilled to make another discovery – the implied individual CoS rises by perhaps 15%.
However, we remain cautious. Investors have to take account of the time to appraise and develop discoveries. When are subsequent wells going to be drilled to enable possible discoveries, are all going to be co-developed or will others be tied-back after first oil or have a longer term phased development?
In the case of small oil companies, the effect of financing (dealt with in many previous blogs) and possible farm-downs/delays should also be accounted for. Given a failure is far more likely than a success, we are happy to continue to examine only the value of a drill until a result is known. This analysis then gives a possible framework for how an investor (and shares) may then react after a result.