Today’s Finanical Express carries an interesting column by Vikram Mehta, Chairman of the Shell Group in India.

The following passage caught my eye:

“Success in the exploration and production of oil & gas requires a company to overcome three interlocking sets of probabilities. The probability that a given geologic structure contains hydrocarbons [let’s call this Event A]; the probability that hydrocarbons will be located [lets call this Event B], and the probability that once located, the find can be commercially exploited [let’s call this Event C].”

Vikram’s statement has vast practical implications for security analysts.

The market value of an asset is the present value of its expected future cash flows. Cash flows from an oil exploration company can be derived only out of hydrocarbons which can be commercially exploited. And for that to happen ALL of the above three events must happen.

Suppose that the probability of Event A happening is 40%, that of Event B happening is 20%, and that of Event C happening is 25%.

Then the probability of seeing cash flow which is valuable is 0.40 x 0.20 x 0.25 or 0.02. That comes to just 2%!

I wonder if the market participants think in those terms before valuing oil exploration stocks.

The man who said that “a chain is only as strong as its weakest link” was wrong.

He should have said “a chain has to be weaker than its weakest link.”

Sir, what matter is returns. If they can make 100x their investment on an oil find that meets all three parameters, and they have enough blocks to explore, then the 2% probability is ultimately a reasonably large return. For every $100 they invest they will eventually make $200.

Costs (E&P, Drilling, gas/oil removal) versus returns today seem to show more than 100x in a longer term scenario, in some cases substantially more. Even to the BP that will pay out for the US oil spill, the return is enormously positive. But for this they have to make enough bets.

Another point: Every event is impacted by externalities. A low reservoir of oil, once explored, may find that the Oil and Gas gets replenished through some deep underwater fissures from some other geological block, which is obviously not factored into any probabilities. The price of oil, as it changes, makes commercial viability difficult to predict – at $140 there are blocks that are commercially viable versus at $80.

We see the increasing ability to harness oil from shale rock; should that become cheap enough, oil becomes much more accessible so there may be a (temporary) ceiling on prices.

A good portion of oil E&P business is timing and if you look far back enough, luck.