Lesson 1.01 Introduction

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01. DCA Reserves and Economics - Lesson 1.01: Introduction

Years ago, a friend of mine took his first job in the petroleum industry at a small private operator in West Texas. He sat down in his office the first day and the owner came to see him. The owner sat down and said, now listen son, I know that you've spent 4 years studying petroleum engineering at one of the finest schools around... Texas A&M. But notwithstanding that fact, you are no longer a petroleum engineer. He said, from now on, you're an economics engineer. Your job is not to tell me how many barrels of oil or MCF of gas we're going to produce, your job is to make sure that our company makes money. Maybe I'm the only one but for me, I can lose track of that fact. And what we're going to do in this course is try to keep that issue, that ultimate issue front and center.

02. Objective

We're going to talk about what it takes to make a quality estimate of future cash flows so that we can enable profitable decisions. Quality means fit for purpose, useful for the purpose. So I think of it with 3 criteria:.

03. Quality

Quality engineering or quality cash flow analysis first must be reliable for the question at hand. It's not that one analysis is complete and useful for all time and all situations. Often the analysis runs in an iterative and progressive manner, and we'll talk more about that. But it only has to be reliable for the decision at hand. And that helps people like me to twisted off and sometimes not be done where it should be, because that's the second criteria.
The reliable analysis, quality analysis, must be timely. That it's better not to make a decision then to make a decision on bad analysis. And I've seen plenty of times where people in a rush made large decisions using inadequate data, unreliable work, that is a bigger mistake. But to be a good engineer, to support the business, we must be timely.
Third, and this one is often overlooked, quality engineering work is transferable. What you do does not belong to you. It belongs to your future self and it belongs to the rest of the people who are going to use it in the future. And if it's not taken care of, if it's not handled well, then you create waste and you make things harder in the future. But this kind of cash flow analysis has only three parts. And we're going to talk about it each in turn with an emphasis on the first part.

04. Volumes, Prices & Costs

The first part is volumes. What will the oil and gas wells produce in the future? That is subject to engineering. Geology as well. We can do lots of work to try to define that part of the equation.
The second part, prices. The prices do not follow science, they do not follow physical laws. They tend to be, if not chaotic, mean reverting in any event, but erratic. But prices and costs have just as much impact on the revenue of the business. Because, of course, revenue is volume times price. Volumes go down, follow science. Prices go up or down, follow sometimes irrational patterns but have just as much impact on the business.
The third component costs. These are the costs first that we spend to acquire the cash flow, the capital costs. And second, the costs that we incur on a month to month basis to continue operating. To continue receiving the cash flow stream.
Volumes, prices, cost, each with some subsets. But that wedge in the middle that's left over, that is our net cash flow. That's the money stream that we receive to compensate for the money that we've payed at the beginning to get it.

05. Diminishing Cash Flow

So what we get is a diminishing cash flow. It starts high at the beginning, gets smaller with time. All else being equal prices can outweigh that, but it accumulates.

06. Accumulated future profits must be converted to present time

And we have to decide how to translate those future accumulated cash flows back to a particular point in time. And make the decision, does that present value or some other method, some other kind of economic yardstick, does it justify the expense? How much can we pay? How much should we pay. Should we drill? Should we not drill? How do we balance the issues of costs, capital costs and future net income?

07. Cash Flow Table

Now all of those variables end up on a cash flow table that looks like this. This is a portrait layout, others are very commonly... I'm sorry, this is a landscape layout. Others are very commonly portrait. But you can see all of the pieces. A cash flow, like any work, must have a label, must have an identifier to explain what it is. And then we have a column for years for orientation. After that, it flows left to right. Volumes, prices. There are some columns there for revenues, a subtotal. Then we have various kinds of costs. Cash flows at the right, net cash flows, cumulative cash flows. And then yardsticks at the bottom.

08. Each part requires analysis, but...

And those streams of incomes are the pillars of the overall analysis that we're building. They're not the foundation, they're not the ultimate, those are the pieces. They are very important pieces, everything else relies on them.

09. ...analysis is only part of a larger process

But at the foundation of the larger process is data. Collecting data and putting it into some sort of useful form. Everything that we do is built on that foundation. And if you want to spend a lot of time remodeling your work, just change that data foundation. But then we go into the various kinds of analysis; LOS analysis, price differentials, variable cost, gathering and processing costs. When we get all of those pieces together, then we can make a holistic view of what's going on in that situation, in the cash flow that we want . That's not still the ultimate. Ultimately, we want to make a decision. What are we going to do? What does this mean? And what does it mean not just here, for this one cash flow, what does it mean in the context of the business?

10. Course Overview

Now we're going to break this down into 5 parts. Very fancy here, we're going to begin at the beginning. My dad's a preacher. His narrative style is maybe a little different, but we're going to talk about how to start a project. It is said from research that an expert spends more time than an amateur planning his work, but less time performing it. Lets talk about how to start right as one of my early mentors used to say.
Then will talk about decline curve analysis itself as its own piece of the overall puzzle.
But I'm going to break that out a little separately from the idiosyncrasies of shale. Talk more about the general process and some specific concepts from millidarcy reservoirs and then separately talk about how some of those concepts apply to shale.
The next part we'll talk about the economics components. There's certainly good and better ways to do the analysis and less productive, less reliable ways to do the analysis.
And then true to good engineer fashion we will end at the end. What I mean by that is we'll talk about how to publish a report and also how to document and store your analysis so that it is transferable.
Now in all 5 of those we're going to talk not just about the what to do, but also about how, how to do it. Two separate things. You can do the right thing, but you do it the wrong way and you'll still get an unreliable answer.

11. Generic Cash Flow Table

And at the end of that, I hope you'll be able to make a cash flow analysis that looks kind of like this. Now, this one is a portrait view, but it's the same basic layout. We have headers at the top. Years, volumes, prices, costs, cash flows and yardsticks.
Let's look at those yardsticks a little closer. This is a generic cash flow and it assumes you're going to drill an 8.5 million dollar horizontal well, 7,500 ft lateral. And it's telling us that the present value is $406,500. That the total cash flow we can go down to a $10 unit there. That last digit is at $10. So if we had a pile of $10 bills that were 8.5 million dollars high, it would be 3,700 inches over 300 ft. What the cash flow is telling us, is that it knows how much we're going to make in return all the way down to the single $10 bill. This is the difference between accuracy and precision. Precision is how exact the measurement is. Accuracy is how close it is to the truth. And I promise you that the resolution of cash flow analysis is not down to a single $10 bill. So we'll talk about what to do, how to do it. We'll talk about also how to view the results, how to understand risk and the risk embedded, the uncertainty embedded in the cash flow.

12. Me...

In the 25 years I've been at this career, I've worked all over the world helping people to make decisions. I've been the engineer. I've been the engineering manager. I've been the reserves manager. I've been the executive making the decision. And I've been the expert witness whose job it is to come along at the end of the day and decide whether people make good decisions or not decisions. Now I said before that we want to focus on making money but the truth is, we don't actually make money. We don't write it, we don't print it. And in truth, we don't even make oil and gas. We can't create it.

13. Analyses and Holes in the Ground

What we do make are analyses and holes in the ground. And we hope that we've made good decisions, the juncture of these two, interface with these two, so that we get oil out of the ground, so it's produced naturally. But all we have control over are our analyses, holes in the ground and their intersection at decisions, and that's what we want to talk. Building good analyses so we can make good decisions. Now let's get started.

14. A Note of Thanks

So notwithstanding that I just said let's get started, let's do a detour. A note of thanks and a little bit of a commercial. I've been teaching the materials that we're going to talk about for 5 years. But some of those materials have been codified into a course that I teach for the American Association of Petroleum Landmen called Petroleum Economics. This course is designed for non-engineers to give a survey of the kinds of decisions we make and how we build cash flows.
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Decline Curve Analysis, Reserves and Economics for Shale Course
Chapter 1 - Engineering and Economics (2:43:21)
Chapter 2 - Decline Curve Analysis (4:24:41)
Chapter 3 - Idiosyncrasies of Shale (3:27:15)
Chapter 4 - Economics (4:41:39)
Chapter 5 - Quality Control & Transferability (1:20:51)