System Dynamics of Petroleum Development

– Training for Long-Term Cooperation Across Cultural Divides –

by

James L. Ritchie-Dunham
Instituto Tecnológico Autónomo de México
Río Hondo No. 1, (Col. Tizapán San Angel)
01000 México, D.F., MEXICO
Tel: 5 (25) 628-40-00 ext. 3430
Fax: 5 (25) 550-77-84
E - mail: jrdunham@taylor.rhon.itam.mx

ABSTRACT:
This paper addresses the dynamics of energy development projects. Nationalization has
repeatedly squandered the economic, physical and mental resources of large joint-
ventures between multinational oil companies and developing countries. A deteriorating
relationship between multinational oil company (MNOC) management and regional
hosts consistently leads to nationalization. This cultural gulf between corporation and
regional host, while existent in many regions, is most significant in high conflict areas,
which is why petroleum managers, with most of their experience in low conflict areas,
have mostly ignored the cultural gulf. To form strong relationships that bridge the
cultural gulf requires cultural sensitivity. Neighbor conflict studies show this problem to
be most prevalent in developing countries, but also existent in emerging areas such as
offshore California, Florida and Alaska.

The proposed microworld trains first world petroleum managers, through cause-effect
analysis, that while cultural-sensitivity to the developing country's needs increases
marginal costs, it lowers the probability of nationalization, generating positive project
economics1 and raising expected payouts from extended project life.

1 In the petroleum industry, "petroleum economics" refers to the project financial viability analysis.
INTRODUCTION:
Failing multinational petroleum projects provoked by poor relationships between the
MNOC and the developing country have squandered great economic, mental and
physical resources. IPREMARA, an Integrated Petroleum REservoir MAnagement Risk
Analysis system dynamics model, illustrates the cultural dynamics of development
projects to petroleum managers and host region leaders. IPREMARA integrates the
primary factors driving the international petroleum management environment to
determine what interrelations exist.

This paper presents a set of hypotheses and their historical basis, then introduces a
system dynamics model designed to test these hypotheses. Next, the paper details each
field in the model and shows how the model integrates the fields. A brief description of
system behavior follows, setting the stage for conclusions and plans for further research.

PRELIMINARY HYPOTHESIS:
1) IPREMARA, by systematizing international petroleum project economic
analysis for culturally-sensitive investments, raises expected value.

2) IPREMARA, by raising the probability of complete economic reserve recovery,

offsets the higher initial investment and costs required to promote cultural
stability.

3) IPREMARA, by stabilizing the investment environment, promotes technology

modernization making Latin American energy exploitation projects more
efficient.

4) IPREMARA, by improving control over cultural stability and the investment

environment, improves access to increasingly inaccessible and therefore
increasingly valuable natural resources.

HISTORICAL BASIS
In developing countries, the multinational firm typically implements its standardized
work culture (i.e., work ethic, modern western management styles, language, work hours,
customs). Often this is substantially different from that of the host nation, which creates
tension with the national workers. As host workers feel more competent in managing the
project, they pressure government officials to nationalize the project and return to the
national work culture. Coupling this with political instability multiplies the
nationalization risk. The higher expropriation risk reduces the expected value of project
cash flows by shortening the economic project life. Under these conditions, project IRR
falls below the cost of capital. The MNOC regrets its project investment and the host
country loses access to the advanced technology flow-stream needed to maintain and
improve the large project.

Concern over this reoccurring problem prompted this initial research into the variables
that promote disintegrating relationships between the host country and the multinational
company and frequent nationalization and expropriation.
INITIAL MODEL CONCEPT
IPREMARA integrates four interdependent fields usually considered independent: finan-
cial asset management, development engineering, investment portfolio analysis and
socio-political-economic (SPE) risk analysis. The following brief definitions demonstrate
the interdependency among these fields. Traditionally the separate disciplines indicated
below took complete responsibility for each field, leading to independent analysis.

Financial Asset Management: Maximize project Return on Investment (ROI) by

scheduling sales that determine production volumes.
-- by financial analysts

Development Engineering: Maximize recovered reserves over time by

scheduling production volumes that determine sales.
-- by petroleum engineers and geoscientists

Investment Portfolio Management:

Maximize firm's Return on Equity (ROE) by select-
ing portfolio of projects.
-- by middle to upper management

SPE Risk Analysis: Assess SPE environments for investment suitability.

-- by country risk specialists

These definitions show obvious interdependencies among the fields - value

maximization. However, separating the responsible disciplines filters relevant
relationships from the global analysis. Losing relevant relationship information before
the investment decision frustrates the shareholder wealth maximization goal. The
IPREMARA model (Graph 1) integrates all four areas concurrently, ensuring that all
relevant relationships enter the investment decision.

Equity

Financial Asset Management

Revenues Investment

Development Engineering
Production Exploration

Investment Portfolio Analysis

Portfolio Evaluation

Socio-Political-Economic
SPE Stability
Relationship with Regional Host Risk Analysis

Graph 1: Integrated Reservoir Management Risk Analysis Model

Story Line: In the petroleum business, production constantly depletes the MNOC's
equity in its reserves. To maintain equity, MNOCs continually acquire reserves through
purchase or exploration. This continuing experience in financial asset management,
development engineering (including exploration technology), investment portfolio
analysis and political risk analysis, allows MNOCs to better manage opportunities. As
each opportunity becomes more valuable, the relationship with the opportunity's host
becomes more valuable. [Historical evidence shows, though, that MNOCs lose
opportunities by undervaluing the commercial and cultural relationships with the host,
and underinvesting in relationship maintenance.] Improving the relationship raises SPE
stability and project strength in the portfolio evaluation. As project strength triggers
investment, production generates cash flows that increase the MNOC's equity.

To illustrate the model, the following sections describe the role of each field in the
model. The final section presents the fully developed model.

Financial Asset Management

Equity

Revenues Net Income Investment

Graph 2: Financial Submodel

Story Line: As production increases income, equity increases at the portfolio required
rate of return. Production depletion thus requires reinvestment in exploration to maintain
or increase the ROE.

Situation: Since the early 1980s, flattened revenues and increased investment costs
lowered net income per barrel of oil equivalent (BOE), forcing management to improve
portfolio selection methods to meet required rates of return.

Exploration (Part of Development Engineering)

Exploration Budget Exploration Technology and Experience

Area Discovery Risk Factor

Price per BOE Discovery of Economic Reserves

Graph 3: Exploration Submodel

Story Line: Increased investment in exploration improves available corporate

exploration experience and technology. Since technology and training relate directly to
the probability of discovering reserves, the more experienced exploration group finds
more reserves and better determines the risk of reaching and recovering these reserves. If
the price per BOE less investment meets ROE requirements, reserves are economically
recoverable.
Situation: Typically, a management team of geologists, geophysicists, petroleum
engineers, and financial analysts use industrial statistical information and intuitive
knowledge to determine exploration project risk.

Investment Portfolio Analysis

Company Attitude to Host

Social Political
Discovery of Economic Reserves Feasibility Study
Economic Stability

Project Approval

Reserves Additions

Graph 4: Investment Portfolio Analysis Submodel

Story Line: The discovery of economically recoverable reserves and a stable SPE
environment positively influence project feasibility. As project feasibility increases, the
MNOC's attitude toward the host and the project approval improve, which directly
affects reserve addition.

Situation: Typically, four separate groups analyze and recommend project alternatives.
This information synthesis from four independent sources filters out many significant
variable relationships too complex to see without proper modeling. This weakens
critical investment decision processes.

Production (Part of Development Engineering)

Price per BOE Reservoir Characteristics

Reserves Additions Economic Reserves Production Revenues

Graph 5: Production Submodel

Story Line: Added economic reserves increase the petroleum reserves asset base. Reser-
voir characteristics and price per BOE directly determine production rates and
corresponding revenues.

Situation: Ever decreasing net income causes management to demand more efficient
production methods, yet financial demands often adversely affect optimal production
rates. External factors, such as topography and pipeline routes through politically-
sensitive areas, directly determine production rates, increasingly complicating production
rate determination.

Socio-Political-Economic Risk Analysis

 Company Attitude to Host

Feasibility Study Company Management Style

Social Political Economic Stability Host Attitude to Company

Urgency for Change

Company Investment in Relationship Host Technical Control Social Wellbeing

Graph 6: SPE Risk Analysis Submodel

Story Line: Increased project feasibility improves the MNOC's attitude and subsequent
management style towards the host, positively affecting the host's attitude to the
company. This increases regional SPE stability. In a deteriorating relationship, lowered
future revenue expectations directly augment the urgency for change to a better
relationship. To improve the host's attitude toward the relationship, the MNOC invests in
the host's technical skills and social well-being, increasing SPE stability and project life.

Situation: Historically strong cultural differences between MNOCs and developing

nations in need of advanced energy development technology caused many of the high-
risk investment failures. Neither party benefits from this cultural gap.

SYSTEM BEHAVIOR
Case studies in Ecuador, Colombia and Indonesia show a "typical" behavior for large-in-
vestment petroleum projects. Production lags behind investment in exploration and
exploitation (drilling and production system installation). The following graphs
demonstrate this systemic behavior.

OBSERVED BEHAVIOR
O B S E R V E D B E H A V IOR
10,000
1000

500
0
0 0 10 20 30
0 10 20 30
T ime (Years)
Time (Years)

Inv e s tme nt P ro d uctio n Cum. Inv e s tme nt Cum. P ro d .

Inco m e Inc o m e

The lag time between initial investment and income is five to ten years, for large-scale
projects. Cumulative production income does not surpass the cumulative investment
until the tenth year of the project and the fifth year of production.
 NPV o f V A R Y ING LIF E IR R o f V A R Y ING L IF E
TIME S TIME S

6,000 40
20
4,000 0
2,000 -20 0 10 20 30
-40
0 -60
-2,000 0 10 20 30 -80

T I M E ( Y e a rs) T IM E ( Y e a rs )

The project's NPV becomes positive after the 13th year2. The project IRR becomes
positive in the 13th year and quickly reaches its maximum of 30% at year 20. This
"typical" scenario indicates that management must ensure a minimal project life of 12-15
years to recuperate the investment and 20 years to generate the required ROE. Since
nationalization or non-renewed concessions prematurely terminate many long-term
projects after 10-15 years, corrective system behavior generation is crucial.

PROPOSED INTEGRATED MODEL

Appendix 1 shows the complete IPREMARA model. Appendix 2 displays an executive
flight simulator that controls the main variables determining system behavior. As
Kleindorfer states, "the general conclusion is that the reliability of intuitive judgments,
even for experts, is usually low. People can often be outperformed by their own
models..." This realization provides the impetus for further model development and
utilization.

CONCLUSIONS
Petroleum projects that fail due to poor relationships between the corporation and the
regional host waste great economic, mental and physical resources. System dynamics
modeling provides an integrated view of the complex, international petroleum
management environment and determines what interrelations exist between decision
variables and how to generate a stronger, value-creating system behavior.

SUGGESTED FURTHER WORK

Further case study will validate the relationship of those variables that most directly
affect "nationalization" and project life variables. The researcher proposes in-depth
interviews, before and after simulation training, with petroleum executives and
developing country petroleum agency and government officials to determine insights
gained through this executive flight simulator approach to project stability maximization.

2 From the researcher's experience at two large oil companies, a 12% capital rate is considered typical in
project economic analysis for large oil companies. Though it is significantly higher than current 1994
lending rates, it is considered to reflect long-term rates in the U.S.A. for this type of investment project.
REFERENCES
Empirical Data
Banco Central del Ecuador, Anuario, Quito, Ecuador: 1987.
Chang, Dr.. Lecture on Historical and Immediate Implications of the Crash. Class on Rock and
Fluid Properties. University of Tulsa. Department of Petroleum Engineering. March 1984.
Decker, David R.. Ignacio Duran. The Political, Economic, and Labor Climate in Colombia.
University of Pennsylvania. The Wharton School. Industrial Research Unit. 1982.
Economist Intelligence Unit Limited. Ecuador Country Profile 1989-90. London, U.K.: 1989.
Ministerio de Energía y Minas. Perspectivas hidrocarbuiferas del Ecuador 1988-92, Quito,
Ecuador: 1988.
Muller, Kristen. "Ecuador." Oil & Gas Investor, Sept. 1988, p. 50.
World Bank. Ecuador: An Agenda for Recovery and Sustained Growth, Washington, D.C.:
1984.

Model Development
Cockcroft, James. Neighbors in Turmoil: Latin America. New York: Harper & Row, 1989.
Grimaldi, Antonio. "Interpreting Popular Culture: The Missing Link Between Local Labor and
International Management." Columbia Journal of World Business. Vol. 21 Winter 1986. pp.
67-72.
Hofstede, G., Culture's Consequences: International Differences in Work-Related Values, Beverly
Hills: Sage Publications. 1980.
Kleindorfer, P.R., H.C. Kunreuther, and P.J.H. Schoemaker. Decision Sciences: An Integrative
Approach. New York, Cambridge University Press, 1993.
Mack, T., James Norman, Howard Rudnitsky and Andrew Tanzer., "History is Full of Giants that
Failed to Adapt", Forbes, February 28, 1994.
Powersim 1.1.
Sagasti, Francisco R. "Crisis and Challenge: Science and Technology in the Future of Latin
America." Futures (UK). Vol: 21. April 1989. pp. 161-168.
Tahija, Julius. "Swapping Business Skills for Oil", HBR September-October 1993.
VenSim Pro 1.6.1.

Trends in Industry
Bamrud, Joachim. "Oil Fever", U.S./Latin Trade. March 1994. pp. 50-60.
“Borja Springs Surprise Takeover of Ecuador's Foreign Oil Firms”. Latin American Weekly
Report, 29 Sept. 1988, p. 1.
“Borja: A Look at Future Policies.” Latin American Weekly Report, 12 May 1988, p. 9.
Bulletin for Latin America (Santiago, Chile: 1983).
Charlier, Marj. "U.S. Mining Firms, Unwelcome at Home, Flock to Latin America", WSJ.
6/18/93.
Nulty, Peter. "Who Lost the U.S. Oil Industry?", Fortune, November 29, 1993, p.53.
U.S. Embassy. “Investment Climate Statement for Ecuador," Washington, D.C.: 1982.

Paper Preparation
Special thanks for useful comments on form to: Dr. Mark V. White and Leslie S. Ritchie-Dunham.
 APPENDIX 1
IPREMARA - INTEGRATED MODEL

FINANCIAL ASPECTS
Equity
?
IRR_required Cost_of_Capital
Incr_Wealth Rate_Reinvest_Rqrd

Intrntl_Mana_Turnover
CULTURAL ASPECTS
Net_Income Budget
Revenues Reinvestment Expenses Intl_Stndrd_ofLiving
Max_Knwldg_Incr_Rate
EXPLORATION Incr_HostKnwldgof_Co
PRODUCTION Incr_Knwldg_of_Host HostKnwldg_of_Co
Avg_Percent_Explor
Co_Knowldg_of_Host
Host_WellBeing
Econ_Rsrvs Co_Mngmnt_Style Incr_Wellbeing
Organiz_Maturity
Rsrvs_Addition Production Explr_Well_Cost Percent_to_Explor Host_Attitude_to_Co MultiplFctr_Invstmnt
ProdPerWell Co_Invstmnt_LocalCulture_Infrastructure
Exploration Geology

Co_Attitude_to_Host Urgency_forChange
Rsrvs_Well
Num_Prod_Wells
Discovery_Econ_Rsrvs Incr_InvstmtLocal
New_Wells Area_Maturity
Co_Invstm_Devel_Rltn
Prod_Well_Cost Incr_Invstmnt_Rate
Chance_of_Finding_HC
SPE_Stability
Percent_CoInvst_to_Local
CoNeed_toImproveRltnshp
PricePerBBL
 APPENDIX 2
IPREMARA EXECUTIVE FLIGHT SIMULATOR

80

60
Net_Income Co_Invstm_Devel_Rltn
1 1
Revenues 40 MNOC Invests in Developing
2 2 Relationship
Reinvestment Host_WellBeing
3 20 3

0
0 50 100 150 200 0 50 100 150 200
Month Month

IRR,dsrd Area Geology Organiz_Maturity

0.1 0.2 0.3 0.4 0.5 0.0 0.2 0.4 0.6 0.8 1.0 0.0 0.2 0.4 0.6 0.8 1.0

Price/BOE Exploration Well Cost Urgency for Change

5 10 15 20 25 1,000,000 2,500,000 0 1 2 3 4 5

Cost of Capital Production Well Cost Other_SPE_Factors

0.05 0.15 0.25 200,000 800,000 0.00 0.50 1.00

Reinvestment Rate, dsrd Avg % to Exploration Intrntnl Mana Turnover

0.0 0.4 0.8 0.027 0.029 0.031 0.033 0.095 0.105