1994 INTERNATIONAL SYSTEM DYNAMICS CONFERENCE
System Dynamics of Petroleum Development Training for Long-Term
Cooperation Across Cultural Divides
James L Ritchie-Dunham
Instituto Tecnolégico Auténomo de México
Rfo Hondo No. 1, (Col. Tizapan San Angel)
01000 México, D.F., Mexico
Tel: 5 25 628 40 00 ext 3430
Fax: 5 25 55077 84
E-mail: jrdunham @taylor.rhon.itam.mx
Abstract
This paper add the ics of energy 1 projects. Nationali: has repeatedly
squandered the economic, physical and mental of large joint-ventu between
Itinational oil panies and developing i A iorati lationship between
1 oil 1 (MNOC) 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 petrol through ffect analysis, that
while cultural itivity to the d ping country's needs increases marginal costs, it lowers the
probability of nationalization, generating positive project economicsand raising expected payouts
from extended project life.
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1994 INTERNATIONAL SYSTEM DYNAMICS CONFERENCE
System Dynamics of Petroleum Development
Training for Long-Term Cooperation Across Cultural Divides
INTRODUCTION:
Failing multi 1 projects provoked by poor relati ips between the MNOC and the
developing country have squandered great economic, mental and physical resources. IPREMARA, an
P REservoir MA Risk Analysis system dynamics model, illustrates the
cultural d ics of projects to petrol and host region leaders. IPREMARA
integrates the primary factors driving the ii
what interrelations exist.
to
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 p ility of yt ic reserve recovery, offsets the
higher initial investment and costs required to promote cultural stability.
3) IPREMARA, by stabilizing the i i hnology mod:
making Latin American energy exploitation projects more efficient.
4) IPREMARA, by improving caiitrol over cultural stability and | the investment environment,
ip access to i ly ible and th ingly valuable natural
resources.
HISTORICAL BASIS
In developing countries, the firm typically impl its dardized 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.
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1994 INTERNATIONAL SYSTEM DYNAMICS CONFERENCE
INITIAL MODEL CONCEPT
IPREMARA integrates four interdependent fields usually considered independent: financial asset
management, development engineering, investment portfolio analysis and socio-political-economic (SPE)
risk analysis. The following brief defi the interdepend among these fields.
Traditionally the separate disciplines indicated below took | ponsibility 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 petrol and
Investment Portfolio Management:
Maximize firm's Return on Equity (ROE) by selecting 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,
parating the responsible discipli filters relevant relationships from the global analysis. Losing
relevant relationship information before the i decision the wealth
maximization goal. The IPREMARA model (Graph 1) integrates all four areas concurrently, ensuring
that all relevant relationships enter the investment decision.
_— Equity 7
ee Sy Financial Asset Management
Revenues Investment
4 ~ \ 4
\ 5 + ; } Development Engineering
Production Exploration
_ Poitfalis Evanianon | Investment Portfolio Analysis
/
| ia i \
< NY? spe Stability Socio-Political-Economic
Relationship with Regional Host A Risk Analysis
X L =
v
Graph 1: Integrated Reservoir Me Risk Analysis Model
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1994 INTERNATIONAL SYSTEM DYNAMICS CONFERENCE
Story Line: In the petrol business, producti ly 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 engineering (includi:
technology), investment portfolio analysis and political risk analysis, allows MNOCs to better manage
As each opp ty becomes more valuable, the relationship with the opp ity's host
becomes more valuable. [Historical evidence shows, though, that MNOCs lose opportunities by
Gadervaluing the J and cultural lationships with the host, and underinvesting in relationship
ing the ship raises SPE stability and project strength in the portfolio
evaluation. - 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 i income, equity increases at the portfolio required rate of return.
Pi ion thus requires rei 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 De Engineering)
Exploration Budget Technology and
| Area Discovery Risk Factor
Price per BOE——— Discovery of Economic Reserves
Graph 3: Exploration Submodel
Story Line: Increased investment in exploration imp! i oration 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 i meets ROE i reserves are
economically recoverable.
Situation: Typically, a team of logi geophysicists, petrol i and
financial analysts use industrial statistical information and intuitive ge to determine
project risk.
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1994 INTERNATIONAL SYSTEM DYNAMICS CONFERENCE
Investment Portfolio Analysis
‘Company Attitude to Host
Discovery of Economic Reserves ——D> Feasibility Study <— Bonnie uaity
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 ibility. As project bili 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 Engineeri:
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. Reservoir
characteristics and price per BOE directly determine production rates and pondii zg
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,
ly Pp rate deter
Microworlds, page 97
1994 INTERNATIONAL SYSTEM DYNAMICS CONFERENCE
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 J \
Company Investment in Relationship—B> 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
energy hnology 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-investment
petroleum projects. Production lags behind i in exploration and exploitation (drilling and
duction system installation). The following graphs di this ic behavior.
OBSERVED BEHAVIOR oon OBSERVED BEHAVIOR
Units:
10
Time (Years)
i
| Gum Investment - - - - Gum Prod
i Income
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.
Microworlds, page 98
1994 INTERNATIONAL SYSTEM DYNAMICS CONFERENCE
NPV of VARYING LIFE IRR of VARYING LIFE
TIMES TIMES
40.
‘Si
© Bis 20 30
€ *s0
-80.
TIME (Years) TIME (Years)
The project's NPV becomes positive after the 13th year!. 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 nationali or terminate
many long-term projects after 10-15 years, corrective system behavior generation is crucial.
PROPOSED INTEGRATED MODEL
Appendix 1 shows the complete PREMARA 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 System d i deling provides an i d view
of the complex, i i 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 ard after
simulation training, with petroleum uti and di ping country p agency and
officials to d ine insights gained through this ive flight i h to
project stability maximization.
1 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.
Microworlds, page 99
1994 INTERNATIONAL SYSTEM DYNAMICS CONFERENCE
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Decker, David R.. Ignacio Duran. The Political, Economic, and Labor Climate i in Colombia. University
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Muller, Kristen. "Ecuador." Oil & Gas Investor, Sept. 1988, p. 50.
World Bank. Ecuador: An Agenda for Recovery and Sustained Growth, Washington, D.C.: 1984.
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U.S. Embassy.
Paper Preparation
Special thanks for useful comments on form to: Dr. Mark V. White and Leslie S. Ritchie-Dunham.
Microworlds, page 100
