Palisade @RISK Conference 2007

Significance of Risk Quantification

The Smart Decision-making Process John G. Zhao

Abstract The significance of risk quantification in decision-making process reflects the emergence of modern risk management within project management discipline. Using commercial @RISK suite, the integrated process forces decision makers to quantify risk impacts rather than, as current practice, to qualify risk effects on their decisions. The author has integrated Risk Register, Monte Carlo Simulation, Decision Trees and Force Field Analysis to facilitate a decision-making process. This system has been used and applied to Suncor Bitumen Selection Strategy and other applications, the case study proved to be successful. In addition, the result of this case study, along with further research work, may have potential commercial values if the processes are properly generalized, theorized and formalized; it will be valuable to Suncor or any other energy company who desires a proven methodology for their future major capital project selection decisions, because many organizations continue using decision practices that are decades out of date (Schuyler, 2001, p.29). Why Risk Quantification ? Many papers and books have narrated in length on the topic of project risk management in recent years, thanks to the PMIs promotion on risk management. However, most of the topics have focuses on the risk management process, paying more attention to qualitative risk assessment and leaving quantitative risk analysis an area of vacuum. The importance of quantifying identified risks can not be emphasized more as it is the foundation of a meaningful decision making process. Many researchers and scholars have written extensively on decision theories, few however have attempted to answer the questions of what the risk quantification is, how risks are quantified and why they are necessary in decision-making process. Decision theories, and empirical studies under risk and uncertainty have produced a

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rich collection of findings (Simon1, 2006), their practicality in directing real-life project decision-makings has yet to stand the industrys tests. The significance of risk quantification, its correlation to other decision variables, and importance of risk categorization, and the use of integrated risk management techniques are paramount in deriving future project option selection decisions during an organizations business case study phase. Unfortunately, many organizations, including some predominant large firms, still lack scientific approaches in their decision strategy. Static or deterministic numerical calculations still prevail large portion of decision-makings which may not truly reflect the complexity of the scenarios that are often than not risky, uncertain and probabilistic. Precision in calculating these uncertainties is nearly impossible simply because risks are hard to quantify, needless to mention computation of risks. The author proposed the following hypothesis, which is being both theoretically and practically proved, through an integrated risk modelling technique using @RISK suite, including Monte Carlo simulation and PrecisionTree: If risks are only identified but not quantified, decisions under uncertainty become intuitive and a gut feel; if identified risks are better quantified, the credibility and the quality of decisions made are significantly enhanced. When talking about risk quantification, Bernstein (1998, xxiii) unambiguously stated that without numbers, risk is wholly a matter of gut. To avoid arbitrary decisions with absolute subjectivity or pure instinct, the succinct risks which are associated with business decision objectives must be identified and quantified for its probabilistic value, that often reflect on the business case NPV (net present value) or IRR (internal rate of return). To achieve this objective, a stipulated process, or procedural step to derive the conclusion, has to be detailed and communicated clearly to the business stakeholders. Background of the Case Study The author has developed the project risk management processes and successfully implemented across Suncor Major Projects, a business division of Suncor Energy Inc., the 2nd largest integrated oil and gas company in Canada. At the request of a business development group, an option selection decision process aided by @RISK software was designed and proposed to Growth and Planning group. Upon their acceptance, I enthusiastically facilitated the 3-day business case workshop which
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Dr. Herbert Simon received his Nobel Memorial Prize in 1978 and national Medal of Science in 1986.

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formulated the specific but strategic decisions on bitumen supply to Suncors future refining business. As the result of this decision, a multi-million dollar new project was initiated and being developed. This process required interpreting the implied and veiled descriptive risks and translating the qualitative consequences to quantitative numerical figures for calculation or simulation. Fortunately as the workshop facilitator, I have accumulated rich experiences in collecting raw data using personal interview techniques, and thorough understanding of theories behind translating qualitative text to quantitative numerical data for the purpose of risk analysis (Taylor, 1990, p.211), therefore the above process was a scientific approach backed up by academic theory in terms of epistemology, and a practical one easily understood and accepted by 20 some workshop attendees. Suncor has produced raw bitumen from varied oilsands mining sources since 1967 as feedstock to its refineries, and an environmental friendly SAGD2 operation was added to its bitumen production capacity in 2003. To reach the goal of 500,000 barrels per day (bpd) production by 2012 from the current 260,000 bpd, it was very critical to properly and wisely decide what bitumen sources, mining or SAGD, should be invested on as capital growth project (Suncor, 2005). Increasing business complexity, speed, and competition pressure us to improve decision making (Schuyler, 2001, p.4). In-depth understanding of risks and their quantified impacts or opportunities is the prerequisite for making intelligent decisions. It is the authors hope that this paper will contribute to the existing knowledge base of decision theory from the narrowest perspective of project management, and the most practical aspect of methodology. Current Gaps in Decision Science Many literatures have been produced and researches conducted about decision analyses. CCPS (1995, p. 43) categorized all recognized risk decision aids into five branches which have totalled to 17 techniques, and most of which are based on fuzzy set theory. The essential ingredients of modern techniques for quantifying risk had been developed in 1730, all the tools we use today in the risk management and in the analysis of decisions and choices, stem from the development that took place between 1654 and 1760 (Bernstein, 1998, p.5). Early development of Game Theory, Utility Theory, Payoff Matrix and Bayes Theorem, and so on built solid foundation for decision science; modern decision theories of Fuzzy Decision Analysis (Zadeth,1965 cited by French 1986, p.361), Subjective Expected Utility (Simon,
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Steam Assisted Gravity Drain (SAGD): Inject high temperature and pressure steam into about 400m deep bitumen reservoir (wells) to produce raw bitumen.

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2006), Decision Support System (DSS) (Bodily, 1985) and etc. have been developed mostly in academia without much practical meanings. About 60 years ago, von Neumanns Monte Carlo simulation which was applied in Atomic Design during WWII was a big practical leap in modern decision analysis. Morris (1994, p. 217) even concluded that only risk management has received new development since 1960s in the discipline of project management, however, the advancement was made mostly in general terms, lacking specifics of risk quantification to aid decision-making process. Bernstein (1998,p.73) affirmed that we all have to make decisions on the basis of limited data, and most critical decisions would be impossible without sampling. He credited statistics for its crucial role in decision making. Statistics exists because we live in an uncertain world, and decisions are made in the face of probabilities. Business decisions, either using Value at Risk theory or the theory of Real Options, seek to promote various business objectives (Mclaney, 2006, p.19), however, often risks are not sufficiently taken into consideration or inadequately quantified. New computer-based decision tools, such as Palisade PrecisionTree3 for example, addressed subjective probability distribution quite well, but neglected to mention how risk values can be objectively quantified (Palisade, 2000, p.53). Prichard (2001, p.39) twice theorized in his writing that risk quantification is to produce project contingency reserve, but failed to mention anywhere its function in decision-making process. French (1986, p.324) impatiently stated that we have developed enough theory. The time has come to call a halt and interpret that theory. A practical decision-making framework is what the industry needed to guide decision makers in their day-to-day job. Contrary to meeting the practical demands, academia continued to battle each other on theories, such as Shackles strongest objection to probability-based decision making (Dembo and Freeman, 1998, p.58). The lack of recognized theoretical basis on practical decision-making process still haunts lots of corporations, and in spite of the emergence of decision analysis during 1960s from modern management science, evaluation practices and decision policy remain a weak link in many organizations (Schuyler, 2001, p.4), needless to mention risk quantification technique. Decisions are made at every step in the analysis of a business and of its economic dimensions (Drucker, 1964, p.195). Due to project risk managements novelty and infancy, a mature and systematic process to identify, quantify and apply risks to the science of decision-making has yet to be generalized and theorized in academic
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Developed and commercialized by Palisade Corporation, New York, USA

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world, practical process implemented as a decision policy within organizations, however it proves not only to be exigent but very challenging as well. Isolated Single Decision Method In todays computer technology advancing era, one needs to remember that only combination of scientific methods and experienced heuristics can provide better end results. No evidence exists that complex models do better than heuristics (Mowen, 1993, p.132). Having stated that, the computer aided methods do offer tremendous advantages in the face of decision science, because uncertainty analysis using traditional deterministic calculus and algorithm proves to be not only labour-intensive and time consuming, but also impractical and unachievable. With the helps of @RISK Monte Carlo simulation and PrecisionTree package, an integrated process is proposed hereof to support business decisions embracing the concepts of risk management. Hammond et al (1999, p. 2) stated that the ability to make smart decisions is a fundamental life skill for both professionals and personnel. Decisions can be fairly obvious and intuitive requiring non-brain work; however life is far more complex than simple instinct therefore we always face touch decisions. Businesses are even more so when they come to encounter decisions which may seem unilateral ones but can impact many facets across the organization. Worse yet when decisions involving uncertainties and risks, since decisions are normally made for future events and decision-makers expect favourite future outcomes, that decision-makers may loose their sensible intuition and logics. The future is inherent with risks and unnecessarily coherent, wise decision-makers supplement intuition with logical and rational decision (analysis) methods (Schuyler, 2001, p.140). One of methods proposed and used by many scholars and practitioners is Decision Tree approach. Decision Tree is very popular among decision makers and business consultants. Palisade PrecisionTree is a book by itself and Palisade (2000, p.15) says it brings advanced modelling and decision analysis to Excel worksheets to set up systematic process for decision-making. Interestingly some world scale large business mergers, acquisitions and new mega project decisions are made solely dependent upon decision tree conclusions, plus decision-makers smart and wise intuitive judgement. Probabilistic decision trees are constructed based upon an expert opinion at his discretion at any give chance node for the probability of event occurrence, and the subjectively estimated single deterministic consequences should the risky event occur. Qualitative risk identification, itemization, categorization, severity ranking and

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evaluation are not taken into consideration in decision derivation, neither are built into decision tree formulae for quantification. Another well-liked stochastic method for decision-making is Monte Carlo simulation for which Palisade is famed for its @RISK suite. In many cases risks are random and conjecture but often continuous and correlated instead of discrete and distinct, therefore this type of risks are better suited for simulation. For some applications in Oil and Gas industry, random simulations have far more advantages over decision tree method, such as cost estimate contingency simulation based on certain risk tolerability, but the reverse proves to be true as well, for instance the chances of dry reservoir well in exploration project. In recent years, however, advanced computer technology and developed software allow the combination of Monte Carlo simulation with decision Tree method. Palisade (2000, p.188) and Murtha (2000, p.17) both talked about possibilities of integrating the two, however, their practical application in the industry has not yet been common and visible. Can an integrated and risk-based decision-making process be made practical and workable in the industry? The author, through a live case study4 in Suncor Energy Inc, the 2nd largest integrated energy firm in Canada, demonstrates in the proceeding sections procedural steps to integrate qualitative risk assessment and quantitatively risk-adjusted NPV, feeding the both into PrecisionTree for smart option decisions. An Integrated Approach Most firms operate a hierarchical decision making process. Each level of the firm has a range of actions and is accountable to higher levels. (Unpublished Thesis, Year U/A, p. 7). Conventionally the highest levels in an organizational hierarchy make final decisions and middle / lower levels participate in decision-making process, often lacking scientific and thorough decision back-ups. Although the force-field analysis is probably adopted at managerial level for option selection decisions, relative subjectivity in the static process heavily affects proportional scores assigned against or for each option. The option with the highest positive scores usually wins, but risks associated with each option are not necessarily or adequately addressed, needless to mention quantified. Real Option Theory blossomed in recent years following Back-Scholes invention in early 1970s. There is an options way of thinking in the financial decision-making process through the use of an options framework (ed. Fusaro, 1998, Miller, p. 134).
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The true numbers in the case study have been replaced with fake figures for confidentiality reasons.

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Within business decision realm, decision-makes are often challenged with various options, and the decisions on different options could steer the organization in a totally opposite direction, deviating from companies vision, mission and business objectives. A proven probabilistic model and business process for option selections at the business case study or project feasibility study phase is essential, paramount and of necessity. The model is built to follow business process. In the pyramid diagram (Figure 1-1), the Force Field Analysis becomes a depository and a useful apparatus for the purposes of options comparison and analysis, when hard decisions must be made in selecting one of many optional choices. Contradictory to the static force-field analysis method, the risk-based force-field is used to solicit collective opinions of decision workshop attendees who are not necessarily in decision-making levels but subject matter of experts. These opinions are interpreted into quantifiable numerical figures as inputs to feed the PrecisionTree and risk-adjusted NPV Monte Carlo simulation model, whose results are correlated and linked to the PrecisionTree. Qualified risks for each option are further quantified for their expected monetary values (EMV), and WTI-driven5 NPVs for each choice are further simulated based on defined risk ranges. Both results are tabulated in the Force Field Analysis Table and will be analyzed and presented to the higher levels in an organization as decision recommendations. Figure 1-1

Suncor major projects group has devised and labelled their risk management process RISCOR which has three distinct functions. RISCOR Decision has integrated risk register (RISCOR PM), PrecisionTree and risk-adjusted NPV economic Monte Carlo simulation (@RISK) model, and this integrated decision analysis model
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In any economic model, WTI pricing is the most sensitive variable and has bigger vulnerability.

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is Excel spreadsheet based, and operated on Palisade @RISK platform. The business process mapping is designed as illustrated in the following flow diagram to direct decision stakeholders to avoid making obvious mistakes, because people make a variety of systematic and predictable mistakes by following their heuristics (Bazerman, 2002, p.11). The process flow map, supported by computer-aided stochastic decision model, takes stakeholders through each procedural steps to identify key risks in the category of P (political), E (economical), S (social), and T (technological) during various business case studies for each case option. Figure 1-2
Clearly lay out Each Options Assumptions Options Criteria: PEST RAM NPV/IRR Other Risk (Negative) Opportunity (Positive)

Decision Objective Options

Options Description: Feasibility Study

Risk-adjusted NPV @RISK Monte Carlo Simulation Model

Force Field Analysis: # R = (- EV$) # O = (+EV$)

Qualitative R & O Assessment: Risk Matrix (Prob x Conq + R + P)

PRECISIONTREE The Best EMV of Risked NPV

Decision Recommendation TABLE

These key risks are assessed based on the pre-established Risk Matrix, and quantified for its Expected Value (Probability x Consequence $) and total risk severity scores. These scores of qualitative risk / opportunity assessment for each option are entered into the Force Field Analysis table to derive qualitative conclusions / decisions on the optimal option solution. An algorithm is built in the Force Field table using raw data from the scores to calculate the objective probabilities of occurrence of each risk category at the Chance Node of the PrecisionTree for each option. The quantitative economic analysis model based NPV values simulated from Monte Carlo @RISK for each option are also entered as end results into the PrecisionTree. This simulation model, which is used to simulate an options net present value, contains the variables of WTI oil pricing, production volume, Capex and Opex, Tax and Royalties, etc. whose risk ranges and their correlations have been addressed in @RISK simulation formulae. After all, the business objective is the maximization of

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the market value of owners wealth (Baker, 1981, p.21). The best EV of risk adjusted NPV associated with a particular option after running Tree Analysis shall yield the final conclusion. Figure 1-3
Opportunities - For Force Field Scores Against - Risks
Natural Gas Intensity Political pressure to reduce NG, GNG Emissions/Carbon Tax, Commodity Decoupling/NEPII (National Energy Program) Supply Costs ($/bbl), Natural Gas Price/Oil Price, CAPEX, Labour Productivity, SOR/Reservoir performance. Remote location - Ability to attract/retain skilled workforce. Community reaction to mitigations. Infrastructure. SAGD/Reservoir Reservoir performance and understanding of the geotechnical issues.

1PO

Tax Policy (Royalties) - More favorable treatment due to provinces desire to preferentially develop large insitu resource base.

15

-24

1PR

1EO

Share Value/Credit, Increased value in product due to flexibility in marketing (reduced upgrading costs)

30

-29

1ER

1SO

Reduced Footprint / Ecological Impact = Better company image

23

-28

1SR

1TO

Young Technology Opportunities Upside realized as knowledge of process/reservoir increases.

24

-22

1TR

Benefit SUM (1)

92

-103

Impact SUM (1)

NET FORCE

-11

Legend: 1PO = Option one Political Opportunities; 1ER = Option One Economic Risk; (P.E.S.T.)

Summary and Conclusion Fishhoff et al. (1981, by Bazerman, 2002, p.43) pointed out that perceptions of risk are often faulty, resulting in misdirected risk reduction efforts by decision makers. This further stressed the importance of risk quantification in the context of risk management, which is often referred to as descriptive and qualitative process. Risk management process can also be quantitative based, and risk severity levels and risk tolerance levels are virtually measurable and quantifiable, though subjectivity may skew the results. Risk quantification plays a significant role in business decision making process in the circumstance of risk and uncertainty, more over, Baker (1981, p.48) distinguished risk from uncertainty, and the latter was used to describe situations in which probabilities could not be assigned against outcomes. While decisions under uncertainty are subject to other theories such pay-off matrix, game
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theory and MinMax regret theory, to quantify the degree of uncertainty is as important as to measure risk. The decision complexity often surpasses human ability, both psychologically and physiologically, in many aspects. Calculation or simulation of considerable amount of quantitative data in various forms and graphs can cause enormous stress in humans, and in many cases wise decisions are only feasible with the help of computer-aided decision supporting system or models, after all, all we need is the information-based knowledge to make right business decisions, most of which are optimization problems where there is a range of choices for several decision variables (Schuyler, 2001, p.199). Quantitative decision analysis using appropriate stochastic tools, such as @RISK, provides a more realistic and more accurate depiction of business option values for making smart decisions. And the integrated process, as illustrated in the case study, makes smart decisions possible.

END ( 3,188 words)

REFERENCES
Baker, A. (1981) Business Decision Making. Published by Croom Helm Ltd., London, UK Bazerman, M. (2002) Judgment in Managerial Decision Making. 5th Ed. Published by John Wiley & Sons, Inc. New York, USA Bernstein, P. (1998) Against The Gods The Remarkable Storey of Risk. Published by John Wiley & Sons, Inc. New York, USA Bodily, A. (1985) Modern Decision Making A Guide to Modelling with Decision Support System. Published by McGraw-Hill, Inc., USA CCPS (1995) Tools for Making Acute Risk Decisions with Chemical Process Safety Applications. Published by Centre for Chemical Process Safety (CCPS) / AIChE

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Dembo, R. and Freeman, A. (1998) The Rules of Risk A Guide for Investors. Published by John Wiley & Sons, Inc., New York, USA Drucker, P. (1964) Managing for Results Economic Tasks and Risk-taking Decisions. Published by Harper & Row, Publishers, New York, USA French, S. (1986) Decision Theory An Introduction to the Mathematics of rationality. Published by Ellis Horwood Ltd., West Sussex, England Hammond, J., Keeney, R. and Raiffa, H. (1999) Smart Choices A Practical Guide to Making Better Decisions. Published by Harvard Business School Press, Boston, Massachusetts McLaney, E. (2006) Business Finance Theory and Practice. Publications, Inc. Published by Sage

Morris, P (1994) The Management of Projects. Published by Thomas Telford Services Ltd., Heron Quay, London, UK Mowen, J. (1993) Judgement Calls High stake Decisions in a Risky World. Published by Simon & Schuster, New York, USA Murtha, J. (2000) Decisions Involving Uncertainties An @RISK Tutorial for Petroleum Industry. Published by Palisade Corporation, New York, USA Pritchard, C. (2001) Risk Management Concepts and Guidance. 2nd Edition, Published by ESI International, Virginia, USA Palisade (2000) PrecisionTree Powerful Decision Analysis for Spreadsheets. Published by Palisade Corporation, New York, USA Schuyler, J. (2001) Risk and Decision Analysis in Projects. 2nd Edition, Published by Project Management Institute, Pennsylvania, USA Simon, H. (2006) Empirical Studies of Choice Under Uncertainty. Available at: http://dieoff.org/page163.htm Accessed on April 16, 2007. Suncor (2005) Strategic Risk Management Process - Proposal for Bitumen Supply Strategy. Unpublished document, Suncor Energy Inc., Canada

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