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A discrete adjoint method for generating sensitivity coefficients related to two-phase flow production data is derived. The procedure is applied to calculate the sensitivity of wellbore pressure and water-oil ratio to reservoir simulator gridblock permeabilities and porosities. Using these sensitivity coefficients, an efficient form of the Gauss-Newton algorithm is applied to generate maximum a posteriori estimates and realizations of the rock property fields conditioned to a prior geostatistical model and pressure and/or water-oil ratio data obtained under two-phase (oil and water) flow conditions.