Petroleum Economic

Decision Tools

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Background

We must remember
 oil companies are BUSINESSES whose primary aim is to
generate cash for their investors
 investment decisions are therefore among the most
important decisions that a company can take

Everyone of us must at all times be aware of

 current trends in oil and gas prices,

 targets,

 financial returns,

 budgets for wells and fields……

Production Optimization????

• It is not to put holes in the ground

• It is not to move equipment and materials
underground
• It is not to complete wells as cheaply as possible
• It is not necessarily to produce fluids as fast as
possible

It is to maximize rate of return on the

investments
 What Does It Take?

Alignment of Goals and Strategies

 Economic drivers
 Productivity targets
 Geographic and Operational constraints

Reservoir Competency

Proper Well Design
 Take drilling, completion and production concerns into account
 Maintain philosophy that equipment is designed to meet
application, application is not adapted to fit equipment
 Life of reservoir productivity

Project Execution

Monitoring
Situations Requiring Economic Analysis
• Establishing economic feasibility of an investment or rate
acceleration opportunity (screening)
• Weighing the relative merits of several investment
prospects, when funds are not available for all (ranking)
• Evaluating purchase proposals from several suppliers
• Buy or Lease decisions
• Determining a value/price for buying/selling producing
properties
• Establishing the cost of borrowing funds from lending
institutions
• Replacement of existing equipment or service
• Choosing among mutually exclusive alternatives:
– Initial investments are substantially different
– Timing of cash flows is substantially different
Decisions Through The Life Cycle of Petroleum Project
Apply Bid •Drop

License
In All these
Accept Work •Drop Phases you
Program have to take
Decision
•Drop
3 D- Seismic

Drill a Wild •Drop

Cat

•Drop Investment Analysis

Appraisal is used as a
managerial tool to
•Drop take such Decision
Develop
Economic Yardsticks
• Measures that do not
Measures that do
consider the time value consider the time value
of money of money (Capital
– Profit Budgeting/Methods of
– Payout time Project Analysis)
– Cost to find & develop
 Net Present Value
reserves or unit
(NPV)
development cost  Rate of Return (IRR)
 Profitability Index (PI)
Profit

Money going out

Money taken in • initial investment
• capital expenses
• operating costs
• taxes
Payout Time

Time from investment

to positive net cash
flow
Usually easy to calculate
• Can be days to several years
• Time of payout may be criterion
for investment (in combination
with other decision methods)
 Cost of Finding Reserves

To find and
develop reserves

( $/bbl or $/Mscf )
General measure for comparing exploration
and development opportunities
Example
Restoring a Well to Production
• A well is shut in after it can no longer flow naturally
• After review a proposal is prepared for recompletion at a cost of
US$750,000.
• This recompletion includes a fracture stimulation job and installation
of gas lift. The team is very confident that well can be successfully
returned to production.
• Predicted production estimate is also provided.

What management would like to know here?

• the total profit,
• payout time, and
• cost to find and develop reserves
Example
Restoring a Well to Production

Revenue Net
Year Production Cash Flow Expenses Taxes Investment Cash Flow
STB/yr M$ M$ M$ M$ M$
0 750 -750
1 48,800 976 233 297 446
2 48,700 974 233 296 445
3 39,000 780 206 230 344
4 29,300 586 170 166 250
5 19,500 39 143 99 148
6 9,800 0
196 107 36 53
7 4,900 98 38 24 36
Example; Solution
Restoring a Well to Production

Revenue Net Cum. Net

Year Production Cash Flow Expenses Taxes Investment Cash Flow Cash Flow
STB/yr M$ M$ M$ M$ M$ M$
0 750 -750 -750
1 48,800 976 233 279 446 -304
2 48,700 974 233 296 445 141
3 39,000 780 206 230 344 485
4 29,300 586 170 166 250 735
5 19,500 390 143 99 148 883
6 9,800 196 107 36 53 936
7 4,900 98 38 24 36 972

TOTAL 200,000 4,000 1,130 1,148 750 972

Total Profit = US $ 972,000

Example; Solution
Restoring a Well to Production
Cumulative net cash flow
≅ initial investment
Revenue Net Cum. Net
Year Production Cash Flow Expenses Taxes Investment Cash Flow Cash Flow
STB/yr M$ M$ M$ M$ M$ M$
0 750 -750 -750
1 48,800 976 233 279 446 -304
2 48,700 974 233 296 445 141
3 39,000 780 206 230 344 485
4 29,300 586 170 166 250 735
5 19,500 390 143 99 148 883
6 9,800 196 107 36 53 936
7 4,900 98 38 24 36 972

TOTAL 200,000 4,000 1,130 1,148 750 972

Payout time is 1.7 years

Example; Solution
Restoring a Well to Production

Revenue Net Cum. Net

Year Production Cash Flow Expenses Taxes Investment Cash Flow Cash Flow
STB/yr M$ M$ M$ M$ M$ M$
0 750 -750 -750
1 48,800 976 233 279 446 -304
2 48,700 974 233 296 445 141
3 39,000 780 206 230 344 485
4 29,300 586 170 166 250 735
5 19,500 390 143 99 148 883
6 9,800 196 107 36 53 936
7 4,900 98 38 24 36 972

TOTAL 200,000 4,000 1,130 1,148 750 972

Cost to Develop Reserves = $750 M/200 MSTB

= $3.75/bbl
Time Value of Money
Time Value of Money
Time Value of Money
Time Value of Money
Time Value of Money
Time Value of Money
Future Value (FV)
• Future value measures the nominal future sum of money that a given
sum of money is "worth" at a specified time in the future assuming a
certain interest rate (or more generally, rate of return)
• It is the present multiplied by the accumulation function
n
FV = PV× (1 + i )
i = Interest Rate
n = Number of periods
PV = Present Value , FV = Future Value

What is $10,000 worth in 20 years at an interest rate of 15%/year?

20
FV = $10, 000 × (1 + 0.15 )
FV = $163, 665
Present Value (PV)

Present value is the value on a given date of a future
payment or series of future payments, discounted to
reflect the time value of money and other factors such
as investment risk
−n
PV = F V× (1 + i )
i = Interest Rate
n = Number of periods
PV = Present Value , FV = Future Value
I want $15,000 in the bank in 5 years. I feel, I can earn 15%/year, how much will I need to
invest today?
5
 1 
PV = $15000 ×  
 1 + 0.15 
PV = $7, 458
Capital Recovery Factor
• Provides the amount of a series of equal payments
when a principal amount, PV, is invested at a given
rate. Used to compare facilities with unequal lifes.
 i(1 + i)n  i = Interest Rate
CF=PV  n 
n = Number of periods
PV = Present Value ,
 (1 + i ) − 1  CF =Capital Recovery Factor

A lease needs compression. Two vendors respond to the bid request:
 Vendor A offers compression for $450M with a 6 year life
 Vendor B offers compression for $500M with an 8 year life.

Evaluate the bids.  0.15 (1 + 0.15 )6 
CFA = 450, 000  6
 = $118,912
 (1 + 0.15) − 1 
 0.15(1 + 0.15)8 
CFB = 500, 000  8  = $111, 426
 (1 + 0.15 ) − 1 
Present Worth Factor
• Often used in evaluating a lease vs. buy scenario. This equation
calculates Present Value of a lease payment plan, assuming equal
payments.
 (1 + i )n − 1 
PV = CF  n 
 i (1 + i ) 

You can lease compression equipment for $300M per year
for five years, or you can purchase the equipment for $800M
today. What is the best alternative.
 (1 + 0.15 )5 − 1 
PV = 300, 000  5
 0.15 (1 + 0.15 ) 
PV = $1.005Million
Therefore, best to purchase equipment.
Decision Method Number 1; NPV

• NPV puts all costs an revenues into equivalent basis (present value)
and sums them up
• Or simply

NPV = PV of Future Benefits - PV of the Cost

• Logically, if NPV > 0, benefits exceed costs, and the project should be
accepted. If NPV < 0, the project should be rejected
• If the Net Present Value is positive, the project will increase the
present wealth of the company by the NPV amount
• The general rule followed in comparing projects is to choose one
that results in highest NPV
Arithmetic of Determining NPV

A discount rate of 10% is assumed as the company’s marginal rate

Project cost $500 in year 0

Operating expense $200/year for 4 years

Cash flow is positive but declining over the years
Present Value of $1 @ 10%

Year Present Value (Today's Value)

0-1 0.9516
1-2 0.8611
2-3 0.7791
3-4 0.705
4-5 0.6379

Arithmatic of determining NPV

Year Benefit ($) Cost ($) Cash Flow ($)PV of $1 Discounted Cash Flow ($)
0-1 0 -500 -500 1 -500
1-2 425 -200 225 0.9516 214
2-3 425 -200 225 0.8611 194
3-4 350 -200 150 0.7791 117
4-5 250 -200 50 0.705 35
Total 1450 -1300 150 60
Arithmetic of Determining NPV

• Net positive cash flow over the life of the

project is $150, before discounting
• When the cash flow is adjusted for the present
value of the dollar, the NPV is found to be $60
• The proposed investment is better than doing
nothing because
– All the costs are covered
– 10% opportunity cost of the company’s funds is
realised
– In addition project yield an additional $60 return
Decision Method Number 2; IRR

• IRR = the rate of return earned on the project

• IRR is the rate that makes the Net Present Value of
a series of costs and revenues equal to zero
– The interest rate that equates the equivalent worth of
an alternative’s cash inflows to cash outflows
– PV (inflow) = PV (outflow)
• Logically, if IRR > the cost of capital to finance the
project, the project should be accepted
• If IRR < cost of capital, the project should be
rejected
• The IRR is a relative measure, and does not
measure an increase in the company’s wealth
 Decision Method Number 3; PI

• Profitability index identifies the relationship of investment to payoff of a

proposed project
PV of Future Benefits
PI=
PV of the Cost
• Profitability Index is also known as Profit Investment Ratio, abbreviated to P.I.
and Value Investment Ratio (V.I.R.)
• When various projects are converted into a profitability index, selection is
further facilitated
• Profitability index is a good tool for ranking projects because
– it allows you to clearly identify the amount of value created per unit of investment,
– thus if you are capital constrained you wish to invest in those projects which create
value most efficiently first
• Rules for selection or rejection of a project:
– If PI > 1 then accept the project
– If PI < 1 then reject the project
 Profitability Index Example
• Calculating PI for example
– Present Value of total benefits from the project = 272,600
– Present Value of total cost on the project = 250,000
– PI = 272,600/250,000= 1.09

• Since PI>1.00, the project may be accepted

 The payback period
Recap from previous discussion on payback:

Payback period = the number of years it will take to
return the original investment

Calculation of payback period ignores the time value of
money (This is a critical flaw!)

• Payback period is recognized today to be an

inappropriate way to make capital budgeting
decisions
• However, it is still a number that is useful to
some decision makers in combination with one
of the three other methods already explained
Flow of Funds

Loan capital
Shareholders’ funds Loan repayments
Shareholders’ profit

Re-
Re-investment

Shareholders’ dividend
 Calculating Project Cash Flow

• Gross revenues from sales • Capex

of hydrocarbons Capital expenditure on
• Payments for farming out assets (platforms, facilities,
project or part of project wells)
• Opex
Operating expenditure for
assets (maintenance,
insurance)
• Government take
(PSA’s, royalties, taxes)
Components of Cash Flow
Capex
600
Cash
500 Surplus

400 Royalty

300 Opex
Cash
flow, 200 Tax
$M 100
0
3 4 5 6 7 8 9
-100
Time, years
-200
Cumulative Cash Flow

Cumulative cash surplus Cumulative amount accruing to the

or field net cash flow company at the end of the project
2000
Capex
1500 Opex
Tax
1000

500 Royalty
Cash
0 Surplus
4 5 6 7 8 9
-500 Time (years)
Cash surplus Gross revenue – capex - opex - tax -royalty
Net Cash Flow Indicators

30
Maximum
20
losses?
10

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
-10

-20

-30
Time (years)
Cumulative Cash Flow

100
80
60
Cash accrues to investor
40 at end of economic
Surplu lifetime of project
s ($M) 20
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
-20
Time (years)
-40
-60
Summary
• Time value of money is important in estimating profitability
• Profit, payout, and cost to find and develop reserves are not affected by
the time value of money
• NPV, IRR and PI are dependent on the time value of money
• Either the NPV, IRR, or PI methods can be used to make good decisions
about capital budgeting investments
• Uncertainty about the future cash flow estimates is problematic
• Payback period is often calculated for investment projects, but it should
not be used by itself to make accept/reject decisions
• Also we need to remember:
– invest in projects where the value of future return is greater than the cost
– larger monetary benefits, (i.e. Profits) over the smaller ones
– earlier benfits (quick return) over the later ones
Need more….
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Optimization, reach us:

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