Petroleum Economics

Student Notes
Chapter 1 - Introduction - Royal Dutch Shell (IPC)
- KPC (NOC Kuwait)
1. Summary - Petrochina (NOC)
- Chevron Texaco (IPC)
Concerns the economic evaluation of petroleum projects. Petroleum - BP (IPC)
investment is subject to considerable risk and attacks much attention from
Government. 4. BP

 Upstream – relates to the discovery and the production of oil BP is one of the former seven sisters and one of the three International
and gas Petroleum Companies, with more than one century of history and
 Downstream – relates to refining and manufacture of chemical successful investment in upstream and downstream
products
 Midstream – The transportation phase between upstream and 5. Investment In Petroleum
downstream
The business layers of the petroleum industry are:

2. History: The Oil Century 1. Exploration and Appraisal, which is the first stage in the process of
producing oil, standard practice is to consider the expenditure in
Most of the significant events in the history of Petroleum industry belong seismic and drilling of successful exploratory wells as Capex and
to the 20th Century: the costs of unsuccessful wells as Opex.
2. Field Development, Investment in wells, structures, production
a. Oil Demand, petroleum market share increase from 5% in 1900 to facilities and export
60% in 2000, associated factors: 3. Transportation, transfer from oilfield to refinery by pipeline or
stages including storage and tankers
- Petroleum industry is a successful business 4. Refining, designed to produce a range of refined products
- Fluids are easy to handle 5. Distribution and Marketing, the output of refinery for feedstock for
- Transportation technology is increasingly based in oil other downstream processes, or transferred directly into a
products (significant grow in use of motor vehicles 650 distribution system for sale customers.
millions today)
- Economies of scale applies Upstream Investment
- Dependency of Economic and military systems
1. Expensive (exploratory well costs from US$ 1 m to $ 100
Gas production increase factor from 1970 to 2000 is 220%, oil mm, 75% chance of failure, a field development can cost a
increase factor idem period 158%. few thousand of millions of dollars)
2. Long Term (up to half a century of revenue)
b. Oil Supply, the progressive grow in production and geographical 3. Risk (uncertainty environment)
diversity, shows the following numbers: 4. Highly Profitable

- In 1900 the production was 0.5 million barrels per day Chapter 2 – Evaluation Methods
(mbpd), 95% produced in USA
- In 1945, 7 mbpd, USA maintained the 65% of global 1. Define Asset
production, 35% produced by Russia, Venezuela,
Mexico, Iran, Rumania and Persia. Items or entities, which brings benefits or positive value to an
- In 2000, 65 mbpd, +40 producer countries, the Top 40 is owner, and, therefore require careful and appropriate measurement.
lead by USA, Russia, Saudi Arabia, Canada and Iran

c. Oil Price, has shown dramatic fluctuations during time. Supply 2. Different types of Assets
disruption, shortage causes prices to increase (WW1, WW2, ect).
Exploration success causes prices to fall (East Texas 1930, North a. Land, mineral rights relating to a land probably constitute the
Sea and Mexico 1980). most important source of value, to a petroleum company.
d. Controls, various attempts have been made over years to control b. Equipment, man made facilities range from individual items
elements of the market, in order to reduce costs, competition and to complete manufacturing systems
investment risks: c. Project, a project is an identifiable activity or enterprise, with
specific objectives and associated costs and benefits.
- Standard Oil was the biggest oil company in the world d. Company, is a legal entity, which may be independent or
during 1870 till 1911, after split into more than 30 subsidiary to another.
separates companies. e. Financial Investment, they form an important group of assets
- Red Line Agreement, established in 1914 as the for most organizations
Ottoman Empire, between large companies to avoid f. Intangible
competency within the region of Saudi Arabia (UK, g. Human resources
France and USA)
- Achnacarry Agreement, established in 1928 between
producers companies in Europe and parts of Asia 3. Identify and explain the three important valuation concepts
- OPEC was created in 1960 by Saudi Arabia, Iran, Iraq,
Kuwait and Venezuela to restore prices, production a. Book Value Method, current value relate to the financial
regulation, solidarity against sanctions and consultation history of the asset
in pricing issues. b. Market Value, in the concept of transactions, the asset is
converted to currency
3. Companies c. Cash Flow, asset in terms of revenue and cost, the asset
is used to generate currency
The major classification is between National Oil Companies (NOC) and
International Oil Companies (IOC), the world oil production is the
following (Top 10): 4. Business situations where asset evaluation is required

- Saudi Aramco (NOC) In order to make an accurate assessment or to make an appropriate

- NIOC (NOC Iran) decision:
- Pemex (NOC)
- PDVSA (NOC)  Purchase or hire of equipment
- ExxonMobil (IPC)  Oilfield Development Plan

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Petroleum Economics
Student Notes
 Purchase or disposal of a production facility value. The Book Value of an oil-field is the cost of its
 Takeover of another company development.
 Reporting to shareholders
 Tax assessment 7. Market Value

5. Define the concept of book value and depreciation Is derived from consideration of comparable asset transactions, is
dependent on: Asset Definition, Transaction statistics and Market
Book Value is a method based in the premise that the value of a knowledge. Price is a function of market conditions represented by
single asset, after “n” time periods, equals the original cost (Ao) Supply, Demand and Market structure and competition.
minus depreciation (d).
8. Cash Flow Concept

The cash flow method concerns the future; this is normally in the
form of a series of revenues and expenditures, which we call cash
Depreciation is the accountant’s method to write down the value of flow. Cash Flow has important characteristics:
an asset over time. There are commonly used three schemes:
 Currency Units, Oil is normally priced in dollars
 Straight Line Depreciation, is the simples form of  Sign associated with cash flow indicates: revenue when
depreciation, values diminishes linearly over the planned it is positive and Capital Expenditure, Operating
life of the asset, to a residual value of zero: Expenditure and Taxation when it is negative
 Timing which is a important feature because each cash
flow must have a subdivision of time (usually calendar
years), a net cash flow over time or aggregation of cash
flow and a time origin or the point in time where the
cash flow is considered.
Where
9. Cash Flow Models
Ao Original Value
An Written-Down Value Models represent the cash flows associated with a project; models
N Defined Life of the Asset may be applied to tracking cash flow for budgetary purposes, to
n Number of years lapsed compute relevant data or derive project parameters for decision-
making. Some cash flow categories are:
 Declining Balance, the written-down value of the asset
declines at a rate, which is a constant proportion of that  Capex, which is associated to early stages of the project
written-down value  Opex, is assumed to coincide with production
 Sales Revenue coincides with production
 Taxation start with production
 Net Cash Flow is the aggregate cash flow for each
specific time period.

Common variations: Chapter 3 – Time Value of Money

P=1 single declining balance
P=2 double declining balance 1. Time Value
P/N = 0.25 25% Declining Balance
Time value of money varies according to the timing of its receipt or
 Unit of Production, the written-down value of the asset expenditure. It is generally accepted that money received today is
declines in proportion to the depletion of reserves of a preferable to money received tomorrow or at some time in the
finite resource future; early receipt carries logical benefits:

 Investment opportunity, the sooner one receives

the money, the sooner it may start to grow
 Purchasing Power, money spent sooner can buy
more goods and services
Where:  Risks, markets may change and commitments may
be broken or forgotten
P is cumulative production  Security, flexibility, opportunity
R is recoverable reserves
Investment opportunity is usually considered to be most important
6. Applications of Book Value Method component and is modeled mathematically through variants of the
compound interest equation.
Is used extensively in the preparation of company accounts and
annual reports, Book value is subject to severe limitations and
practical problems: 2. Compound Interest

a. Inappropriate depreciation Interest

b. Price Inflation, standard depreciation schemes do not
recognize price inflation, therefore written-down value will Economic activity is based on three fundamental resources: land
tend to underestimate true value (the owner of the land receives income in the form of Royalties or
c. Worthless Assets, asset value is based on cost, when a rent), labour (receives a wage or salary) and the owner of capital
company spends money, it has a choice between writing it off, (receives rent or interest). All of which are entitled to a return or
as an expense, or capitalizing it as an asset. In Oil Company profit.
accounts, the classic worthless asset is the “dry hole”.
d. Value without cost, where something has value beyond its Interest is the basis of investment analysis; it is the income either as
cost of acquisition. For the petroleum industry, is likely to be a lump sum or as a periodic payment.
a reserve of oil and gas in the ground, such reserves are not
created by the company and consequently have no direct book Types of Interest

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Petroleum Economics
Student Notes
 Effective Annual Interest for an investment is the rate of
 Fixed Interest, the most basic form of interest is defined interest, which, if applied once per year, would generate
as a lump sum, or as a proportion of the amount the same growth as that investment.
invested. Note that there isn’t an explicit period of time
attached.

Where Where
Future Amount Nominal Interest
Compounding Periods per
Initial Amount
year
Interest Effective Annual Interest

 Simple Interest, when the interest is defined as a  Continuous Compounding, the compound factor
constant proportion of the initial amount, per period of increases with increasing values of p, when this values
time. tends to infinite, the compounds factor tends toward a
constant value. Compounding based on an infinite
number of compounding periods in the year is usually
termed continuous compounding.
Where
Future Amount

Initial Amount Where

Proportional Interest Future Amount
Number of periods Initial Amount

 Compound Interest is the proportion of the accumulated Nominal Interest

debt or investment. Thus, interest charged or paid in the Number of years
current year includes a proportion of interest incurred or
awarded in previous years.  Compounding schemes, when the number of
compounding periods is increasing, the effective annual
rates of interest increase. The shorter is the investment
period, the more important is the length of the
compounding period.
Where
Future Amount
Applications of Compounding
Initial Amount
Compounding is widely used in business and commerce; the
Proportional Interest
following are some of the important applications:
Number of periods
a. Terminal Value is just the application of the Compound
 Nominal Annual Interest, is applied when investments or Interest equation.
debts are based on compounds periods of less than one b. Time Shifting of Cash Flow, for analysis or assessment the
year, two further definitions of interest can be cash flows must be brought to a common point in time, there
recognized: are two methods of calculation:

o Period Interest, is the proportional interest  Cumulative Method, each cash flow is compounded
which is added after each compounding forward by one time step. In general this method
period. generate an aggregate value of each particular cash flow
o Nominal Interest, is the period interest, times for each particular period of the form:
the number of periods in a year.

Where
Cash Flow
Where Number of Periods
Future Amount
 Direct Method, each cash flow is taken separately and
Initial Amount compounded directly forward to an appropriate time
period.
Nominal Interest
Compounding Periods per c. Account Balance Calculations
year
The base for all these calculations is the Compound Interest
Number of years equation; there are three alternative methods of calculation:
Calculating Interest, Period Balance and General balance;
Period Interest Calculating compounded balance for each period and General
Balance; using the compounding interest equation for each
period.

d. Price Escalation

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Petroleum Economics
Student Notes
 Rank by Present Value, Discount can be applied to a cash
The future price at any point in the future can be calculated flow or series of cash flows at any point in the future so that
using the following equation: present value equivalent can be computed for any single cash
flow or series of cash flows. These present values can then be
used as a basis for comparison and for making choices. Same
considerations about risks are equally valid here.

Where
Future Price 4. Annuities

Base Price Annuities are a series of cash flows over a defined number of years.
The present value “P” of an annuity is:
Annual Rate of Change
Number of Years into the future

e. Rank by Terminal Value

where:
This application of compounding is used to compare terminal Present value
values at the same point in time, so it is necessary to have
some considerations to adjust the length of each project. In Cash Flow Amount
real analysis it is included some considerations about risk in Discount Interest Rate
addition to the financial criteria.
Number of cash flows (years)

3. Discounting In the situation when A=1, the right hand side of the equation
represents the annuity factor.
Mathematically, discounting is the inverse or opposite of
compounding: 5. Interest Table

Discounted Rate and Discounted Production

Discounting of future cash flows clearly influences our perception

Where of the value of producing oil in the future. If for the moment, we
assume that oil price is constant and that taxes and costs of
Future Amount
production can be ignored, the value of reserves in the ground can
Initial Amount be represented by an equation of the form:

Discount Rate Value = Reserves x Price x Discount Factor

Number of periods
There are a number of factors:
Applications of Discounting
 Discount Factor, the process of discounting
progressively reduces the present cash flows, the further
 Present Value, this is the standard application of the discount
into the future they occur.
equation, and it enables the present value to be calculated
 Declining Production, Petroleum production is
when the future amount, the discount rate and the investment
controlled by reservoir energy and is normally
period are known.
characterized by progressive decline.
 Taxation, profit based taxes normally increase over time
 Series of Cash Flow, similar to the application in
as a proportion of revenue.
compounding, the same logic applies to the discounting of a
 Oil price variation
series of cash flows which are spread over time and they may
be aggregated either cumulatively, one year at a time
Choice of Discount Rate
(Cumulative Method) or directly one cash flow at a time
(Direct Method).
It becomes necessary to consider how an appropriate discount rate
may be selected; choice of discount rate requires consideration of
 Screening by Discounting, screening of an investment is the
the following factors:
process of comparing with a standard criterion or test as a
basis for accepting or rejecting that opportunity. The
 Acquisition Cost of Capital, most companies have
following equation is used:
access to two types of money or capital:

o Equity represents the part of a company,

which is owned by its shareholders. They
may invest directly in a company through the
original purchase of shares from that
Where company.
Present value o Debt, the other component of business
finance is money, which has been borrowed.
Initial Investment Amount All such debt carries a legal obligation for the
borrower to pay interest from time to time
Discount Interest Rate
and eventually to repay the borrowed
Compounded Interest rate amount.
Number of years o It is generally accepted that the cost of equity
is greater than the cost of debt.
If j=i P=0, the investment has just satisfied the screen criterion
 Opportunity Cost of Capital, relates to an investment
If j>i P>0, the investment has exceeded the screen criterion
situation where choice is required, assuming that the
If j<i P<0, The investment is below the screen criterion
company has identified two investment opportunities
and has resources for one only

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Petroleum Economics
Student Notes
 Risk, is related to investment decisions and is evaluated Cash Flow is the most appropriate methodology for evaluating
against better return. It generate a problem of choice long-term investments. The objective in this chapter is to derive
because all of the identified factors are subject to from project Net Cash Flow (NCF) a range of numerical
uncertainty and to changes over time. parameters, which may be used to characterize economic potential
or profitability, these measures fall into two distinctive groups:

6. Price Inflation  Undiscounted group includes parameters such as

“Packbak” and Profit to Investment Ratio (PIR).
The prices of most goods and services change over time. Price  Discounted Group, when time value of money is
inflation relates to rising prices and deflation relates to falling included parameters such as Net Present Value (NPV)
prices. There are two forms of inflation: and Internal Rate of Return (IRR) may be calculated

 Demand Pull Inflation, if a single market has an excess After obtained these parameters may be used for the investment
of demand over supply, a shortage develops and there is decision process, which may include:
an upward pressure on prices.
 Cost Push Inflation, prices reflects the cost of production  Screening, the company does the testing of each
and rising cost of factors of production will available project against a set of appropriate criteria or
consequently contribute to inflation standards, to determine whether these opportunities are
suitable of profitable.
Measurement of Inflation  Ranking, is the process that follows and requires
comparison between suitable projects to determine the
Price variation is seldom uniform, in any given time period, some best candidate for investment.
prices will rise, some will fall and some will remain constant. The
following are inflation parameters: 2. Cash Flow Modeling

 The Retail Price Index (RPI), is a measure derived from 2.1 Currency Units
the cost of goods and services purchased by an average
family Cash flow models may be compiled in:
 Sector Indices (SI) are based on the cost of goods and
services purchased by companies in specific industrial  Money Of the Day (MOD), incorporates the
sectors expenditures and revenues for each project year, using
 The Gross Domestic Product (GDP) deflator is a currency units appropriate to that year. The advantage is
measure of changing prices, which is derived from the that the model can interface directly with the world
GDP. outside the project (used as input for corporate budget,
or tax liability, etc.). The disadvantage is that the
Implications of Inflation purchasing power of the data varies from year to year.
 Real terms, incorporates the expenditures and revenues
Our primary concern with inflation is the manner in which it may for each project year, using currency units of constant
impact on project evaluation and our decision-making process. purchasing power. The disadvantage is that the model
There are some issues to consider: does not relate to the world outside (data may not be
used as input for corporate budget or accurate
 Planning for Inflation calculation of tax liability). The advantage is that the
 Fixed Prices Contracts NCF derived from it is in real terms.
 Fiscal Drag (tax effects)
 Cash Flow distortion and purchasing power 2.2 Managing MOD and Real Terms
 Real return on investment
Companies that concentrate on short-term investments, focus on
Purchasing Power MOD data, the NCF derived from it will also be in MOD terms. At
this stage, the NCF may be converted to real terms using simple
It is vitally important to incorporate the concept of purchasing conversion factors based on inflation data.
power when representing a project as a series of cash flows,
particularly if the project extends over a long period of time. Here Whereas those companies involved with longer-term investments
appears some new terms: “Money of the Day” and “year 2000 may prefer to use real data. The derived NCF will also be in real
terms”. terms and will relate directly to purchasing power.

Real Growth 2.3. Model Construction

Investment normally takes place in an environment of price A Cash flow model is used to derive a range of economic
inflation; the purchasing power of the currency earned is different parameters:
from the purchasing power if the currency invested. Real growth
relates to any increase in purchasing power. The real interest  Physical Model, the starting point of any cash flow is a
calculation is obtained from the equation below: model of the physical project, incorporating best
estimates for development and production phases and all
the relevant timing.
 Relevant Data, it is fundamental to the cash flow method
to distinguish between those cash flows, which result
from the decision / investment and those, which would
Where have occurred regardless. Only those, which are
dependent on the decision, are relevant.
Real Interest  Cash Flow (CF), involve the physical transfer of funds
Compound Interest Rate from one account to another (depreciation is not a cash
flow), cash flow is represented by costs estimates and
Annual Rate of Change
revenues (which are subject to uncertainty). Here units
of currency are important, also a decision must be taken
between MOD and real terms.
Chapter 4 – Project Parameters  Net Cash Flow (NCF), is the aggregate cash flow for a
specified time period. The currency units for NCF are
1. Introduction the same as for the cash flows from which it is derived.

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Petroleum Economics
Student Notes
At this stage is preferable for NCF to be converted to known as Profit to Investment Ratio (PIR). The calculation of
real terms. PIR from cumulative NCF data is entirely straightforward.
 Timing, first it is normal to sub-divide project time into PIR value indicates that there will be a cash surplus of PIR
calendar years, short projects (less than five years), times every unit of currency invested, independent of project
might be better modeled on a monthly basis. Second, size. This provides a simple and convenient method for
within each period, aggregation of cash flow takes place, making comparison between projects in terms of investment
to produce a single net cash flow. Third, each model has efficiency.
a time origin, or the date to which any derived economic
parameter is attached. There are two common forms of
cash flow model structure: 4. Cost Per Barrel
o Simple structure, with mid-year aggregation
and discounting back to the origin, which is Several parameters are used to indicate the relationship between
the mid-point of project year one. cost and production or productive capacity; two forms of the
o Alternative Structure, also has a mid-year parameter are commonly used:
aggregation, but the origin is now located at
the beginning of project year one. As a a. Cost per daily barrel, relating to productive capacity. This
consequence, there is a half-year step measure focuses on investment and is assumed to be Capex.
between project year one aggregation and Capex per daily barrel is a measure of the cost of creating a
project origin system with the capacity to produce one barrel of oil per day.
There are some issues associated:

3. Cumulative Cash Flow  Production Profile, every field is unique in terms

of reserves, peak production and life, so it is
The cumulative of NCF over time, forms a measure of performance difficult to define typical values. As an alternative
or value and gives rise to a number of useful parameters: to peak production, it may be appropriate to use
average rate as a measure of productive capacity.
 Cumulative Cash Flow in Real Terms, the starting point for The simplest form of average is reserves divided
this type of analysis is the net cash flow (NCF) in real terms. by field life (Average Production). If time value of
Price inflation (positive inflation) implies declining money is considered, some relevant calculations
purchasing power, negative inflation have the opposite result. are made: Production Profile, Discounted
 Measurement of Investment Size, There are two commonly Production, Average production, discounted
used measures of investment size: average production, annuity factor, average
production and present value of reserves.
o Capital Expenditure (Capex), it represents the cost  Units and Conversion Factors, a typical oil field
of creating productive capacity. In some situations produces both oil and gas, and in these
most of the Capex is committed and spend, before circumstances, it is necessary to consider both as
the facility becomes productive. In many projects, part of production. It is normal to apply a
however, investment continues long after conversion factor for the secondary product using
production has started and then expenditure on energy equivalents.
capital items is often difficult to differentiate from  Capital Intensity, these parameters focus on Capex
Opex. as measure of cost and Opex is not included.
o Maximum Capital Outlay (MCO), is defined as the  Capital Exposure, creating productive capacity
minimum value on the cumulative Net Cash Flow takes time, aggregation of Capex, which is spread
NCF curve. The MCO, therefore represents the over time, becomes an important issue in the
worst financial position over the life of the project. derivation of any parameter based on Capex.
Mathematically, MCO is the sum of all Capex, up Where the economic cost of a productive facility or
to the time of production start-up or, to the period system is required, it is appropriate to calculate the
before the one in which annual Net Revenue first Interest During Construction (IDC).
exceeds annual Capex. Capex values are likely to b. Cost per Barrel, relating to reserves or production. This
be greater than MCO values for the same project. measure may be either Capex or Opex (or both):
MCO is proposed as a better indicator of financial
commitment, because it reflects the interaction  Opex per Barrel (Lifting Cost), relates operating
between positive and negative cash flow over time. cost to production. It is highly variable, depending
The timing of cash flows can significantly on the location and technology of the project and
influence MCO. In the event of project delay, the stage in its life. Costs rise over time for all
particularly close of production start-up, MCO fields, leading to eventually abandonment, when
incorporates more Capex, before positive Net lifting cost exceeds selling price.
revenue kicks in with production.  Capex per Barrel

 Payback Period, it is the point in time at which the cumulative

NCF returns to zero. The Payback Period is defined as the 5. Discounted Measures of Value
time taken, from the start of the project, to reach this position.
It is to be expected that larger, more complex projects have We cannot ignore the fact that revenue earned sooner, or
longer Payback Periods. Some credence is given to the idea expenditure made later is preferable. We shall focus on parameters,
that Payback Period is a useful indicator of risk. which incorporate time value of money concepts. These parameters
 Terminal Cash Surplus (TCS), in the context of project NCF, may be separated into two important groups:
the cumulative value at the end of the project’s life is such a
surplus. It is the sum of all project Revenues, minus the sum  Discount Rate Specified:
of all Capex, Opex and Taxes, this sum is called Terminal o Net Present Value (NPV)
Cash Surplus (TCS). TCS is he end point of the cumulative o Net Present Value Index (NPVI)
curve, not the highest value achieved during the life of the o Annual Capital Charge (ACC)
project. Projects have inevitable commitment to abandonment  Discount Rate Derived:
in their final years. If project NCF is in money of the day o Initial rate of return (IRR)
(mod), TCS is a meaningless value.
 Profit to Investment Ratio (PIR), is the simplest measure of
efficiency between TCS, as a measure of profit and MCO, as a
measure of investment. These data are derived directly from 6. Cumulative, Discounted Cash Flow
the cumulative NCF, and the resultant ratio is popularly

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Petroleum Economics
Student Notes
Net Present Value and its Index are the most widely used:  NPV Index

 Net Present Value (NPV) NPV Index (NPVI) is the discounted equivalent of the PIR, by
analogy, NPVI is the ratio of NPV / MCO when calculated at
Net Present Value (NPV) is the sum of all projects cash flows, discount rate:
discounted back to a common point in time. In order to
compute NPV, the following must be specified:

Project cash flows

Discount Rate
Time Origin NPVI is a very useful measure of investment efficiency,
which incorporates time value of money.
It may be represented by the following equation:

7. Annual Capital Charge

The Annual Capital Charge analysis is based in a slightly modified

Where version of the Present Value of an annuity:

Project Net Cash Flow for

each period
Discount Rate (a)
Project Periods
Where
Discount Factor 1 Represents one unit of investment
Represents the Annual Capital Charge (ACC)
Discounted Cash Flow Discount Rate
Life of the Project in years
(DCF) or Present Value (PV)

The sum of all such, calculated Discounted Cash Flows is the Using the same mathematical procedure as in chapter 3:
present value equivalent of all future Net Cash Flows. This
total has the name of Net Present Value (NPV).
Annual Capital Charge Factor (ACCF)
NPV as Measure of Profit:

NPV may be considered as a measure of profit. It is a sum of represents the proportion of the initial investment, which must
money, in the same units as the NCF, from which it was
derived. Once the calculation is completed, the NPV can be be earned each year (for years) to give the investment a return
converted into another currency unit. There is some of . By rearranging equation (a) gives the following:
justification in stating that the sum of money, which we call
NPV, represents the value of the project to the investor at the
point in time defined as the origin of discounting.

Discount Origin and Rate

Once Net Cash Flow, Discount Rate and Origin are defined, Zero NPV is significant, representing minimum acceptable
so is Net Present Value (NPV), if the origin is changed, so profitability. Due to the fact that project investment in these
NPV. Once calculated for a specific discount origin, it is equation is represented by a single unit cash flow, whereas in
straightforward to compute equivalent NPVs for any other practice, Capex may extend over a number of years. It is important
origin, by compounding forward or discounting backward in to retain the concept of time value, which is achieved by including
time, at the same rate of interest. Increasing discount rate Interest During Construction (IDC). The term in
reduces individual DCFs and consequently reduces NPV.
There is an inverse relationship between NPV and Discount the previous equation is considered to be replaced by a series,
Rate (NPV declines with increasing Discounting Rate). representing all components of Capex, which will normally precede
year zero and may also continue for one or more years after:
NPV and Cumulative DCF

NPV is the discounted equivalent of TCS, as Discounted Rate

Increases, NPV diminishes and becomes negative. With
increasing Discount Rate, Maximum Capital Outlay (MCO) is
also seen to diminish. MCO represents the financial
This equation implies that any historical (prior to year zero) Capex
commitment to the project. The basis of discounting is an
assumption that investment opportunity exists and that money cash flows are compounded forward to year zero at per year and
invested will grow in value over time. With increasing that any future Capex flows are discounted back to year zero at the
Discount Rate, investment opportunity increases and money same rate.
invested grows faster over time. Under these circumstances, as
Discount Rate increases, a future cash flow or series of cash 8. Internal Rate of Return
flows becomes smaller, in Present Value terms.
The Internal Rate of Return (IRR) is the discount rate, which
Note that with increasing discount rate, the Payback period is reduces the project NPV to zero. It is, therefore, the solution to the
extended and eventually becomes infinitely long. In other following equation:
words, the project has a negative terminal value NPV and
never returns to cumulative zero.

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Petroleum Economics
Student Notes

 Project Ranking, the screening process generates a list of

projects, which have passed the various technical and
economic selection criteria, then the projects are
compared and ranked one against another following the
The solution to this equation follows the numerical methods criteria below:
described below:
o Resource Limit, all organizations have finite
 Trial an Error, computing NPV(i) and check for zero. resources, the most important of these are
 Graphical, by plotting NPV profile and finding interception on likely to be specialist manpower and finance.
x-axis. o Mutual exclusion, project A and B may be
 Extrapolation, interactive calculations to find zero NPV.
alternate development plans for the same
petroleum reservoir, in which case ranking
However, modern electronic spreadsheets and financial calculators
and choice are inevitable.
usually incorporate an iterative algorithm to compute IRR
o Best First, it is always prudent to identify
automatically, so traditional methods are no longer necessary.
which are the best opportunities and to
consider making this investment early.
Significance of IRR
Ranking Parameters:
The IRR is an interest or growth rate and is assumed to be a
measure of investment efficiency. It is arithmetically analogous to
a. Net Present Value, simply the Surplus
the interest earned on a bank account. In this analogy:
b. Internal Rate of Return indicates the return per unit
investment. It is therefore a measure of investment
 Negative NCF, is equivalent to a Deposit
efficiency, there are two major issues: IRR is very
 Positive NVF, is equivalent to a Withdrawal
sensitive to the timing of cash flows and the
 IRR, is equivalent to the Interest Rate
discount rate is determined by the pattern of cash
flows.
c. Net Present Value Index, it is used when the
Abandonment Expenditure
requirement is to rank by investment efficiency
using the corporate rate.
Many projects incur significant expenditure relating to
decommissioning, site clearance etc and it is important to consider
the implications for cash flow evaluation. Such expenditure is a
legal obligation on the project and must be paid for out of project Chapter 5 - Government
revenues.
1. Introduction
The “Extended Yield” method assumes that cash flows,
immediately preceding abandonment, are set aside and invested at Government involvement in the industry is considered under the
an explicit rate, to be available to meet the financial obligations following headings:
associated with abandonment. Such an investment may be called a
”sinking fund”, i.e. a fund created to meet a future obligation.  National Interest; it concerns the role, the status and the
security of each state on the world stage, some acronyms
referred here: NPR – Naval Petroleum Reserve, SPR –
9. Acceleration Projects Strategic Petroleum Reserve, IEA – International Energy
Agency, OECD – Organization of Economic Co-
An acceleration project is one in which the main objective of the operation and Development.
investment is to bring production forward in time. When production  Economic Development; it is a complex process, based
is brought forward in time, without significant incremental on exploitation of available resources including human
recovery, more production now is at the expense of less production and material, indigenous and imported. Consumption of
later. When combined with Capex and Opex, this creates a energy is sometimes used as indicator of economic
characteristics cash flow distribution with two phases of negative, development. One of the major problems facing the
with positive in between. The double intercept on the X-axis, is an world community is how to enhance standard of living,
indicative of multiple roots. without further damage to the environment (1997 The
Kyoto Protocol). The impact of petroleum on an
economic system can be measured in terms of:
10. Applications i. National Income; Petroleum resources are
not uniformly distributed in the world, so
Economic parameters, which are derived from project cash flow, only those countries with significant
have a number of important applications: petroleum benefit from production, through
taxation, employment and development of
 Transaction Valuation, relates to the process of buying infrastructure (six countries are responsible
or selling. NPV is a reasonable basis for transaction for 50% of world output of oil and gas, and
negotiation. 40 countries are responsible for more than
 Project Screening, in the context of project evaluation, 95%)
screening is the process of comparing projects against a ii. Regional Development; the petroleum
set of standard criteria. Here specifically we consider industry must develop, where the resources
projects cash flows and measures of profitability. happens to be found, and this is not always
convenient (it may be a remote offshore
Assuming time value of money for the investor to be location, desert, permafrost or nature
, the three most important economic parameters give rise reserve). Development creates employment
to identical screening criteria as follows: and requires the establishment of suitable
infrastructure (pipelines, terminals, etc.).
o NPV[ ] >= 0 Government become involved through
o NPVI[ ] >= 0 investment in housing, schools, roads and
other communication systems.
o IRR >= iii. Balance of Trade; Oil and gas production or
consumption can cause a significant shift in a
Secondary criteria may be considered, for example, a country’s balance of trade, and can be a
maximum Payback period. factor-influencing exchange rate.

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Petroleum Economics
Student Notes
 Performance of the applicant in previous licenses
The other aspects of government involvement will be reviewed in  Contribution to the local economy
the next sections.  Willingness to co-operate with national oil
company
2. Resource Ownership  Nationality of the Applicant

Oil and gas in the subsurface normally belong to the nation, rather  Financial Benefit, The licence defines the framework of the
than to a company or to and individual. When the industry has financial agreement between the company and the
ventured offshore, away from the country boundaries, there has government, licences commonly include: Rent (regular
been inevitable disagreement regarding ownership. payment), Bonus ( a one-off, up-front payment), royalty
(proportion of revenue paid to owner)
The United Nations Convention of the Law of the Sea (UNCLOS)  Technical Issues, some licences authorized not only
came into force in 1994, the contents of the convention concerns all exploration, but also the exploitation of any subsurface
aspects of offshore activity: discoveries, without further reference to government. Today,
the licence sanctions exploration, but that subsequent
- Coastal states have a sovereign right to manage and exploit development requires separate approval.
offshore resources in an adjacent area (Continental Shelf or  Ownership of Production, ownership of the produced oil and
Exclusive Economic Zone) gas can be a sensitive issue. Some licence agreements,
- Exclusive Economic Zone (EEZ) extend up to 200 nautical therefore stipulate that government has control over disposal
miles from the coast  Risk, petroleum exploration is a high-risk business, with
- Continental Shelf (CS) is a contiguous extension of the land, investment carrying a 75% probability of failure. Most
to the continental margin licensing systems require the company to carry risk through to
- Habitable islands may have EEZ and CS discovery.
- Subdivision of EEZ and CS between facing and adjacent  Participation, companies normally form partnerships at the
states is subject to agreement (in the absence of such exploration stage, to spread risk over a larger number of
agreement, the equidistant principle should apply) opportunities. As a result, many licences are shared by two or
more companies. The partner with the largest equity share
Conflict of Ownership normally acts as Operator of the licence and in this capacity
performs an important role. The Operator acts on behalf of the
Over the past 50 years, some conflicts of ownership happened joint operating committee and is responsible for the technical
mainly in regard of island ownership issues, some examples: programme, for budgets and maintaining a flow of
information.
- American Tidelands (near-shore zone, from low water mark),
it was a conflict for offshore mineral rights in USA between Licensing Agreements
Federal and State Government.
- UK Channel Island, it was an ownership discussion between There are a number of styles of licensing agreement within the
France and UK for a group of inhabited islands located ten petroleum industry:
miles from the coast of France.
- Timor Gap, the Island of Timor, in the Malay Archipelago  Old Style Concession; a concession is an arrangement
was colonized by Portugal and then was invaded by Indonesia, between a government and a company, whereby the
the territory was divided and when the offshore resources with produced oil and gas becomes the property of the
Australia were discussed it was necessary to agree separately company and the government receives various
with Indonesia and Portugal payments, in the form of royalties, taxes, etc.
- South China Sea, it can be the most disputed area of the  Production License; modern production licences offer
planet, between Brunei, China, Indonesia, Malaysia, much more control to government. Prospective areas are
Philippines, Taiwan and Vietnam. The issue include divided into many small blocks to increase competition
navigation, fishing, petroleum, nationalism and defense. and to reduce government dependence on any single
- Caspian Sea, it is an enclosed sea, which historically was company. Licences relate to shorter time periods.
bordered by the Soviet Union and Iran. In 1991, with the fall Companies must compete for licences on financial or
of the Soviet Union, offshore petroleum resources became a technical basis. Development plans are subject to
major issue between the new states. government approval.
 Production Sharing Agreement (PSA) and Joint
Ventures; A PSA is based on the principle that produced
3. Licensing oil is shared, or split between the company and
government (or its NOC) in agreed proportions. In some
The term licensing is used here to identify the process of granting cases, the company and the NOC form a separate
permission to explore for and/or to produce petroleum. The owner company for the purpose of development. This
of the resource grants permission. Usually the owner is the arrangement is a form of Joint Venture.
Government, and is expected to maximize economic benefit to its  Services Contract; in a service contract, the company
citizens, which may include taxation, industrial development, receives non-equity in the project. All components,
infrastructure, training and employment. Licensing procedures and including reduced oil and gas belong to the state. The
issues may include: company receives a fee for exploration and production
services and may have an opportunity to purchase the
 License Area, legally and logically, before drilling activity production.
commences, a company should have a license to produce from
that specific area. A license normally relates to a specific
geographical area, defined by co-ordinates, maps or physical 4. Petroleum Development
markers.
 License Allocation, licences may be allocated by competitive, Government may take and active interest in various aspects of
financial bidding (auction) or by some form of discretionary petroleum development. The following are important aspects of this
process, involving government selection. In an auction, the interest:
license is awarded to the highest bidder, which is normally for
an up-front payment (bonus bid), but may be for a percentage  Engineering Quality; previous to 1900, the industry was
of revenue (royalty bid), or of profits (net profit share). subject to few constrains, technology and understanding
Discretionary allocation implies that government has the evolve over time. Companies invest in research and
authority to make choices. The following are some of the development to improve profitability and gain competitive
criteria, on which this process may be based: advantage. They also learn from experience and significant
events may generate significant change. Good Oilfield
 Work Programme proposed

Page 9
Petroleum Economics
Student Notes
Practice (GOP) concerns the quality of scientific and 5. Taxation
engineering activity.
 Environmental Impact; Pollution and other forms of Taxation is a compulsory financial contribution, which is imposed
environmental damage are common of most industrial activity by government to raise revenue. Industry is an important source of
with zero financial implication to the business. In the absence tax income for government, and petroleum companies, being large
of effective penalties, the avoidance of pollution increases and profitable, make a significant contribution.
operating costs and is likely to reduce. Therefore , there is not
direct, economic incentive for a profit maximizing Tax Mechanism
organization to think about pollution. It is consequently
necessary for government to build a framework of legislation Government has developed a wide range of mechanism for raising
for environmental protection. Historically, the petroleum tax revenue from petroleum industries:
industry has been responsible for a range of environmental
damage: tanker disasters, systematic disposal of saline and  Ownership; of the production process is the simplest
oily water, flaring of gas, etc. Greenpeace the environmental mechanism for ensuring that benefit accrues to the state
group.  Fixed Payments; are those which must be made at various pre-
 Field Development; the field development decision is critical determined stages in a project and may not relate directly to
for both to company and to government. It is a time, when the levels of activity or profitability. Lump Sum payments are
company makes a large investment, which may have long- sometimes referred to as bonus payments
term implications. Issues here may include: technical  Royalty; is a payment made to the owner of a resource and is
standards, environmental impact, flaring of gas, use of normally fixed as part of a licence agreement. It is a payment,
existing infrastructure, limitations on rates of production, directly related to volume or to sales, in petroleum production
unitization, etc. The document prepared by the company it is a percentage of sales revenue.
includes: Field Description(seismic, geology, Petrophysics,  Constrained Disposal; disposal of oil or gas may be at a
hydrocarbons in place, well performance, reservoir units and government imposed or fixed price. It may be a condition of a
modeling, etc), Development Plan (drilling and production licence that produced oil or gas accrues to the government for
facilities, process facilities, project planning, abandonment, disposal, or alternatively that a proportion of production is
etc), Field Management and Environmental impact. sold into domestic markets.
 Flaring of gas; flaring of associated gas is one of the negative  Field Profit; an oilfield or an upstream, petroleum-based
images of the petroleum industry. It is wasteful, and it is project may be used as a basis for taxation. If the field or
harmful to the environment. I.e. methane and carbon dioxide project is owned by two or more companies, these are liable
are both greenhouse gases, which contribute to global for the tax in proportion to ownership.
warming.  Corporate Profit; corporate tax is based on the assessed
 Unitisation; petroleum resources in the subsurface commonly profitability of the company and therefore involves
overlap ownership boundaries at the surface. The mobility of aggregation of cash flow from a range of projects and
petroleum implies that reserves may migrate towards a activities.
production well drilled on the opposite side of a boundary and
that production activity on one side may interfere with
production potential in the other. Early legislation on Tax and Profit
ownership of petroleum was founded on the “Rule of
Capture”. Oil and Gas were treated in the same manner as a Petroleum is a high-risk business and companies expect to earn
will animal moving from place to place: it is owned where it is above average profit, in return for taking above average, investment
produced or captured (it is not included the case of drilling risks. Normal profit is the surplus of revenue over cost, which is
deviated wells). Additionally, due to early excessive required by a company to justify investment. Economic rent is
production of petroleum which generate collapse of prices in profit beyond normal profit. Rent is considered to be a suitable
the early 1930, there was a gradual introduction of “pooling” target for taxation, since it may be removed, without damaging
and “unitization”. Pooling is a process, whereby the spacing of investment strategy. Taxes are classified as:
wells is controlled, thereby limiting the rate at which reserves
are depleted. Unitization is the process whereby co-operation  Progressive, is a tax which takes a higher proportion of
between participants takes place at the level of the reservoir profit from highly profitable projects, than from less
and therefore involves all participants in the field. Fully profitable projects. (more equitable)
implemented unitization implies that the whole reservoir is  Regressive, is a tax which takes higher proportion of
developed as a single unit, regardless of the number of owners profit from less profitable projects and may exceed the
or licence holders. economic rent (inequitable).
 Decommissioning; the decision of terminate a project is an
economic one, but normally subject to government guidelines
and approval. Government interest relates to efficient recovery Marginal Rate of Tax
of reserves and to appropriate abandonment of wells and
facilities. Some factors may extend economic production: A measurement of the severity of a regime is the Marginal Rate of
tax (MR), which is a combination of the rates applicable to the
 Incremental reserves can be located inside or various layers, example:
outside the field
 Reduction of operating expenditure (Opex) - Royalty @ 12.5% (Roy)
 Oil price projections - Supplementary Petroleum Duty @ 20% (SPD)
 Royalty payments should be re-negotiated - Petroleum revenue tax @ 75% (PRT)
 Selling the project to another operator - Corporation Tax @ 52% (CT)

When abandonment is the only alternative for a project, some The MR for this regime is as follows:
technical, economic and legal issues must be considered:

 Companies must abandon individual wells and

other facilities according to prevailing regulations
 The larger the cost of abandonment, the greater its Chapter 6 – Sources of Uncertainty and Risk
influence on timing
 Abandonment expenditure is a form of Capex, and 1. Introduction
normally gives rise to a tax allowance
 Abandonment is a legal commitment on the part of The petroleum industry is often described as being the archetypal
participants in the project, each is responsible in risk business. This chapter will review the various sources of
proportion to ownership uncertainty and associated investment risk as encountered by the
modern petroleum industry. Some definitions within this context:

Page 10
Petroleum Economics
Student Notes
The larger and more obvious traps have been mapped and
a. Uncertainty, relates to our imperfect knowledge of the future drilled, so the task of finding the next become more difficult,
and to those factors which are liable to change (sources of exploration success may be analyzed at various levels:
uncertainty)
b. Risk, infers that the uncertainty has financial impact on  Regional Statistics; is associated to the number of
investment or material implications, so they are also source of exploratory wells compared with the number of
risk. Risk is normally assumed to be a negative factor success finding in the area, during the year 2000
(downside risk), but some parameters, may turn out better the exploratory industry success rate was 25%. In
than expected (upside potential). absence of local statistics, the company might
assume +/- 25% as the probability of initial
Our primary concern here is the impact of uncertainty on petroleum exploration success, and probability of eventual
investment, we have made an investment based on a specific commercial development of +/- 15%. Over time
dataset. targets diminish, knowledge increases and
technology improves, but it is clear a long-term
In general terms the petroleum industry encounters a wide range of decline in size of discoveries. Approximately 270
uncertainty factors, some of which give rise to considerable risk, oil and gas accumulations have been identified
they are: with reserves from 3,000 to 1 million barrels, 70%
of all those fields have reserves of 100 million or
 Geological Risk; most Petroleum engineering activity take less.
place subsurface, remote from direct observation and is  Exploration Play; the accumulation of commercial
dependent of data derived from various remote-sensing quantities of oil and gas require generation,
technologies, decisions are based on incomplete dataset and migration and entrapment, together they constitute
consequently subject to uncertainty and associated risk. a specific exploration play; once recognized, the
 Facilities Risk; Petroleum production systems extend into subsequent development of the play will depend on
subsurface, through marine salt-water or desert sand. Fluids to the size, distribution and complexity of the
be contained are at elevated temperature and pressure, of reservoir between other factors like trapping
corrosive nature and highly inflammable. Production systems mechanism, the evolution of exploration
must survive interaction with these fluids on the inside and the technology, etc.
outside environment, and they have propensity to fail.  Specific Targets; the existence of an accumulation
 Political Risk; companies negotiate production rights, live of petroleum is dependent of a number of factors,
within a regulatory framework and pay taxation, changes to if one factor is missing, the enterprise is a failure:
the contracts, to the rules or to the numbers can have
significant impact on project profitability - Generation and migration of petroleum fluids
 Economic Risk; here equates with market prices, Oil and gas [fluids]
markets have become particularly volatile, and any enterprise - Existence of Reservoir lithology [lithology]
which invest long-term and operates internationally must - Existence of sealing mechanism [seal]
expect problems from inflation and exchange rate fluctuation. - Existence of trapping Geometry [trap]
 Partner Risk; petroleum companies commonly create joint - Suitable timing of geological events [timing]
ventures for exploration and field development. Concept of
partner may also be extended to include contractors from the So the probability of success is the formula below:
service sector. Such relationships can generate significant
benefits and economy of scale. It can also create conflicts of
interest and of personality.
b. Appraisal
2. Geology
Appraisal is the process of converting geological success into
commercial success. Appraisal of a property involves
Uncertainty and consequential risk originates from the fact that oil
choosing between making a commercial investment and
and gas reservoirs remain underground. Discovery, collecting
walking away. Appraisal Issues:
information and building models is therefore dependent of the
interpretation of remotely collected data. Three distinct stages can
- Existing Dataset; is the information that
be recognized:
demonstrate technically a suitable investment
- Reserve Potential; is the calculation of the
a. Exploration
estimated volumetric reserves (STOOIP)
- Geological Complexity; the more complex is the
Exploration is traditionally the activity that has characterized
basin and trapping structure, the more difficult it
the petroleum industry as a high risk. The cost of a single
will be to build a coherent model, the more
exploration well may range from $1 million (onshore location)
expensive and the greater the risk.
to more than $100 million (offshore location). Success is
- Drilling programme and cost; drilling well is the
dependent on a decision to drill in the “right place” and that
only reliable method of providing the distribution
something of value has been found, but the confirmation may
of petroleum in the subsurface, the more complex
take several years to determine, definitions of success may
the subsurface, the more wells required.
include:
- Data Collection and Cost; include logging, coring,
well testing and probably detailed seismic.
 Evidence of Hydrocarbon in the well
- Development economics; the aim is to demonstrate
 Well tested and flowing at a minimum rate (5000
commercial viability by generating a technical
bopd)
development plan and speculative economics.
 Discovery of enough petroleum to justify further
- Tax incentives; depending on the country, taxation
investment and commercial development
can be handled in a different way when associated
to pre-development expenditure.
In the short term, the success is defined in terms of geology
- Licence relinquishment; is the time limit available
factors:
to he licensee to make an assessment of the block.
- Corporate View; is to include the investment
 Nature and Complexity of the geological basins
criteria, tax position and attitude to risk from a
 Trap mechanism and size
company point of view
 Recognition of and exploratory “play”
 Geophysical technology available
Appraisal Time
 Experience and competence of explorationist

Page 11
Petroleum Economics
Student Notes
Time is an indicator of challenge and also of cost. Appraisal is Government creates the legal framework within which the
ranging from 3 months to 25 years. Some of this time is petroleum industry must operate. Areas of government interest
spending in drilling, collecting and analyzing data, some in include:
waiting for investment or technology improvement and some
for the official review and approval process. - Ownership and Licensing; the right to produce petroleum
from a designate area, for a defined period of time, subject to
Appraisal time reflects the degree of difficulty, firstly in technological and financial conditions. Licensing is a formally
reaching an investment decision, secondly in planning how the contracted legal process, acknowledge the right of companies
reservoir should be developed. to operate under the terms of their licences without
interference.
c. Field Development - Health and Safety; the industry is self-regulating; accidents
cost time and money and reduce profits. Standards may vary
A successful appraisal programme delivers a geological model widely. The problem arises when changes in standards or in
of the reservoir to be developed. From this model are derived working practices are imposed retrospectively.
estimates of recoverable reserves, production profiles and - Environmental Standards; government may regulate company
plans for well distribution and reservoir management activity for the protection of the natural environment,
standards may change as a result of knowledge or experience
gained, or political change or international agreement.
3. Facilities - Taxation; taxation regimes afford the opportunity for changes.
Taxation normally represents one of the significant cash flows
Facilities risk pertains to the man-made systems, which are of a project. Changing tax structure and rate can easily render
installed, partly in the subsurface, to enable petroleum fluids to a profitable project uneconomic or vice versa. Taxation is an
flow, with suitable control, to the surface and onwards towards important and necessary source of income to government and
processing and eventual sale to customers. If facilities are not normally government has the power to decide what the tax
completed on schedule, or do not perform as expected, this will should be. Increasing tax is often associated with rising oil
impact directly on the investment, problems may result from any of price, reducing tax is used as an incentive to increase
the following: exploration and development.

 Produced Fluids; the first task of these systems is to contain

the produced fluids, which may be at high temperature and 5. Economics
pressure, may contain toxic or corrosive components, and they
are flammable and damaging to the environment. Petroleum investment takes place within an economic system,
 Subsurface Interaction; engineering operations in the where many important parameters are subject to change over time,
subsurface are exposed to increasing temperature, pressure many of these outside the control of the investor:
and stress with depth. Drilling bit is always penetrating the
unknown. The skill of the driller is to achieve TD in good a. Market for Oil; the price of oil and its variation over time has
time. Production tubing and completion systems must be become one of the dominant features of the petroleum
designed to deliver reliably over the life of the field, otherwise business and uncertainty over its future direction constitutes
it will carry out expensive activities in the future operations. considerable investment risk. The market of oil involve every
 Surface Facilities; includes well control, fluid separation and country as consumer and more than 40 as significant
export, plus appropriate power generation, accommodation, producers (75 million bopd, 40 million traded internationally).
transportation of staff and materials etc. Systems must be At any point in time, price differences may exist, some factors
designed to survive extremes of temperature, salt water, and are:
ocean storms. Stress fatigue and corrosion are problems
encountered typically in long term facilities. - Geographical location of the source; the greater the distance
 Environmental Issues; some environmental issues to consider between market and source, the lower the price must be at
are: source, to allow for cost of transportation. Producers cannot
price to be competitive in every market.
- Seismic impact on marine mammals - Hydrocarbon Composition; the value of the barrel is derived
- Disposal of drilling fluids, cuttings, oil water, directly from the market value of the products, which the
industrial and human detritus refiner can generate from the barrel. Typical split into light,
- Flaring of surplus gas middle and heavy distillates. Lighter products command a
- Leaks from valves and pipelines higher price and heavier products a lower price. The price
commanded by each product in the marketplace depends on
In general, petroleum fluids do not integrate easily with the supply and demand. Factors here include competition and
biological environment. season.
- Inorganic Impurities; undesirable component increased cost
 Human Involvement; petroleum system are designed, incurred to remove sulphur and vanadium, reasons for price
constructed and maintained as result of human talent and carry differentials.
the risk of human error. Learning from experience is an - Security of supply
important mechanism for moving forward. Maintenance is the - Price fixing and political intervention
most difficult process to control, when carried out improperly
can generate tragic consequences. Also a human involvement b. Oil Demand; demand for crude oil is based on a demand for
must include the possibility of sabotage, theft, extortion and the refined products, which in turn is based on demand for the
terrorism. goods and services, which require petroleum products. Oil
dependency is a feature of our develop economies, essential
Case of Study - Piper Alfa for transportation, heat and electricity generation.
Characteristics of demand is its elasticity, which is the
The Piper Alpha disaster, the worst offshore petroleum accident in measure of the response of the market to changing price,
history is attributed to human failure, both in terms of system numerically, it is proportional change in quantity divided by
design and of working practice. proportional change in price.

, >1 Price is elastic, and if <

4. Government Regulation
1 then price is inelastic (more revenue)

Where

Page 12
Petroleum Economics
Student Notes
Proportional Change in Quantity Initial Price of Gas
Proportional Change in Price Gas Oil Price
Fuel Oil Price
The importance of Elasticity relates to revenue, the product of
price and volume. Oil is a price inelastic commodity, because Retail Price Index
there is no obvious substitute and where reduced consumption Electricity Price
would lead to perceived reduction in standard of living.

c. Oil Supply and Price Evolution; since 1986 the market has f. Exchange Rate; the petroleum industry is truly international
changed and oil behaves as a primary product. Price has and must therefore buy and sell, borrow and invest in different
become highly volatile with time. countries, with different currencies. International currency
d. Oil Price Risk; prices derives from the interaction between markets set the value of a specific currency. Two of the areas,
supply and demand, and anything that changes the behaviour where exchange rate risk are commonly encountered are:
of producers or consumers may disturb the equilibrium of the
market. Demand in the future will change as a result of: a. Sale of Oil; the price of oil is normally defined in terms
of US Dollars, a company with a tax base in another
 Growth of less developed economies currency faces uncertainty and risk with respect to the
 Availability of alternative energy technologies relevant exchange rate.
 Price in relation to alternative technologies b. Overseas Debt; large companies borrow from a wide
 Weather and climatic change range of institutions, each debt contract in foreign
currency exposed the borrower to exchange rate risk,
Supply in the future will change as a result of: when the interest is paid and the capital is repaid,
planning overseas debt involves more than simply
 OPEC market share negotiating a rate of interest.
 UN policy on Iraq
 Growth of non-OPEC production. Eg Russia, g. Debt Finance; investment capital is a blend of Equity and
Caspian Debt, a lending institution consider a number of factors:
 Evolution of production technology
 The risk nature of business activity; the more
OPEC remains a potent force in the market. Its policy for most highly focused a company in high risk areas of
of this period was to try to maintain a price band between $22 business, the less likely that debt will be available
and $28, to them. The lender may negotiate a form of equity
involvement, as is found in certain forms of project
e. Market for Gas; the market for methane gas is different from financial arrangements.
that of oil. It must be compressed or liquefied for  The track record of the company in generating
transportation, storage and distribution and this can cost ten profits and repaying debt; debt interest is met from
times as much per unit energy content, as for oil. There are corporate profit, before the payment of taxes.
regional, rather than global markets for gas or Liquefied  The proportion of company finance already
Natural Gas (LNG). The energy units used are British provided; the proportion of debt is commonly
Thermal Units (BTU) and Kilocalories [Kcal]. Units for gas known as the debt ratio for the company. Ratio of
are usually cubic meters [cm] or standard cubic feet [scf]. The 50% implies that half the company’s capital is
sales contract is an important element of gas trade and provided by shareholders and half is borrowed.
becomes a focal point in relation to market risk, some issues The higher is the proportion of debt, the higher the
to be considered are: risk of failure to pay, leading perhaps to
bankruptcy. The process of borrowing to invest is
- Contract Term; Gas is normally sold long term (10 to 20 sometimes called gearing or leverage. Debt ratio is
years) or spot (life of a producing field) one of the important factors in determining
- Quantity; gas supply is normally defined as an Annual or whether an institution will provide debt finance,
Daily Contract Quantity (ACQ or DCQ). Demand for gas, as a and how much it will cost, the higher the perceived
source of heat, is seasonal, gas is not easily or cheaply stored, risk, the higher the rate of interest.
so variation indemand is normally satisfied by varying the rate
at which gas is supplied from the reservoir. h. Lease Finance; is a form of debt, whereby the ownership of
- Gas Specification; relates to chemistry and physical relevant assets remains with the financier. This implies that
properties. Sulphur content concerns human safety and the lessor [the bank] is responsible for expenditure, up front
environmental pollution. and that the lessee [the customer oil company] makes regular
- Gas Price; there is limited global trade in gas, consequently, payments for the use of the equipment. There are various
gas price has evolved on a regional basis (at current rates the forms of lease contract: Financial Lease, Sale and Leaseback,
reserve would last for 64 years). The largest market for gas is Hire Purchase and Operating Lease.
the USA, consuming more than 27% of world supply, at i. Inflation; since business is always carried out in an
current production rates, USA reserves would be depleted in 9 environment of changing prices, investment calculations
years and Canada in 10 years. Europe is the third gas market, normally includes a projection over the relevant time period.
Japan and South Korea, the next market in terms of size. For Risk results from rates of change, which were not anticipated.
protection of buyer and seller, long term gas prices are Some of the problematic areas are:
normally tied to other commodity prices, since gas is normally
competing directly with electricity and energy products such  Fixed Price Contracts; as explained previously,
as fuel oil and gas oil. These are commodities used for this form of contract is no longer popular, because
calculation, the inflation may also be included. The following of inflation problems.
is an example of a price escalation formula:  Taxation; is calculated in money of the day terms,
higher inflation often implies higher incidence of
tax.
 Rate Divergence; Retail Price Index is the
mathematical link between money of the day and
real terms cash flows and return on capital. If some
cash flows are not subject to the average rate of
Where inflation, distortion can arise. Oil price, is
independent of RPI, oil sales continue throughout
Price of Gas at Time period n the life of the project.

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Petroleum Economics
Student Notes
- Maximum lost and probability assessment
6. Partners - Independence of lost occurrence
- Size of maximum possible lost
Most companies enter partnerships as a means of spreading risk
during exploration. When two or more organizations come together b. Farm-Out Agreement, mostly associated to drilling of
in partnership, it is inevitable that there will be differences of exploratory wells, is the situation when a company
opinion. If the partners fail to work effectively together, the releases partially its equity to other company to retain
operation may be less than optimum. The following are some of the some involvement, when they have some financial
issues that may arise: restrictions or reach the limit for investment.
c. Construction Contracts, mostly associated to the
- Technical Preference construction of entire production facilities is called also
- Conflict of Interest “TurnKey” contracts, in such contracts the operator
- Analysis and Perception release some of the risk for development cost to the
- Corporate Issues contractor.
- Human Relationships d. Lease Finance Contract, the lessor acquire a field for
production, and payment to the lessee company is based
Chapter 7 – Risk Management according to system performance; in such a way the
lessee company has transferred part of the reservoir risk
to the lessor.
1. Introduction e. Project Finance Contract, is useful when a company
have am investment opportunity, which they cannot
Management of risk requires: finance by conventional methods, thus the purpose is to
get involved the lender based on company capacity and
 Understanding the sources of risk (Chapter 6) showing a solid project, because the debt is secured
 Looking for opportunities to reduce risk (next section) against the project cash flow stream. In this mechanism,
 Incorporating risk into the decision process the borrower transfers some measure of project risk to
the lender. Examples of project using this type of finance
are Piper, Niniam and Forties.
2. Risk Reduction f. Commodity Trading, this mechanism is associated to the
price risk, basically the way it works is by transferring
The most common methods that company use for Risk Reduction the risk from one party to another, at a price. The
are: following are considered:

2.1. Acquisition of Information - Forward Contracts,

- Futures Contracts,
Uncertainty and risk result from incomplete information, some - Options,
of the tactics that companies use to reduce this risk are: - Swaps,
- Netback Pricing,
 Building more detailed reservoir simulations models to - Price escalation formulate,
investigate behaviour and to identity areas of critical
uncertainty 2.3. Diversification
 Running new seismic surveys to improve the overall
The purpose is to ensure that all the investments are separated
shape, volume and structure
to ensure that they are unlikely all to be harmed by a single
 Drilling additional wells to clarify layers in poor
negative event. Investment can be diversified in different
defined areas
ways:
 Running further well test, to verify production rates and
continuity a. Joint Ventures; is a form of alliance between two or
 Initiating geological studies of sedimentology to more companies. It is also a mechanism for sharing
improve confidence expertise and resources, and for spreading investment
 Identify properly the reserve potential and risk.
b. Geographical Spread; ensure that the company is
Company may use also the information of factors today that exposed to a range of geological, development and
may create a threat in the future, for example: political environments, which increases marketing
opportunities and reduce the risk of vulnerability by
 Corrosion in pipelines geological, environmental and political changes.
 Fatigue process in offshore platform c. Vertical Integration; the route from oil reservoirs to
 Vulnerability of system that require human intervention customers comprises a number of stages: Exploration,
 Markets fluctuations for Oil and Gas Production, Transportation, Refining, Manufacture,
 General Economical and Political situations Distribution, Marketing and Sales, vertical integration
implies that a company operates in more than one of
The purpose is to reduce the surprise element, based on these stages.
company experience and knowledge of previous development d. Conglomeration; is something composed of
projects. heterogeneous elements, as a company it consists of
diverse business activity, investing outside the core
2.2. Transfer to another company business area of the company, thereby reducing exposure
to risk from that core market.
There are several mechanism that companies use to pass risk e. Scenario Planning; scenario are models of, or stories
to another company, always involving some extra cots, the about the future, several scenarios may be constructed as
more typical are: alternative views of the future.

a. Insurance Policy, is one of the traditional methods

usually adopted because legal requirements for the 3. Decision Methods
project. If used, the monthly insurance cost affects
directly the monthly cash flow. Some criteria used to Decisions are the basis of successful business; here we restrict our
decide for an insurance coverage include: discussion to decisions pertaining to project investment and good
financial performance. The nature of petroleum business precludes
- Randomness of loss occurrence the elimination of risk; there are some procedures and methods to
- Definition of maximum possible lost

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Petroleum Economics
Student Notes
incorporate risk within the decision-making process that we will
review further. 3.2.3. Cash Flow Logic

3.1. Simple Methods The project cash flow model is constructed in the
usual way, to include all the appropriate
3.1.1. Payoff Matrix computational logic and values for all relevant
parameters.
A payoff matrix is a simple method of representing the
key elements of a decision: 3.2.4. Stochastic Parameters

 Actions available to the decision-maker Example of Stochastic parameters can be: Project
 Possible states of nature, as perceived by the Capex, Fixed Opex, Oil Price, etc. Some
decision-maker distribution types used in stochastic with stochastic
 Monetary value of possible outcomes of the values are:
decision
- Uniform, a uniform distribution specifies a
A decision criteria is required to convert this matrix range of values, with no central tendency, the
into a decision. The pessimist rule is based on the probability of occurrence is uniform across
premise that whatever course of action is taken, the the specified range, some parameters
worst possible outcome will happen. The Regret is considered here are: Rate of Inflation,
defined as the difference between a matrix element Exchange rate and Corporation Tax Rate.
and the best possible outcome (payoff) for that - Triangular, specified a range of values and a
particular state of nature. most likely or modal value, the distribution is
symmetrical, two of the parameters here are:
3.1.2. Payback Period Capex and Fixed Opex.
- Irregular, a non-geometrical and non-
Payback (payout) is the time taken to recover invested theoretical distribution may be described as
capital from a project. It may be derived from irregular. An example of irregular parameter
discounted cash flows; the longer the payback period, is the Oil Price.
the higher the perceived risk. - Theoretical, normal or lognormal
distributions.
3.1.3. Discount Rate Adjustment - Parameter Dependence, this procedure is
only valid, if the parameters are truly
One of the most common and effective methods of independent.
handling risk in an investment decision is to adjust
the discount rate. The important issue here is that a 3.2.5. Random Number Samples
risky investment must offer a higher potential
return, in order to become more attractive than a The calculation method requires individual of each
safer investment. stochastic parameters to be chosen to create
multiple states of nature, all of which are feasible.
3.2. Base Case Methods Two methods are commonly applied: Monte Carlo
Sampling (MCS) and Latin Hypercube Sampling
Base case methods of incorporating risk, focus on a base case (LHS) or Stratified Sampling. Both methods use
as a central value and review the impact of parameters random number generation
variation on this central value.

3.2.1. Sensitivity Analysis 3.3. Mathematical Expectation (EMV)

Sensitivity analysis is a review of the impact of The expected value of an event may be defined as the
change on a system. In the context of project product of its numerical outcome and its probability of
economics, this normally involves representing a occurrence. If the outcome is financial, the product may be
system or project by its cash flow and investigating called Expected Monetary Value [EMV]:
the implications of changing one or more of the
input parameters. The output is commonly
measured by calculating a measure of value such
as NPV. Input parameters are varied individually,
maintained the others constant. The representation Where is cash value or payoff and is its probability
is using Spider Diagram or Tornado Charts. of occurrence, also is a similar equation when there is more
than one outcome value. An EMV parameter is a
3.2.2. Simulation Studies probabilistic or weighted average.

Simulation is the process of building a physical or The Binomial probability function is a mathematical
theoretical model of a system, in order to representation of the probability of success over a number of
reproduce significant elements of condition or trials, where there are two possible outcomes:
behaviour. The simulation process involve:

 Cash Flow Model, build a cash flow

logic & identify deterministic and
stochastic parameters
 Parameter Probabilistic Distribution Where: s, number of success; n, number of trials; p,
(Oil Price, Capex, Opex, etc) probability of success at a single trial
 Value Selection, using Monte Carlo or
alternate random process to create 3.4. Preference Theory
“States of Nature”
 Model Iterations, for each “State of
Nature” generate measure of project Application of the EMV criterion implies a neutral attitude to
value risk across the range of monetary values incorporated in the
 Results, Collect & Plot results calculation. Decisions takers are influenced by potential loss
in relation to available or expandable resources, as well as to

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Petroleum Economics
Student Notes
psychological attitude to gains and losses. The formal
analysis of these issues is called Preference or Utility Theory.

Attitude to monetary amounts may be modeled by means of a

graphical Utility Function. This is a plot of monetary values
versus some form of utility unit to indicate individual or
corporate attitude to sums of money.

3.5. Decision Trees

A decision tree is a graphical representation of a sequential

decision problem, incorporating logic, value and probability.
Construction of the tree requires the compilation of relevant
data and organization of the problem into a logical sequence
of information gathering and decision-making. Solution of
Bayes calculations may be represented in an alternative
the tree provides an optimum sequence of decisions and a
format, which may be more easily remembered:
value for the initial decision.
a. States of Nature; these are all possible specified
outcomes.
Tree Elements
b. Initial Probabilities; these are estimates or
calculations of the probabilities of the various
In constructing a decision tree, it is very important to order
states of nature, available before the sampling
information and decisions correctly. The main elements of a
occurs.
decision tree are:
c. Conditional Probabilities; these are the
probabilities of the specified samples or events
- Decision Node, is a point in which the
arising, from each identified state of nature.
decision-maker may choose the route, they
d. Combined Probabilities; for each state of nature,
are commonly represented by square symbol.
multiplying its initial probability by the
A decision tree always commences with a
conditional probability of the sample arising from
decision node.
that state of nature, gives the probability of both
- Chance Node, is a point at which there is an
occurring together.
uncertain outcome, they are commonly
e. Revised Probabilities; once the samples have
represented by circular symbol.
appeared, we have the opportunity to revise our
- Branch, is a line joining two nodes.
estimates for each probability.
- Composite Branch, is a sequence of nodes
and branches, forming a route through the
Bayesian analysis is commonly required in decision
tree. Tree branches usually represent
situations involving imperfect information. Seismic
activities or information. Each composite
information is considered to be imperfect.
branch has an associated revenue, positive for
a successful project, zero for a failed
- Value of Information, decisions are often concerned
investment. Under normal circumstances,
with the purchase of information. The cost of such
these numbers represent NPV’s.
acquisition may be justified in terms of reduced risk
and higher expected value for subsequent decisions.
Tree Solution
The sense of value here being a measure of whether the
acquisition of the data is beneficial to the project. There
Solution of tree is the first step being to compute payoff
are different methods of approaching and different
values for each composite branch termination. Payoff for one
definitions of value:
composite branch is the algebraic sum of all costs and
revenues associated with that composite branch from
a. Cost of Data Acquisition Included; value of
beginning to end.
the information may be defined as the
difference between the value of the decision
Solution of a tree involves solving each Node in turn, starting
option, containing the cost of acquisition, and
at the right and working towards the principal decision node
the next best value.
on the left.
b. Expenditure Limit; this value indicate the
maximum that may be spent
Tree Probability
c. Zero EMV; the maximum value of
information should be the positive EMV for
The general principle here is that each branch is part of a
the decision to acquire the data.
unique sequence of activity and outcome, and probability
must reflect project history along its composite branch. Tree
probabilities are what we know as conditional probabilities,
the condition being that we have followed a unique sequence
leading to that location in the tree. There are some other
concepts that illustrate the probability relationships:

- Venn Diagrams, they are used to represent probability,

with a rectangular boundary enclosing unit area,
equivalent to unit probability.
- Bayes Theorem, it concerns the relationship of A and
B when in a Venn Diagram they overlap.

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