petroleum economics

INTEGRATED GRADUATEDEVELOPMENT PROGRAM

CLASS 2011

PETROLEUM ECONOMICS

David Wood

IN-HOUSE COURSE

prepared for

OMV EXPLORATION & PRODUCTION GMBHVienna, Austria

HOT Engineering GmbHParkstrasse 6

A-8700 Leoben, AustriaTel: +43 3842 430530Fax: +43 3842 430531

E-Mail: [email protected]

Copyright 2012 by HOT Engineering GmbHParkstrasse 6, A-8700 Leoben, AustriaAll rights reserved. No part of this publication may be reproduced, stored in a retrievalsystem or transmitted in any form or by any means: electronic, mechanical, photocopying,recording or otherwise, without written permission from HOT Engineering GmbH.

Printed in Austria.Not for sale.

Overview of Course Objectives & Materials

The Need for Petroleum Economics

Project Cash Flow & Income Components

Project Cash Flow & Income Components (Exercise #1)

Petroleum Reserves Categories & Valuation

Discounting & Time-Value Considerations (Exercise #2)

Rates of Return

Payout Time or Payback Periode

Profit to Investment Ratios

Risk and Opportunity Analysis

Capital Budgeting Techniques & Yardsticks (Exercise #3)

Which Oil & Gas Prices Should be Used to Value Assets?

Valuing Incremental Investments

Inflation, Buying Power, Money of the Day & Real Values

Inflation Indices

Estimating Values & Costs and Budget Cost Control (Exercise #4)

Introduction to Upstream Fiscal Terms & Contract Types

Production Sharing & Cost Recovery (Exercise #5)

Funding Criteria: The Cost of Capital & Oil & Gas Finance

Hurdle Rates and Selection of Discount Rates

Probabilistic Methodology & Techniques for Economics & Risk Analysis

Decision Analysis, Decision Trees & Flexibility

Monte Carlo Simulation Demonstration (Exercise #6)

Petroleum Economics

Overview of Course Objectives & Materials

David A. Wood

by David A. Wood

Course Structure & Approach

The course is structured into a sequence of PowerPoint presentations and exercises.

Your participation is welcome. My preference is for an informal approach to

encourage an exchange of ideas and experience.

The course aims to be a stimulating & enjoyable experience for all!!

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by David A. Wood

Course Director: David A. Wood

Some 30 years of energy industry experience Widespread international operations & project exposure Governments, majors, independents, services & consultants Technical, commercial, training and senior corporate expertise Risk, economics, portfolio and fiscal modelling & research Advises governments and companies on approaches to fiscal design Broad focus: upstream, midstream and downstream Technical evaluation, numerical modelling and due diligence Mergers, acquisitions and divestments (management & negotiation) Project finance, hedging and trading Oil, gas (LNG, GTL and storage), power and renewables Strategy, geopolitics and contract negotiations PhD - Imperial College London (1977) geology / deepwater drilling Diploma Company Direction Loughborough / IOD (1996) Independent consultant since 1998; widely published; expert witness

[email protected]: @DWAEnergyFacebook: DWA Energy LimitedLinkedIn: David A. Wood

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by David A. Wood

Petroleum Economics2-day Module Daily Themes

Day 1 Basic Analysis & Valuation Techniques Day 2 Constructing Economic Evaluation Models

Outline structure of course - each day has a distinct theme.

The aim is to provide delegates with a comprehensive introduction andbalanced view of petroleum economics.

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DAY 1 Basic Analysis & Valuation Techniques

Morning Session 4.1

Overview of Course Objectives & Materials The Need for Petroleum Economics Project Cash Flow & Income Components

Morning Break

Morning Session 4.2

Distinguishing Cash Flow & Other Measures of Profitability (Exercise#1) Petroleum Reserves Categories & Valuation Discounting & Time-Value Considerations (Exercise#2)

Lunch Break

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by David A. Wood

DAY 1 Basic Analysis & Valuation Techniques

Afternoon Session 4.3

Rates of Return Payout Time Profit to Investment Ratios Risk and Opportunity Analysis

Afternoon Break


Capital Budgeting Techniques & Yardsticks (Exercise#3) Which Oil & Gas Prices Should be Used to Value Assets?

End of Day 1

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DAY 2 Constructing Economic Evaluation Models

Morning Session 4.5

Valuing Incremental Investments Inflation, Buying Power, Money of the Day & Real Values Inflation Indices Estimating Values & Costs and Budget Cost Control (Exercise #4) Introduction to Upstream Fiscal Terms & Contract TypesMorning Break

Morning Session 4.6

Production Sharing & Cost Recovery (Exercise #5) Funding Criteria: The Cost of Capital & Oil & Gas Finance Hurdle Rates and Selection of Discount Rates Probabilistic Methodology & Techniques For Economics & Risk AnalysisLunch Break

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Decision Analysis, Decision Trees & Flexibility Monte Carlo Simulation Demonstration (Exercise #6) Assessment Test

Afternoon Break


OMV Session on in-house Easy Evaluation Pre-tax Cash Flow ToolEnd of Module

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DAY 2 Constructing Economic Evaluation Models

by David A. Wood

Ask if You Need Clarification

Dont be shy!

There is a lot of material to get through, but time will be made for discussion.

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Petroleum Economics

The Need for Petroleum Economics

David A. Wood

by David A. Wood

Key Metrics Show Distinctive & Dislocated Trends For E&P Assets

Key performance indicators (KPIs) give different impressions at different stages of an oil and / or gas assets life cycle.

Economic and risk analysis provides a means of clarifying and quantifying the importance and relevance of these trends.

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E&P Investment Appraisal & Decisions

Large initial capital investment High rate of capital investment

throughout asset life

Long payback period High risk and uncertainty Complexity Multiple stages with deferrable decision

points

Incremental information flows and decision points

Dependency upon volatile product prices and demand

Upstream projects are characterised by:

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Cost Time Cycle for ExplorationThrough to Field Production

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Constraints on Upstream Oil & Gas Companies

Large portfolios of E&P projects available for investment at any one time.

Finite technical resources & skills to evaluate & manage each project.

Finite time in which to perform commitment work programmes

Finite financial resources and frequent budget constraints making them not indifferent to the level of risked capital required to optimise the portfolio.

Major upstream companies are characterised by:

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Which Development Option Makes Most Economic Sense?

The type of field facilities, number of wells, timing of drilling, owning or leasing facilities are all decisions that require economic and risk analysis as well as engineering design.

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Volatility caused by booms and recessions driven by the supply-demand balance and oil prices. For how long will such cycles be repeated?

Oil Industry of Last 30 Years has been Characterised by Volatility

Oil supply & demand main drivers for volatility in recent decades

Access to quality international upstream permits to explore and develop is a major challenge for IOCs, together with finding and retaining skilled staff.

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Boundary Scenarios Can FrameEconomic Sensitivity AnalysisFraming the future in terms of options helps to identify and quantify key issues and potential risks and pitfalls. Sensitivity and Simulation analysis are frequently essential to understanding the full picture.

It is important for economic analysts to consider more than one future.

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Costs of Delays in The Exploration & Appraisal Portion of Field Life Cycle

Delays in exploration / appraisal always have a negative impact on project / company profitability over the long-term project or field cycle. Economic and risk analysis quantifies this impact.

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Economic analysis can identify when it is necessary to introduce structural changes in order to extend the projects commercial life by reducing operating / production costs.

Extending Field Life by Reducing Operating Costs & Overheads

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Risk & Fiscal Analyses are Key Parts of the Investment Decision Process

The economic structure of the oil and gas industry is intimately associated with risk versus reward tradeoffs and fiscal designs.

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In a portfolio approach projects are judged based on their contribution to long-term strategy, and how they interact with the other projects in the portfolio, as displayed by the feasible envelope, efficient frontier and probabilities of metrics being achieved. This is a dynamic process.

Modern Portfolio Modelling Approach:Economic, Risk and Strategy Analysis

Portfolio modelling & management should firmly link investmentdecision-making at the asset, portfolio and merger / acquisition/ divestment levels to a quantified corporate strategy.

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There are Many Different Reasons Why Valuation & Risk Analysis are Required

Establishing that a project can achieve acceptable profitability Comparing the value of projects & investment opportunities Allocating values to different categories of reserves Indicating threshold commercial field sizes in specific environments Distinguishing the most appropriate field development plans Testing the impact of different economic scenarios (e.g. oil price) Assessing the impact of costs and overheads on project returns Identifying value at different points along the supply chain Consider available options for optimising returns from reserves Evaluating merger, acquisition and divestment opportunities Justifying budgets, forecasts, business plans and strategic options Negotiating and comparing fiscal and contract terms Securing project finance and other forms of debt Reporting historical performance & forecasting to stakeholders Quantifying the impact of risk and opportunity on projects Valuing portfolios of oil and gas projects & assessing performance

The results of such analysis are almost always ultimately linked to assisting and clarifying decisions. Some of the main reasons are:

We will address these reasons and several others during this course. 13

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Petroleum Economic & Risk Analysis Aids Decisions to Balance Risk & Reward

Balancing is never easy!!!

Economic & risk analysis is a fundamental process in strategic and operational management of the oil and gas industry.

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Petroleum Economics

Project Cash Flow & Income Components

David A. Wood

by David A. Wood

The role of financial management is to optimise the value and use of the basic reservoir of cash and its associated funds flow.

Simplified Flow Chart For The Financial Process in a Typical Upstream Oil Company

Financial management involves funding decisions in the raising of cash in the form of equity and debt.

It also involves the efficient allocation of funds between assets, credit investments, etc.

Reserves do not appear in this model but can influence depreciation.

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For an oil and gas company to prosper it has to find and/or acquire new reserves and make a financial profit.

Focus of Economic Analysis

E&P companies do not stay in business long without returning a financial profit.

Production cannot be sustained without new reserves to produce. Economic analysis must therefore be focused on increasing profits and

optimising profitability from their reserves.

A key question is how do we define and measure profit?

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Costs are an important component controlling the overall value of projects and reserves. Costs are distinguished as CAPEX & OPEX.

Upstream Cash flow Components:Influence Diagram Role of Reserves

CAPEX Decisions, such as project design or field development often pivot on cost, timing, efficiency and capital constraints,e.g. well design.

In the production stage OPEX is often the focus in determining efficiency,profitability and viability.

Reserves and reservoir characteristics have huge influence on cash flow components.

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None of the economic calculation techniques commonly applied are complex but their analysis can become so.

Basic E&P Economic AnalysisTechniques Are Straight-forward

Most economic evaluations readily establish: levels of capital investment required future cash flows national or local tax liabilities earned and paying interests

The complications arise in: ranking projects against each other allowing for existing commitments allocating & monitoring sources of funds identifying risks and opportunities correctly adjusting cash flow for uncertainty Estimating chances of success. market conditions and product price forecasting.

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Petroleum Projects Require High Capital Outlay to Achieve Long-term Returns

There is an unparalleled relationship of expenditure, risk, timing and revenue in the oil and gas industry that distinguishes it from other industries.

E&P economic analysis focuses on the value of available reserves and the timing of their production that maximizes cash flow and profits (earned income) for those holding interests in those reserves.

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Cumulative net cash flow is the basis for most economic analysis. It is calculated on a before and after tax basis and has these major components:

Cash Flow Projections

Cash Items: monies actually paid and received. Non-Cash Items: such as depreciation, depletion (North America), book

values used mainly for tax and accounting calculations.

Royalties: property of the state either paid in money or product is not technically a cash or non-cash item as it is never owned by the E&P company.

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Monies actually paid and received can be subdivided into a number of specific categories:

Cash Flow Components - Cash Items

Working interest E&P revenues Income from property sales (and their capital gains tax) Working interest local taxes Operating costs Overheads (corporate / operational, G&A, loan interest) Capital investments Land, lease and licence fees and bonuses Corporation taxes (investment tax credits) Special petroleum taxes (e.g. PRT in older UK licences) Debt capital and interest repayments

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Inflows usually equate to production revenues but also may include asset sales. Outflows include expenditures and taxes.

Cash Flow Combines Cash Inflows with Cash Outflows

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Calculations of taxable income depend upon accounting and tax rules which vary from country to country and sometimes between E&P contracts in the same country.

It is often referred to as Net Income or Earnings (in US)

Taxable Income is Not Cash Flow but Profit Adjusted by Accounting & Taxation Rules

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The term Mineral-Interest Reserves is used to distinguish projects from those projects subject to the terms of Production Sharing Agreements (PSAs).

Some companies focus more on cash flow performance (~EBITDA) others more on earnings.

Calculation of Key Project & Corporate AccountingMeasures Applicable to Oil & Gas Projects

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The Tax Burden in E&P Contracts Has Many (Often Complex) Components

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Calculations of taxable incomes depend upon accounting and tax rules, particularly involving the depreciation of capital costs.

Taxable Income Is UsuallyNot Cash Flow

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Calculations of taxable incomes, particularly in tax-royalty fiscal regimes, are usually complex and require specialist tax advice.

Generic Corporate Tax Model

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This is applied to costs for items that will benefit the company for more than a single year. It is a system that spreads the costs of such items over each year of its useful life or production unit.

Depreciation of Capital Costs

Depreciation can be calculated in a variety of ways some of which load more depreciation on to the early years where the equipment is most useful and its maintenance costs should be lowest. Methods allowed depend upon prevailing legislation.

Book value of capitalised assets is their original cost less the accumulated depreciation. It should not be confused with market value or replacement value.

A gain or loss on the sale of an asset is computed by comparing the sale price with the book value. These are included as extra line items on income statements.

Small items even though they may last several years are often treated as an expense in the year in which they are purchased provided it does not yield material errors.

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Asset lives will depend upon prevailing legislation, but example ranges are:

Typical Asset Lives For DD&A Purposes

Production plant including in-field flow lines and tangible well costs - 5 to 10years.

Intangible costs (sometimes a portion of these have to be capitalised ratherthan expensed) 5 years.

Drilling equipment & vehicles 5 years. Transmission / Trunk pipelines 10 to 40 years. Refinery Plant & equipment 10 to 20 years. Buildings 20 to 30 years. Computer hardware and software 3 to 5 years.

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Depreciation records are concerned with costs not value. Hence purchase price less accumulated depreciation equals remaining cost but is termed the book value. This is not a value but a remainder.

Depreciation & Calculation of Book Value

Consider a machine that cost $60,000 and management estimates its useful life to be 10 years and its salvage value after 10 years to be $10,000.

On a straight-line depreciation basis the annual depreciation rate will be ($60,000 - $10,000) /10 which equals $5,000 per year.

At the end of the second year an accumulated depreciation schedule for the machine could be:

Original purchase costs: $60,000 1st year depreciation allowance: $5,000 2nd year depreciation allowance: $5,000 Total accumulated depreciation: $10,000 Book Value: $50,000

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Amortisation of capital investments so as to spread costs over a period of time for tax or accounting purposes. Methods are designed to recover capital costs over the life of an asset. Some depreciation methods accelerate the amortisationprocess (e.g. double declining balance; SYD; MACRS).

Depreciation is a Key Non-cash Component in Calculating Net Income

Depreciation methods used in E&P industry are:

Units of Production (costs recovery linked to production and reserves) - widely used for accounting purposes.

Straight Line - costs recovered in equal fractions per year.

Declining balance - various rates are applied - single(100%), 150% & double (200%) rates used.

Sum of the Years Digits (rarely used outside North America).

MACRS -(modified accelerated cost recovery system) used for U.S. federal income tax (FIT) capital cost depreciation

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Depreciation rate is important to project valuation in that it controlshow quickly capital investments are recovered from cash flow.

Depreciation & Capital Cost Recovery

From the investors point of view it wishes to recover all costs as soon as possible. The best solution would be expensing all capital costs together with operating cost (equivalent to a 100% annual depreciation rate applied from the year of expenditure).

If capital costs are depreciated over 5, 10, or 20-year periods discounted cash flow values for a venture decrease as the annual depreciation rate reduces.

Governments like to have low annual depreciation rates as it increases their tax revenues as companies show higher taxable incomes in the early years of a project.

This is a means of governments receiving a share of revenues from oil and gas projects from early in the production life of a field development.

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It is not unusual for different depreciation rates to be applied to different categories of capital expenditure.

Different Rates of Depreciation

Exploration costs (drilling & G&G costs) are often depreciated at 100%(i.e. expensed) to provide investors with an incentive to make new and risky investments.

Development costs are often divided into categories such as tangible (plant with a long life) and intangible (materials or services consumed in an operation, e.g. drilling mud, wire-line services). The intangibles are often expensed or subject to a more rapid depreciation rate.

Allocation between categories can be arbitrary and subject to change. It is the cause of many disputes with the tax authorities.

UK authorities have in recent years reduced the depreciation rates applied to intangibles on development wells in response partly to side-track technology developments.

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This originally North American concept is now also widely used in international oil and gas accounting.

Depreciation, Depletion & Amortization - DD&A

Depreciation is a means of accounting for the recovery and allocation of costs associated with fixed (tangible) assets over the deemed useful life of an asset. Annual depreciation charge is deducted from revenue in the net income calculation.

Depletion is the same concept as depreciation but applied to purchase prices (i.e. acquisition values) of mineral resources (e.g. oil & gas) enabling them to be deducted for tax purposes over time.

Amortization is the same concept as depreciation but applied to intangible assets.

Commonly these terms are used interchangeably and /or collectively as DD&A.

Depreciable life of specific assets is governed by rules specified in the prevailing accounting and tax legislation. 21

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The following extract comes from Apache Corps form 10-K submission of Feb, 2011 to SEC for year ending Dec 31st 2010:

Example DD&A Methodology Stated by US Oil Company in a 10-K Return to SEC

22Source: Apache Corp 10K 2010

by David A. Wood

The following extract comes from Apache Corps condensed statement of operations in its 10-K submission of Feb, 2011 to SEC for year ending Dec 31st 2010:

DD&A is an Operating Expenseon the Income Statement

23Source: Apache Corp 10K 2010

by David A. Wood

DD&A is the only impact reserves have on the profit & loss (income) statement. The unit of production annual depletion calculation can be expressed generically by the equation:

Depletion (DD&A) Calculated by Unit of Production Method

(C AD S) * P / R

Where:

C = Capital cost of plant and equipment AD = Accumulated depreciation to date S = Salvage or residual value P = Annual production (boe) R = 1P Reserves Remaining at beginning of year (or 2P

reserves in Canada and many other countries)The unit values that are deducted for tax purposes can be substantial (e.g. $2/boeup to >$10/boe. The higher values may indicate higher cost / lower reserves than originally expected. Good performers maintain DD&A charges below $5 / boeparticularly when calculated on a 2P basis. Merger and acquisition costs are usually included in the depletion cost pool.

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Petroleum Economics

Project Cash Flow and Income Components(Exercise #1)

David A. Wood

by David A. Wood

Calculation of Profit, Cash flow & Income Measures Applicable to Oil & Gas Projects

When a figure is referred to as profit, cash flow or income without qualification or explanation it is important to distinguish what it is actually measuring. There are several different possibilities!

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Input Information for Calculating Measures of Profit

When a figure is referred to as profit, cash flow or income without qualification or explanation it is important to distinguish what it is actually measuring. There are several different possibilities!

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Petroleum Economics

Petroleum Reserves Categories & Valuation

David A. Wood

by David A. Wood

How Do We Know There are Reserves Out There?

Shell said the oil exists if only they can find it. Trouble is, they cant convince the SEC. Same applied in 2004 to El Paso, Forest, Nexen, Husky, etc. Many reserve write-downs occurred.

These headlines in the general media and cartoons emphasize the popular view of how oil reserves are measured and how they exist in the sub-surface.

Reality is more complex and uncertain, but Shell are damaged by both popular image and the technical reality.

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Relevance of Resources Versus Reserves to Petroleum Portfolios

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Conventional versus Non-conventional Petroleum Resources

SPE Oil & Gas Resource Committee (2007) place Ultra-heavy crude, tight gas sands and shale gas in their conventional categories. They draw the horizontal line lower.

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Classification of Upstream Oil & Gas Assets & their Reserves

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Reserves Terminology Commonly Applied in Valuation

1P Reserves Proven Developed (PD)

Producing (PDP)

Non producing (PDNP)

Proven undeveloped (PUD)

2P Reserves Proven plus Probable

3P Reserves Proven plus probable plus possible

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Petroleum Reserves ClassificationSPE versus SEC

Until 2010 SPE and SEC have had different requirements for reserves reporting that has caused many issues for petroleum companies registered on US stock exchanges.

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Petroleum Reserves ClassificationSPE / WPC / AAPG / SPEE

This approach is in line with SPE /WPC / AAPG /SPEE guidelines and the Petroleum Resource Management System (PRMS) approved in 2007 updated November 2011.

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Resource Classification Commenceswith In-place Classifications

Culmination of two-year review approved in March 2007 (updated Nov 2011).

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Bookable Oil & Gas Reserves Valued in Production Asset Sales

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Aligning Reserves Definitions withPetroleum Project Cycle

This approach is in line with SPE /WPC / AAPG /SPEE guidelines and the Petroleum Resource Management System (PRMS) approved in 2007.

SPEE = Society of Petroleum Evaluation Engineers

AAPG = American Association of Petroleum Geologists

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Project-based Approach Works best for Petroleum Reserves Valuation

Petroleum Resource Management System (PRMS, 2007) recognises the need for much more than establishing resource volumes.

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Categorizing Reserves by Levels of Uncertainty Key to Valuation

Petroleum Resource Management System (PRMS, 2007, 2011) acknowledges deterministic and probabilistic methodologies. In practice integrating both approaches is useful.

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Forecasts and Valuation Scenarios

Valuations and decisions are based on the evaluators view of Forecast Conditions i.e. those assumed to exist during a projects implementation.

Alternate valuation scenarios are typically considered in the decision process and, in some cases, to supplement reporting requirements.

One sensitivity case commonly reviewed assumes current conditions will remain constant throughout the life of the project (constant case).

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Pivotal Role for Probable Reserves in Acquisition Valuations

In some areas, probable reserves assume a key role in acquisition values.

Significant value is ascribed to probable reserves in:Offshore, particularly in hostile or deep water environments.where significant investment decisions for facilities and infrastructure have to be made early in development.Assets are immature and lots of undeveloped potential remains.

Internationally probabilistic reserves categories are applied.2P reserves (probabilistic proved plus probable) is the reserve estimate commonly where probable reserves are to form a significant part of the assets to be acquired. Method is suited to valuing whole fields rather than small parcels of land.However, internationally it is also not unusual to discount or risk probable reserves more heavily than proved reserves when calculating acquisition values.

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Because the benefits out-weigh the downsides and growth or focus on material assets can be achieved.

Why Do Companies Acquire Assets,Merge or Divest?

The most common reasons given by oil companies are to: achieve greater efficiency; consolidate and grow to meet increased competition; increase shareholder value; benefit from operational synergies; diversify asset portfolio; balance asset portfolio.

Mergers and acquisitions do allow economies of scale and step-decreases in G&A costs.

Downsides are potential job or location cuts. Restructuring and relocation often mean many voluntary and involuntary redundancies.

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How Does an Acquisition or Divestment Add Value to an Asset Portfolio?

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Petroleum Economics

Discounting & Time-Value Considerations(Exercise #2)

David A. Wood

by David A. Wood

Oil and gas projects are characterised by high capital investment in early years, without revenue, followed by high revenue after production startup which gradually declines in line with production towards field abandonment.

Time-Value Considerations

Rate at which costs are recovered impacts contractors value.

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Money to be received at some time in the future is said to have a present value which is less than the amount received by the interest that could be earned on it in the interim.

Present Value (PV) Concepts

The PV is the amount that could be invested at an interest rate such that the amount plus the total interest earned equals the future value (FV).

Future value (FV) = PV + (i * PV ) (where i is the interest rate for one interest period and FV is the value at the end of that one interest period).

Re-arranged to: FV = PV (1 + i)

An example: FV = ($2,000) (1+0.15) = $2,300 so that $300 is the simple interest at 15% on an investment of $2,000 (the principal).

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PV and FV are related to each other through interest rates and discount factors.

Present & Future Values and the Time Value of Money

For example, if an interest rate (i) of 10% applies for one investment period then a PV of US$10 million has a FV of US$11 million at the end of the investment period:

FV = PV * (1 + i)

In this example the FV of US$11million can be discounted to a PV of US$10 million at the start of the investment period by applying a discount factor(1 + d) of 10%:

PV = FV / (1 + d)

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If the interest is withdrawn at the end of the period only simple interest (on the principal investment) is earned the next period.

Simple Versus Compound Interest

If the interest is re-invested in subsequent periods it will earn interest itself in addition to that earned by the principal, i.e. compound interest.

Compound FV for a second period: = ($2,300)(1.15) = ($2,000)(1.15)(1.15) = $2,645

Thus FV of a PV invested at an interest rate of i per year has the general form:

FV = PV (1 + i)n where n = number of years

(1 + i)n is called the compound factor.

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This is the reciprocal of the compound factor and represents one ofthe most important concepts of cash flow analysis.

The Discount Factor

Applying the discount factor to the FV calculates its PV such that:

PV = FV [ 1 / (1 + i)n ] = FV (1 + i) n

Hence the PV of an FV of $6,125 to be received at the end of three years based on an annual interest rate of 7% is $5,000.

$5,000 = $6,125 (1 + 0.07) 3

In this case the 7% is called the discount rate.

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Higher discount rates preferentially penalise later years in a cash flow profile.

Risking Cash Flow Profiles by Increasing Discount Rate is Not Appropriate

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A general solution for the NPV calculation is:

Net Present Value (NPV) is the Sum of Discounted Cash Flows for Each Period

where CFj is the annual net cash flow in year j, i is the discount

rate, n is the total number of time periods. Cash flow in the initial period CF0 remains undiscounted. This can be more neatly expressed as:

Most spreadsheets have NPV functions. It is important to take care that the initial investment and type of discounting applied to it are appropriate.

by David A. Wood

Calculating the NPVs of cash flows of projects to be compared at different discount rates and viewing them graphically can discriminate.

Net Present Value Profile Trends

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Projectsthatlookthemostattractiveatonediscountvaluemaynotdosoatanother.Present Value Profile Trends

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Interest earned on money in a deposit account is normally paid at set regular (discrete) intervals. The example below shows an investment of $10,000 accumulating with interest earned at 6% per annum. It grows discretely at the end of each annual investment period.

Discrete Investment Functions

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Production from an oil or gas well accumulates continuously by the minute and over a long period its cumulative production represents a continuous function (usually with breaks for well service). The example here shows a well producing at an initial rate of 10,000 bopd and declining exponentially at a rate of 20% per annum for 10 years.

Discrete Versus Continuous Functions

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Nominal interest is the annual interest rate if money is compounded annually.

Nominal Versus Continuous Compounding

If compounding is set at periods other than one year then the FV equation needs re-stating:

FV = PV [ 1 + (i / P)] n where P equals interest conversions per year and n equals the number of interest conversions for the total investment period and i equals nominal interest rate per year.

$2,000 compounded quarterly at 6% per year becomes $2,000 [1 +(0.06/4)]12 after three years = $2,391. Annual compounding equals $2,382.

For continuous compounding: FV = PV (e in) where n is the number of iinterest periods. $2,000 after three years at 6% is: $ 2,000 (e 0.18) = $2,394.

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Common compounding methods are summarised in this table for an investment period of one year, but with formulae that work for multiple years. In the formulae shown n equals the number of years in the total investment period (n=1 in the examples shown for just one year) and i equals nominal interest rate per year:

Various Compounding Outcomes

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You have the option to select one project for investment from projects X, Y and Z and the discount rate for all three projects is 10% per annum.

Net Present Value (NPV): A YardstickUseful for Ranking Projects (Exercise #2)

X costs $2million now and returns $3 million in 4 years. Y costs $2million now and returns $4million in 6 years. Z costs $3million now and returns $4.8 million in 5 years.

Calculate the NPV for each project, using the discount factor table provided. Then use the NPVs to rank the projects in order (best to worst) and select the best for investment.

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by David A. Wood

In practice a spreadsheet, calculator or economic software package would calculate this for you.

Discount Factor Table

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Petroleum Economics

Rates of Return

David A. Wood

by David A. Wood

An earned interest on the money invested.

Rates of Return

There are two quite distinct rates of return commonly used and referred to:

The accounting or book rate of return including return on net assets and return on capital employed (ROCE) or return on average capital employed (ROACE).

The internal or investors rate of return (IRR) and its modifications.

It is important not to confuse the two. Accountants, investors and financial analysts often refer to the former.

It is the later that interests petroleum economists and investors when looking at project economics.

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by David A. Wood

This is a single-year performance measure usually extracted from financial accounts.

Book Rate of Return

Book ROR = Profit/Year Investment

The average value for the total life of a multi-year project can however be approximated as:

Book ROR = Profit Investment RatioNumber of Years

Such ratios are used for annual financial reporting purposes and corporate performance analysis and are not suitable for economic decisions concerning specific projects.

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by David A. Wood

The rate which will discount the cumulative cash flow to zero, before or after taxes. Put another way it is the rate of return at which the PV of future returns equals the initial outlay.

Investors Rate of Return (IRR)

d equals the IRR when: Rn (1+d) -n = 0 where n is the number of years and R is the net cash

flow in each year.

For such a series of cash flows, a trial-and-error or iterative solution is required to obtain the IRR; there is no direct solution with more than two cash transactions.

d is sometimes compared with a hurdle rate or minimum acceptable rate of return (MARR). If it exceeds that value the project is viable.

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by David A. Wood

Although widely used as an investment yardstick it has significant problems.

Investors Rate of Return: Appropriate Uses

Advantages: Valid as a qualifying parameter. Widely used within industry. Does not depend on project magnitude.

Disadvantages: Assumes all monies can be & are reinvested at IRR.(but can be

modified for a specific re-investment rate MIRR) Not valid as a ranking parameter. May not yield a unique solution. Gives no indication of project magnitude.

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by David A. Wood

Consider cash flows X and Y. The only difference is in the timing of the investment, but note the impact on both NPV and IRR.

IRR and NPVReflect Time-Value Influences

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NPVs for a range of discount rates either side of the IRR.

IRR and Discount Rate Relationship

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by David A. Wood

The undiscounted cash flow for each period is discounted back to its equivalent value at the start of period 1 by the discount rate and formula.

Discounted Versus UndiscountedCash Flows

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by David A. Wood

For an interest hurdle rate of 6% project A requires an investment of $18,000 for a $20,000 return one year later while project B involves an initial outlay of $2,000 for a return of $2,500 one year later. Which project should be selected for investment?

Investors Rate of Return Example

IRRA = (20,000/18,000) - 1 = 0.11 = 11%. IRRB = (2,500/2,000) - 1 = 0.25 = 25%. NPVA = -18,000 +(20,000/1.06) = $868. NPVB = -2,000 +(2,500/1.06) = $359. IRR suggests B is better than A; NPV suggests A is better than B. More

information than IRR in isolation is needed for a good decision.

If there were 8 other projects like B then they would represent the best investment of $18,000.

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by David A. Wood

IRR is not a good yardstick for discriminating between projects or justifying projects as this example shows.

Investors Rate of Return is an Indicative not a Definitive Yardstick

IRR does not alwaysgive a unique solution.

NPV is more realistic as it is calculated at adiscount rate that ismeaningful to thecompany concerned (e.g. its investment hurdle rate or cost of capital).

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by David A. Wood

Spreadsheets offer good IRR functions but it can be calculated by interpolation or graphically. Table below uses mid-year discounting.

Investors Rate of ReturnExcel versus Interpolation

[5 / (5+13)] * (25 -20) +20 = 21.28% Interpolation must not be over more than 10 percentage points.

YearNet Cash

Flow

Present Value (PV10)




0 -500 -500 -500 -500 -5001 400 381 373 365 3582 100 87 81 76 723 100 79 71 63 57

Totals 100 47 25 5 -1321.29% IRR (Excel)21.28% quick hand calculation

Example of Investor's Rate of Return Calculation

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by David A. Wood

There are two IRR points for this project. Both are mathematically correct one ~ 5% the other ~29%. The shape of the graph shows that for discount rates betweenthese two values the project is profitable.

IRR Does Not Always Provide a Single Solution

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by David A. Wood

AcalculatedIRRisnotactuallyearnedunlesspositivecashflowsfromeachperiodarereinvestedattheIRRrate.Considerthefollowinginvestment:

IRR & MIRR (ERR):The Reinvestment Issue

Year Net Cash Flow PV@: 38%0 ($1,000) ($1,000)1 $680 $4652 $680 $3183 $680 $217

Totals $1,039 $0PV = FV * e -in 0% IRR

If $680 is taken out each year and not re-invested:then FV= 3* $680 = PV * e 3i

then FV= $2040 = $1000 * e 3i

then Ln (2.040) / 3 = i = 23.8%

If $680 is taken out each year and re-invested atrates less than 38% then 24%< i

Petroleum Economics

Payout Time or Payback Period

David A. Wood

by David A. Wood

Delays Erode ValueIt is not only the magnitude of the cash flow components that influence value, it is also the timing of the cash flow elements:

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David Wood & Associates

by David A. Wood

Such measures have a calendar significance:

Time Related Yardsticks

Project life. This is the length of a project, usually in years. It is related to the time horizon of a corporations strategy and its long and short-term goals.

Pay-back or pay-out period. This is the time, usually in years, for a project to return the after-tax investment. It is the point at which the cumulative net cash flow becomes positive.

Discounted pay-out time. Payout calculated using discounted revenues and investments

Time to first revenue. This is the time from first investment to first income. Useful for those companies requiring operating cash flow.

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Payout is the time at which the cumulative cash flow, discounted or undiscounted (depending on selected definition), becomes positive. Most analysts quote undiscounted payback times.

Pay Back Period or Payout

Advantages:

Is a measure of liquidity. Is a measure of risk exposure.

Disadvantages:

No indication of what occurs after payout. Multiple payouts with staged investments. Reflects no magnitudes. Is affected only by total cash flow to that point and not by timing of that

cash flow.

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by David A. Wood

Payout / Payback CalculationsPayout time indicates liquidity (risk) rather than profitability:

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Simple Payout CalculationIgnores Time-Value Considerations

Discounted Payout formula:

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Where:Rk = revenue year kEk = expenditure year kI = initial investment

Petroleum Economics

Profit to Investment Ratios

David A. Wood

by David A. Wood

These ratios divide returns by costs but have several options for calculation which can lead to confusion.

Cost to Benefit Ratios

Defined using different values for the investment, which may be the same for any one project:

Net cash flow/maximum negative position

Net cash flow /risk capital (also referred to as risk capacity and number of times investment returned (NTIR).

Net cash flow /development capital

Net cash flow/total investment

These may be before-tax or after-tax values and both or either numerator and denominator may be calculated on a discounted or undiscounted basis depending on the preferred definition.

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by David A. Wood

These are widely used investment efficiency indicators.

Cost to Benefit Ratios:Pros & Cons

Advantages: Measure magnitude of cash flow (profit) per dollar invested

Discounted values give a measure of the efficiency of the use of capital; can be used as a ranking parameter

Independent of project magnitude

Disadvantages: Give no indication of time flow of money May not reflect total investment Do not reflect project magnitude

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by David A. Wood

These are widely used because they are easy to calculate.

Undiscounted Benefit to Cost Ratios

Return on Investment:

ROI = Cumulative Net Cash FlowMaximum Negative Position

Profit to Investment Ratio:

PIR = Cumulative Net Cash FlowTotal Investment

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by David A. Wood

Discounted ratios are more useful ranking yardsticks, particularly when capital is rationed. What costs are included in the denominator needs to be clear.

Discounted Benefit to Cost Ratios

Discounted Return on Investment:

DROI = NPV of Cash FlowMaximum Negative Cumulative PV

Discounted Profit to Investment Ratio:

DPIR = NPV of Cash FlowPV of Total Investment

Profitability Index:

PI = NPV of Cash FlowPV of Capex only

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Ranking of projects can vary depending upon which ratio is used.

Benefit to Cost Ratios Compared

Examples of Cost Benefit Ratios To Describe Cash Flows

Project Project Project ProjectYear I II III IV

0 ($500) ($500) ($100) ($500)1 $100 $200 $100 $1002 $100 $200 $100 $2003 $100 $200 $100 ($500)4 $100 $200 ($400) $5005 $100 $200 $200 $4006 $100 $0 $100 $3007 $100 $0 $100 $08 $100 $0 $100 $09 $100 $0 $100 $0

10 $100 $0 $100 $0Net Cash Flow $500 $500 $500 $500

Cost to Benefit Ratios

First Investment Payback (years) 5.0 2.5 1.0not

reached

Next Investment Payback (years)not

reachednot

reached 5.0 4.5ROI 1.000 1.000 2.500 0.714PIR 1.000 1.000 1.000 0.500DROI10 0.309 0.590 2.000 0.273DPIR10 0.309 0.590 0.650 0.191

When capital is constrained discounted cost to benefit ratios are the best measures to use to discriminate between projects.

Note: it is important to discount investment

ROI requires calculation of cumulative cash flow to establish maximum negative cash flow exposure.

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David Wood & Associates

by David A. Wood

It is important to check how they are calculated. Promoters can make the ratios appear more favorable than they are:

Misleading Benefit to Cost Ratios

Well Costs 175,000Completion Costs 95,000

Total Investment $270,000

Gross Revenue $922,000Operating Costs 20,000

Net Revenue $902,000Cash Flow $632,000

Two benefit /cost ratios could be presented: Promoters PIR = 902 / 270 = 3.34 Actual PIR = 632 / 270 = 2.34

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Petroleum Economics

Risk and Opportunity Analysis

David A. Wood

by David A. Wood

Because of the common misuse of the term risk it is appropriate to distinguish clearly what we mean by the terms risk and uncertainty. The term opportunity can help to clarify our understanding.

Uncertainty: Risk and Opportunity

To many people risk means a potential for loss Positive outcomes from risk can equate to opportunity Uncertainty implies outcome is unknown (usually within limits) Uncertainty suggests potential for loss (risk) or gain (opportunity) The chances for loss are sometimes discrete and easy to distinguish In most cases outcomes cover a wide grey (continuous) spectrum Interactions between many continuous uncertainties are complex Risk is highly non-linear in its outcomes Combining the impact of risk events is not a simple additive process Some uncertainties are dependent upon or impact others

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Not all uncertainty is captured by continuous probability distributions.

Discrete & Continuous Components to Risk

There is uncertainty associated with both discrete and continuous aspects of risks

Example shows an exploration prospect with a 10% chance of success and a range of possible reserves outcomes if successful.

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by David A. Wood

Much that uncertainty in nature follows normal distributions. Situations that compound many individual uncertainties tend to follow lognormal distributions, but it is difficult to capture all potential contractual, human, social and political impacts and uncertainties in such distributions.

Probabilistic Approaches Help But Rarely Capture All of the Uncertainty

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by David A. Wood

It is useful to consider the collective impact of these uncertainties in an holistic risk assessment.

Upstream Risk & Opportunityis Multi-faceted

Updated from: David Wood et al. World Oil, September 2007

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by David A. Wood

Extreme risks need to be addressed, particularly in the upstream oil and gas sector?

Exercise: Extreme Risks

Try to identify some of the possible extreme /catastrophic events that should be considered?

What contingency steps / actions might be taken to respond if such events should actually occur?

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by David A. Wood

Risk Diagram Showing the Shareholder and Judicial Scrutiny Regions

Shareholders and many operations managers often focus more on events with greater likelihood of occurrence. When extreme events (black swans / catastrophes) occur inquiries are more likely to be focused on high impact - low likelihood events. Risk management systems need to address the full spectrum of events.

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by David A. Wood

Potential Events, Actual Incidents and Risk Management

The relationship between potential events and actual incidents requires clarification. It is always better to focus on preventing (or exploiting) potential events rather than managing incidents from a control viewpoint.

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by David A. Wood

Risks Usually Outweigh OpportunitiesOnce a project is underway the downside risks are usually greater than the upside opportunities. But it is important not to lose sight of the fact that opportunities exist.

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Three Broad Types of Risk Assessment Prevail in Industry

Qualitative Semi-quantitative Quantitative

Some organisations resist moving to a quantitative approach.

Moving to more quantitative techniques does not have to mean involving more complexity, time and cost.

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by David A. Wood

Pure & Speculative Risks Compared

Speculative risk events involve a greater spectrum of choice and uncertainty of outcomes.

For speculative risk management success often means optimizing financial, political or other outcomes from speculative investments of various kinds and avoiding loss or disadvantage.

For pure risks, hazards or threats are objects, substances, activities, behaviours or situations capable of causing harm. Managing pure risks can result, at best, in no harm outcomes from a specific hazard or threat.

Because pure and speculative risks often overlap and interact, creating artificial boundaries between them may be inappropriate.

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Risk Profiling Traffic Light AnalogyRisk profiling (or mapping) is a good starting place for risk identification.

The impact needs to be assessed in terms of key objectives.

Risks should be plotted on a gross basis i.e. before mitigation actions are taken - in order to ensure resources are deployed to manage them.

On a net basis - i.e. after mitigation actions are taken -all risks should plot in manageable squares

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Useful for identifying multiple outcomes and multiple causes for events. Focuses mitigation strategies on the ultimate causes of identified risks.

Bowtie & Butterfly DiagramsLink Risks to Causes & Impacts

David Wood et al. World Oil, September 2007

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by David A. Wood

If the outcomes of two events are mutually exclusive the addition rule determines their combined probability of occurrence.

Addition Rule of Probabilities

This rule states that the probability that one or another of two or more mutually exclusive outcomes will occur is the sum of their separate probabilities.

Consider the probability of rolling a 1 with a single die. It is one of six alternatives so the probability is:

P(1) = 1/6 or 16.67%.

The probability of rolling a 1 or a 5 with one roll of the die. The events are mutually exclusive so the addition rule applies:

P(1 or 5) = 1/6 + 1/6 =1/3 or 33.33%

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by David A. Wood

If the outcomes of two events are independent of each other the multiplication rule determines their combined probability of occurrence.

Multiplication Rule of Probabilities

This rule states that the probability of two or more independent events having specific outcomes is the product of their separate probabilities.

Consider the probability of rolling a double 1 with a single roll of two dice. It is one of six alternatives on one die together with one of six independent alternatives on the other die. The probability on each die remains:

P(1) = 1/6 or 16.67%.P(1 and 1) = 1/6 * 1/6 =1/36 or 2.8%

There are 35 other combinations for two die.

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by David A. Wood

Possible Outcomes With Two Dice

Probability of throwing a 7 with two dice = 6/36 = 16.7%Probability of throwing a 7 or a 3 = (6/36) + (2/36) = 22.2%Probability of two straight sevens = (6/36)*(6/36) = 2.8%

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by David A. Wood

Estimating the chance of success, is most consistent when several discrete probability estimates of independent geological attributes are combined to yield a chance factor by a semi-quantitative justification.

Chance of Finding Some Hydrocarbons Multiplication Rule For Geological Risk

Since the chance of success is much less than the chance of failuremost of the time one or more of the geologic controls will be lacking.

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by David A. Wood

Probability of Wildcat Success

A geological chance of success (Pdiscovery) of 25% may only equate to a commercial chance of success (Pcommercial success ) of 15% because of reserve size and also: technological, economic infrastructure, fiscal terms and political risks

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by David A. Wood

The difference between technical and commercial success is the development threshold field size. The higher this threshold size the greater the difference between the chances of commercial and technical success.

Development Threshold Field Size

Threshold field size will vary according to:1. Cost related factors:Reservoir depthNumber of wellsReservoir qualityWater depthProximity to infrastructure

2. Product related factors:Oil and gas pricesProduct quality

3. Fiscal terms

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by David A. Wood

Two-step Approach to E&PChance of Success

Step 1: Sub-surface Chance Factor (GCF)Step 2: Above-ground Chance Factor (ECF)

Sub-surface Chance Factor:

Greater than ECF as it is easier to find small fields

Usually expressed as a percentage chance of success

Probability of accumulation being of economic size

log-normal field size distributions help to estimate it

Political, fiscal, market, technological issues etc., etc.

Above-ground Chance Factor:

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by David A. Wood

Key Economic Success Factors

Chance of Economic Success will also depend upon:

Fiscal Terms

Depth to Pay

Reservoir performance & well flow rates

Location of field relative to infra-structure

Complexity of development engineering

Quality of hydrocarbon and its market

Proximity to market (for gas)

Prevailing oil, gas or product prices

Political and business environment

Chance of Geologic Success will vary from basin to basin and prospect to prospect. It is unlikely to be higher than 25 to 30% in wildcat prospects.

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by David A. Wood

The economic risk factors can be as difficult to estimate as the geologic risk factors.

Aspects of Economic Risk Factors

Technological Risk: risk of drilling problems or of achieving the well path and flow rate performance expected.

Oil & Gas Price Risk: large effect on NPVs. Project Over-Run Risk: cost and time variances. Political risk: risk of civil unrest in a country delaying or preventing

development of a discovery (e.g. Iraq, Libya, Nigeria, Sudan, Syria, Yemen etc.). But there are also many political and regulatory risks in OECD countries.

Fiscal risk: risk of government introducing new tax or changing the cost recovery mechanism that will make economics of a discovery less favorable or even uneconomic.

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Petroleum Economics

Capital Budgeting Techniques & Yardsticks(Exercise#3)

David A. Wood

by David A. Wood

Few opportunities are good investments just by inspection.

Most Investment Opportunities Require Analysis

Analysis is required for:

Very large investments.

Complex investments inter-related with and incremental to existing projects with several choices or possible outcomes.

Marginal investments.

Incremental investments

High-risk investments.

New venture investments (new geology, new industries, new markets).

Capital budgeting: selecting the best projects to pursue when funds are limited and it is possible to fund all profitable projects

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by David A. Wood

Investment yardsticks are the various criteria used to help in measuring, comparing and describing investment opportunities.

Investment Yardsticks(Economic Key Performance Indicators)

Comparative investment evaluation implies:

The expectation of future profits, usually involving both uncertainty and risk associated with two or more mutually exclusive investments.

Income generated over a period of time from each potential investment.

A freedom of choice among investments, i.e., the discretion to select the best from various opportunities.

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by David A. Wood

A single ideal yardstick which properly ranks each investment opportunity would have the following characteristics:

The Ideal Investment Yardstick

It would illustrate the effect on corporate profits of making a specific investment and incorporate an assessment of risk.

It would isolate only those investment opportunities which are acceptable within the confines of a defined corporate strategy.

It would always make the correct choice from a group of mutually exclusive opportunities.

Unfortunately, no ideal yardstick exists. Several yardsticks are necessary for comparative investment evaluation. Wise decisions are more likely when measuring an opportunity from several viewpoints.

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by David A. Wood

Cash flow components themselves provide potential yardsticks:

Cash Flow YardsticksNot Involving Discount Factors

The investmentboth before and after tax (if investment tax credits are available). A unit basis (i.e., pence/therm or $ / barrel.) is sometimes used for pre-tax investments.

Maximum negative cash flow. This is largest sum of money, out-of-pocket at any one time.

Ultimate net positive or negative cash flow. This is the cumulative net cash flow (or actual value profit) from a project. It is the sum of inflows minus outflows.

Ultimate net cash flow to investment ratio. This is the cumulative net cash flow divided by the cumulative maximum negative cash flow.

Profit (Income) -to-investment ratio. This is the total actual value profit divided by investment. Complicated by profit and investment not always being defined in the same way, but usually with accounting rules included.

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by David A. Wood

These have a calendar significance.

Time Related Yardsticks

Project life. This is the length of a project, usually in years. It is related to the time horizon of a corporations strategy and its long and short-term goals.

Pay-back or pay-out period. This is the time, usually in years, for a project to return the after-tax investment. It is the point at which the cumulative net cash flow becomes positive.

Time to first revenue. This is the time from first investment to first income. Useful for those companies requiring operating cash flow.

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by David A. Wood

These yardsticks reflect the time value of money:

Time-Value Related Yardsticksthat Incorporate Discounting

Present value profit (loss) or Net Present Value (NPV). This is the total of a discounted net cash flow stream.

Present value profiles. These are curves resulting from plotting present value profits versus a range of discount rates.

Investors rate of Return (IRR). This is the discount per cent which reduces a cash flow stream to zero. Also MIRR

Discounted profit-to-investment ratio (P/I). This yardstick measures investment efficiency. The investment should also be discounted if the investment stream goes beyond year zero.

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by David A. Wood

These are rarely good economic discriminators for single projects. They are company specific and are clouded by accounting principles.

Yardsticks Extracted from Financial Statements / Accounts

Booked investment. These are the items that accounting principles allow to be capitalized in the financial accounts or corporate books.

Annual, cumulative and average booked net income (earnings). The net profit (or loss) reported to shareholders on the profit and loss statement is the booked net income.

Earnings Before Interest & Tax (EBIT) and EBITDA (also excluding depreciation) now commonly used in conjunction with project cash flows to assess a projects economic potential.

Annual or average booked rate of return. The booked net income divided by the average net booked investment is the booked rate of return. Traditionally return on net assets has been used for one or several years.

Return on Capital Employed (ROCE or ROACE) includes long-term debt with assets as capital employed and is widely used as a yardstick for company wide investment performance.

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by David A. Wood

It is important to use a range of investment yardsticks.

Investment Yardsticks Commonly Used

The yardsticks [KPIs] that the E&P investment analyst generally consider are:

Magnitude of investment & maximum financial exposure

Time scale of project (length of cash flow stream)

Time to pay back

Cash flow (annual, total and cumulative trends)

Discounted indicators to establish the time-value (PV, NPV, IRR)

Investment efficiency - profit/investment ratios

Risk capacity total cash flow divided by risk capital

Risk adjusted indices expected monetary value (EMV)

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by David A. Wood

A value of an investment yardstick may be considered to be good or acceptable in some circumstances but unacceptable in others.

Interpretation of Investment Yardsticks For Project Ranking & Investment Thresholds

Consider the values of the yardsticks in the context of:

Risk - technical and / or political risks often overwhelm all other aspects of an investment opportunity.

Availability of capital to undertake projects.

Corporate strategy - short and long-term goals and corporate attitude to risk.

Number of available opportunities and competition for them.

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by David A. Wood

As an E&P manager, you must decide which of 8 projects labelled A to H are profitable and compatible with your company's strategic goals and objectives. Your technical team and economic analyst have evaluated and submitted the projects shown below for your consideration and approval under the current exploration budget.

Exercise to Rank Projects Using Investment Yardsticks

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by David A. Wood

The following investment yardsticks have been calculated from the project cash flow profiles for 8 projects (A to H):

Exercise: Investment Yardsticks

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by David A. Wood

Construct a ranking matrix in tabular form of the projects based on a selection of the nine most useful investment yardsticks. Rank 1 = best; Rank 8 = worst. Rank the projects using letter codes (A to H):

Ranking Projects:Use Yardsticks to build a Matrix

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by David A. Wood

Use the matrix you have constructed to help you to list the projects that would be selected under the following conditions assuming and there are no other investment opportunities available:

Which Projects (A to H) Should be Selected?

I. Capital limited to a total $180 million investment budget and your companys cost of capital is 9%.

Projects? Total Investment? @9% discount rate NPV?

II. Capital limited to a total of $105 million, your cost of capital is 15%.Projects? Total Investment? @15% discount rate NPV?

III. Same as II but Project E is in a country where a civil war has started?Projects? Total Investment?@15% discount rate NPV?

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by David A. Wood



IV. No limit on capital resources and your cost of capital is 9%.Projects? Total Investment?@9% discount rate NPV?

V. Capital is limited to US$60 million and the board has issued an initiative to improve investment efficiency and shorten payout time. Cost of capital remains at 9%.

Projects? Total Investment?@12% discount rate NPV?

VI. Same as 5 but corporate directives say that projects maximizing P/I discounted @9% should be prioritized and a longer term view adopted.

Projects? Total Investment?@12% discount rate NPV?

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VII. You have only projects E & B left from which to make a selection. You are capital limited with other reinvestment opportunities having a Profit / Investment ratio discounted at 9% equal to:

(a) 0.6 (b) 0.50 (c) 0.4

VIII. You decide to rank the projects in order of their liquidity (i.e. those that provide maximum positive cash flow in the shortest period of time) and take the four most attractive.

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by David A. Wood

OMVs Prefered YardsticksFor Economic Analysis

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Petroleum Economics

Which Oil & Gas Prices Should be Used to ValueAssets?

David A. Wood

by David A. Wood

Short-term Oil & Gas Price Drivers

Global supply and demand (commodities & products) Refinery surplus capacity OPEC surplus capacity Market perception Weather Unexpected supply disruptions Stock-building in consuming markets (particularly OECD)

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by David A. Wood

Long-term Oil & Gas Price Drivers

Non-OPEC new sources. e.g. deepwater Gulf of Mexico, Caspian Demand growth in developing economies: China, India Global and regional economic cycles New technologies e.g. fuel cells, gas-to-liquids (GTL), substitutes Expanding demand for natural gas, LNG, GTL, Gas-to Power Unconventional oil and gas exploitation (high-cost supply) Renewables, alternatives, biofuels take market share Politics, geopolitics and politics (with a small p)

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by David A. Wood

Crude Differential Trends Enable Arbitrage Opportunities in Markets

Oil Market Report, IEA 2005 to 2011

2006 2007 2008 2009 2010

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2011

by David A. Wood

U.S. Long-term Price Forecastsby EIA for 2011 to 2035In real terms EIA sees natural gas prices rising modestly in real terms ($2009) to 2035 reaching about US$7.0/mmbtu. Over-optimistic? 3Q-2011 Henry Hub spot natural gas price was about $4.0/mmbtu. Crude oil forecast to rise to $(2009) 125 by 2035 in the EIAs reference case. Note the large uncertainty for oil forecast.

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by David A. Wood

U.S. Light Sweet Crude Forward Curve28 October 2011CME quotes nine years forward (six years monthly and final 3 years for June and December). WTI moderate contango.

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by David A. Wood

U.S. Light Sweet Crude Forward Curve9 September 2011CME quotes nine years forward (six years monthly and final 3 years for June and December). WTI moderate contango.

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by David A. Wood

Brent Crude Oil Forward Price CurveSeptember 2011Steep backwardation.

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by David A. Wood

Spot & Forward Curves Evolve

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by David A. Wood

Real & Nominal Crude Oil Prices ShowVolatility Since the 1970s

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by David A. Wood

Short-term versus Long RunCrude Oil Prices (Nominal & Real)

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by David A. Wood

The new OPEC Reference Basket (ORB), introduced on 16 June 2005, is currently made up of the following: Saharan Blend (Algeria), Girassol (Angola), Oriente (Ecuador), Iran Heavy (Islamic Republic of Iran), Basra Light (Iraq), Kuwait Export (Kuwait), Es Sider (Libya), Bonny Light (Nigeria), Qatar Marine (Qatar), Arab Light (Saudi Arabia), Murban (UAE) and Merey (Venezuela).

Notes:

As of January 2006: The Weekly, Monthly, Quarterly & Yearly averages are based on daily quotations.

As of January 2007: The basket price includes the Angolan crude "Girassol".

As of 19 October 2007: The basket price includes the Ecuadorean crude "Oriente".

As of January 2009: The basket price excludes the Indonesian crude "Minas".

As of January 2009: The Venezuelan crude "BCF-17" was replaced by the crude "Merey".

OPEC Reference Basket (ORB)

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OPEC Reference Basket Price Historical 1998 to 2011

Historical annual average ORB prices and comparisons to Brent.

www.opec.org

1998 $12.28/bbl1999 $17.48/bbl2000 $27.6/bbl 2001 $23.12/bbl 2002 $24.36/bbl 2003 $28.1/bbl 2004 $36.05 /bbl2005 $50.64 /bbl2006 $63.18 /bbl2007 $69.08/bbl2008 $94.45 /bbl2009 $61.06/bbl 2010 $75.59/bbl

Dated Brent $54.52 (2005Avg)Dated Brent $65.14 (2006 Avg)Dated Brent $72.39 (2007 Avg)Dated Brent $97.26 (2008 Avg)Dated Brent $61.67 (2009 Avg)Dated Brent $79.50 (2010 Avg)

US$ / barrel

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by David A. Wood

2011 OPEC Reference Basket Price The new OPEC Reference Basket (ORB) introduced in June 2005 is made up of twelve crudes: Saharan Blend (Algeria), Girassol (Angola), Oriente (Ecuador), Iran Heavy (Islamic Republic of Iran), Basra Light (Iraq), Kuwait Export (Kuwait), Es Sider (Libya), Bonny Light (Nigeria), Qatar Marine (Qatar), Arab Light (Saudi Arabia), Murban (UAE) and Merey (Venezuela).

www.opec.org

Indonesia withdrew to observer status from OPEC in 2008.

Prices based on daily quotes since Aug 2009.

Note that OPEC crudes are not traded on any exchange so do not represent internationally traded benchmarks.

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US$ / barrel

by David A. Wood

OPEC Reference Basket (ORB) Price Relative to Benchmarks

The OPEC basket price follows Brent.

2010

OPEC Market Report April,2011

2011

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by David A. Wood

US Natural Gas Forward Curve28 Oct 2011

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by David A. Wood

UK & US Forward Gas Curves 2006 and 2008

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by David A. Wood

Hedging & Margin Erosion

Near-term commodity price risk can be partially mitigated in an acquisition through an aggressive hedging program.

Longer-term issues do arise if prices continue to rise (e.g. in hindsight companies that hedged in 2003 / 2004 sacrificed much upside in 2005/2006).

Hedging provides top line protection (reduces leverage) should prices ease. It enables leveraged buyers to repay debt finance.

Hedges cannot, however, protect a company from rising costs or "bottom-up" margin erosion.

Equity of companies that hedge aggressively can often trade at significant discounts to that of their unhedged peers. Puts pressure on management to fund the next acquisition(s) in a more leveraged manner?

Fully (over?) valued acquisitions executed in a high commodity price environment can present future profitability risks for buyers.

18

Petroleum Economics

Valuing Incremental Investments

David A. Wood

by David A. Wood

Often there are more than two investment alternatives on offer. An unrealistically positive NPV or other yardstick may result if the options are considered in isolation rather than on an incremental basis.

Analysis of Incremental Investments

Examples of incremental investments are:

Drill a prospect versus farmout the prospect

Complete versus abandon well

Develop versus sell field discovery

Install enhanced recovery systems versus deplete field

Offshore pipeline versus shuttle tanker to produce field

Upgrade /simplify plant versus keep existing facilities

Install Electric Submersible Pumps (ESPs) versus keep beam pumps, screw pumps, jet pumps or gas lift.

Etc2

by David A. Wood

Analysis can provide additional insight for decisions by focusing on incremental benefits or sacrifices associated with different project options.

Analysis of Field Development:Case A No Secondary Recovery

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by David A. Wood


Analysis of Field Development:Case B With Secondary Recovery

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by David A. Wood


Incremental Analysis of Field Development:Case B versus Case A

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by David A. Wood

This considers a straightforward upfront equity investment to drill the well.

Cash Flow Analysis of Drilling Opportunity

Year Production Revenue Expenses NCF PV15 NCFBarrels Pre-tax Pre-tax

0 0 $0 $0 ($10,000) ($10,000)1 1000 $20,160 ($1,000) $19,160 $17,8672 550 $11,090 ($1,080) $10,010 $8,1173 300 $6,100 ($1,160) $4,940 $3,4834 175 $3,350 ($1,260) $2,090 $1,2815 100 $1,840 ($1,360) $480 $256

Totals (yrs1 to 5) 2125 $42,540 ($5,860) $36,680 $31,004Net Totals (yrs 0 to 5) $26,680 $21,004

ROI: 2.67Note: IRR function calculates back to year 0 IRR: 143%Discount factor applied mid-year from year 1 DROI: 2.10

Cashflow Analysis of Drilling Opportunity

(Values in 000's)

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by David A. Wood

It is often not necessary to calculate the incremental case as decisions can be based on relative NPVs of two or more alternatives. However the incremental value between two options can often provide useful additional insight.

Drill versus Farmout OptionsAnalysed Incrementally

Values in 000's Drill Case Farmout Case Incremental CaseInvestment $10,000 Investment $0 Investment $10,000

Year Drill NCF PV15 NCF Farmor NCF PV15 NCF Incr. NCF PV15 NCFA B A-B

0 ($10,000) ($10,000) $0 ($10,000) ($10,000)1 $19,160 $17,867 $2,290 $2,135 $16,870 $15,7312 $10,010 $8,117 $2,503 $2,029 $7,508 $6,0883 $4,940 $3,483 $1,235 $871 $3,705 $2,6124 $2,090 $1,281 $523 $320 $1,568 $9615 $480 $256 $120 $64 $360 $192

Totals (yrs1 to 5) $36,680 $31,004 $6,670 $5,420 $30,010 $25,584Net Totals (yrs 0 to 5) $26,680 $21,004 $6,670 $5,420 $20,010 $15,584

ROI: 2.00Note: IRR function calculates back to year 0 IRR: 114%Discount factor applied mid-year from year 1 DROI: 1.56

Farmout Option Where Farminee Pays All Well Costs -Farmor has 25% Back-in Option at Payout

7

Petroleum Economics

Inflation, Buying Power, Money of the Day & Real Values

David A. Wood

by David A. Wood

Cost Inflation: Significant Impacts on Oil & Gas Industry

Oil industry cost inflation since 2005 has impacted upstream and downstream industry acting as drags on development leading to project cancellations and delays.

Costs escalated through 2008 despite economic slowdown. World steel demand down 15% in 2009. Activity and inflation increased again 2010 to 2011.

UCCI:Equipmentthatcost$100in2000costs$230atend3Q2008($218atend1Q2011)DCCI:Equipmentthatcost$100in2000costs$176at

end1Q2008($192atend1Q2011)

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by David A. Wood

If a 15% rate of return is desired and 10% /year inflation is forecast:

Inflation and Cash Flow Calculations

Cash flow adjusted for 10% inflationValues in 000's PV25 NCF Revenue Expenses NCF PV15 NCF NCF PV15 NCF

Year Pre-tax Pre-tax Pre-tax Pre-tax Pre-tax0 ($10,000) $0 $0 ($10,000) ($10,000) ($10,000) ($10,000)1 $4,651 $6,000 ($800) $5,200 $4,849 $5,454 $5,0862 $2,361 $4,000 ($700) $3,300 $2,676 $3,807 $3,0873 $1,374 $3,000 ($600) $2,400 $1,692 $3,046 $2,1484 $779 $2,000 ($300) $1,700 $1,042 $2,373 $1,4555 $293 $1,000 ($200) $800 $427 $1,228 $655

Totals (yrs1 to 5) $9,458 $16,000 -$2,600 $13,400 $10,686 $15,908 $12,430Net Totals (yrs 0 to 5) ($542) $3,400 $686 $5,908 $2,430

ROI: 0.34 0.59Note: IRR function calculates back to year 0 IRR: 14.8% 23.4%Discount & inflation mid-year from year 1 DROI: 0.07 0.24

Cashflow Analysis of Investment Opportunity With 10% Inflation of Revenue and Expenses

No inflation considered in calculating net cash flow

Implication of this calculation is that factoring in inflation increases value! Adjustments to the discount rate are required.

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by David A. Wood

It is not correct to simply add the inflation rate to the discount rate to compensate for inflation (but when inflation rates are very low it makes very little difference to the analysis).

Allowing for Inflation in Cash Flows

A composite discount rate accounting for inflation is provided by:

(1 +r) = (1+ i)(1 + f) where i is the desired rate of return, f is the rate of inflation and r is the composite discount rate. If i = 15% and f = 10% then: r =26.5% (not 25%).

However there are complications:

Costs and product prices often inflate at different rates. This is particularly so in the petroleum industry.

In after tax calculations some components (e.g. depreciation) are not adjusted by inflation in many fiscal regimes.

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by David A. Wood

It is usually more effective and realistic for economic analysis to inflate cash flow components separately and then to deflate the resulting combined cash flow before applying discount factors.

Money of the Day (MOD or Nominal) Cash Flow Values

Costs are adjusted for inflation using the formula:

FVm =FVt * (1+fc)n

where: FVm is money of the day value, FVt is todays value, fc is the annual rate of inflation for costs and n is the number of years. (n-0.5 can be used for mid-year inflation factors)

fp is substituted for fc to give an equation for prices.

Future inflated cash flows calculated by combining the inflated components are said to be expressed in money of the day or nominal terms.

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by David A. Wood

Money of the day cash flows can be deflated before applyingdiscount factors to provide cash flows in real rather than nominal terms.

Real Cash Flow Values

Money of the day or nominal cash flows are deflated back to todays values (or values of any specified period) by adjusting for inflation using the formula:

FVr =FVm * (1+d)-n

where FVm is money of the day value, FVr is the real value, d is the annual rate of deflation and n is the number of years. (n-0.5 can be used for mid-year factors).

unlike the inflation factors which are cost and price specific for the industry the deflator should be related to broader economic inflation indicators to reflect forecasts for the effective buying power of money.

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by David A. Wood

Two forecasts for natural gas prices in Canada at Alberta Hub. Real terms is in the money of year 1. MOD terms is in the money of each year including inflation.

Oil & Gas Prices are Often Expressedin Both MOD (Nominal) and Real Terms

The effects of inflation can be removed by deflating the cash flows to real $ year 0.

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by David A. Wood

Buying power is synonymous to the expression of future cash flows PVs or of future cash flows in terms of current monetary values.

Buying Power Concept Supplier Example

A supplier buys 1000 valves in year 1 at $30 each and fits them into a simple surface meter that is sold for $100. His other materials and overhead costs are $30,000. For year 1:

Sales: 1000 metres $100,0001000 Valve Costs ($30,000)Other Costs & Expenses ($30,000)Profit taken ($10,000)Net cashflow for reinvestment $30,000

Suppliers First Year Cash Flow

The supplier reorders the valves to find they are now $50 each (a 66.7% increase). His $30,000 will now only buy 600 valves. His money is now only worth 600 * $30 = $18,000 in year 1 terms

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by David A. Wood

The equation also has to consider the potential earning power of year 1 money.

Equation to Calculate Buying Power

The situation for the supplier is worse than it appears because he has also foregone interest that could have been earned on the original $30,000 investment. If that interest (i) is say 10%:

PV10 ($30k) = ($30k)(0.9091) = $27,273

This has to be combined with the effective value of the ($30,000) to the supplier (i.e. the inflation rate, f) to calculate the buying power.

BPVi = CFn*[(1+i)(1+f)] -n is the general buying power equation, where n is number of years.

BPV10 = $30K*[(1 + 0.1)(1 + 0.667)] -1 =$16,331

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by David A. Wood

There is another relationship between the desired discount rate and inflation rate that is used to calculate the rate of return in real terms.

Real Rate of Return

Equation to calculate real rate of return is:

S = (i - f)*(1 + f) -1

where i is the nominal rate of return, f is the inflation rate of investment costs and S is the real rate of return.

If a cash flow with f=10% has a nominal rate of return of 23.4%. The real rate of return was:

(0.234 - 0.1)*(1+ 0.1) -1 = 12.2%

The same equation can be re-arranged to give the nominal rate of return needed for a desired real rate:

i =S + f(1 + S) e.g. 0.15 + 0.1(1+ 0.15) = 26.5%

10

Petroleum Economics

Inflation Indices

David A. Wood

by David A. Wood

By expressing values in terms of prices of a particular year it removes price inflation or fluctuation and gives volume information but expressed in monetary terms, i.e. output in real or constant prices.

Constant or Real Price Terms

Current prices, nominal prices and nominal terms or values include the effects of inflation.

Volumes, constant prices, real prices and real terms or values exclude any inflationary influences.

Price indicators used to convert between current and constant prices (to deflate) are sometimes called price deflators.

Any series of numbers can be converted into index numbers with a base of 100 by: 1) selecting a reference base year value; 2) dividing that number by 100; 3) dividing all the numbers in the series by the result of step 2.

2

by David A. Wood

Constant Versus Current Dollar Energy Costs

3

by David A. Wood

Any series of numbers can be converted into index numbers with a base of 100 by:

Calculating Price Indices

1. Selecting a reference base year value

2. Dividing that number by 100

3. Dividing all the numbers in series by result of step 2.

Index numbers have no units. This avoids distracting units and changes are easier to assess.

4

by David A. Wood

Index numbers have no units. This avoids distracting units and changes are easier to assess.

Current & Constant Price Indices & Price Deflators

5

by David A. Wood

Basis for weighting indices and assessing the effect of the base year selected.

Indices: Points To Be Aware of

Frequently two or more indices are combined to form one composite index (e.g. Purchase Price Index PPI or Consumer Price Index CPI). The different components are weighted according to their contribution to the index in the base year.

Composite indices can become distorted if one component becomes much more or much less significant in terms of its contribution compared with that in the base year. Always check when an index was last re-based and whether there were significant changes in its components.

Two or more indices will always meet at the base period because they both equal 100. This can be misleading. Always check where the base is located. This is known as illusory convergence.

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by David A. Wood

The base year selected will arbitrarily control when current and constant price indices converge.

Index Numbers Do Not Be Fooled By Illusory Convergence

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by David A. Wood

Long-term product sales and pipeline tariff contracts sometimes include indices to adjust prices each year (or quarter). This protects buyer and seller from inflation and other changes in market conditions.

Contract Prices & Tariffs are Often Escalated Periodically Using Composite Indices

Co

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