Professional Documents
Culture Documents
DEVELOPMENT PROGRAM
CLASS 2011
PETROLEUM ECONOMICS
David Wood
IN-HOUSE COURSE
prepared for
Petroleum Economics
Overview of Course Objectives & Materials
David A. Wood
by David A. Wood
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Petroleum Economics
2-day Module Daily Themes
Outline structure of course - each day has a distinct theme.
The aim is to provide delegates with a
comprehensive introduction and
balanced view of petroleum economics.
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Morning Break
Morning Session 4.2
Lunch Break
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Rates of Return
Payout Time
Profit to Investment Ratios
Risk and Opportunity Analysis
Afternoon Break
Afternoon Session 4.4
End of Day 1
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Morning Break
Morning Session 4.6
Lunch Break
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Afternoon Break
Afternoon Session 4.8
End of Module
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Dont be shy!
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Petroleum Economics
The Need for Petroleum Economics
David A. Wood
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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Complexity
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Constraints on Upstream
Oil & Gas Companies
Major upstream companies are characterised by:
Large portfolios of E&P projects available for investment at any one time.
Finite technical resources & skills to evaluate & manage each project.
Finite financial resources and frequent budget constraints making them not
indifferent to the level of risked capital required to optimise the portfolio.
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Access to quality
international upstream
permits to explore and
develop is a major
challenge for IOCs,
together with finding
and retaining skilled
staff.
Oil supply & demand main drivers for volatility in recent decades
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We will address these reasons and several others during this course.
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Petroleum Economics
Project Cash Flow & Income Components
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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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Production plant including in-field flow lines and tangible well costs - 5 to 10
years.
Intangible costs (sometimes a portion of these have to be capitalised rather
than expensed) 5 years.
Buildings 20 to 30 years.
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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
$5,000
$5,000
$10,000
Book Value:
$50,000
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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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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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AD
The unit values that are deducted for tax purposes can be substantial (e.g. $2/boe
up to >$10/boe. The higher values may indicate higher cost / lower reserves than
originally expected. Good performers maintain DD&A charges below $5 / boe
particularly 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)
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Petroleum Economics
Petroleum Reserves Categories & Valuation
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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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SPEE = Society of
Petroleum
Evaluation Engineers
AAPG = American
Association of
Petroleum Geologists
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Petroleum Economics
Discounting & Time-Value Considerations
(Exercise #2)
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Time-Value Considerations
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.
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).
interest period and FV is the value at the end of that one interest period).
Re-arranged to: FV = PV (1 + i)
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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)
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FV = PV (1 + i)n
(1 + i)n
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PV = FV [ 1 / (1 + i)n ] = FV (1 + i) n
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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:
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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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Petroleum Economics
Rates of Return
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Rates of Return
An earned interest on the money invested.
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.
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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 Ratio
Number 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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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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Year
0
1
2
3
Totals
Present
Present
Present
Net Cash
Value
Value
Value
Flow
(PV10)
(PV15)
(PV20)
-500
-500
-500
-500
400
381
373
365
100
87
81
76
100
79
71
63
100
47
25
5
21.29% IRR (Excel)
21.28% quick hand calculation
Present
Value
(PV25)
-500
358
72
57
-13
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PV@: 38%
($1,000)
$465
$318
$217
$0
MIRR modifiedIRRfunction
incorporatesareinvestment
ratesoovercomesthis
shortcomingofIRR.
MIRRExcelfunctionreturnsthe
modifiedinternalrateofreturn
foraseriesofperiodiccash
flows.Itconsidersboththecost
oftheinvestmentandthe
interestreceivedon
reinvestmentofcash.
MIRRsometimescalledexternal
rateofreturnERR.
PV = FV * e
-in
0% IRR
3i
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Petroleum Economics
Payout Time or Payback Period
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Where:
Rk = revenue year k
Ek = expenditure year k
I = initial investment
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Petroleum Economics
Profit to Investment Ratios
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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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Return on Investment:
ROI =
PIR =
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DROI =
DPIR =
Profitability Index:
PI =
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Project
I
($500)
$100
$100
$100
$100
$100
$100
$100
$100
$100
$100
$500
Project
II
($500)
$200
$200
$200
$200
$200
$0
$0
$0
$0
$0
$500
Project
III
($100)
$100
$100
$100
($400)
$200
$100
$100
$100
$100
$100
$500
Project
IV
($500)
$100
$200
($500)
$500
$400
$300
$0
$0
$0
$0
$500
1.0
not
reached
5.0
2.500
1.000
2.000
0.650
4.5
0.714
0.500
0.273
0.191
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5.0
not
reached
1.000
1.000
0.309
0.309
2.5
not
reached
1.000
1.000
0.590
0.590
175,000
95,000
Total Investment
$270,000
Gross Revenue
Operating Costs
$922,000
20,000
Net Revenue
Cash Flow
$902,000
$632,000
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Petroleum Economics
Risk and Opportunity Analysis
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Example shows an
exploration prospect
with a 10% chance of
success and a range of
possible reserves
outcomes if successful.
There is uncertainty associated with both discrete and continuous aspects of risks
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Try to identify some of the possible extreme /catastrophic events that should be
considered?
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Qualitative
Semi-quantitative
Quantitative
Moving to more quantitative techniques does not have to mean involving more
complexity, time and cost.
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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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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%
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Since the chance of success is much less than the chance of failure
most of the time one or more of the geologic controls will be lacking.
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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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Technological Risk: risk of drilling problems or of achieving the well path and
flow rate performance expected.
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Petroleum Economics
Capital Budgeting Techniques & Yardsticks
(Exercise#3)
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Marginal investments.
Incremental investments
High-risk investments.
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Investment Yardsticks
(Economic Key Performance Indicators)
Investment yardsticks are the various criteria used to help in measuring, comparing
and describing investment opportunities.
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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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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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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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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Ranking Projects:
Use Yardsticks to build a Matrix
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):
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Which Projects (A to H)
Should be Selected?
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:
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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Which Projects (A to H)
Should be Selected?
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:
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.
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Which Projects (A to H)
Should be Selected?
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:
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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Petroleum Economics
Which Oil & Gas Prices Should be Used to Value
Assets?
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Market perception
Weather
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2006
2007
2008
2009
2010
2011
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$12.28/bbl
$17.48/bbl
$27.6/bbl
$23.12/bbl
$24.36/bbl
$28.1/bbl
$36.05 /bbl
$50.64 /bbl
$63.18 /bbl
$69.08/bbl
$94.45 /bbl
$61.06/bbl
$75.59/bbl
US$ / barrel
www.opec.org
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Indonesia withdrew to
observer status from OPEC
in 2008.
US$ / barrel
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2011
2010
15
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Petroleum Economics
Valuing Incremental Investments
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Etc
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Production
Barrels
0
1000
550
300
175
100
2125
Revenue
Expenses
(Values in 000's)
$0
$0
$20,160
($1,000)
$11,090
($1,080)
$6,100
($1,160)
$3,350
($1,260)
$1,840
($1,360)
$42,540
($5,860)
ROI:
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NCF
Pre-tax
($10,000)
$19,160
$10,010
$4,940
$2,090
$480
$36,680
$26,680
2.67
IRR:
DROI:
PV15 NCF
Pre-tax
($10,000)
$17,867
$8,117
$3,483
$1,281
$256
$31,004
$21,004
143%
2.10
Drill Case
Investment $10,000
Drill NCF
A
($10,000)
$19,160
$10,010
$4,940
$2,090
$480
$36,680
$26,680
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PV15 NCF
($10,000)
$17,867
$8,117
$3,483
$1,281
$256
$31,004
$21,004
Farmout Case
Investment $0
Farmor NCF
B
$0
$2,290
$2,503
$1,235
$523
$120
$6,670
$6,670
PV15 NCF
$2,135
$2,029
$871
$320
$64
$5,420
$5,420
ROI:
Incremental Case
Investment $10,000
Incr. NCF
A-B
($10,000)
$16,870
$7,508
$3,705
$1,568
$360
$30,010
$20,010
2.00
IRR:
DROI:
PV15 NCF
($10,000)
$15,731
$6,088
$2,612
$961
$192
$25,584
$15,584
114%
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Petroleum Economics
Inflation, Buying Power, Money of the Day & Real Values
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UCCI:Equipmentthatcost$100
in2000costs$230atend3Q
2008($218atend1Q2011)
DCCI:Equipmentthatcost
$100in2000costs$176at
end1Q2008($192atend1Q
2011)
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The effects of inflation can be removed by deflating the cash flows to real $ year 0.
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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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Petroleum Economics
Inflation Indices
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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.
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1.
2.
3.
Index numbers have no units. This avoids distracting units and changes
are easier to assess.
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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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Composite indices such as PPI are often used in long term sales and
transport contracts to take account of inflation and changes in market
conditions. For example a price formula in a UK long-term gas contract was:
P = IP[0.4(X/X0)+0.2(E/E0)+0.25(G/G0)+ 0.15(H/H0)]
Where P is the inflated price, IP is the base price, X is Producer Price Index,
E is the industrial electricity index, G is the gas oil index and H is the heavy
fuel oil index. X,E, G & H are all quoted in UK Government statistical
publications. The base year index (denominator)values have a 0 suffix.
All components to such indices should ideally be appropriate to the market
and be based to relevant years.
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Petroleum Economics
Estimating Values & Costs and Budget Cost Control
(Exercise #4)
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Actual
Price
Costs in an Upstream
Oil & Gas Perspective
Costs are not usually the most important influence on overall project value. Oil
price, reserves & production rate and even exchange rates often have largest
impact on NPV. Tornado charts are useful to display sensitivities.
In the case of a single
asset, project level and
corporate level cost
drivers often have less
impact on long term
profitability than revenue
drivers.
For LNG, deep water and
marginal field
developments costs are
more important but
usually remain subordinate
to the revenue and
production drivers.
Can use absolute numbers and / or percentages
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The challenge is to
predict realistic cost
early in the project. The
cost curve here shows
a common estimating
trend, a pattern of
increasing costs from
one phase of the
project to the next.
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Probabilistic Approaches
to Cost Estimate Uncertainties
It is useful to clearly indentify what is involved in cost estimate contingencies and
uncertainties. Probabilistic distributions offer a useful technique to do this that can
be sampled in simulation analysis.
by David A. Wood
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by David A. Wood
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The AFE is a document describing the scope of work and associated costs required for a
project. It usually includes:
Cost estimate breakdowns of the items of expenditure needed to complete work
Timing and duration of activities involved
A total of the base case project cost with contingencies and any escalation factors
associated with inflation to provide a cost estimate for approval
Details including a project description and economic justification to support the cost
estimate are usually included in a brief 3 to 4 page document.
Participants in the joint venture are expected to give their formal signature/ approval to the
AFE within a specified period, commonly 30 days. They are then cash called by the
operator to provide their shares of the required funds.
If expenditures during the project seem likely to exceed 10% of the approved cost then a
supplemental AFE is issued. A cost control report is prepared at the end of the project.
by David A. Wood
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by David A. Wood
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Petroleum Economics
Introduction to Upstream Fiscal Terms & Contract Types
David A. Wood
by David A. Wood
CONTRACTOR / IOC
by David A. Wood
by David A. Wood
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Nelson Field
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Petroleum Economics
Production Sharing & Cost Recovery (Exercise #5)
David A. Wood
by David A. Wood
by David A. Wood
2.
3.
4.
by David A. Wood
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DavidWood&Associates
by David A. Wood
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DavidWood&Associates
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Bookable
In Financial
Statements
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ExercisetoCalculateRevenueSplit
ForExampleProductionSharingTermsFillintheGaps!
DavidWoodExercise#5
Petroleum Economics
Funding Criteria: The Cost of Capital
& Oil & Gas Finance
David A. Wood
The simplest case is: all money is provided by a single lending agency at a
single rate.
The cost of capital is the before-tax or after-tax interest charge, e.g: A
bank loan at 10%
Cost of Capital =
Cost of Capital =
by David A. Wood
by David A. Wood
A third, real world case, is a public corporation with debt (loans, bonds, etc.)
and equity (stock/traded shares) capital. In this case, the cost of capital can
be estimated as:
by David A. Wood
by David A. Wood
by David A. Wood
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.
by David A. Wood
by David A. Wood
www.exim.gov (U.S.A)
www.ecgd.gov.uk (U.K.)
http://www.oekb.at (Austria)
by David A. Wood
The Libor is the average interest rate that leading banks in London charge
when lending to other banks. It is an acronym for London Interbank Offered
Rate. Banks borrow money for various time periods(up to one year) and
they pay interest to their lenders based on certain rates. The Libor figure is
an average of these rates. The Libor rate is announced daily at 11 a.m.
And is used by financial institutions to fix their own interest rates (when
lending to others), which are typically higher than the Libor rate. LIBOR is
therefore a benchmark for finance all around the world.
Euribor is short for Euro Interbank Offered Rate. The Euribor rates are
based on the average interest rates at which a panel of more than 50
European banks borrow funds from one another. There are different
maturities, ranging from one week to one year.
by David A. Wood
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Petroleum Economics
Hurdle Rates and Selection of Discount Rates
David A. Wood
Rate of interest paid on borrowed capital (i.e. the cost of debt capital).
by David A. Wood
Different companies can have different criteria for selecting discount rates.
Commonly used rates are:
Cost of capital
Prevailing interest rates available for bank deposits or money market
Arbitrarily selected values above cost of capital to represent
expectations of equity investors (e.g. 15% or 20%)
These are often used and referred to as Hurdle rates or minimum
acceptable rate of return (MARR)
by David A. Wood
by David A. Wood
by David A. Wood
by David A. Wood
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Petroleum Economics
Probabilistic Methodology & Techniques For Economics
& Risk Analysis
David A. Wood
Investment Yardsticks
Incorporating Evaluations of Risk
It is important to take risk into account in economic analysis:
by David A. Wood
Consider tossing a coin: heads you win $100; tails you lose $100. The
expected outcome (EMV) from one toss is (+$100 * 0.5) + (-$100 * 0.5) =
$0. But from one toss that can never be the outcome. That EMV will be
the average result from repeated trials a large number of tosses.
No two oil and gas ventures are exactly the same, in terms of probabilities
and outcomes. Therefore, even this average outcome cannot really be
expected.
If each individual decision is made on the basis of optimising EMV, the
overall ultimate outcome can be expected to be the average of all the
individual EMVs.
In an EMV calculation, the sum of the probabilities obviously must be 1.0
or 100 percent.
by David A. Wood
by David A. Wood
by David A. Wood
Pf + Ps =1.0
so
Pf = 1 Ps
by David A. Wood
by David A. Wood
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Petroleum Economics
Decision Analysis, Decision Trees & Flexibility
David A. Wood
by David A. Wood
by David A. Wood
by David A. Wood
The EMV is placed by the event node and represents the risked value of
everything to the right of it, i.e. the value of what would follow from the
decision to drill. To maximise EMV decision here would be to drill.
by David A. Wood
Petroleum Economics
Monte Carlo Simulation Demonstration (Exercise#6)
David A. Wood
In the oil & gas industry Monte Carlo simulation is widely used to model
uncertainty & value for field / prospect reserves, economics, risks and
portfolios as well as for cost, time, resource analysis in project planning.
by David A. Wood
by David A. Wood
by David A. Wood
The laptop lottery barrel would contain 1 $700 ball but 6 $1,200 balls, etc.
The software lottery barrel would contain 1 $500 ball but 8 $700 balls.
It is therefore 6 times more likely that a $1,200 ball will be drawn from the
laptop lottery barrel than a $700 ball.
For each trial it then adds the value on the two samples drawn from the
lottery barrels or distributions to give the combined cost.
The process then replaces all the balls and repeats the process for the
number of iterations (trials) specified.
by David A. Wood
Randomly buying the two articles in any store the chance of paying the
lowest combined price of $1,200 or the highest combined price of $3,200 is
much less than the chance of paying the combined average prices of the
two distributions.
by David A. Wood
A random number is
linked to a cumulative
probability and the price
associated with the next
lowest cumulative
probability in the tables
adjacent to previous
graphs is selected.
The model then adds
the two prices derived in
each trial to provide a
combined price.
by David A. Wood
by David A. Wood
People accept the technique and believe the results (sometimes too readily!!).
by David A. Wood
by David A. Wood
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David Wood has published details of simulation applications in the Oil & Gas
Journal (e.g. OGJ 1 Nov, 1999; 23 Oct 2000 plus executive reports).
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by David A. Wood
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Numerous passes through the entire calculation are made. For each
calculation the value assigned to each variable is determined by a random
number sampling the variable distribution.
In this way, each value utilized for each variable occurs according to its
prescribed frequency function for the distribution type selected.
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Simulation Exercise #6
Sequence of analysis:
1.
2.
3.
4.
5.
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