PETROLEUM ECONOMICS

Dr. Syahrir Ridha

PETROLEUM MANAGEMENT PROCESS (SPE 39713)

PETROLEUM ECONOMICS

ECONOMIC
INDICATORS
(E&P Project Economic Evaluation)

Course Outcomes
Having worked through this chapter the
Student will be able to:
Describe two methods of economic indicators
Describe the underlying concept of key economic
indicators for undiscounted method, such as payback
period, maximum capital outlay, terminal cash
surplus, and profit to investment ratio.
Describe the underlying concept of key economic
indicators for discounted method, such as net
present value, internal rate of return, discounted
payback, and profitability index.
Describe the significant of net present value and
internal rate of return for investment decision
making.
Describe the application of economic indicators for

Economic
indicators are
devices which
reduce a net cash
flow projection to
single numbers in
time.

NET CASH FLOWS

Cost

Profit

conomic Indicators Application

Economic indicators tell us whether one investment gives a
greater economic benefit than other investments

a. Project Screening
Comparing all projects with a set of company
investment criteria to identify suitable candidates for
investment

b. Project Ranking
Comparing all acceptable projects and placing in rank
order for investment purposes

Economic Indicators Methods

1. Undiscounted method

Payback Period
Maximum Capital Outlay
Terminal Cash Surplus
Profit to Investment Ratio

2. Discounted method

Note:
All the measures are norisk profitability criteria. It
is assumed that all of the
projected cash flows and
expenditures are guaranteed
to occur at the exact time
specified

Net Present Value (NPV)

Internal Rate of Return (IRR)
Discounted Payback
Profitability Index (PI)

1. Undiscounted method
(c)

(d)
(a)

(b)

Maximum Capital Outlay

Terminal Cash Surplus

The simplest measure of a profit

relates to the concept of a surplus.

TCS is the cumulative value at the end of the

projects life, not the highest value achieved.
It is the sum of all project Revenue,
minus the sum of all Capex, Opex

and Taxes.

TCS is usually called Net Cash,

Profit and Terminal Value of the
project.

Profit to Investment Ratio

TCS

MCO

Short Exercise:

Cash flow
Performan
ce

No
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22

Year
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015

Cash
flow
-24
-102
-316
-321
10
245
448
113
223
197
152
146
126
114
101
94
84
77
69
72
-56
9

Total

1461

From the Cash Flow profile,

define the values of:
1.
2.
3.
4.

Payback period?
Maximum capital outlay?
Terminal cash surplus?
Profit to investment ratio?

Note: First, Develop the Net Cash Flow.

Solution.
Year
Durati
on
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22

Year
Proje
ct Cash flow
1994
-24
1995
-102
1996
-316
1997
-321
1998
10
1999
245
2000
448
2001
113
2002
223
2003
197
2004
152
2005
146
2006
126
2007
114
2008
101
2009
94
2010
84
2011
77
2012
69
2013
72
2014
-56
2015
9
Total

1461

2000

Net cash
flow
-24
-126
-442
-763
-753
-508
-60
53
276
473
625
771
897
1011
1112
1206
1290
1367
1436
1508
1452
1461

1500
1000
Net Cash Flow

500
0
2 4 6 8 10 12 14 16 18 20 22
1 3 5 7 9 11 13 15 17 19 21 23
-500
Project Durations (years)
-1000

1. Payback period = 7.6 years of project duration

2. Maximum capital outlay = 763
3. Terminal cash surplus = 1461
4. Profit to investment ratio = 1.91

2. Discounted method

Net Present Value (NPV)

Internal Rate of Return (IRR)
Discounted Payback
Profitability Index (PI)

. Net Present Value (NPV)

It is a measure of how much more we gain by

putting our money into the project by
comparison with putting it into the bank or
some alternative investment.
or,
NPV measures how much more we would have
to put in the bank today ( or an alternative
investment) to give the same net cash flow as
the project.

Features of NPV

Assuming a risk-free investment opportunity of

$100 with the promise of $120 after exactly 1 year

Compare the investment project against putting

the money in the bank (Assuming the bank is
risk-free too) @ the bank rate of 10%

Cash flow of the investment and the present value

of our cash flow using a discount rate of 10% ?

Features
of NPVof NPV
Features
Present value of a simple investment
Net cash flow $MM =
(investment)

Time =
0
-100

Time =
Invested in Bank $MM =
0
-100
We lost 10 $MM if investing in the Bank

Time =
1
+120

Time = 1
+110

Features of NPV
At discount rate of 10%, the investment
is $10 better than putting the money in
the bank
We would have to put $109 in the bank to
get the same return as the investment!
DIFFERENT INPUTS

Bank

$10
9

Alternative
Investment

$100

$120

The alternative investment

In previous sections, we established that the NPV
of a project told us how much better (or worst) the
project is than investing our money in the bank
Must we make reference to the bank as the only
investment? NO, we can use other kinds of
investments
We can make reference to investing in oil industry
shares on the stock market, for instance.

Features of NPV
In the case of investments other than banks,
there would be a risk attached to the investment
and the discount rate would be correspondingly
greater than the bank rate
When we make an NPV calculation, we are
implicitly making a comparison with alternative
investments and calculating how much better or
worse the project is than those alternatives

The NPV is a single indicator

The NPV combines into one number all the
physical and financial attributes of a project-:

the production profile,

the capital and operating costs,

the fiscal terms,

the timing,

and the discount rate

The NPV fulfills our first requirement of an
economic indicator, which is - To represent the
project by a single number

..as a Measure of Profit

Caution, It is not valid to add cash

flows

The NPV takes time into account

It is therefore invalid to add up the individual

net cash flows of a project unless we first
discount them to bring them back to the
present day

We can only add net cash flows after we have

discounted them and translated them into
equivalents units.

The NPV aids decision making

The NPV is a useful tool in making decision

whether or not to go ahead with a project

A positive NPV suggests that we should go

ahead with the project

A negative NPV tells us we should not go

ahead with the project

In summary, the NPV is an important part of the

go/no-go decision.

The NPV and asset acquisition

Since the NPV is a measure of value, it helps to
determine the price the seller would seek in a sale
of a petroleum asset.
The NPV is based on the sellers views of the assets
attributes (reserves, production potential, capital
and operating costs and so on) and its economic
circumstances (future oil prices, escalation rates and so
on)
Similarly, the NPV helps to determine the price the
buyer would be prepared to pay

Short exercise:

A company is expected to have RM

2500, RM 4500, and RM 5000 in years
3, 4 and 5. With the initial investment of
RM 7500, does the project benefits with
the assumed interest return of 12%?

Solution

12%
0

- RM7500

+RM2500 +RM4500 +RM5000

NPV

3yrs

= 2500 (1.12)-3 = 2500 x 0.7118 = RM 1779.5

NPV

4yrs

= 4500 (1.12)-4 = 4500 x 0.6355 = RM 2859.8

NPV

5yrs

= 5000 (1.12)-5 = 5000 x 0.5674 = RM 2837.2

NPV = RM 7476.5

Total NPV = RM 7476.5 RM 7500 = - RM 23.5

The investment is not recommended since the NPV < 0.

Internal Rate of Return (IRR)

IRR is the discount rate, which reduce the project NPV to zero.
IRR follow the equation: + + ++ = 0
Unlike NPV calculation, there is no analytical solution to this IRR equation.
Therefore, numerical methods may be applied:
Trial and error : Compute NPV index and check for zero
Graphical : Plot NPV profile and find intercept on x axis
Extrapolation : Iterative calculations to find zero NPV

Trial and error

By computing NPV index and check for zero NPV

The calculation of
NPVs for the
Foinaven project at 0,
10, and 20 %
discount rate.

This constitute a
trial and error
sequence, with NPV
reducing from 1460
to 321 and minus 44.

Since IRR locate

when NPV = 0, it
must between 321
and -44.

At this case, the IRR

= 18% that produce
NPV slightly equals
zero.

Graphical
By plotting NPV profile and find intercept on x axis
Example of NPV profile of Foinaven project

18%

- 44

Extrapolation
Iterative calculations to find zero NPV

Significant of
IRR
A measure of growth rate
A measure of investment efficiency

IRR efficiency, quality and

yield of an investment
NPV value or magnitude of
an investment

It is arithmetically analogous to the

interest earned on a bank account, which
is:
Negative NCF is equivalent to Deposit
Positive NCF
is equivalent to a Withdrawal
IRR
is equivalent to the Interest rate
IRR calculations are commonly used to evaluate the
desirability of investments or projects.
The higher a project's IRR, the more desirable it is to
undertake the project.
Assuming all projects require the same amount of upfront investment, the project with the highest IRR
would be considered the best and undertaken first.

Short Exercise:
The BIG Fish company decided to choose an
investment with has a return of RM 5000 after
15 years with initial investment RM 800. What
is the IRR if interest rate is 12% per annum.
What is your recommendation for the
investment? (hint: use Graphical method)

Solution:
IRR calculation using graphical method, we should define another 2 NPV values.
Assume we use 13% and 15% interest rate,
12
%

PV of RM 5000 for 15 years = 5000*(1+0.12)-15 = 5000 * 0.1827 = RM 913.48

NPV = 913.48 + (- 800) = RM 113.48

13
%

PV of RM 5000 for 15 years = 5000*(1+0.13)-15 = 5000 * 0.1599 = RM 799.45

NPV = 799.45 + (- 800) = RM 0.55

15
%

PV of RM 5000 for 15 years = 5000*(1+0.15)-15 = 5000 * 0.1229 = RM 614.47

NPV = 614.47 + (- 800) = RM 185.53
Interest rate
NPV

12%
RM 113.48

13%
RM 0.55

150
100
50
NPV

0
-500.1
-100
-150

0.11

0.12

0.13

Interest rate

0.14

0.15

0.16

15%
RM 185.53

Using graphical
solution below, the IRR
is when NPV= 0) and is
about 13%.

-200
-250

Since IRR > i, the investment is preferable.

Discounted Payback Period

A capital budgeting procedure used to

determine the profitability of a project.
In contrast to an NPV analysis, which
provides the overall value of an project, a
discounted payback period gives the
number of years it takes to break
even from undertaking the initial
expenditure.
This procedure is similar to a payback
period; with ignoring the time value of
money.

Comparison of Undiscounted and Discounted payback period

5%
0% 10%

Profitability Index
also known as profit investment ratio (PIR)
(PI)
is the ratio of present value of
future cash flow to investment of a
proposed
project.
It is a useful tool for ranking projects because it
allows you to quantify the amount of value created
per unit of investment.
PV of future cash flow
Profitability Index =
Initial investment

PI > 1, the project accepted (attractive)

PI < 1, the project rejected (PV less that investment)
PI = 1, breakeven

NPV = PV of future cash flow - Investment

Short Exercise:
Calculate the net present value and
profitability index of a project with a
investment of $20,000 and expected net cash
flows of $3,000 a year for 10 years. The
project's required return is 12%. Is the project
acceptable using NPV and PI?

Solution:

Present Value of Future cash flows= 3000/year

for 10 years @12%= $16951.
Time
1
2
3
4
5
6
7
8
9
10
PV of

Discounted Cash flow @12% NPV= Present value of Future

Cash flow
cash flows- Investment
30002678.571429
=16951-20000
30002391.581633
= minus $3049
30002135.340743
30001906.554235
30001702.280567
PI= Present value of Future cash
30001519.893364
flows/ Net Investment
30001357.047646
=16951/20000
30001211.649684
=0.85
30001081.830075
3000965.9197098
The project is not acceptable
future16950.66909
cash flow:

as NPV is negative and PI is

less than 1.

Application of Economic Indicators

Economic indicators, which are derived from project cash
flow, have a number of important applications:
1. Project screening
Comparing projects with a set of
company criteria
to identify suitable candidates for
investment
2. Project ranking
Comparing acceptable projects and
placing them
in suitable rank order for investment
purposes

1. Project Screening

THREE most important economic parameters for screening criteria:

NPV

IRR 0
PI

In screening evaluation, secondary criteria might be considered,

for example, maximum Discounted Payback Period.
The big issue is the choice of an appropriate discount
rate it should reflect the companys perception of
investment opportunity and risk.
Screening process generates a list of projects marked
as good or no-good projects.
However, passing the screen test does not necessarily lead
to investment.
They need to rank one against another.

2. Project Ranking
Ranking decision is taken by several consideration:
a. Resources Limitation

All organizations have finite resources might constrain investment

The most important are specialist manpower and finance
b. Mutual Exclusive
Project A & B may be alternative development plan for the
same reservoir
Take over of Company X may be seen as alternative to
exploration in Country Y
c. Bestinitiating
First

Company performance is optimized by making the best

possible investments.
Lesser projects may be enhanced by new technology or
replaced by new opportunities.
Earning profit early will contribute to corporate growth.
b. Risk
Company may have a specific attitude to risk or prefer a
mix of high and low risk

Projects comparison

The dilemma is whether to rank by NPV, IRR or PI?

Project A has undiscounted profit of 50 and an IRR of 50%.
Project B has an undiscounted profit of 80 and an IRR of 36%.
Below a discount rate of about 21%, B has a higher NPV, but A has a higher IRR
So which his the better project when there parameters rank differently?

Ranking Parameters
1. NPV as Ranking Criterion

NPV is a measure of profit prefer largest

profit. With 12% discount rate, Project B
produce profit 44 million and Project A 34
million.

NPV reveal nothing about the investment

size. It is imply the surplus. Investment
could be 50 million or 500 million.

Larger projects produce larger NPV.

If investment requirements are similar, NPV

is prefer.

If projects are mutually exclusive, NPV

optimize profit generation.

Government tends to use NPV as a basis for

2. IRR as Ranking Criterion

IRR indicates the return per unit investment and a

measure of investment efficiency.

As a ranking parameter, it indicates where

investment will grow faster. Project A: 50%, B: 36%
per annum.

IRR is very sensitive to the timing of cash flows. High

IRR is often associated with small projects and early
production.

IRR must not be used to rank mutually exclusive

projects.

Importantly, IRR is appropriate in a small company

where individual investment is likely to represent a
larger proportion on investment opportunity.

with
high IRRfor
may
generatesequences
income very quickly
IRRProject
is useful
indicator
investment
amongst opportunity.

3. PI as Ranking Criterion

PI is very useful to rank investment efficiency.

PI is very recommended, if a company try to

maximize profit and has limited funds to invest.
In this case:
NPV and PI produce
the same result in
about 22%.
Below 22%, Project
B is better
investment

Conflicts Between NPV and IRR

NPV directly measures the increase in value to the
company
Whenever there is a conflict between NPV and
another decision rule, you should always use NPV
IRR is unreliable in the following situations:
Non-conventional cash flows
Cash flow signs change more
than once
Mutually exclusive projects
Initial investments are
substantially different
Timing of cash flows is
substantially different

NPV & IRR Selection on Single project valuation

Example:
Suppose an investment will cost $ 90,000 initially
and will generate the following cash flows:
Year 1: 132,000
Year 2: 100,000
Year 3: -150,000
The require return is 15%. Should we accept or
reject the project?
As a petroleum economist you are asking to use
NPV and IRR for answering this.

Solution:
i = 15%,
NPV NPV = -90,000 + 114783 + 75,614 98,627
= $ 1,770

If i = 10%,
NPV = -90,000 + 120,000 + 82,645 112,697
= $ -52

IRR

If i = 25%,
NPV = -90,000 + 105,600 + 64,000 76,800
= $ 2,800
If i = 45%,
NPV = -90,000 + 91,034 + 47,562 49,202
= $ -606

By Graphical method:

THE END
&
THANK YOU