Basic Petroleum Economics

by Mari Kvaal

August 2004 3rd PPM Philippines Case Study Workshop 1

Objectives

Š Basic knowledge and techniques for performing

investment analysis
Š Use the tools and concepts on petroleum investment
projects
Š A field development project
Š An exploration project
Š Be able to understand the concepts used and do the
economic calculations needed in the case study.

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 Investment decisions

Š Investment decisions are among the most important

decisions that a company/government can make

Š capital intensive
Š irreversible
Š high risk/uncertainty

August 2004 3rd PPM Philippines Case Stydy Workshop 3

Decisions through the life-cycle of a petroleum project

In all these phases

you have to make
DROP decisions.
Apply/bid
license .
DROP
Accept
work
DROP
progr
3D
seismic DROP
Drill a
Investment analysis wild-cat
Appraisal DROP
is used as a management tool
when making such Develop

decisions
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 Investment analysis
..main economic terms
Š Investment analysis- main economic terms

Š Cash flow
inflation
time value of money
uncertainty

Š Economic Decision Criteria

net present value
internal rate of return (IRR)
payback & maximum exposure?

August 2004 3rd PPM Philippines Case Stydy Workshop 5

Main elements in economic investment analysis

Idea
Establish a cash flow forecast
Nominal/real values
Consider the uncertainties
Analysis Discount the cash flow
Net Present Value
Invest

Make a Drop
decision

Wait
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 Investment analysis
..main economic terms
Š Investment analysis- main economic terms

Š Cash flow
inflation
time value of money
uncertainty

Š Economic Decision Criteria

net present value
internal rate of return (IRR)
payback & maximum exposure?

August 2004 3rd PPM Philippines Case Stydy Workshop 7

Cash flow
..the starting point of an investment analysis

Š What cash flow will be generated in & out?

Š Why concerned about the cash flow?

Š Investor invests $ today (outflow)
hoping to harvest more
$ in the future (inflow)

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 Cash flow
…annual cash flow
Budgeting techniques are used to calculate the projects
cash flow for each year:

Year 1:

Income
- costs
= Net cash flow
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Cash flow
…over the lifetime of the project

Income Income Income

- costs - costs - costs

= Net cash flow = Net cash flow = Net cash flow

Year
t
August 2004
0 1
3rd PPM Philippines Case Stydy Workshop
2 10

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 Cash flow
...an oil investment - the investment project’s cash flow
Cash inflow (income)
1200

1000

800

600

400

200

-200

-400

-600
1 3 5 7 9 11 13 15 17 19 21 23 25 years
Cash outflow (costs)
August 2004 3rd PPM Philippines Case Stydy Workshop 11

Cash flow
..comparing cash flow elements over time

Š We can’t simply add up inflow and outflow, due to

Š Inflation

Š Time Value of Money

Š Uncertainty

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 Cash flow
..inflation

Š As long as there is inflation, the consumers’

purchasing power (i.e. what you can buy) for 10$
will be reduced the later you receive the money.

Š You could buy more for 10$ in 1960 than in 2004

- and probably more in 2004 than in 2010

Š We adjust for inflation by using real values instead

of current values
August 2004 3rd PPM Philippines Case Stydy Workshop 13

Cash flow
..inflation - from current to real values (to deflate)

2004 2005 2006

Current -1000$ 212$ 449$
value
Real 2004 -1000$ 212/(1+0,06)$ 449/(1+0,06)2$
value = 200$ = 400$

Expected inflation is 6 % per year

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 Cash flow
..inflation
Cash inflow (income)
1200

1000

800

600

400

200

-200

-400

-600
1 3 5 7 9 11 13 15 17 19 21 23 25 years
Cash outflow (costs)
August 2004 3rd PPM Philippines Case Stydy Workshop 15

Cash flow
..inflation - an example

Š A friend ask to borrow 350$

today and pay you back 400$ in
this way:

Š 100$ the year after and so on the

next three years

Š If the inflation rate is 5 % per

year, is this a good deal?
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 Cash flow
..inflation - an example
Nominal Real
An example
values values
This year -350
+1 100 You
+2 100
+3 100
+4 100

Sum 50 Friend
STAVANGER 31.08 - 22.10 1998

…so far so good

August 2004 3rd PPM Philippines Case Stydy Workshop 17

Cash flow
..inflation - an example
Nominal Real
An example
values values
This year -350 -350
+1 100 95 You
+2 100 91
+3 100 86
+4 100 82

Sum 50 4 Friend
STAVANGER 31.08 - 22.10 1998

…so far so good

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 Cash flow
..comparing cash flow elements over time

Š We can’t simply add up inflow and outflow, due to

Š Inflation

Š Time Value of Money

Š Uncertainty

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Cash flow
..Time value of Money

Š Even after you have adjusted for inflation, it is not

correct to simply add up inflow and outflow of the
project.
Š Assume the bank offers an interest rate equal to 5 %.
2004 2005
Example 1 1$ 1$5cent

Example 2 92,5cent 1$

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 Cash flow
..Time value of Money – an example

Bank deposit: $ 100

Annual interest rate: 10 %

After 1 year: V1 = $100 * (1 + 0.10) = $110.0

After 2 years: V2 = $110 * (1 + 0.10)
= $100*(1 + 0.10)*(1 + 0.10)
= $100 * (1 + 0.10)2
= $121.0
After 3 years: V3 = $121*(1 + 0.10)
= $100*(1 + 0.10)3
= $133.1
etc
August 2004 3rd PPM Philippines Case Stydy Workshop 21

Cash flow
..Time value of Money – end value
Vn = the amount of money we can take out
of the bank after n years

Vo = the amount of money we put in

the bank today

r = a fixed interest rate in % per year

Vn = Vo (1 + r)n
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 Cash flow
..Time value of Money
Š Money received today is worth more than money
received in the future:

Š Money today can immediately go to consumption or

investment and so give an interest income

Š If you have to wait, you miss the interest income or you

have to wait with your consumption

People are impatient

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Cash flow
..comparing cash flow elements over time

Š We can’t simply add up inflow and outflow, due to

Š Inflation

Š Time Value of Money

Š Uncertainty

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 Cash flow
..uncertainty

Š There is always some uncertainty in investment

analysis. The future cash flow can not be projected
with certainty at the time of investment.

Š As long as today is more certain than the future, there

is a third reason to prefer money today instead of
tomorrow - we are risk averse

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Cash flow
..uncertainty - risk premium

Š By investing in a diversified (varied) project

portfolio, you can lower your total risk exposure

Š Only the change of risk an individual project

contribute to an investment portfolio is relevant for
compensation.

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 Cash flow
..uncertainty - risk premium

Š Risk averse companies will demand a compensation

for taking risk - they want a risk-premium.

Š You can express this by correcting the discount-rate

August 2004 3rd PPM Philippines Case Stydy Workshop 27

Cash flow
…discounting

Vn = Vo (1 + r)n
Vn
Vo =
(1 + r)n

To calculate the present value is often called

discounting

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 Cash flow
..present value

Calculating the Present Value (PV) of an amount is the

opposite operation of calculating the end-value

0 T
Time
End-value V0 VT ?

Present value ? V0 VT

August 2004 3rd PPM Philippines Case Stydy Workshop 29

Cash flow
..discounting a cash flow - Net Present value -an example

1 Calculate separately the 2 Add together the

present value of all the cash discounted cash flow
flow elements elements
Time 0 1 2 -100 + 75 + 62 = 37
Cash flow -100 80 70

Present value: The net present value of

-100 the cash flow of the
80/(1.06)
75
70/(1.06)2 project is 37
62
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 Cash flow
..discount rate

Š Discount rate – the rate used to determine the present

worth of future value by discounting.

Š The choice of discount rate reflects the cost of capital

Š Time Value of Money
Š Uncertainty

Š Banks usually use the interest rate as a discount rate

August 2004 3rd PPM Philippines Case Stydy Workshop 31

Cash flow
..discount rate
Cash inflow (income)
1200

1000

800

600

400

200

-200

-400

-600
1 3 5 7 9 11 13 15 17 19 21 23 25 years
Cash outflow (costs)
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 Cash flow
..Net Present Value – an example

Nominal Real NPV

values values 7%
This year -350 -350
+1 100 95
+2 100 91
+3 100 86
+4 100 82

Sum 50 4

August 2004 3rd PPM Philippines Case Stydy Workshop 33

Cash flow
..Net Present Value – an example

Nominal Real NPV

values values 7%
This year -350 -350 -350
+1 100 95 89
+2 100 91 79
+3 100 86 71
+4 100 82 63

Sum 50 4 -48

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 Cash flow
..a summary

Š Future in- and outflow have to be discounted to be

comparable.
Š The present value of a project is the sum of
discounted cash flow elements.
Š You have to use the rate of return of the best
alternative use of money as the discount rate.
Š Then the net present value means the increase in value by
choosing this project instead of the best alternative.

August 2004 3rd PPM Philippines Case Stydy Workshop 35

Investment analysis
..main economic terms
Š Investment analysis- main economic terms

Š Cash flow
inflation
time value of money
uncertainty

Š Economic Decision Criteria

net present value
internal rate of return (IRR)
payback & maximum exposure?

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 Economic Decision Criteria

Š In this part we will see how we can use cash flow and
discounting to decide whether a project is economic
or not.

August 2004 3rd PPM Philippines Case Stydy Workshop 37

Economic Decision Criteria

..discounting a cash flow - Net Present Value -an example

1 Calculate separately the 2 Add together the

present value of all the cash discounted cash flow
flow elements elements
Time 0 1 2 -100 + 75 + 62 = 37
Cash flow -100 80 70
The net present value
Present value: of the cash flow of the
-100 project is 37
80/(1.06)
75
70/(1.06)2
62
August 2004
interest rate is 6%
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 Economic Decision Criteria
..Net Present Value

Š The Net present value (NPV) concept says:

Š Accept all projects with NPV > 0

Š Reject all projects with NPV < 0
Š If NPV = 0, we are indifferent between accepting or rejecting the
project

August 2004 3rd PPM Philippines Case Stydy Workshop 39

Economic Decision Criteria

..Net Present Value – an example
Discount rate: 10%

Project Cash flow Present Value

A (-200, 120,140) 25
B (-390, 270, 220) 37
C (-600, 300, 350) -38

The net present value concept:

Accept project A
Accept project B
Drop project C
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 Economic Decision Criteria
..Internal Rate of Return

Š The discount rate that yields NPV=0 defines the

Internal Rate of Return (IRR)

Š Accept all projects with IRR > discount factor

Š Drop all projects with IRR < discount factor
Š If IRR = discount factor we are indifferent

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Economic Decision Criteria

..Present Value Profile – an example

Š If we go back to project A we have a real cash flow of

(-200, 120, 140) million $. The net present value as a
function of the discount rate, can be written as:

NPV = -200 + 120/(1+r) + 140/(1+r)2

Š If we put in different values for r we can come up with

a present value profile

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 Economic Decision Criteria
..Present Value Profile – an example
Discount Discounted cash flow Present Value
rate (%)

0 -200+120/(1.00)+140/(1.00)2 60
5 -200+120/(1.05)+140/(1.05)2 41
10 -200+120/(1.10)+140/(1.10)2 25
15 -200+120/(1.15)+140/(1.15)2 10
18.9 -200+120/(1.189)+140/(1.189)2 0
20 -200+120/(1.20)+140/(1.20)2 -3
25 -200+120/(1.25)+140/(1.25)2 -14

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Economic Decision Criteria

..present value profile – an example
NPV
7 0

6 0

5 0

4 0

3 0

2 0

1 0
IRR
0
0 5 1 0 1 5 1 8 ,9 2 0 2 5
-1 0

-2 0
Discount rate

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 Economic Decision Criteria

Š Maximum Exposure
Š The maximum negative cash flow on a project.

Š Pay-back
Š The time required for an investment to generate sufficient cash
flow to recover the initial capital investment

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Economic Decision Analysis

..summary
Š The results and the quality of the economic analysis
depend on
Š The quality of the cash flow elements
Š Whether the discount rate reflects the best alternative value of the
money

Š Then NPV is the best suited decision criteria, and

positive NPV means that the project is profitable.

Go ahead with the investment!

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