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INTEGRATED GRADUATE

DEVELOPMENT PROGRAM
CLASS 2011
PETROLEUM ECONOMICS
David Wood

IN-HOUSE COURSE
prepared for

OMV EXPLORATION & PRODUCTION GMBH


Vienna, Austria

HOT Engineering GmbH


Parkstrasse 6
A-8700 Leoben, Austria
Tel: +43 3842 430530
Fax: +43 3842 430531
E-Mail: training@hoteng.com
www.hoteng.com

Copyright 2012 by HOT Engineering GmbH


Parkstrasse 6, A-8700 Leoben, Austria
All rights reserved. No part of this publication may be reproduced, stored in a retrieval
system 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

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!!

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

www.dwasolutions.com
dw@dwasolutions.com
Twitter: @DWAEnergy
Facebook: DWA Energy Limited
LinkedIn: David A. Wood

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

by David A. Wood

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.

Day 1 Basic Analysis & Valuation Techniques

Day 2 Constructing Economic Evaluation Models

by David A. Wood

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
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
Afternoon Session 4.4

Capital Budgeting Techniques & Yardsticks (Exercise#3)


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

End of Day 1
by David A. Wood

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 Types

Morning 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 Analysis

Lunch Break
by David A. Wood

DAY 2 Constructing Economic Evaluation Models


Afternoon Session 4.7

Decision Analysis, Decision Trees & Flexibility


Monte Carlo Simulation Demonstration (Exercise #6)
Assessment Test

Afternoon Break
Afternoon Session 4.8

OMV Session on in-house Easy Evaluation Pre-tax Cash Flow Tool

End of Module

by David A. Wood

Ask if You Need Clarification

There is a lot of material to get


through, but time will be made for
discussion.

Dont be shy!

by David A. Wood

Petroleum Economics
The Need for Petroleum Economics
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.

by David A. Wood

E&P Investment Appraisal & Decisions


Upstream projects are characterised by:

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

by David A. Wood

Cost Time Cycle for Exploration


Through to Field Production

by David A. Wood

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 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.

by David A. Wood

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.

by David A. Wood

Oil Industry of Last 30 Years has


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

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
by David A. Wood

Boundary Scenarios Can Frame


Economic Sensitivity Analysis
Framing 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.


by David A. Wood

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.

by David A. Wood

Extending Field Life by Reducing


Operating Costs & Overheads
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.

by David A. Wood

10

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.

11

by David A. Wood

Modern Portfolio Modelling Approach:


Economic, Risk and Strategy Analysis
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.

Portfolio modelling &


management should
firmly link investment
decision-making at the
asset, portfolio and
merger / acquisition/
divestment levels to a
quantified corporate
strategy.

by David A. Wood

12

There are Many Different Reasons Why


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

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

We will address these reasons and several others during this course.
by David A. Wood

13

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.
by David A. Wood

14

Petroleum Economics
Project Cash Flow & Income Components
David A. Wood

Simplified Flow Chart For The Financial


Process in a Typical Upstream Oil Company
The role of financial management is to optimise the value and use of the basic
reservoir of cash and its associated funds flow.
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.

by David A. Wood

Focus of Economic Analysis


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

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?

by David A. Wood

Upstream Cash flow Components:


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

by David A. Wood

Basic E&P Economic Analysis


Techniques Are Straight-forward
None of the economic calculation techniques commonly applied are complex but
their analysis can become so.
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.

by David A. Wood

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.

by David A. Wood

Cash Flow Projections


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 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.

by David A. Wood

Cash Flow Components - Cash Items


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

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

by David A. Wood

Cash Flow Combines Cash Inflows


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

by David A. Wood

Taxable Income is Not Cash Flow but Profit


Adjusted by Accounting & Taxation Rules

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)

by David A. Wood

10

Calculation of Key Project & Corporate Accounting


Measures Applicable to Oil & Gas Projects

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.

by David A. Wood

11

The Tax Burden in E&P Contracts Has


Many (Often Complex) Components

by David A. Wood

12

Taxable Income Is Usually


Not Cash Flow
Calculations of taxable incomes depend upon accounting and tax rules,
particularly involving the depreciation of capital costs.

by David A. Wood

13

Generic Corporate Tax Model


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

by David A. Wood

14

Depreciation of Capital Costs


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 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.

by David A. Wood

15

Typical Asset Lives For DD&A Purposes


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

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.

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.

by David A. Wood

16

Depreciation & Calculation of


Book Value
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.

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

17

by David A. Wood

Depreciation is a Key Non-cash


Component in Calculating Net Income
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 amortisation
process (e.g. double declining balance; SYD; MACRS).
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

by David A. Wood

18

Depreciation & Capital Cost Recovery


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

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.

by David A. Wood

19

Different Rates of Depreciation


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

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.

by David A. Wood

20

Depreciation, Depletion &


Amortization - DD&A
This originally North American concept is now also widely used in international oil
and gas accounting.

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.

by David A. Wood

21

Example DD&A Methodology Stated by


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

Source: Apache Corp 10K 2010


by David A. Wood

22

DD&A is an Operating Expense


on the Income Statement
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:

Source: Apache Corp 10K 2010

23

by David A. Wood

Depletion (DD&A) Calculated by


Unit of Production Method
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:
(C AD S) * P / R
Where:

= Capital cost of plant and equipment

AD

= Accumulated depreciation to date

= Salvage or residual value

= Annual production (boe)

= 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/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.
by David A. Wood

24

Petroleum Economics
Project Cash Flow and Income Components
(Exercise #1)
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!
by David A. Wood

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!
by David A. Wood

Petroleum Economics
Petroleum Reserves Categories & Valuation
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.

by David A. Wood

Relevance of Resources Versus


Reserves to Petroleum Portfolios

by David A. Wood

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.

by David A. Wood

Classification of Upstream
Oil & Gas Assets & their Reserves

by David A. Wood

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

by David A. Wood

Petroleum Reserves Classification


SPE 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.

by David A. Wood

Petroleum Reserves Classification


SPE / 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.

by David A. Wood

Resource Classification Commences


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

by David A. Wood

Bookable Oil & Gas Reserves Valued in


Production Asset Sales

by David A. Wood

10

Aligning Reserves Definitions with


Petroleum 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

by David A. Wood

11

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.

by David A. Wood

12

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.

by David A. Wood

13

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).

by David A. Wood

14

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.

15

by David A. Wood

Why Do Companies Acquire Assets,


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

by David A. Wood

16

How Does an Acquisition or Divestment


Add Value to an Asset Portfolio?

by David A. Wood

17

Petroleum Economics
Discounting & Time-Value Considerations
(Exercise #2)
David A. Wood

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.

Rate at which costs are recovered impacts contractors value.


by David A. Wood

Present Value (PV) Concepts


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.

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).

by David A. Wood

Present & Future Values and


the Time Value of Money
PV and FV are related to each other through interest rates and discount factors.

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)

by David A. Wood

Simple Versus Compound Interest


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

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

(1 + i)n

where n = number of years

is called the compound factor.

by David A. Wood

The Discount Factor


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

by David A. Wood

Risking Cash Flow Profiles by Increasing


Discount Rate is Not Appropriate
Higher discount rates preferentially penalise later years in a cash flow profile.

by David A. Wood

Net Present Value (NPV) is the Sum of


Discounted Cash Flows for Each Period
A general solution for the NPV calculation is:

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

Net Present Value Profile Trends


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

by David A. Wood

Present Value Profile Trends


Projectsthatlookthemostattractiveatonediscountvaluemaynotdosoatanother.

by David A. Wood

10

Discrete Investment Functions


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.

by David A. Wood

11

Discrete Versus Continuous Functions


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.

by David A. Wood

12

Nominal Versus Continuous Compounding


Nominal interest is the annual interest rate if money is compounded annually.
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 i
interest periods. $2,000 after three years at 6% is: $ 2,000 (e 0.18) =
$2,394.

by David A. Wood

13

Various Compounding Outcomes


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:

by David A. Wood

14

Net Present Value (NPV): A Yardstick


Useful for Ranking Projects (Exercise #2)
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.

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.

by David A. Wood

15

Discount Factor Table


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

by David A. Wood

16

Petroleum Economics
Rates of Return
David A. Wood

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.

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.

by David A. Wood

Book Rate of Return


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

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.

by David A. Wood

Investors Rate of Return (IRR)


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.

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.

by David A. Wood

Investors Rate of Return:


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

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.

by David A. Wood

IRR and NPV


Reflect Time-Value Influences
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.

by David A. Wood

IRR and Discount Rate Relationship


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

by David A. Wood

Discounted Versus Undiscounted


Cash Flows
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.

by David A. Wood

Investors Rate of Return Example


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?

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.

by David A. Wood

Investors Rate of Return is an Indicative


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

IRR does not always


give a unique solution.
NPV is more realistic as it is
calculated at a
discount rate that is
meaningful to the
company concerned (e.g. its
investment hurdle rate or cost
of capital).

by David A. Wood

10

Investors Rate of Return


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

Example of Investor's Rate of Return Calculation

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

[5 / (5+13)] * (25 -20) +20 = 21.28%


Interpolation must not be over more than 10 percentage points.

by David A. Wood

11

IRR Does Not Always


Provide a Single Solution
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 between
these two values the project is profitable.

by David A. Wood

12

IRR & MIRR (ERR):


The Reinvestment Issue
AcalculatedIRRisnotactuallyearnedunlesspositivecashflows
fromeachperiodarereinvestedattheIRRrate.Considerthefollowinginvestment:
Actual "i" Earned May Not Be the IRR
Year
0
1
2
3
Totals

Net Cash Flow


($1,000)
$680
$680
$680
$1,039

PV@: 38%
($1,000)
$465
$318
$217
$0

MIRR modifiedIRRfunction
incorporatesareinvestment
ratesoovercomesthis
shortcomingofIRR.

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


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

MIRRExcelfunctionreturnsthe
modifiedinternalrateofreturn
foraseriesofperiodiccash
flows.Itconsidersboththecost
oftheinvestmentandthe
interestreceivedon
reinvestmentofcash.

If $680 is taken out each year and re-invested at


rates less than 38% then 24%< i <38%

MIRRsometimescalledexternal
rateofreturnERR.

PV = FV * e

-in

0% IRR

If $680 is taken out each year and not re-invested:


then FV= 3* $680 = PV * e

3i

David Wood & Associates

by David A. Wood

13

MIRR / ERR Provides


a More Realistic Rate of Return
The formula is, however, quite difficult to visualise.
MARR = minimum acceptable rate of return (hurdle rate).

by David A. Wood

14

Petroleum Economics
Payout Time or Payback Period
David A. Wood

Delays Erode Value


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

David Wood & Associates

by David A. Wood

Time Related Yardsticks


Such measures have a calendar significance:

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.

by David A. Wood

Pay Back Period or Payout


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.
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.

by David A. Wood

Payout / Payback Calculations


Payout time indicates liquidity (risk) rather than profitability:

by David A. Wood

Simple Payout Calculation


Ignores Time-Value Considerations

Where:
Rk = revenue year k
Ek = expenditure year k
I = initial investment

Discounted Payout formula:

by David A. Wood

Petroleum Economics
Profit to Investment Ratios
David A. Wood

Cost to Benefit Ratios


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

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.

by David A. Wood

Cost to Benefit Ratios:


Pros & Cons
These are widely used investment efficiency indicators.
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

by David A. Wood

Undiscounted Benefit to Cost Ratios


These are widely used because they are easy to calculate.

Return on Investment:

ROI =

Cumulative Net Cash Flow


Maximum Negative Position

Profit to Investment Ratio:

PIR =

by David A. Wood

Cumulative Net Cash Flow


Total Investment

Discounted Benefit to Cost Ratios


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

DROI =

NPV of Cash Flow


Maximum Negative Cumulative PV

Discounted Profit to Investment Ratio:

DPIR =

NPV of Cash Flow


PV of Total Investment

Profitability Index:

PI =

NPV of Cash Flow


PV of Capex only

by David A. Wood

Benefit to Cost Ratios Compared


Ranking of projects can vary depending upon which ratio is used.
Examples of Cost Benefit Ratios To Describe Cash Flows
Year
0
1
2
3
4
5
6
7
8
9
10
Net Cash Flow

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

Cost to Benefit Ratios


First Investment Payback (years)
Next Investment Payback (years)
ROI
PIR
DROI10
DPIR10

by David A. Wood

5.0
not
reached
1.000
1.000
0.309
0.309

2.5
not
reached
1.000
1.000
0.590
0.590

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.

David Wood & Associates

Misleading Benefit to Cost Ratios


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

175,000
95,000

Total Investment

$270,000

Gross Revenue
Operating Costs

$922,000
20,000

Net Revenue
Cash Flow

$902,000
$632,000

Two benefit /cost ratios could be presented:


Promoters PIR
= 902 / 270 = 3.34
Actual PIR
= 632 / 270 = 2.34

by David A. Wood

Petroleum Economics
Risk and Opportunity Analysis
David A. Wood

Uncertainty: Risk and Opportunity


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.

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

by David A. Wood

Discrete & Continuous


Components to Risk
Not all uncertainty is captured by continuous probability distributions.

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
by David A. Wood

Probabilistic Approaches Help But


Rarely Capture All of the Uncertainty
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.

by David A. Wood

Upstream Risk & Opportunity


is Multi-faceted

It is useful to consider the


collective impact of these
uncertainties in an holistic risk
assessment.

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


by David A. Wood

Exercise: Extreme Risks


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

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?

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.

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.

by David A. Wood

Risks Usually Outweigh Opportunities


Once 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.

by David A. Wood

Three Broad Types of Risk


Assessment Prevail in Industry
Some organisations resist moving to a quantitative approach.

Qualitative

Semi-quantitative

Quantitative

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

10

Pure & Speculative Risks Compared


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.
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.

Because pure and


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

11

by David A. Wood

Risk Profiling Traffic Light Analogy


Risk profiling (or mapping) is a good starting place for risk identification.

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

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


by David A. Wood

12

Bowtie & Butterfly Diagrams


Link Risks to Causes & Impacts
Useful for identifying multiple outcomes and multiple causes for events. Focuses
mitigation strategies on the ultimate causes of identified risks.

David Wood et al. World Oil, September 2007

13

by David A. Wood

Addition Rule of Probabilities


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

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%

by David A. Wood

14

Multiplication Rule of Probabilities


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

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.

by David A. Wood

15

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%

by David A. Wood

16

Chance of Finding Some Hydrocarbons


Multiplication Rule For Geological Risk
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.

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.

17

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

by David A. Wood

18

Development Threshold Field Size


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.
Threshold field size will vary
according to:
1. Cost related factors:
Reservoir depth
Number of wells
Reservoir quality
Water depth
Proximity to infrastructure
2. Product related factors:
Oil and gas prices
Product quality
3. Fiscal terms

19

by David A. Wood

Two-step Approach to E&P


Chance 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
Above-ground Chance Factor:
Probability of accumulation being of economic size
log-normal field size distributions help to estimate it
Political, fiscal, market, technological issues etc., etc.

by David A. Wood

20

Key Economic Success Factors


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.
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

by David A. Wood

21

Aspects of Economic Risk Factors


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

by David A. Wood

22

Petroleum Economics
Capital Budgeting Techniques & Yardsticks
(Exercise#3)
David A. Wood

Most Investment Opportunities


Require Analysis
Few opportunities are good investments just by inspection.
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

by David A. Wood

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.

by David A. Wood

The Ideal Investment Yardstick


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

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.

by David A. Wood

Cash Flow Yardsticks


Not Involving Discount Factors
Cash flow components themselves provide potential yardsticks:

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.

by David A. Wood

Time Related Yardsticks


These have a calendar significance.

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.

by David A. Wood

Time-Value Related Yardsticks


that Incorporate Discounting
These yardsticks reflect the time value of money:

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.

by David A. Wood

Yardsticks Extracted from


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

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.

by David A. Wood

Investment Yardsticks Commonly Used


It is important to use a range of investment yardsticks.
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)

by David A. Wood

Interpretation of Investment Yardsticks For


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

by David A. Wood

10

Exercise to Rank Projects


Using Investment Yardsticks
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.

by David A. Wood

11

Exercise: Investment Yardsticks


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

by David A. Wood

12

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):

by David A. Wood

13

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?
by David A. Wood

14

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.

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?

15

by David A. Wood

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.

by David A. Wood

16

OMVs Prefered Yardsticks


For Economic Analysis

by David A. Wood

17

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

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)

by David A. Wood

Crude Differential Trends Enable


Arbitrage Opportunities in Markets

2006

2007

2008

2009

2010

2011

Oil Market Report, IEA 2005 to 2011


by David A. Wood

U.S. Long-term Price Forecasts


by EIA for 2011 to 2035
In 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.

by David A. Wood

U.S. Light Sweet Crude Forward Curve


28 October 2011
CME quotes nine years forward (six years monthly and final 3 years for June and
December). WTI moderate contango.

by David A. Wood

U.S. Light Sweet Crude Forward Curve


9 September 2011
CME quotes nine years forward (six years monthly and final 3 years for June and
December). WTI moderate contango.

by David A. Wood

Brent Crude Oil Forward Price Curve


September 2011
Steep backwardation.

by David A. Wood

Spot & Forward Curves Evolve

by David A. Wood

Real & Nominal Crude Oil Prices Show


Volatility Since the 1970s

by David A. Wood

10

Short-term versus Long Run


Crude Oil Prices (Nominal & Real)

by David A. Wood

11

OPEC Reference Basket (ORB)


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".
by David A. Wood

12

OPEC Reference Basket Price Historical


1998 to 2011
Historical annual average ORB prices and comparisons to Brent.
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010

$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

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)

www.opec.org

13

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).

Indonesia withdrew to
observer status from OPEC
in 2008.

US$ / barrel

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.
www.opec.org
by David A. Wood

14

OPEC Reference Basket (ORB) Price


Relative to Benchmarks
The OPEC basket price follows Brent.

2011

2010

OPEC Market Report April,2011


by David A. Wood

15

US Natural Gas Forward Curve


28 Oct 2011

by David A. Wood

16

UK & US Forward Gas Curves


2006 and 2008

by David A. Wood

17

Hedging & Margin Erosion


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

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?

by David A. Wood

18

Petroleum Economics
Valuing Incremental Investments
David A. Wood

Analysis of Incremental Investments


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.
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.

Etc

by David A. Wood

Analysis of Field Development:


Case A No Secondary Recovery
Analysis can provide additional insight for decisions by focusing on incremental
benefits or sacrifices associated with different project options.

by David A. Wood

Analysis of Field Development:


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

by David A. Wood

Incremental Analysis of Field Development:


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

by David A. Wood

Cash Flow Analysis


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

Cashflow Analysis of Drilling Opportunity


Year
0
1
2
3
4
5
Totals (yrs1 to 5)
Net Totals (yrs 0 to 5)

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:

Note: IRR function calculates back to year 0


Discount factor applied mid-year from year 1

by David A. Wood

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 versus Farmout Options


Analysed Incrementally
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.
Farmout Option Where Farminee Pays All Well Costs -Farmor has 25% Back-in Option at Payout
Values in 000's
Year
0
1
2
3
4
5
Totals (yrs1 to 5)
Net Totals (yrs 0 to 5)

Drill Case
Investment $10,000
Drill NCF
A
($10,000)
$19,160
$10,010
$4,940
$2,090
$480
$36,680
$26,680

Note: IRR function calculates back to year 0


Discount factor applied mid-year from year 1

by David A. Wood

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%
1.56

Petroleum Economics
Inflation, Buying Power, Money of the Day & Real Values
David A. Wood

Cost Inflation: Significant Impacts


on Oil & Gas Industry

UCCI:Equipmentthatcost$100
in2000costs$230atend3Q
2008($218atend1Q2011)
DCCI:Equipmentthatcost
$100in2000costs$176at
end1Q2008($192atend1Q
2011)

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.

by David A. Wood

Inflation and Cash Flow Calculations


If a 15% rate of return is desired and 10% /year inflation is forecast:
Cashflow Analysis of Investment Opportunity With 10% Inflation of Revenue and Expenses
Cash flow adjusted for 10% inflation
No inflation considered in calculating net cash flow
Values in 000's
PV25 NCF Revenue Expenses
NCF
PV15 NCF
NCF
PV15 NCF
Year
Pre-tax
Pre-tax
Pre-tax
Pre-tax
Pre-tax
0
($10,000)
$0
$0 ($10,000)
($10,000)
($10,000)
($10,000)
1
$4,651
$6,000
($800)
$5,200
$4,849
$5,454
$5,086
2
$2,361
$4,000
($700)
$3,300
$2,676
$3,807
$3,087
3
$1,374
$3,000
($600)
$2,400
$1,692
$3,046
$2,148
4
$779
$2,000
($300)
$1,700
$1,042
$2,373
$1,455
5
$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
$12,430
Net Totals (yrs 0 to 5)
($542)
$3,400
$686
$5,908
$2,430
ROI:
0.34
0.59
Note: IRR function calculates back to year 0
IRR:
14.8%
23.4%
Discount & inflation mid-year from year 1
DROI:
0.07
0.24

Implication of this calculation is that factoring in inflation increases value!


Adjustments to the discount rate are required.

by David A. Wood

Allowing for Inflation in Cash Flows


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).
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.

by David A. Wood

Money of the Day (MOD or Nominal)


Cash Flow Values
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.
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.

by David A. Wood

Real Cash Flow Values


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

by David A. Wood

Oil & Gas Prices are Often Expressed


in Both MOD (Nominal) and Real Terms
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.

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

by David A. Wood

Buying Power Concept


Supplier Example
Buying power is synonymous to the expression of future cash flows PVs or of
future cash flows in terms of current monetary values.
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:
Suppliers First Year Cash Flow
Sales: 1000 metres
$100,000
1000 Valve Costs
($30,000)
Other Costs & Expenses
($30,000)
Profit taken
($10,000)
Net cashflow for reinvestment
$30,000

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

by David A. Wood

Equation to Calculate Buying Power


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

by David A. Wood

Real Rate of Return


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

10

Petroleum Economics
Inflation Indices
David A. Wood

Constant or Real Price Terms


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.

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.

by David A. Wood

Constant Versus Current Dollar


Energy Costs

by David A. Wood

Calculating Price Indices


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 series by result of step 2.

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

by David A. Wood

Current & Constant Price Indices


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

by David A. Wood

Indices: Points To Be Aware of


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

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.

by David A. Wood

Index Numbers Do Not Be Fooled


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

by David A. Wood

Contract Prices & Tariffs are Often


Escalated Periodically Using Composite Indices
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.

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.

by David A. Wood

Volume and Price Usually Determine Value


When interpreting economic figures it is important to distinguish between the effects
of inflation and the real level of economic activity.
Economic indicators measure one of three things:

Volume - e.g. barrels of oil.

Price - e.g. market price of 1 barrel of oil.

Value - e.g. market value of oil produced in 1 year.

The relationship between them is simple:

Volume * Price = Value.

Inflation indices enable us to express price and value at different


periods of time.

by David A. Wood

Petroleum Economics
Estimating Values & Costs and Budget Cost Control
(Exercise #4)
David A. Wood

Oil Price Forecast


Energy Specialists 1998

Actual
Price

We are worse (as individuals or groups) than we think we are at forecasting!


by David A. Wood

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
by David A. Wood

Tornado Charts Display


Relative Importance of Costs
Capital expenditure is a key project driver for deepwater Nigerian prospects.
Absolute numbers and percentages are usefully displayed.

by David A. Wood

Spider Charts Widely


Used for Sensitivity Analysis

by David A. Wood

Spider Charts Interpretation:


Steep Trends Indicate High Sensitivity

by David A. Wood

Opportunities to Simplify Old Facilities


& Reduce Operating Costs
As production / revenues decline in mature fields management must seek changes to
the operation that reduce OPEX and extend field life.

Fixed costs can often be


reduced by facilities
rationalisations in stages
as a field matures.
Variable costs often
fluctuate over the life of a
project and may
increase as break-even is
approached as economies
of scale are lost.

by David A. Wood

Eliminating Bias from


the Estimation Process
Systematic bias the tendency for us to consistently overestimate reserves or
underestimate costs permeate the upstream oil & gas industry!

Two biases that commonly bedevil our geotechnical forecasts are:

over-confidence setting predictive ranges too narrow, resulting


in frequent surprising outcomes.

over-optimism motivational bias, caused by excessive zeal in


selling the prospect prompted by perceived competition from
the prospects of others.

by David A. Wood

Common Estimating Trend of Increasing


Costs Through Project Life

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.

by David A. Wood

Reasons for Poor Early Cost Estimates


Most common ailments or root causes are optimistic estimates and schedules,
lack of experienced personnel, lack of time, lack of money, manipulative access
to funding and / or poor execution.

Optimistic early estimates may secure project sanctioning, but once


exposed after commitments are secured may reveal that the sanctioned
project is uneconomic.
Poor early estimates once quoted are difficult to replace in contracts with
better defined and possibly more expensive.
A poor early estimate can result in a loss of credibility between the client
and estimator.

by David A. Wood

10

Cost Estimating Phases & Accuracies


Early estimates should not be over-defined to a degree that is excessive for that
estimating phase.

11

by David A. Wood

Contingency Versus Accuracy


Contingency is the amount added to the base estimate to achieve a P50 cost. The
P50 cost has a 50% probability of either under-running or overrunning the final actual
cost. Contingency is an allowance for costs expected to occur but currently
undefined and unknown.
Contingency does not allow
for costs associated with
scope growth or premises
changes.
The amount of contingency
applied should be an ownerdefined cost and
responsibility based on an
empirical method, one which
documents the process and
provides some explanationjustification to support the
allowance.

by David A. Wood

12

Cost Risk Analysis Example


Example of a pre-FEED cost risk analysis performed on a GOM deepwater subsea
tieback project (excludes costs of drilling and completion).

Yale & Knudson, Deepwater Technology, Jan 2006


by David A. Wood

13

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

14

The Time to Influence Expenditure


is During the Planning Stage

15

by David A. Wood

Authority for Expenditure (AFE)


Essential for Cost Control & Approvals
AFE system is widely used in the oil and gas sector because of joint ventures.

All joint venture parties are


expected to sign off an AFE
produced by the project
sponsor or operator.
By doing this all parties
formally approve project
costs which are documented
and explained in the AFE.

by David A. Wood

16

AFE Process, Cash Calls


& Cost Control Report

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

17

80:20 and 95:60 Rules of Thumb


Provide Useful Guides for Cost Control
Concentrate efforts on the 20% of key items / services that drive the project and
minimize time and overhead spent on the 40% of items that represent only 5% of
the costs.

by David A. Wood

18

Petroleum Economics
Introduction to Upstream Fiscal Terms & Contract Types
David A. Wood

Parties & Agreements Commonly


Involved in Petroleum Field Projects

Note: 1. Lenders can be banks and or multi-lateral agencies (e.g. IFC)


2. Offtake here includes transportation, throughput & processing.
by David A. Wood

Strategic Objectives of Fiscal Design


& Types of Fiscal Agreement

by David A. Wood

Key Government and Contractor Aspirations


HOST GOVERNMENT

Maximise/optimise its share of the


economic rent
Ensure good governance (safety,
environment & corporate)

CONTRACTOR / IOC

Avoid undue speculation and


corruption

Create competitive investment


climate

Sustain growth and development

Create employment, training and


commercial opportunities for its
nationals

by David A. Wood

Build equity and maximise value


for the shareholders
Maximise return on investment
and its share of reserves and
production
Provide fiscal stability and
flexibility
Reward risk taking
Minimise bureaucracy, fiscal
complexity (ambiguity) &
corruption
Offer progressive taxation

Overall Government Takes from Petroleum


Production Varies Substantially
Governments need to retain the ability to adjust fiscal designs to meet changing
conditions.
Most governments
open new areas for
licensing, re-licensing,
or for contract by IOCs
in stages over time.
Often such activity is
linked to bidding
rounds. It is useful for
the governments to
retain rights to adjust
fiscal terms associated
with new licensing.

by David A. Wood

Components of Government Take


in Terms of Economic Rent
Governments and IOCs shares of economic rent.

by David A. Wood

Progressive and Regressive


Fiscal Elements & Government Risk

by David A. Wood

Progressive Fiscal Structures


Respond to Changing Conditions
Progressive fiscal structures take more for the state when prices are high or
costs are low.

by David A. Wood

Regressive Fiscal Structures


Less Flexible in Changing Conditions
Regressive fiscal structures will damage commerciality in harsh economic conditions.

by David A. Wood

Royalty Can Become a Significant Burden


The regressive nature of royalties is easy to demonstrate:

by David A. Wood

With a gas price of $10 /


mmbtu, a 20% royalty
accounts for 50% of the gross
profit of a field costing
$6/mmbtu to produce.
With a crude oil price of
$15/mmbtu, the royalty share
of profit decreases to 33.3%
With a crude oil price of
$20/mmbtu the royalty share
of profit decreases to 28.6%.
This graph illustrates the
regressive impact of royalties
on profits.

10

Time-Value-Cost Analysis of Oil & Gas


Projects & Fiscal Terms

Cross plotting, on a per


barrel basis, discounted
contractor cash flow (NPV)
and full project costs
reveals much more about
the economic performance
of specific projects and
contract terms.
Such plots are useful
negotiating aids for both
contractor and
government.
Such plots can be
enhanced by incorporating
assessments of risk.(i.e.
using EMV instead of
NPV).

by David A. Wood

11

Licence Agreement Terms Influencing


Financial & Economic Performance

Contract area / prevailing law


Duration of phases / contract management / voting rights
Relinquishment Schedule / accounting procedures & currencies
Land rentals ($/km2) / employment obligations
Exploration obligations and work commitments
Bonuses (signature, training, production, reserves thresholds)
Royalty (% of gross production- perhaps sliding scale)
Cost Recovery Allocation (% of gross revenue)
Uplift Allowances of Capital Costs (% of eligible costs)
Overhead and debt interest cost allowances
Customs duties and other local levies and employment taxes.
Cost Amortization (%/yr depreciation rates for cost categories)
Profit Oil or Gas Split (% usually a sliding scale)
Domestic Market Obligation subsidy to world market price
Ring fencing (of costs and/or revenues); oil / gas price caps
Income Tax (% of contractor profits)
Tax Credits for additional capital expenditure (e.g. exploration)
Withholding / Remittance Tax (% of profits remitted overseas)
State Participation / back-in option (% of joint venture group)
Rights of Assignment / dispute resolution / arbitration

by David A. Wood

12

Long-term Fiscal and Contractual


Stability Often Proves to be Elusive
Key issues:
Alignment
Empathy
Understanding
Trust
Long-term
Perspectives
Flexibility
Sustainability

13

by David A. Wood

E&P Licence Areas and Unitisation


Offshore UK quadrants of 1 degree latitude by 1 degree longitude are subdivided
into 30 blocks of about 250 sq. km.

Original Unitisation of Nelson Field


22 / 06a: 43.29%
22 / 07: 0.75%
22 / 11: 53.33%
22 / 12a: 2.63%

Nelson Field

by David A. Wood

14

Joint Development Zones


Nigeria / Sao Tome JDZ

by David A. Wood

15

Unitisation- Definition of Process

A process to facilitate the equitable distribution of volumes to the


stakeholders of a petroleum accumulation, and to share in the benefits
of production, revenues and the costs of obligations inherent in the
development and production within the oilfield.

by David A. Wood

16

Petroleum Economics
Production Sharing & Cost Recovery (Exercise #5)
David A. Wood

Division of Proceeds from


Oil & Gas Production Sharing Contracts
This scheme considers how the profit and cost components from oil (or gas) fields are
divided on a full project basis.

Contractor Take: Government Take


The division is simplistic as it
ignores the time value of money
and risk versus reward concepts

by David A. Wood

Time-Value Considerations For


Cost Recovery Mechanisms
Oil and gas projects are characterised by high capital investment in early years,
without cash flow, followed by high cash flow after production startup which
gradually declines in line with production towards field abandonment. Rate of cost
recovery impacts contractors value.

by David A. Wood

Production Sharing Contracts:


Basic Fiscal Components
Over time PSCs have changed substantially and today many have complex features
to refine the production sharing process. In its most basic form a PSC has four main
fiscal properties.
1.

Contractor often pays a royalty on gross production.

2.

Contractor is entitled to a pre-specified share (e.g. 40 percent) of production


for cost recovery (termed cost oil).

3.

The remainder of the production, so called profit oil, is then shared


between government and contractor at a stipulated share (e.g. 70%
government: 30% contractor) or on a sliding scale.

4.

In some contracts income tax is paid from the governments share. In


others the contractor has to pay income tax on its share of profit oil. In some
contracts (e.g. Nigeria) a pre-specified share of production is designated for
the payment of tax and termed tax oil.

by David A. Wood

PSA Take & Cash Flow Breakdown


Average Over Field Life

Taxation, cost recovery


(allocation and depreciation)
and state participation all have
significant impact on the
economic performance of
upstream oil and gas contracts.
Some taxes may be paid from
the Governments share to
attempt tax stability.

by David A. Wood

PSC Take & Cash Flow Breakdown (1a)


Average Over Field Life Good Cost Oil
Signature and other
bonuses should also
be included in the
State Take.
This average barrel
over the life of the field
ignores the effects of
depreciation.

DavidWood&Associates

by David A. Wood

In this example cost


recovery is sufficient
to recover the cost of
the average barrel,
but it may not be
enough to recover the
all the costs in the
early years of
production.

PSC Take & Cash Flow Breakdown (1b)


Average Over Field Life Good Cost Oil
In this example cost
recovery (E) is
sufficient to recover the
cost of the average
barrel, but it may not
be enough to recover
the all the costs in the
early years of
production.
Gross revenue is split
approximately:
62% to State
7% to Contractor
31% to Costs

by David A. Wood

PSC Take & Cash Flow Breakdown (2a)


Average Over Field Life Poor Cost Oil
Cost recovery
allocation is reduced
here to 25%. It is now
not sufficient for all the
costs to be recovered.
Unrecovered costs
remain in a cost pool.
Contractor has spent
$6 but only recovered
$4.25.
Contractors take and
cash flow are
significantly reduced.

DavidWood&Associates

by David A. Wood

PSC Take & Cash Flow Breakdown (2b)


Average Over Field Life Poor Cost Oil
In this example cost
recovery (E) is insufficient
to recover the cost of even
the average barrel in a single
period.
The States Take and cash
flow are the same. The
contractors are not, because
contractor is funding upfront
capital costs.
Gross revenue is split
approximately:
69.5% to State
-0.7% to Contractor
31.2% to Costs
But nearly one-third of
those costs (10% of gross
revenue) are not recovered
in a single period.
by David A. Wood

Yearly Price Fluctuations Influence


Reserves Booked Under PSCs
Higher the product price the lower the number of barrels to satisfy the cost oil
allocation. Remaining barrels go into profit split.

by David A. Wood

10

Contractor: Government Takes & Interests


Bookable in Financial Statements

The tax component is


also accepted as a
bookable component
in some PSCs

Bookable
In Financial
Statements

by David A. Wood

11

ExercisetoCalculateRevenueSplit
ForExampleProductionSharingTermsFillintheGaps!
DavidWoodExercise#5

Petroleum Economics
Funding Criteria: The Cost of Capital
& Oil & Gas Finance
David A. Wood

Cost of Investment Capital is Usually


Complicated by Taxation Issues
Tax allowances for debt and equity sources of capital are usually different.

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 =

10% before tax.

Cost of Capital =

(10)(1 - 0.29) = 7.1% after tax.

Note that in most countries the government effectively subsidises


borrowing by allowing corporate tax relief on loan interest.

by David A. Wood

Cost of Investment Capital:


Weighted Average Cost of Capital
The weighted-average cost of investment capital (WACC), from all sources, is
usefully expressed as a percentage interest cost, not as an absolute currency
amount.

A second simple case of investment money derived from three separate


lending agencies:
Bank A: 100 M$ at 10%
Bank B: 200 M$ at 12%
Bank C: 300 M$ at 15%

Cost of Capital = [(100)(10) + (200)(12) + (300)(15)]/600


= 13.17% before tax.
Cost of Capital = (13.17)(1 - 0.29) = 9.35% after tax.

by David A. Wood

Cost of Debt Plus Equity


Investment Capital (1)
Most companies fund ventures with both debt and equity making the cost of
capital calculation more complex. All sources of capital funds have associated
costs that must be consider in calculating WACC.

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:

[(% Equity) * (Growth Rate + Dividend Rate)]


+ [(% Debt) * (Interest Rate)]

Consider such a corporation trying to maintain a 10% stock value growth


rate and paying a 4% dividend. Debt consists of 75% in 7% bonds and 25%
in 15% short-term notes. The debt : equity split is 40 : 60 and the percent
equity is 60, for a debt/equity ratio of 0.67.

by David A. Wood

Cost of Debt + Equity Investment Capital (2)


Most large companies fund ventures with both debt and equity.

Cost of Capital = (0.6)(10 + 4) + (0.4)[(0.75)(7) + (0.25)(15)]


= [8.4/(1 - 0.29)] + 3.6
= 15.43% before tax
Cost of Capital = 8.4 + (3.6)(1 -0.29)
= 10.96% after tax
Growth and dividend payments are accomplished with after-tax funds so
before tax calculation requires tax adjustment (which will increase the
equity cost pre-tax).
After taxes, debt capital is cheaper than equity capital, even at relatively
high interest rates for borrowing.

by David A. Wood

Link Discount Rate To Cost of Capital


Most companies fund ventures with both debt and equity.

Prudent practice dictates that investments not be made in projects returning


less than the cost of capital.
Therefore, the minimum investors rate of return for qualifying projects, as
well as the appropriate minimum discount rate for present value
calculations, is the cost of capital.
IRR, PV and NPV should all be determined on an after-tax basis and with
risk and inflation prefigured into the net cash flow stream and not
incorporated into the required rate of return or discount rate.

by David A. Wood

Simplified Flow Chart For The Financial


Process in a Typical Upstream Oil Company
The role of financial management is to optimise the value and use of the basic
reservoir of cash and its associated funds flow.

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

Providers of Project Finance to


Major Energy Projects
Energy investors and commercial banks make the major funding contributions.

by David A. Wood

OECD Export Credit Agencies


Export credit agency contributions as debt or guaranties help to reduce
project risk.

www.exim.gov (U.S.A)
www.ecgd.gov.uk (U.K.)
http://www.oekb.at (Austria)

by David A. Wood

LIBOR and EURIBOR


Benchmark lending rates.

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

10

Petroleum Economics
Hurdle Rates and Selection of Discount Rates
David A. Wood

How Do Organisations Select an


Appropriate Discount Rate?
Commonly applied discount rates are.

Rate of interest paid on borrowed capital (i.e. the cost of debt capital).

Full cost of capital, cost of debt plus equity.

Effective rate of return offered from available competing investments or


from an existing portfolio.
Minimum threshold effective interest rate desired for available investment
capital. Oil & gas equity investors generally want a greater return than they
can earn from less risky investments. (Equity therefore usually costs an oil
and gas company more than debt)
The discount rate should not be less than the cost of the capital being
invested in the project.

by David A. Wood

What Discount Rate Should be Used?


Discounted cash flow calculations form the cornerstone of modern economic
analysis. However, there is often uncertainty as to what
discount rate should be used to calculate present values.

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

Invalid Discount Rates


Many companies mislead themselves by applying invalid rates to calculate the
discount factors used in their economic evaluations:
Inappropriate rates often applied are:
Inflation rate
An interest rate plus inflation
An interest rate increased to account for risk
An interest rate plus a desired return
Considerations such as risk, inflation and interest paid need to be included in
the cash flow calculation but not in the form of the discount factor which can
distort calculated present values.
by David A. Wood

Taking the Project Inventory


to the Portfolio Level

by David A. Wood

Risking Cash Flow Profiles by Increasing


Discount Rate is Not Appropriate
Higher discount rates preferentially penalise later years in a cash flow profile.

by David A. Wood

Discount Rate Versus Success Rate


Consider a cash flow profile discounted at several rates. The cash flow column is
undiscounted (i.e. zero rate)
For this cash flow profile the
relationship between the net
present values (NPVs - total
discounted values) is:
NPV@16% is 35% of the
undiscounted cashflow, 59% of
the NPV@8% and 76% of the
NPV@12%.
Increasing the discount rate to
compensate for perceived higher
risk will reduce the value by a
fixed amount which will usually
not correspond to the level of risk
associated with each of a number of
projects.

by David A. Wood

Risk-Weighted Prospect Cash-flows


Risk should be applied to cash-flows using risk factors (chance of success or
failure) not by raising discount rate.
Risked NPV@8%
for a chance of
success of 40% is
$11.5 million which
drops to $5.7 for a
chance of success of
20%.
Doubling the
discount rate from
8% to 16% only
reduces the NPV to
$8.8 million.

by David A. Wood

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:

Expected monetary value (EMV). This is the combination of the net


present value of success weighted with the chance of success and the
present value (discounted cost) of a failure weighted with the chance of
failure.
Risk-weighted profit (EMV) to investment ratio. This is the EMV
divided by the discounted total investment weighted for success plus the
discounted risk investment lost on failure and weighted for failure.
Risk Capacity. This is the NPV divided by the PV of the risk capital.
Statistics from calculated probability distributions. The interrelation of
numerous uncertainties is evaluated by the Monte Carlo simulation
mathematical technique.

by David A. Wood

Quantifying Risk: the Probability Scale


Quantifying risk on a numerical scale of probability offers a more systematic and
consistent approach to expressing risk than adjectives.

Replaces verbal expressions of outcome like good or almost certain.


by David A. Wood

Expected Monetary Value (EMV)


EMV is the average value obtained when all outcomes are weighted on the basis
of their respective probability of occurrence.

In an EMV calculation the sum of the probabilities must be 1.0 or 100%.


by David A. Wood

EMV is Not Usually the Value Realised


from a Single Trial
It is the average outcome (value) expected from a large number of ventures of the
same type.

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

The Zero to One Sum Game


Exploration projects commonly have potentially multiple success and failure
outcomes. For example:

Consider another exploration venture. A dry hole costs $1,000,000, and


there is a 60% probability that one dry hole will condemn the prospect,
with a complimentary probability of 40% that two dry holes will be
required. If a discovery is made, four outcomes are considered to be
possible:

20% probability of losing $500,000 (discounted values).


40% probability of making $500,000.
30% probability of making $10,000,000.
10% probability of making $20,000,000.

There is a 70% probability (Pf) of finding no production and therefore Ps =


30% as:
Pf + Ps =1.0 = 100%

by David A. Wood

Example of a Two-stage EMV Calculation


Reduce the dry hole alternatives to one EMV for failure and the discovery
alternatives to one EMV for success then combine the two:

Decision rule using EMV: if EMV is positive it is a worthwhile


venture if EMV is negative it is not a worthwhile venture.

by David A. Wood

Calculating Probability of a Specific EMV


This also gives the maximum probability of failure.

Pf + Ps =1.0

EMV = (Ps * NPV success)+ (Pf * NPV failure).

Ps to achieve an EMV of +$1,000,000 is calculated:

so

Pf = 1 Ps

In millions: $ 1.0 = (Ps)(+$5.1)+(1 - Ps )(-$1.4)


this simplifies to:
6.5(Ps ) = 2.4
Ps = 36.9% and Pf = 63.1%
This means that for the EMV to equal +$1,000,000 then the Ps value in
stage 2 of the calculation must equal 0.369.

by David A. Wood

Risk / Opportunity Models Often Need to


Combine Discrete & Continuous Probabilities
Combining discrete event likelihood estimates with continuous cost / value
consequence distributions is a key part of the expected value calculation process of
simulation models.
Simulation models also need
to incorporate timing
estimates and discounting
calculations to generate
valuations of projects
extending over many years.
Logic of when events occur
is a key part of the modelling
process. It is important for
the analyst to understand the
implications of any
assumption made in this
regard.

by David A. Wood

Risk Capacity, Risk Reward Ratio


& EMV All Yield Valuable Information
If EMV & Risk-Reward Ratio > 0 then a project is commercially viable on a risked
basis. Values of zero indicate the minimum reserves threshold for a commercially
viable risked project.

by David A. Wood

10

NPV and Reserves Risk Need to be


Combined to Reveal Risked Values
It is instructive to review the full probability distributions to understand the range of
possible outcomes.

by David A. Wood

11

Risk Capacity Can Quickly Define


the Minimum Reserve Threshold
Cross plotting risk capacity and reserves risk against field size is a quick method of
identifying the minimum reserves threshold, i.e. where the curves intersect is
equivalent to the reserves size at EMV =0.

by David A. Wood

12

EMV:Risk-Reward Ratio Relationship:


Both = 0 at Minimum Reserve Threshold

13

by David A. Wood

Risk-Reward Relationships are


Influenced By Fiscal Terms
Expected Value theory weights the value of a successful project with the chance of
success and cost of failure with the chance of failure.

The discounted cash flow


(Net Present Value
NPV) is the value of
success.
The risk capital
expenditure on exploration
measures the potential
cost of failure i.e. the
dry hole cost.

by David A. Wood

14

Petroleum Economics
Decision Analysis, Decision Trees & Flexibility
David A. Wood

Decision Tree Nomenclature


Decision trees are a means of diagramming a series of decisions, events, and
outcomes to incorporate probabilities and EMVs.

They make analysis of a tortuous sequence of decision alternatives


possible and presentable.
They provide a permanent record of the analysis contributing to a
decision as it existed, or was thought to exist, at the time of an original
decision.
Two node symbol convention is commonly used:

Decision node, with actions taken (usually symbolised by a


circle)

Event or chance node, with outcomes that occur (usually


symbolised by a square)

by David A. Wood

Decision Tree Preparation:


A Two-step Process
Decision trees should be constructed systematically.

Step 1: Diagram and label the sequence of decisions, events, and


outcomes with the associated probabilities of each event and outcome.
Probabilities associated with one chance node should sum to 1.0 (i.e. the
sum of all branches having the same origin equals 1).
Step 2: Calculate expected monetary values and post them on the tree
by working from right to left.
It is necessary to calculate and post the EMV of each event node and
leg.

by David A. Wood

Decision Trees: Step 1


A pictorial representation of a sequence of events and possible outcomes can
help make complex decisions. The event node is sometimes referred to as the
chance node.

by David A. Wood

Decision Trees: Step 2


EMV = (-2 * 0.7) + (2 * 0.15) + (15 * 0.1) + (75 * 0.05) = $4.2 mm

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

Quantitative Approaches Require


Probabilistic Models to Handle Uncertainty
Models are required to process economic and risk data provided as probabilistic
input distributions.

Spreadsheets combined with simulation add-ins (e.g. Crystal Ball ,


@Risk ) or driven by self-built simulation and statistical analysis VBA
macros, offer a powerful tool to aid this analysis.

Having defined the range of the expected cost / value distributions of


each event the simulation software transforms this into a distribution of
selected type and then samples that distribution in a statistically valid
way for a large number of model iterations or trials.

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.

Simulation is also widely used in the financial sector to value financial


instruments.

by David A. Wood

Simulation Example: Purchase of


a Laptop & Software as Two Separate Items
Market research of 30 sources suggests that the price of the laptop required can
vary over a range of $700 to $1,700. A single average number does not adequately
describe this range or the shape of the distribution, but it does provide the best
estimate of price at $1,200

by David A. Wood

Simulation Example: The Two Separate Items


May Have Quite Different Price Distributions
Market research of 30 separate sources suggests that the price of the software
required can vary over a range of $500 to $1,500. The distribution is asymmetrical
with a positive skew resulting in mode (most frequent), median (P50) and mean
having different values. Cumulative Probability is calculated for each value to
provide a probability of the price being equal to or less than a certain value.

by David A. Wood

Analogy of Simulation Process


With Selection of Lottery Balls
Consider each of the 30 price samples for each item as the numbered balls inside
two separate lottery barrels.

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.

A well constructed simulation model samples the distributions in a similar


way, i.e. proportional to the frequency of occurrence. It uses cumulative
probabilities to do this.

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

Considerations Based Upon


the Two Cost Distributions
Prior to running a simulation analysis the following points can be deduced:

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.

Cumulative probabilities are expressed on a scale of 0 (price is always


greater than that) to 1 (price is always less than that). If a total number of
30 is used to calculate the cumulative probability the highest price will have
a probability of 1

Spreadsheet random number generators provide numbers randomly


between 0 and 1 (but never actually those two numbers exactly). If the
highest price has a probability of 1 it will never be sampled by a random
number in such a sequence.

To overcome this a total of 31 is used to calculate the cumulative


probabilities shown in the previous graphs.

by David A. Wood

Random Numbers are Selected


to Represent Cumulative Probabilities
This simple model uses
VLOOKUP tables in
Excel to extract values
from the two price data
sets based on two
series of random
numbers.

Other trials omitted.. space constraints

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

Output Distribution From


Monte Carlo Simulation Model
The output or forecast distribution is uneven (and in this case bimodal) with gaps
because limited number of trials make it statistically inadequate with results strongly
influenced by chance. Most sets of 50 trials show a single mode, but some are more
uneven than others. Many more trials are required to generate a statistically smooth
output distribution. Expressing this as a cumulative probability distribution provides
information on the chance of not paying more than a specific combined price. What
if the two price distributions are correlated?

by David A. Wood

Advantages of Monte Carlo Simulation


The main purposes of a simulation study are to generate a statistically valid
probability distribution(s) for the objective function(s) and to provide greater
understanding of the relationship between the input metrics and the objective
functions. Advantages of Simulation are:
Mathematics is relatively straightforward and widely used, forming the heart of
diverse aspects of financial analysis (e.g. pricing options, corporate portfolio
models etc.).

Spreadsheet functions & VBA code are mostly sufficient.

Distributions encapsulate both optimistic and pessimistic estimates and limit


potential for forecasts being unduly biased in either direction. Bias is a
problem with single point estimates.

More trials can be run in seconds to improve statistics.

People accept the technique and believe the results (sometimes too readily!!).

Models can usually be updated easily.


Correlations and complex dependencies can be incorporated.
The effort of using a model once established is low.

by David A. Wood

Monte Carlo Simulation Technique


Step by Step For Cash flow Analysis (1)
A number of different input distributions are combined to calculate reserves and
prospect expected monetary values (EMVs) for a number of trials.

by David A. Wood

10

Monte Carlo Simulation Technique


Step by Step For Cash flow Analysis (2)
A number of different distributions are combined to calculate prospect NPVs &
EMVs by the Monte-Carlo technique.

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

@risk
12

Caution Required For Monte Carlo Simulation


Model Structure & Interpretation
Frequency distributions generated by computer can be very believable despite
being based in some cases on meaningless input distributions.

The computed frequency distributions for in-place hydrocarbons commonly


produced by simulation are only as good as the quality of the frequency
distributions assigned to the input variables.

It is important to identify those variables which are dependent upon (or


correlated with) other variables and treat them as functions of those
independent variables.

A geological example of dependent variables are porosity and water


saturation that are inversely correlated in many cases. Capital costs and
operating costs are positively correlated in some oil and gas projects (i.e. as
one increases so does the other).

If porosity and water saturation are treated as independent then random


numbers will associate an unrealistic water saturation with a porosity in
individual iterations of the simulation.

by David A. Wood

13

Mechanics of Monte Carlo Simulation


Cumulative frequency distributions, random numbers and a large number of
iterations means many numbers to crunch and analyse.

A Monte Carlo simulation requires that the uncertain variables be defined


as either discrete or continuous frequency (probability) functions.

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.

A different random number is applied to each variable for each pass or


iteration of the model.

In this way, each value utilized for each variable occurs according to its
prescribed frequency function for the distribution type selected.

The result is a frequency distribution of the calculated metric.

by David A. Wood

14

Random Sampling of Independent Variables


For independent variables it is important that the random numbers selected to
sample each variable are random and distributed in accordance with the selected
distribution to approximate each variable.
Random sampling of two
uniform distributions crossplotted should appear similar
to the adjacent diagram.
Increasing the number of
sample trials should result in
filling the gaps and not
increasing the clusters.
Different mathematical
routines are available to
smooth sample point spread,
but these are beyond the
accuracy of the method for
most oil and gas problems.

by David A. Wood

15

Statistical Stability & Significance


of Simulations
Sufficient simulation passes should be made so that the standard deviation of the
calculated distribution is no longer changing significantly. Another rule to follow is to
run a simulation until the standard error of the mean (i.e. standard deviation /
number of trials in the simulation) is less than 1% of the mean.

by David A. Wood

16

Decision Trees and Simulation


A Monte Carlo simulation derives a distribution which represents a large number
of possible outcomes rather than a few discrete outcomes of a simple decision
tree.

by David A. Wood

17

Exercise #6: Monte Carlo Simulation:


Two Variable / 10 Trial Problem
To illustrate the technique a simplistic calculation is required in this exercise
using just two variables defined as discrete distributions.

by David A. Wood

18

Example of Monte Carlo Simulation


Perform the 10 Trials (Exercise #6)
Net cash flow is calculated for each of ten iterations (trials) by multiplying the
$/barrel selected value by the reserves selected value. But firstly fill in the blanks
for the two variable columns.

by David A. Wood

19

Simulation Exercise #6
Sequence of analysis:
1.

Select values for each trial

2.

Use rules established in first table

3.

Calculate net cash flow for each trial

4.

Work out the mean of the net cash flow distribution

5.

Arrange the results into a cumulative frequency distribution

by David A. Wood

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