33 голоса за00 голосов против

1K просмотров156 стр.Petroleum Economics

Nov 04, 2014

© © All Rights Reserved

PDF, TXT или читайте онлайн в Scribd

Petroleum Economics

© All Rights Reserved

1K просмотров

33 голоса за00 голосов против

Petroleum Economics

© All Rights Reserved

Вы находитесь на странице: 1из 156

DEVELOPMENT PROGRAM

CLASS 2011

PETROLEUM ECONOMICS

David Wood

IN-HOUSE COURSE

prepared for

Vienna, Austria

Parkstrasse 6

A-8700 Leoben, Austria

Tel: +43 3842 430530

Fax: +43 3842 430531

E-Mail: training@hoteng.com

www.hoteng.com

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.

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

PowerPoint presentations and exercises.

Your participation is welcome.

My preference is for an informal approach to

encourage an exchange of ideas and

experience.

by David A. Wood

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

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.

by David A. Wood

Morning Session 4.1

The Need for Petroleum Economics

Project Cash Flow & Income Components

Morning Break

Morning Session 4.2

Petroleum Reserves Categories & Valuation

Discounting & Time-Value Considerations (Exercise#2)

Lunch Break

by David A. Wood

Afternoon Session 4.3

Rates of Return

Payout Time

Profit to Investment Ratios

Risk and Opportunity Analysis

Afternoon Break

Afternoon Session 4.4

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

End of Day 1

by David A. Wood

Morning Session 4.5

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

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

Afternoon Session 4.7

Monte Carlo Simulation Demonstration (Exercise #6)

Assessment Test

Afternoon Break

Afternoon Session 4.8

End of Module

by David A. Wood

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

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

Upstream projects are characterised by:

High rate of capital investment

throughout asset life

Complexity

points

Incremental information flows and

decision points

Dependency upon volatile product prices

and demand

by David A. Wood

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 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

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

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

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.

by David A. Wood

& 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

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

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

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.

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

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:

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

Decisions to Balance Risk & Reward

Balancing is never easy!!!

management of the oil and gas industry.

by David A. Wood

14

Petroleum Economics

Project Cash Flow & Income Components

David A. Wood

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

For an oil and gas company to prosper it has to find and/or acquire new

reserves and make a financial profit.

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

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

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

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

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:

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

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

specific categories:

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

with Cash Outflows

Inflows usually equate to production revenues but also may include asset sales.

Outflows include expenditures and taxes.

by David A. Wood

Adjusted by Accounting & Taxation Rules

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

Measures Applicable to Oil & Gas Projects

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

Many (Often Complex) Components

by David A. Wood

12

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

Calculations of taxable incomes, particularly in tax-royalty fiscal regimes, are usually

complex and require specialist tax advice.

by David A. Wood

14

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.

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

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.

Buildings 20 to 30 years.

by David A. Wood

16

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

$5,000

$5,000

$10,000

Book Value:

$50,000

17

by David A. Wood

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:

reserves) - widely used for accounting purposes.

& double (200%) rates used.

federal income tax (FIT) capital cost depreciation

by David A. Wood

18

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

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

Amortization - DD&A

This originally North American concept is now also widely used in international oil

and gas accounting.

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

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:

by David A. Wood

22

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:

23

by David A. Wood

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:

AD

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

Measures Applicable to Oil & Gas Projects

or explanation it is important to distinguish what it is actually measuring. There

are several different possibilities!

by David A. Wood

Measures of Profit

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

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

Reserves to Petroleum Portfolios

by David A. Wood

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

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

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

with In-place Classifications

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

by David A. Wood

Production Asset Sales

by David A. Wood

10

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

Petroleum Reserves Valuation

Petroleum Resource Management System (PRMS, 2007) recognises the need for

much more than establishing resource volumes.

by David A. Wood

12

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

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

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

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.

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

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.

by David A. Wood

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).

interest period and FV is the value at the end of that one interest period).

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

interest at 15% on an investment of $2,000 (the principal).

by David A. Wood

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)

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

If the interest is withdrawn at the end of the period only simple interest (on the

principal investment) is earned the next period.

addition to that earned by the principal, i.e. compound interest.

Compound FV for a second period:

form:

FV = PV (1 + i)n

(1 + i)n

by David A. Wood

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

years based on an annual interest rate of 7% is $5,000.

by David A. Wood

Discount Rate is Not Appropriate

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

by David A. Wood

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:

care that the initial investment and type of discounting applied to it

are appropriate.

by David A. Wood

Calculating the NPVs of cash flows of projects to be compared at different discount

rates and viewing them graphically can discriminate.

by David A. Wood

Projectsthatlookthemostattractiveatonediscountvaluemaynotdosoatanother.

by David A. Wood

10

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

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 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

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

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.

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

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.

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

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

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.

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

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

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

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

by David A. Wood

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

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?

IRRB = (2,500/2,000) - 1 = 0.25 = 25%.

NPVB = -2,000 +(2,500/1.06) = $359.

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

not a Definitive Yardstick

IRR is not a good yardstick for discriminating between projects or justifying

projects as this example shows.

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

Excel versus Interpolation

Spreadsheets offer good IRR functions but it can be calculated by interpolation

or graphically. Table below uses mid-year discounting.

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

Interpolation must not be over more than 10 percentage points.

by David A. Wood

11

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

The Reinvestment Issue

AcalculatedIRRisnotactuallyearnedunlesspositivecashflows

fromeachperiodarereinvestedattheIRRrate.Considerthefollowinginvestment:

Actual "i" Earned May Not Be the IRR

Year

0

1

2

3

Totals

($1,000)

$680

$680

$680

$1,039

PV@: 38%

($1,000)

$465

$318

$217

$0

MIRR modifiedIRRfunction

incorporatesareinvestment

ratesoovercomesthis

shortcomingofIRR.

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

MIRRExcelfunctionreturnsthe

modifiedinternalrateofreturn

foraseriesofperiodiccash

flows.Itconsidersboththecost

oftheinvestmentandthe

interestreceivedon

reinvestmentofcash.

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

MIRRsometimescalledexternal

rateofreturnERR.

PV = FV * e

-in

0% IRR

then FV= 3* $680 = PV * e

3i

by David A. Wood

13

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

It is not only the magnitude of the cash flow components that influence value, it is

also the timing of the cash flow elements:

by David A. Wood

Such measures have a calendar significance:

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

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 time indicates liquidity (risk) rather than profitability:

by David A. Wood

Ignores Time-Value Considerations

Where:

Rk = revenue year k

Ek = expenditure year k

I = initial investment

by David A. Wood

Petroleum Economics

Profit to Investment Ratios

David A. Wood

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

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

These are widely used because they are easy to calculate.

Return on Investment:

ROI =

Maximum Negative Position

PIR =

by David A. Wood

Total Investment

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 =

Maximum Negative Cumulative PV

DPIR =

PV of Total Investment

Profitability Index:

PI =

PV of Capex only

by David A. Wood

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

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

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.

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

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

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.

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

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

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

is Multi-faceted

collective impact of these

uncertainties in an holistic risk

assessment.

by David A. Wood

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?

should actually occur?

by David A. Wood

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

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

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

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

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.

speculative risks often

overlap and interact, creating

artificial boundaries between

them may be inappropriate.

11

by David A. Wood

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

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

by David A. Wood

12

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.

13

by David A. Wood

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

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%

by David A. Wood

15

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

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

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

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

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

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

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.

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

Require Analysis

Few opportunities are good investments just by inspection.

Analysis is required for:

projects with several choices or possible outcomes.

Marginal investments.

Incremental investments

High-risk investments.

markets).

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

A single ideal yardstick which properly ranks each investment opportunity would

have the following characteristics:

investment and incorporate an assessment of risk.

acceptable within the confines of a defined corporate strategy.

exclusive opportunities.

comparative investment evaluation. Wise decisions are more likely when

measuring an opportunity from several viewpoints.

by David A. Wood

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

These have a calendar significance.

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

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

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

It is important to use a range of investment yardsticks.

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

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

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:

aspects of an investment opportunity.

attitude to risk.

by David A. Wood

10

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

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.

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

For Economic Analysis

by David A. Wood

17

Petroleum Economics

Which Oil & Gas Prices Should be Used to Value

Assets?

David A. Wood

Market perception

Weather

by David A. Wood

by David A. Wood

Arbitrage Opportunities in Markets

2006

2007

2008

2009

2010

2011

by David A. Wood

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

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

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

September 2011

Steep backwardation.

by David A. Wood

by David A. Wood

Volatility Since the 1970s

by David A. Wood

10

Crude Oil Prices (Nominal & Real)

by David A. Wood

11

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

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 $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

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

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

Relative to Benchmarks

The OPEC basket price follows Brent.

2011

2010

by David A. Wood

15

28 Oct 2011

by David A. Wood

16

2006 and 2008

by David A. Wood

17

Fully (over?) valued acquisitions executed in a high commodity price environment

can present future profitability risks for buyers.

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

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:

screw pumps, jet pumps or gas lift.

Etc

by David A. Wood

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

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

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

of Drilling Opportunity

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

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:

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

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

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

on Oil & Gas Industry

UCCI:Equipmentthatcost$100

in2000costs$230atend3Q

2008($218atend1Q2011)

DCCI:Equipmentthatcost

$100in2000costs$176at

end1Q2008($192atend1Q

2011)

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

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

Adjustments to the discount rate are required.

by David A. Wood

It is not correct to simply add the inflation rate to the discount rate to compensate

for inflation (but when inflation rates are very low it makes very little difference to

the analysis).

A composite discount rate accounting for inflation is provided by:

rate of inflation and r is the composite discount rate. If i = 15% and

f = 10% then: r =26.5% (not 25%).

particularly so in the petroleum industry.

not adjusted by inflation in many fiscal regimes.

by David A. Wood

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

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

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

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

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%:

to the supplier (i.e. the inflation rate, f) to calculate the buying

power.

where n is number of years.

by David A. Wood

There is another relationship between the desired discount rate and inflation rate that

is used to calculate the rate of return in real terms.

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

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

Energy Costs

by David A. Wood

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

1.

2.

3.

Index numbers have no units. This avoids distracting units and changes

are easier to assess.

by David A. Wood

& Price Deflators

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

to assess.

by David A. Wood

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

By Illusory Convergence

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

indices converge.

by David A. Wood

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

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:

periods of time.

by David A. Wood

Petroleum Economics

Estimating Values & Costs and Budget Cost Control

(Exercise #4)

David A. Wood

Energy Specialists 1998

Actual

Price

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

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

Used for Sensitivity Analysis

by David A. Wood

Steep Trends Indicate High Sensitivity

by David A. Wood

& Reduce Operating Costs

As production / revenues decline in mature fields management must seek changes to

the operation that reduce OPEX and extend field life.

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

the Estimation Process

Systematic bias the tendency for us to consistently overestimate reserves or

underestimate costs permeate the upstream oil & gas industry!

in frequent surprising outcomes.

selling the prospect prompted by perceived competition from

the prospects of others.

by David A. Wood

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

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.

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

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

estimating phase.

11

by David A. Wood

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

Example of a pre-FEED cost risk analysis performed on a GOM deepwater subsea

tieback project (excludes costs of drilling and completion).

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

is During the Planning Stage

15

by David A. Wood

Essential for Cost Control & Approvals

AFE system is widely used in the oil and gas sector because of joint ventures.

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

& 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

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

Involved in Petroleum Field Projects

2. Offtake here includes transportation, throughput & processing.

by David A. Wood

& Types of Fiscal Agreement

by David A. Wood

HOST GOVERNMENT

economic rent

Ensure good governance (safety,

environment & corporate)

CONTRACTOR / IOC

corruption

climate

commercial opportunities for its

nationals

by David A. Wood

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

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

in Terms of Economic Rent

Governments and IOCs shares of economic rent.

by David A. Wood

Fiscal Elements & Government Risk

by David A. Wood

Respond to Changing Conditions

Progressive fiscal structures take more for the state when prices are high or

costs are low.

by David A. Wood

Less Flexible in Changing Conditions

Regressive fiscal structures will damage commerciality in harsh economic conditions.

by David A. Wood

The regressive nature of royalties is easy to demonstrate:

by David A. Wood

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

Projects & Fiscal Terms

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

Financial & Economic Performance

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

Stability Often Proves to be Elusive

Key issues:

Alignment

Empathy

Understanding

Trust

Long-term

Perspectives

Flexibility

Sustainability

13

by David A. Wood

Offshore UK quadrants of 1 degree latitude by 1 degree longitude are subdivided

into 30 blocks of about 250 sq. km.

22 / 06a: 43.29%

22 / 07: 0.75%

22 / 11: 53.33%

22 / 12a: 2.63%

Nelson Field

by David A. Wood

14

Nigeria / Sao Tome JDZ

by David A. Wood

15

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

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.

The division is simplistic as it

ignores the time value of money

and risk versus reward concepts

by David A. Wood

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

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.

2.

for cost recovery (termed cost oil).

3.

between government and contractor at a stipulated share (e.g. 70%

government: 30% contractor) or on a sliding scale.

4.

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

Average Over Field Life

(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

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

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.

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

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

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

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

Bookable in Financial Statements

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

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 =

Cost of Capital =

borrowing by allowing corporate tax relief on loan interest.

by David A. Wood

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.

lending agencies:

Bank A: 100 M$ at 10%

Bank B: 200 M$ at 12%

Bank C: 300 M$ at 15%

= 13.17% before tax.

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

by David A. Wood

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:

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

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

Most large companies fund ventures with both debt and equity.

= [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

Most companies fund ventures with both debt and equity.

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

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

Major Energy Projects

Energy investors and commercial banks make the major funding contributions.

by David A. Wood

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

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

Appropriate Discount Rate?

Commonly applied discount rates are.

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

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

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

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

to the Portfolio Level

by David A. Wood

Discount Rate is Not Appropriate

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

by David A. Wood

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 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:

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 on a numerical scale of probability offers a more systematic and

consistent approach to expressing risk than adjectives.

by David A. Wood

EMV is the average value obtained when all outcomes are weighted on the basis

of their respective probability of occurrence.

by David A. Wood

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

Exploration projects commonly have potentially multiple success and failure

outcomes. For example:

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:

40% probability of making $500,000.

30% probability of making $10,000,000.

10% probability of making $20,000,000.

30% as:

Pf + Ps =1.0 = 100%

by David A. Wood

Reduce the dry hole alternatives to one EMV for failure and the discovery

alternatives to one EMV for success then combine the two:

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

by David A. Wood

This also gives the maximum probability of failure.

Pf + Ps =1.0

so

Pf = 1 Ps

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

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

& 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

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

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

Both = 0 at Minimum Reserve Threshold

13

by David A. Wood

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.

(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 trees are a means of diagramming a series of decisions, events, and

outcomes to incorporate probabilities and EMVs.

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:

circle)

symbolised by a square)

by David A. Wood

A Two-step Process

Decision trees should be constructed systematically.

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

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

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

Probabilistic Models to Handle Uncertainty

Models are required to process economic and risk data provided as probabilistic

input distributions.

@Risk ) or driven by self-built simulation and statistical analysis VBA

macros, offer a powerful tool to aid this analysis.

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.

instruments.

by David A. Wood

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

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

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.

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

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.

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

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.

probabilities shown in the previous graphs.

by David A. Wood

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.

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

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

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.).

potential for forecasts being unduly biased in either direction. Bias is a

problem with single point estimates.

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

Correlations and complex dependencies can be incorporated.

The effort of using a model once established is low.

by David A. Wood

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

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).

11

by David A. Wood

@risk

12

Model Structure & Interpretation

Frequency distributions generated by computer can be very believable despite

being based in some cases on meaningless input distributions.

produced by simulation are only as good as the quality of the frequency

distributions assigned to the input variables.

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

independent variables.

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).

numbers will associate an unrealistic water saturation with a porosity in

individual iterations of the simulation.

by David A. Wood

13

Cumulative frequency distributions, random numbers and a large number of

iterations means many numbers to crunch and analyse.

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.

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.

by David A. Wood

14

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

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

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

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

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.

2.

3.

4.

5.

by David A. Wood

20

## Гораздо больше, чем просто документы.

Откройте для себя все, что может предложить Scribd, включая книги и аудиокниги от крупных издательств.

Отменить можно в любой момент.