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This chapter covers the basic economic principles that govern the oil and gas industry.

It can be
considered a microcosm of the topics covered in the remaining three chapters. This chapter is selfcontained in the sense that, by using this chapter alone, many oil and industry problems can be solved.
Many industry professionals use the principles described in this chapter to make daily economic
decisions. Through various case studies, we will illustrate how to apply these principles to real life field
examples.
This chapter contains five main sections. The first section covers the decision-making process in the
industry. In the second section, we cover the basic terminology used in the industry; this includes some
terminology specific to economic theories and some terminology specific to the industry only. In the
third section, we describeil and gas reserves. For any exploration and production company, the main
assets are oil and gas reserves. Understanding the basic definitions is important before we can estimate
those reserves. In the fourth section, we consider two economic methods which are commonly used in
the industry: payback period and profit-to-investment ratio. In the fifth section, we introduce the
concept of time value of money, which allows us to relate monies that are collected at different times.
Underlying all these principles is the common theme of assessing uncertainties. Without incorporating
uncertainties, no realistic economic decision can be made. Although we have an explicit chapter on
Economic Uncertainties, the idea of gaining a solid grasp on uncertainties is an important one.
Therefore, many examples will introduce the concept of uncertainties in an intuitive manner.
DECISION-MAKING PROCESS
Beginning with the decision to explore for oil and gas, economic decisions become an integral part of the
project. Do we need to sign an agreement to acquire a concession on a lease? Will a signing bonus be
paid? If so, how much? Also, what types of additional commitments, such as work programs and future
drilling activities, are needed? If a concession is acquired, does additional geological or geophysical data
need to be gathered before drilling? If sufficient data are available, where should we drill the first well?
If the well is successful, are the hydrocarbon reserves in sufficient economic quantities to justify
additional drilling and exploitation (Davis 1968)?
After finding hydrocarbons and knowing that they can be produced in economic quantities, we first
need to decide whether to develop or sell to another party. If we decide to develop, we need to
consider the decisions required during the drilling and production phases - drilling techniques, well
completion techniques, surface separation equipment, piping and tubing requirements, and the rate of
production. These factors are further compounded by the changing economics of oil and gas prices, over
which the producer may not have any control.
The economic decisions continue throughout the producing life of the project. Once the production
begins, we need to consider the possibilities of secondary and tertiary oil recovery techniques, drilling of
infill wells, and the implementation of artificial lift techniques. Also, the production scenario can be
significantly affected by changing government regulations related to production quotas or to
environmental and political concerns. At the same time, knowing that present reserves are going to last
a finite period, we have to make decisions related to future acquisition and leasing of onshore and
offshore lands.

Economic Evaluation in the Petroleum Industry


Chapter 1 - Economic Principles

As discussed, the decision-making process is cyclical and continues throughout the perpetual existence
of the oil company. As old reservoirs are exhausted, new reservoirs need to be exploited.
Inherent in any economic decision process is the role of uncertainties. Without understanding
uncertainties, no economic decision can be made. In the oil and gas industry, three uncertainties play an
important role: technical, economic, and political.
Technical uncertainties are the uncertainties associated with applying a new technical concept to a
reservoir. This can be due to a new technology that is being implemented for the first time, or an old
technology that is being applied to a new reservoir. Technical uncertainty is highest when the
technology is implemented for the first time. As it becomes routine, uncertainty will be minimized. An
example of this is the drilling of a horizontal well in 1980s. At that time, the technology was new and
the uncertainties were significant. As the technology matured, drilling a horizontal well became routine
and the technical uncertainties were reduced significantly.
Economic uncertainties relate to the uncertainties associated with benefits and costs. The biggest
uncertainty is the price of the commodity. For any economic evaluation, knowledge about the price of
oil and gas is important. Changes in the price of these commodities can have a first order impact on
economic decisions. Any operating company examining the economic viability of the project will be
remiss if it does not include the price uncertainties in its evaluation. Additionally, the uncertainties in
costs related to service activities are also important. For example, as commodity prices increase and
demand for services increases, service prices also increase. Having a good understanding of those
uncertainties is critical in economic evaluation.
Political uncertainties result from uncertainties from new regulations and laws that are anticipated but
not certain to be implemented. As unconventional resources become more important and exploitation
of those resources requires fracturing of the formation, regulations related to fracturing and their
impact on economic viability have become increasingly important. Other examples of political
uncertainties include changes in tax regime and changes in a countrys government after an election or
political turmoil. These changes can have significant impact on economic decisions. Although some of
these changes are difficult to anticipate, consideration should always be given before making any
economic decisions.
When considering uncertainties associated with any particular economic decision, it is not necessary for
all the uncertainties to be present in every decision. For example, running a routine gamma ray log in a
well does not require evaluation of technical or, for that matter, any other uncertainties. Conducting
multi-stage fracturing in a horizontal well has become routine, but could be impacted by new
environmental regulations related to fracturing fluids. The price of natural gas can also have a big impact
on the viability of producing gas from unconventional resources. Each situation requires identification of
uncertainties and ensuring that they are incorporated in the decision-making process.
Any decision-making process has to be a rational, well informed process. It should be consistent with the
available information and the constraints imposed. Unlike playing a card game or gambling, intuitive
deductions or "gut feeling" are rarely useful in making objective decisions related to economic
evaluation. The steps involved in making rational economic decisions are as follows (Newman 1991).

Mohan Kelkar, Ph.D J.D.

RECOGNITION OF PROBLEM
Recognition of a problem includes defining the problem at hand, its importance, and associated
uncertainties and risks in dealing with the problem. For example, typical problems faced in the
petroleum industry are (DeGarmo, Sullivan and Bontadelli 1993):
Should you buy a lease or concession?
How many wells need to be drilled?
What production scheme should be applied?
What type of drilling method should be used?
If we consider the development and exploitation of a petroleum reservoir in chronological order, the
problems we will encounter can be stated as (Campbell 1987):
Will geological/geophysical and surrounding reservoir data locate the reservoir?
Will the wild cat well produce in commercial quantities to justify additional investigation?
Will additional delineation be required before further development?
Is full development of the field economically feasible?
What is the optimum strategy for exploiting the reservoir?
In recognizing these problems, we also need to understand the associated risks and uncertainties.
Complete recognition of a problem should include the identification of a problem and the associated
risks. Without the inclusion of risks, the solutions obtained may be simplistic and are often
misleading.

IDENTIFICATION OF OBJECTIVE/GOAL
Once a problem is identified, the next step is to ascertain the objectives that need to be satisfied.
For the same problem, depending upon the objectives, economic analysis can be different. For
example, an oil company with a goal to optimize production and a lending institution with a goal to
provide a secured loan will analyze the same prospect differently. The oil company will consider the
economic analysis in the most favorable light to secure either a loan or the approval of its
shareholders. The lending institution, on the other hand, will analyze the prospect in the most
conservative fashion; its objective being to provide a secured loan. The lender may cut the potential
reserves of a prospect in half before granting a loan to assure that sufficient collateral exists on the
loan.
As another example of different objectives, a government-owned company may decide to opt for a
less efficient, less mechanized (and probably less profitable) operation to satisfy the objective of
retaining its employees, or an oil company may decide to operate an offshore facility at the expense
of additional safety to ensure the chances of environmental damage are minimized. Another
example is the decision of oil companies to maintain pre-war gasoline price during the first Gulf War
crisis. Although the crude price increased after the war started, by maintaining gasoline prices at
pre-war levels, the oil companies considered the objective of better public perception to be more
important than maximizing profit.

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Chapter TI - Economic Principles

Briefly, typical objectives associated with any petroleum industry problem can be summarized as
follows (Campbell 1987) (lkoku 1985):
Maximization of profit / minimization of loss
Lending of capital using secured credit
Diversification of activities
Determining impact of government regulations
Public perceptions
Maximization of jobs
Environmentally sound operations
Selling and buying properties
Capturing or increasing the market share
Tax assessment
Safety considerations
Improving employee satisfaction
Not all of these objectives are monetary. The non-monetary objectives can result in choosing
different solutions rather than simply concentrating on the objective of maximizing profits or
minimizing losses. In this chapter and throughout this book, we will concentrate on this monetary
objective. Consideration of non-monetary objectives involves factors that are difficult to quantify
and, as a result, difficult to evaluate. If these factors have to be considered, every attempt should be
made to convert them in terms of monetary units, except when the non-monetary objectives have
ethical considerations.

ASSEMBLY OF RELEVANT DATA


Data collection is often tedious and sometimes the most time consuming process. Without careful
collection and analysis of available data, the resulting economic analysis may be worthless. The
assembly of data requires evaluation of available resources and feasibility of obtaining additional
data. This step itself involves decision making. For example, the design of a waterflood can be done
using some simplistic approximations and assuming analytical solutions. It may be quick, but may be
associated with a high degree of uncertainty. On the other hand, the design of a waterflood may
involve methodical collection of additional data through the drilling of additional wells or through
additional geological and geophysical information, extensive numerical simulation studies, and the
implementation of a pilot project. After assessment of the previous steps, field-wide waterflooding
will be implemented. Such an elaborate design will be associated with less uncertainty; but will cost
more to implement; therefore, collection of additional data before implementation of a waterflood
depends on the incremental benefits received by such collection. For small waterfloods, the
simplistic method may be appropriate; for large waterfloods, the detailed procedure will be needed.
Which route to follow will, in itself, involve making a decision. This decision will, essentially, depend
on one principle: the incremental benefits resulting from the collection of additional data should
outweigh the cost of collecting the data.
In oil and gas investment, additional data collection includes the quantification of uncertainties and
the risks associated with any project. More often than not, uncertainties are underestimated

Mohan Kelkar, Ph.D., J.D.

resulting in an improper evaluation of the project. For example, Table 1-1 summarizes the economic
evaluation of several Gulf of Mexico projects. As shown, the reserves are typically overestimated
(Brush and Marsden 1982), investments and time of completion are underestimated, and
profitability is significantly less than predicted. This table is a vivid illustration of what happens if
uncertainties are not properly accounted for in economic analysis. It is also an illustration of an
optimistic bias in petroleum economic analysis. As a rule, if in doubt with respect to quantification of
uncertainties, it is better to err on the conservative side.

Table 1-1: Economic Analysis of Gulf of Mexico Projects (Brush and Marsden 1982)
Estimated

Actual

Overestimated!
Underestimated

Optimistic!
Pessimistic

11,011
7.8
454
7.9
23.0

Underestimated
Underestimated
Underestimated

Platform Time, Months


Project Time, Months

10,849
6.2
328
7.0
17.3

Underestimated
Underestimated

Optimistic
Optimistic
Optimistic
Optimistic
Optimistic

Production Measures
Oil Produced, BOPD
Gas Produced, MMcf/D
Condensate Produced, BCPD

3,612
34.3
368

3,297
31.7
287

Overestimated
Overestimated
Overestimated

Optimistic
Optimistic
Optimistic

6,106
73.7
753

4,906
70.3
711

Overestimated
Overestimated
Overestimated

Optimistic
Optimistic
Optimistic

113
1,288
3,142
6,369
10,262

129
1,400
3,053
9,191
13,285

Underestimated
Underestimated
Overestimated
Underestimated
Underestimated

Optimistic
Optimistic
Pessimistic
Optimistic
Optimistic

Project Scale & Timing Measures


Feet Drilled
Number of Wells
Days of Drilling

Reserves Measured
Oil Reserves, bbl
Gas Reserves, Bcf
Condensate Reserves, Mbbl

Financial Measures
Cost Per Footj$/ft
Equipment Cost, Thousand $
Platform Cost, Thousand $
Well Cost, Thousand $
Total Cost, Thousand $

For a proper evaluation, it is critical that all relevant data be collected with a proper perspective. An
example would be an oil company making a decision to get all the core evaluations done by an
outside lab rather than doing it in-house. In considering the savings by "out-sourcing" the core work,
it is important to collect the information not only related to actual core measurements, but also the
cost of space requirements and the overhead costs associated with respect to that operation (total
cost of ownership). In other words, the perspective should be from the oil company rather than the
team responsible for measuring the core properties.
Also, if we are comparing alternatives lasting for long periods, relevant information with respect to
future cash flows should be gathered. For example, if we are interested in installing an electric
submersible pump on a well, the future benefits received as a result of installation of that pump
over the life of the pump should be collected.
Prediction of future benefits is an integral part of any economic analysis. We also need to quantify
the associated uncertainty. This can be done by analysis of historical data plus engineering judgment
derived from project-specific data. Over a long period of time, uncertainty in prediction will also
increase. Fortunately, the effect of uncertainty on economic evaluation diminishes with time;
therefore, the two effects will compensate for each other. Several techniques are used to forecast
various parameters (Campbell 1987). Most forecasting techniques rely on historical data to predict

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Chapter 1 - Economic Principles

future values. If sufficient historical data are available, future prediction over relatively short times
(times shorter than the available data) should be reasonable.
Prediction of oil and gas prices are also required as part of the collection of data. In general, it is
difficult to predict the price of oil and gas since the supply and demand of the commodities is
dependent on so many intertwined parameters, including political winds. However, the incremental
benefits of reducing price uncertainty are significantly greater than the cost of collecting such
information. As a result, operators always make an effort to come up with the best price prediction
and sometimes pay outside consultants to come up with future price predictions. It is, however,
important to remember that price predictions by different consultants are not truly independent
since they rely on essentially the same information. In the absence of additional data, assuming the
current price of the commodity to predict future prices is as good as any other possible prediction.
Overall, collection of relevant data is one of the most time consuming and the critical steps in
economic analysis. The goal of collecting data is always to reduce uncertainties. In the absence of
any uncertainty, there is no need to collect additional data; however, we always make a decision in
the presence of uncertainties. When data collection becomes expensive and does not significantly
reduce uncertainties, we stop collecting data and make an economic decision.

IDENTIFICATION OF FEASIBLE ALTERNATIVES


Analysis of a given problem may require considering several alternatives. Unless all alternatives are
identified, the overall analysis may result in a sub-optimal solution. Genuine creativity and
innovation are an integral part of this process. For example, during a primary depletion, initiating a
waterflood, drilling additional infill wells, or continuing the primary depletion may be some of the
alternatives to be considered. Sometimes, a combination of various alternatives will result in an
optimal solution. One alternative, which should not be ignored, is to continue the operation under
the existing conditions (the "do nothing" option).

SELECTION OF CRITERION
The selection of a criterion for evaluating alternatives should be consistent with the goals and
objectives of the problem. Using the selected criterion, we should be able to arrange the
alternatives for solving a problem in a way that allows us to select the most desirable alternative.
In selecting the criterion, only the differences in the alternatives are relevant to their comparison.
For example, if comparing two houses with the same price, we will only consider the differences in
location, type and annual maintenance costs. On the other hand, when buying a dining table, if two
tables are the same quality, built by different manufacturers, the differences in the prices would be
the only consideration. If we restrict ourselves to purely economic analysis, most of the criteria can
be grouped into three categories.

Mohan Kelkar, Ph.D., J.D.

FIXED INPUT
This criterion is applicable where the amount of money or resources is fixed. The objective is to
effectively utilize the resources; that is, to maximize the benefits. An example is a fixed
exploration budget that needs to be spent on potentially attractive prospects. The number of
prospects and associated exploration costs are greater than the budget; therefore, prioritization
of the budget may be required depending upon the goals of the company.

FIXED OUTPUT
This criterion is used where a fixed task needs to be accomplished. The objective is to minimize
the resources required to accomplish the task; that is, to minimize the costs. An example would
be laying a pipeline from an offshore platform. We know the diameter and the length of the
pipeline, and the location where the pipeline will be laid. We need to secure the best method to
minimize the resources required for building the pipeline.

NEITHER INPUT NOR OUTPUT FIXED


This criterion is applied where both the input and output are flexible. The objective is to
maximize the output with a minimum of resources; that is, to maximize the difference between
the benefits and costs. An example would be oil production from a field. If we intend to increase
the production through drilling infill wells, we should select the number of infill wells in such a
way that the incremental cost of each new well justifies the incremental benefit received from
the additional production.
Using one of these three criteria, analysis of the various alternatives can be carried out.

CONSTRUCTION OF MODEL
In constructing a model for evaluation of the alternatives, we need to incorporate the goals of our
study, the criterion to be used, and the risks associated with the project. Typically, for economic
evaluations, the constructed model is comprised of a set of mathematical equations. Ideally, these
equations should reflect the time value of money, cash flow schedule, and quantitative evaluation of
the uncertainties. Depending upon the complexity of the problem, the complexity of the model will
also increase.

EVALUATION OF ALTERNATIVES
Using the proper mathematical model, each alternative to a given problem needs to be evaluated.
Application of the model may be computationally intensive and may require the use of computers.
Once the evaluation is complete, the alternatives can be ranked based upon the objectives of the

Economic Evaluation in the Petroleum Industry


Chapter 1 - Economic Principles

project so that proper selection of the best alternative may be made. The best alternative is the one
that provides the most desirable solution under a given criterion.

IMPLEMENTATION OF THE BEST ALTERNATIVE


Once the proper selection of an alternative is made, the next step is to implement the best
alternative.

POST-EVALUATION OF THE ALTERNATIVE


After implementation of the best alternative, it is important to reevaluate the project after a
designated amount of time has passed. This evaluation involves comparison of the observed
performance with the predicted performance. If the comparison is acceptable, no changes need to
be made. If there is a difference, an assessment is needed to determine the reason(s) for this
difference. For example, the implementation of a waterflood may not produce an incremental
increase in oil rate as expected, resulting in reevaluation of underlying assumptions and the input
data. On the other hand, changes in the price of oil may result in an unexpected loss, forcing a
partial or total abandonment of a novel project to minimize the operating losses.
Example 1-1
As a petroleum engineer, you have been asked to evaluate the feasibility of installing a compressor for a gas well. Explain
all the necessary data you will collect. What are the alternatives you will consider? What criterion will you use to select
the best alternative?

Solution i-I
To consider the feasibility of installing a compressor, we need to investigate the additional production received by
installing the compressor versus the costs associated with the compressor. To assess this, the following information
needs to be collected:
1.

The present capacity of the well.

2.

The incremental capacity as a result of the compressor.

3.

The price of gas.

4.

The intake pressure of the pipeline.

5.

The price of the compressor, if purchased.

6.

The maintenance cost of the compressor.

7.

The cost of leasing the compressor.

Alternatives
1.

Produce under existing conditions.

2.

Buy a compressor.

3.

Lease a compressor.

Criterion
Maximizing the

N
.

Mohan Kelkar, Ph.D., J.D.

INTERACTION AMONG VARIOUS STEPS


Although the decision-making process is comprised of the steps discussed above, it is not necessary
for these steps to be taken in a sequence. In contrast, every step may require some feedback from
earlier, as well as later steps. The effects of one step on other steps in a decision-making process
have to be incorporated in the overall analysis. For example, definition of a problem may be
modified after collecting and assessing relevant data. New data may reveal that an important facet
of a problem has been ignored. In a waterflooding program, collection of additional data may
indicate that, without infill drilling, the program may not be successful; therefore, the problem may
need to be redefined. Identification of alternatives may reveal that we need to collect additional
data to analyze all alternatives. For example, when considering all possible alternatives for an
artificial lift process, if we realize that one of the feasible alternatives, the use of electrical
submersible pumps, to lift the liquids has been ignored, we may need to collect additional
information related to the submersible pump.
After evaluating the alternatives, a reality check may reveal that the evaluation is overly optimistic
or pessimistic and does not compare with prior experience. This result may require us to go back to
the data evaluation step to investigate the accuracy of collected data and the underlying
assumptions. For example if, when estimating the possible producible reserves in a prospect, after
analyzing all the data we realize that our estimated reserves are greater than nearby, depositionally
similar, reservoirs by an order of magnitude, we may have to re-evaluate our input data. After reevaluation, our analysis may reveal that some of the key assumptions we made are incorrect and
more data collection may be needed to properly evaluate the prospect.
Figure 1-1 shows the decision process in a schematic fashion. Although not precise, it is a fair
representation of the overall decision-making process. In the first stage, the problem and objectives
have to be defined. The two are independent of each other and do not require any interaction. For
example, drilling an offshore well with an objective of environmentally safe operation are two
separate facets of economic analysis. They are not necessarily dependent on each other; rather they
complement each other in carrying out the economic analysis.

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Chapter 1 - Economic Principles

Figure 1-1: Decision-Making Process


The next phase in decision making includes data collection and identification of various alternatives.
These have to occur simultaneously for proper coordination. Unless the alternatives are selected,
the need for appropriate data collection may not be evident. On the other hand, the data gathering
phase may reveal some alternatives that were not previously evident.
Depending upon the complexity of the project and the alternatives identified, an appropriate
mathematical model needs to be developed. An application of a criterion consistent with the
objectives of the project should result in the ranking of various alternatives. The evaluation phase
identifies the best alternative among the various alternatives.
If the evaluation reveals that the solutions obtained do not satisfy the reality checks, or if none of
the alternatives are feasible, we may have to go back to the data collection phase. Additional data
may identify alternatives that were not analyzed before. The additional data may also identify
possible mistakes in the assumptions or approximations made during the data gathering phase.
Assuming that a feasible alternative is selected, it should be implemented, followed by the
evaluation of the performance after a reasonable period. If the results are not consistent with the

10

Mohan Kelkar, Ph.D., J.D.

estimations, or if the economic conditions have substantially changed after implementation, we may
have to redefine the problem and repeat the process of decision making.
As evident from this discussion, the feedback within the decision-making process is very crucial for a
rational, well informed answer. Figure 1-1 is just one way of incorporating the feedback into the
decision-making process. Suffice it to say, however, it is better to err toward using too much
feedback than none.
Example 1-2
As an engineer, you are investigating the feasibility of improving the productivity of a well by stimulating it. Based on the
calculations you have performed, you expect production to increase by 30 bbls/day. In reality, after the stimulation
treatment, the production has gone up by 5 bbls/day during the first week. What possible actions would you take? Why?

Solution 1-2
In this instance, the estimated performance does not match the observed performance. Based on Figure 1-1, some
feedback in the decision-making process will be needed. You may consider several options:
Option 1: Wait for a longer period to see if production improves after the treatment becomes more effective. In some
instances, stimulating the well will not result in an immediate increase in production. It is better to be patient. Check
with the service company to determine the typical time during which the effect should be observed.
Option 2: Check the consistency of the input data in the stimulation program. Several sources of error are possible:
a)

The predicted damage, say, based on the well test data, may not be correct; therefore, the improvement is not

b)

The rock properties may not be conducive to this particular stimulation. Investigate if this particular rock type

equal to the prediction. Re-analyze the estimated damage.


should be subjected to the prescribed stimulation program. Additional data collection may be necessary.
Option 3: If additional data analysis reveals that the stimulation treatment was not the right treatment for this well,
explore other possibilities of improving the production. These possibilities may include: fracturing the well, or increasing
the number of perforations, changing the tubing size, etc. Although these possibilities should have been investigated
before, it is still better to investigate them now rather than ignoring them completely. This requires re-defining the
problem.
-

Problem 1-1
Suggest the economic criterion for the following situations:
1.

A government is seeking bids for on offshore block. Several companies, equally competent, offer sealed bids. What
should be the governments criterion in selecting a successful bid?

2.

An oil company is seeking a contractor to build a surface facility to process the hydrocarbons produced. The
specifications of the surface facility are known. What should be the companys criterion in selecting a contractor?

3.

An engineer is evaluating the design of a compressor to compress gas at the surface. The higher the compressor
power, the lower the required well head pressure; hence, more gas production. What should be the engineers
criterion in selecting a compressor?

4.

A drilling company has a spore drilling rig. The company con either lease it on a long-term basis at a discounted price
or lease it on a short-term basis at a higher price and keep it idle when not leased. In selecting the proper choice,
what criterion should the company use?

5.

A service company has observed that by reducing its price for acidizing wells, it can capture a bigger shore of the
market. What criterion should the company use in deciding the price?

6.

An oil company is evaluating several producing properties to determine which properties should be sold. What
criterion should the company select in ranking these properties so that the first ranking will be received by the

Economic Evaluation in the Petroleum Industry


Chapter 1 - Economic Principles

11

property which needs to be sold first?


7.

Refer to number 6. If on oil company receives several bids for the property on the market, what criterion should be
used to select a successful bidder?

8.

After the initiation of a CO2 flood, which involved a substantial investment due to a drop in oil prices, an oil company
realized that it will lose money on any conceivable scenario. In selecting a possible scenario, what criterion should
the company select?

9.

An oil company is interested in drilling a deep gas well at a known depth. In selecting a successful drilling company,
what criterion should be used?

10. After studying the production performance of an offshore well, an engineer realized that by injecting gas at the
bottom of the well, the production could be increased (gas-lift). The cost increases as more gas is injected. In
deciding the injection rate, what criterion should the engineer use?
Problem 1-2
If you are assigned the responsibility of investigating the feasibility of drilling an infill well in a mature field, state the
essential data you will collect. What are the criteria? What alternatives would you consider?

COMMON TERMINOLOGY
For any economic decision, an understanding of common terminology is important. In this section,
we introduce both the common economic terminology, as well as common oil industry terminology.

ECONOMIC TERMINOLOGY
BENEFITS
As the name indicates, benefits are the monetary awards received as a result of a given
investment. Typically, the benefits are accrued over a period of time as a result of the
present investment. For example, investing money in a newly implemented waterflooding
project is going to result in incremental production over several years. These benefits are
called future benefits. Most of the economic problems encountered are of this nature:
present investment followed by future benefits. However, in some instances, present
benefits are relevant to a given decision making. In these instances, the influence of time on
money is not significant. If the benefits collected over a very short period of time after the
investment, then those benefits are considered present benefits. An example would be a
service company providing a service to the operating company at some cost and getting paid
within a few months for the services. In this case, the benefits are collected immediately
after the costs are incurred. Unless the service company provides a service which is risked to
the potential benefits from the project, in general, this is the key difference between the
service company and the operating company. An operating company will always make a
present investment to collect future benefits which will be accrued as a result of future
production. In contrast, the service company receives the benefits immediately after
incurring the costs of providing the service.

12

Mohan Kelkar, Ph. D-, 1. D.

FIXED COSTS
Fixed costs are not affected by the activity level (production changes) over a feasible range
of operating conditions. That is, they are not a function of production or output. These costs
remain fixed. These costs typically include insurance costs, management and administrative
salaries and interest paid on borrowed capital.
VARIABLE COSTS
Variable costs vary as a function of operating conditions. These costs are affected by the
rate of output. For example, utility costs (electricity, water, etc.) and labor costs are strongly
dependent on overall production.
INCREMENTAL COSTS
Incremental costs represent additional costs that will result from increasing the output of
the field. For example, if production from a field is to be improved by drilling two infill wells,
the incremental costs will include the cost of drilling the two wells as well as the additional
costs associated with the operation of the two wells.

NWIRWIMIN
Direct costs are the costs that can be directly allocated to a specific output. Costs of utilities
or labor are good examples, as well as the maintenance of pumping units.
INDIRECT COSTS
These costs are difficult to attribute to a specific output. These costs typically include costs
of administration, training programs, legal fees, etc.
SUNK COSTS
Sunk costs represent an important economic concept. These costs were incurred prior to
current and future to decision making. Since these costs have already been committed, they
bear no relevance to any future decision making. Any economic decision depends on future
costs versus future benefits. These are the things we can control based on our analysis.
An illustrative example would be an oil company obtaining two concessions. For one
concession the oil company paid a bonus of $2 million. If exploratory wells are drilled in
both of these concessions, whether to develop the concessions will depend on the relative
performance of the explored well as well as the future costs and benefits associated with
the development. Other than indirect effect on future tax liabilities, the initial paid bonus
will play no role in the development decision.

Economic Evaluation in the Petroleum Industry


Chopter 1 - Economic Principles

13

OPPORTUNITY COST
An opportunity cost is the cost one has to pay by foregoing a potential investment that may
result in some benefit. A personal example is, if you lend money to your friend at a 0%
interest rate that you would have invested in the bank at a 10% interest rate, the
opportunity cost for you is 10%. On a commercial level if, due to a limited budget, you
cannot invest in all the projects you consider desirable, then you would rank them according
to some criterion. After selecting the projects in which you can invest, the best rejected
project represents the lost opportunity. The cost of this lost opportunity is called the
opportunity cost.
The opportunity cost should not be confused with the financial cost. For example, if we
need to borrow money at a 10% interest rate, then the financial cost is 10%. If you can
invest that money in a project which will provide you with a return of 20%, the project
provides you with an opportunity. If you forego this investment, then your opportunity cost
is 20%. In any economic analysis, the opportunity cost must exceed or be at least equal to
the financial cost. You would not borrow money at a 10% interest rate to invest in a project
that will provide you with a return of 6%.
PROFITS
Profit represents the difference between the benefits and the costs. If we define the
benefits as B and the costs as C , then profit can be written as:

P=BC

Equation 1-1

When a given project does not have either fixed benefits or fixed costs, an appropriate
criterion for economic decision making would be to maximize the profit or the difference
between the benefits and the costs.
INFLATION
Money has two faces: 1) It is capable of generating money through investment (earning
power of money). If you invest money in a productive project, it will earn additional money.
We are going to discuss the earning power of the money and its impact on economic
analysis in Chapter 2 - Economic Methods. 2) It is capable of buying goods (buying power of
money).
Inflation deals with the buying power of money (Steiner 1992). Inflation reflects the reduced
buying power of money as a function of time. In other words, the price of goods and
services increase over time - in some countries, very slowly (i.e., United States); in some
countries, at a very rapid rate (i.e., Brazil in the 1990s). Deflation, although not very
common, is the opposite of inflation. It reflects reduction in prices as a function of time.
Inflation plays an indirect role in an economic decision-making process. If the inflation is
high, the decision maker will have to use a higher rate of return to counter the inflation. On
the other hand, if inflation is low, you can get by with a smaller rate of return.

14

Mo/ian Kelkar, Ph.D., J.D.

Example 1-3
An oil well requires pumping equipment. Two companies offer the pump for the well with the following
characteristics:
Company

Company B

Initial Cost

$50,000

$50,000

Maintenance Agreement

$5,000/year

$3,000/year

Pumping Costs

$0.50/bbl

$0.60/bbl

Using the information above, answer the following:


1.

Which are the variable and fixed costs?

2.

If the well produces 40 bbls/d, which pump is preferred?

3.

What is the production from the well at which both pumps will deliver the same economic performance?

Solution 1-3
A.

Fixed costs: Initial cost of the pump


Maintenance costs
Variable costs: Pumping costs

I
I
I
I
I
I
I
II

B.

Since the initial costs for both pumps are the same, we need to compare only the annual costs to choose the
right pump.
Pump A:
(

bbl)

Annual costs = 5,000 + 40

\
d
(
x 0.5 1 = $12,300
x 365( )

yrl

bbl)

Pump B:
Annual costs = 3,000 + 40 x 365 x 0.6 = $11,760
Since the cost of operating pump B is smaller, it should be selected.
C. If we assume the production is x bbls at which both pumps will operate at the same cost, we can write

5,000 + x(365)(0.5) = 3,000 + x(365)(0,6)


Solving for x, x = 54.8 bbls/d.

lb
That is, if the well produces 55 bbls/d, you can choose either of the two pum

Example l4
A proposed enhanced oil recovery project requires a supply of gas containing 90% CO

2 to achieve miscibility with the

remaining oil. Two possible sources of CO 2 are available. Source one contains 97% CO 2 and source two contains 70%
CO 2 . The price of source one gas at the delivery point is $0.35/MSCF; source two gas is $0.2/MSCF. Assume both
sources are abundant in nature and we can use a mixture of the two sources in any proportion. What is the
proportional mixture we should use to minimize the cost? What is the cost of the mixture per MSCF?
Solution 1-4
Considering that the cost of source two is small, we should use as much of source two gas as possible. Assume that X
is the fraction of source two gas used; therefore, (i

-4

is the fraction of source one gas used.

We need a mixture which has a minimum CO 2 concentration of 0.9. Mathematica

Economic Evaluation in the Petroleum Industry


Chapter 1 - Economic Principles

15

x(O.7)+ (i - 40.97 = 0.9


Solving for x, x=0.26. Therefore, we will use a mixture of 26% of source two gas and 74% of source one gas. The price
of the mixture will be:

0.26($0.2/MSCF)+ 0.74($0.35 I MSCF) = $ 0,311/ MSCF


Example 1-5
The drilling of an oil well costs $250,000. Initial tests indicated a marginal well. The well will cost $40,000 to
complete and will produce 15 bbls/day for one year, declining at a rate of 20% per year. The operating costs are
expected to be $30,000 per year. Should this well be completed? If it is completed, in what year should it be
abandoned if the operating costs remain constant throughout the life of the project? Assume the revenue of oil
production to be $19/bbl. Neglect tax consequences.

Solution 1-5
In analyzing this problem, the cost of drilling should never be considered. This is a sunk cost. Irrespective of whether
we complete the well or not, we have already spent the money to drill the well. The decision as to whether to
complete it or not should be based on whether we can recover the cost of completion and the operating costs as a
result of the production. If the revenues generated are sufficient to cover these costs, the well should be completed.
This way, although we may not be able to recover the costs of drilling, we will minimize the overall loss.
The yearly profits from this well are shown below.
Year

Production

Revenue ($)

Costs ($)

Profit ($)

1
2
3
4
5
6
7

5,475
4,380
3,504
2,803
2,242
1,794
1,435

104,025

70,000
30,000
30,000
30,000
30,000
30,000
30,000

34,025
53,220
36,576
23,261
12,205
4,078
-2,731

83,200
66,576
53,261
42,605
34,078
27,269

In year 7, the costs exceed the revenues. Therefore, we should abandon production.
In year 1, the costs include the cost of completion plus the operating cost. The production in each year is calculated
by multiplying the previous years production by 0.8. For example, in year 1, the production is equal to,
= 1 5bbl I day x 365days = 5475bb1s
Therefore, production in year 2 is,
= 0.8x 5,475 = 4,380bbIs
As previously indicated, the decision whether to complete the well does not depend on the cost of drilling. Instead,
since we can recover the completion costs by producing the well, the well should be completed.
Although we recovered the cost of completion in the first year in this problem, it is not necessary to recover the
entire completion cost in the first year so long as the costs are recovered during the producing life of the well.

16

Mohan Kelkar, Ph.D., J. D.

Example 1-6
An enhanced oil recovery using CO 2 flooding is currently being investigated in a depleted oil field. The price of CO 2
including the transportation cost is $.75/MSCF. Based on the simulation studies, it will take anywhere between 3 to 8
MSCF of CO 2 to recover 1 incremental barrel of oil with the most likely value of 5 MSCF/bbl of oil. Due to extra
processing and separation costs, it is expected that the net revenue (excluding the cost of the CO 2 per barrel of oil is
25% of the sates price. The future price forecasts estimate the net revenue to be in the range of $16 to $22 per
barrel with the most likely value to be $20 per barrel. Estimate the economic feasibility of this project under the
)

worst, the best, and the most likely scenario. Should we invest in this project?
Solution 1-6
A.

Most Likely
incremental profit = incremental revenue - incremental cost
= 0.25 x $20 5 x $0.75
= $1.251bb1
This is a positive number indicating that the project is feasible based on the most likely estimate.

B.

Worst Case
incremental profit = 0.25 x $16 8

x $0.75

=$2/bbl
That is, we will lose $2/bbl of oil production.
C.

Best Case
incremental profit = 0.25 x $22 3

x $0.75

= $3.25Ibb1
That is, we will make a profit of $3.25fbbl of incremental production.
Examining these answers, we know that the best-case and thvIorst-case scenarios are highly unlikely, whereas, the
most likely scenario is the most likely estimate. That does not mean that we should select this project because it is
economically feasible under the most likely estimate. Instead, we need to know what is the likelihood that the most
likely estimate will be a reality, as well as the other two extreme cases will be a reality. In addition, we may also want
to know the likelihood of other possible in-between answers. Armed with this additional information, we may be
able to make an educated guess as to the feasibility of the project. Without it, our decision will most likely be based
on a gut feeling.
Case Study 1-1
Dac1ing Oil Field is one of the oldest fields in China. The field produces with a high water cut and several enhanced oil
recovery technologies have been used to improve the performance of the oil field. Starting in 1999, a colloidal dispersion
gel (CDG) pilot was conducted in a double five spot well pattern as shown in Case Study Figure 1-1.

Economic Evaluation in the Petroleum Industry


rhnntpr I - Frnnmir

Princinlps

17

cc tud3 h urr I-11- (IX p loti.n Da gang field ((hwy 200)


The well pattern consists of six injection wells and twelve production wells. Between 1999 and June 2003, three chemical
Case Study Figure 1-2, due to
slugs (about 0.53 pore volumes total) were injected followed by drive water. As shown in
the CDC, slug, the pilot has shown reduction in water production and an increase in oil production.

Case Study F/gore 1-2: Oil production and water cut during Cl)G flood (Chan 200-I)
Based on base line decline curve analysis, incremental oil production from well 131-7.124, as well as the whole pilot, was
gathered. The following table shows key production data.

Well

Pilot
Bi 7 P124

Injected
Polymer
(Ibs)

1173248
261140

Incremental Oil
bbls

Other Costs

757484
171689

84,535,793
81,009,571

The information for an individual producer with respect to polymer injection and other costs (Bl-7-P124) is estimated.
The amounts for pilot are actual numbers. The incremental oil is calculated based on projected decline for the pilot as well
as individual wells. The other costs represent the cost of implementation including chemical plants, additional facilities,
additional operating and facilities costs. Assume the cost of polymer is 81.30/11). Assume further that the average price of
of Cl)G flood per
oil during the incremental production phase was S35/bbl. Using this information, calculate the Cost
barrel of oil produced. If the economic threshold is S10/bbl for the development cost of CIA; flood, is this project
feasible? I low much is the profit generated from this project over its life? \X/hat is the ratio of profit to cost? If our
CCOO( mic criterion for profit to cost ratio is greater than 2, does this project satisfy the economic cnrcrlon?

18

Mohan Kelkar, Ph.D., J.D.

dw

Sttzde

.tOIU CiOsJ

1-i

The following table shows the summary of all results. The explanation for the numbers is provided below the table.

Well
Pilot
B1-7-P124

Cost of
Polymer
($)
1,525,223
339,482

Total Cost Cost/bbl


"/
/
6,061,016
1,349,053

800
7.86

Revenue
/

Profit ($)

26,511,940
6,009,115

20,450,924
4,660,062

PIR
3.4
3.3

The cost of polymer is calculated by multiplying the amount of polymer by $1 .30/lb. The total cost is cost of polymer plus
other costs. By dividing the total costs by oil produced, we can calculate the cost/bbl. If the threshold requirement is less
than 510/bbl, these costs satisfy that criterion. As explained in the section below, this cost represents the costs associated
with accessing the oil in the ground. Knowing the value of the oil in the ground, we can determine what this cost has to be
to ensure that it is profitable. The revenues are calculated by cumulative production by the price of oil. The difference
between revenue and the cost is the profit. The last column represents profit-to-investment ratio or PIR. Uris is calculated
by dividing the profit by the total costs. This number exceeds our threshold requirement of 2.0; therefore, the project is
economically feasible. Profit-to-investment ratio can be important when the company has limited capital available. We will
discuss this further in a future section.

OIL INDUSTRY TERMINOLOGY


Certain economic terminology is unique to the oil industry and understanding it is important in
making economic decisions.
E & P COMPANY
E & P stands for Exploration and Production. Sometimes this represents the "upstream" oil
industry. As the name indicates, E & P companies are mainly involved in exploring and
producing oil and gas. They are not concerned with refining, upgrading and marketing the
final products. In general, oil companies can be divided into two categories: E & P
companies and integrated oil companies. Integrated oil companies (e.g., ExxonMobil or
Shell) have an E & P division but they also own refineries and gas stations. E & P companies
only explore and produce oil; they do not refine or sell the products (e.g., Devon Energy or
Anadarko Petroleum).
MINERAL INTEREST
Mineral interest represents the ownership interest in oil and gas trapped in the sub-surface.
In most countries (with the exception of the U.S. and some parts of Canada), the minerals
are owned by the government. Even in the U.S., more than half of the on-shore minerals are
owned by either federal or state governments and all off-shore minerals are owned by
either federal or state governments. A mineral interest owner may or may not possess the
expertise to explore for or exploit the oil and gas from the sub-surface; therefore, the
mineral interest owner hires an operator (E & P company).
WORKING INTEREST
Working interest is owned by one or more parties. The parties owning the working interest
are responsible for paying for the expenses related to exploration and production of oil and
gas. Typically, there is only one operator and the working interest owned by the operator

Economic Evaluation in the Petroleum Industry


Chapter 1 - Economic Principles

IN

19

(responsible for day-to-day decision making) is called operated working interest. Other
parties, who own the working interest but are not involved in operation of the oil or gas
field, own non-operated working interest. It is possible, but not necessary, for a mineral
interest owner to also own a working interest.
ROYALTY INTEREST
Royalty interest represents cost-free interest in the producing property. Royalty interest
owner will receive a portion of the produced oil or gas (either as the product or the
proceeds from the product) cost free. That is, the royalty owner would not be responsible
for the costs associated with production. Typically, the mineral owner would receive royalty
interest in return for allowing the working interest owners to explore for and exploit the
hydrocarbons.
In some instances, royalty interest could be owned by a party who does not own the mineral
interest. For example, a geologist who develops a prospect (potential location for drilling a
well) sells that prospect to an E & P Company and, in return, receives a portion of the
production free of cost if the well is successful. This is called over-ride royalty interest. It is
also possible for one oil company to get over-ride royalty interest in return for assigning the
rights to explore for and produce hydrocarbons to another company.
NET REVENUE INTEREST
Net revenue interest (NRI) represents the portion of production owned by a party. It is
extremely rare that the working interest (WI) and NRI of a party would be the same. For a
mineral interest owner, typically, the NRI would be greater than the WI; whereas, for an E &
P Company, WI would be greater than NRI.
LEASE BONUS
As part of the enticement to sign an agreement, the operator will give the mineral interest
owner a signing bonus. This signing bonus is called a lease bonus. The amount is typically
determined per acre in the United States. In good areas, the lease bonus can be as high as
$20,000/acre.
SPACING
Spacing represents the surface area per well. For example, in a one square mile area
(equivalent to 640 acres), if we drill eight wells, the spacing of the well is 80 acres; that is
640 acres divided by S.

G & G COSTS
G & G costs represent geological and geophysical costs. These costs are normally incurred
during the exploration phase. These costs include, but are not limited to, seismic data
acquisition and processing, and geological mapping and modeling.

20

Mohan Kelkar, Ph.D., J. D.

JOINT OPERATING AGREEMENT (iDA)


A joint operating agreement (JOA) is signed by the working interest owners to resolve any
disputes related to the operation of the field. JOA will also govern the rules related to
exploration of the project. Among other things, the JOA will include how to receive
permission from non-operated working interest owners to take a specific action (e.g.,
drilling a well), how to deal with non-consenting owners, and how to allow sell off the
ownerships.
EXPECTED ULTIMATE RECOVERY (EUR)
Expected ultimate recovery (EUR) represents the recovery expected from a well or from a
field based on current operating conditions. The units of EUR are either barrels or ft
depending on whether it is mostly oil or gas production.
BARRELS EQUIVALENT
In reporting EUR or other methods of representing reserves, E & P companies will provide
barrels equivalent of the reserves. This is to combine oil and gas reserves into a single
number. The most common number used to convert gas into equivalent oil barrels is 6
MSCF equal to 1 barrel. This is based on an assumption that 6 MSCF of gas will generate the
same amount of energy as one barrel of oil. Please note that energy equivalence does not
translate into price equivalence. Historically, gas has always been sold at a discounted price
compared to oil because of the transportation costs associated with natural gas. It is
possible that the discrepancy between energy equivalence and price equivalence can be
large making it difficult to evaluate a company when only equivalent barrels of oil
production are provided.
HELD AND DEVELOPMENT COSTS
Field and development costs (F & D costs) hac,e the units of currency divided by units of
production (e.g., $/MSCF). These costs include all costs associated with securing the right to
drill a well, as well as the cost of drilling; in other words, all costs associated with securing
access to the resource. For example, if the operator had to spend $5 million to secure the
rights to drill a well, as well as costs of drilling and completion, and the operator expects to
get 5 BCF of gas from the well, then F & D costs would be $1/MSCF.
Example 1-7
A geologist proposes a new prospect (potential drilling location) to an operator in return for 3% over-ride royalty
3116th
royalty interest to the mineral owner to drill the well.
(ORR). In addition, the operator needs to provide
What is the working interest (WI) and net revenue interest (NRI) of the three parties?
If the operator, before drilling, assigns 40% of its working interest to another non-operator and, in return,
secures 1% ORR from the non-operator, what will be the WI and NRI for the four parties?

Solution 1-7
For the first scenario, neither the geologist, nor the mineral owner owns any working interest. Therefore, the
operator owns 100% of the working interest. The following table shows the proportion for each party:

Economic Evaluation in the petroleum Industry


Chapter 1 - Economic Principles

21

NRI

WI
Geologist
Mineral Owner
Operator 1

000%
0.00%
100.00%

3.00%
1835%
78.25%

In the second case, the WI will be split into two operators in the proportion 60 to 40% respectively. However, in
return, the NRI of the operator will not be split into the same proportion since Operator 1 will secure one
additional percentage of NRI. The following table shows the results.
WI
Geologist
Mineral Owner

NRI

0.00%
0.00%
60.00%
40.00%

Operator 1
Operator 2

3.00%
18.75%
47.95%
30.30%

Example 1 -8
Based on decline curve analysis, an operator expects an EUR from a gas well to be 2.3 BCF. The well spacing is 80
acres. The cost of drilling and completion was $3.2 million. in addition, the operator paid $5,500 per acre in lease
bonus and the additional G & G costs were $300 per acre. What are F & 0 costs for this well? The royalty interest
is 20%. If operator requires a well to have F & D costs to be less than $1.50/MSCF, is this well economic?

Solution 1-8
Total costs to access the reserves = 5,500 x 80 + 300 x 80 + 3.2 x 10 6
Net EUR to the operator = 2.3 x 0.8 = 1.84 BCF

F & D Costs

3664x10
1.84x 10 6

= $2/MSCF

Based on the F & D Costs for this well, it is not economic.


Example 1-9
In its July 2011 investor presentation (Chesapeake Energy 2011), Chesapeake Energy shows the results from
various plays in which they are involved (see Example Figure 1 1). Examining the data, what is the equivalence
Chesapeake is assuming in calculating boe/d for each well? Based on the prices of oil and gas, if we assume the
equivalence of 15 MSCF = 1 barrel of oil, how will the Boe/d change in each region?
-

DR

LJ.
- P : -:-

EJ

!I1.d

Wash

Grard te Was

7,907 b~d

if
01 4,tjK-B 12P6

22

268 bld

Mohan Ke/kar, Ph.D., J.D.

Example Figure 1-1: Chesapeake results presented in Investor Presentation (Chesapeake Energy 2011)
Solution 1-9
Below are the results for all of the plays. If qg is gas production in MMSCF/D, q 0 is oil production in STB/D and q 0
is equivalent production, then the equivalence of gas corresponding to one barrel is calculated as:

equivalence = q

9 x iO

(q 0 - q 0 )

Play

Gas Prod
MMSCF/D

Frontier
Tonkawa
Tx PH
valon Shale
Bone Spring
Eagle Ford
Wolfcamp
Granite Wash
Cleveland

1.7
1.2
20.5
2.3
2.1
4.5
0.1
12.0
7.1

Mississippian
Niobrara

1.1
0.3

Oil Prod
STB/d
1,342
1,151
4,496
1,153
2,020
1,519
504
3,273
1,404
1,427
655

Boe/d
1,625
1,351
7,907
1,528
2,445
2,268
523
5,279
2,586
1,609
705

Equivalence

Boe/d

(MscF/bbl)

(is MSCF = 1 Bbl)

6.04
6.00
6.01
6.13
4.94
6.01
5.26
5.98
6.01
6.04
6.00

1,455
1,231
5,863
1,306
2,160
1,819
511
4,073
1,877
1,500
675

As shown, with just a few discrepancies (due to rounding off), the equivalence assumed is 6 MSCF z 1 STB. If we
assume 15 MSCF z 1 STB, we will get lower values of BUE as shown in the last column.
Case Stud 1-2

Eagleford Shale is one of the largest unconventional discoveries in this decade. It is located in South Texas. Unlike
other shale plays, which produce mostly gas, Eagleford Shale produces both oil and gas depending on where the well
is located. According to EOG Resources, Eagleford Shale can be divided Into an oil window, condensate window and
gas window as shown in Case Study Figure 1-3. The northern window is oil, the middle is condensate and the lower
one is gas. Because oil is more valuable than gas in terms of prices, it is more valuable to have acreage in the oil or
condensate window than in the gas window.

Case Study Figure 1-1, fiagle/i.rdpiat in south 7.vas (EOG 2011)

Economic Evaluation in the Petroleum Industry


Chapter 1 - Economic Principles

23

The field is developed using horizontal wells with a lateral length ranging between 4,000 feet and 5,000 feet. The cost
of dialling and completing these wells is between $5 million and $8 million. According to the 170C Resources wcbsite
(EGG 2O11), some wells producing from the oil window are listed below. These rates represent the initial production
(IF) of the well. On average, the CUR from these wells range between 400 and 460 MBOe (thousands of barrels
equivalent - assuming 6 MSCF I STB). A typical spacing varies between 120 and 140 acres per well Assume that
the cost of leasing the land is $6,000 per acre. Assume the average royalty interest to be 25 o

Well Name

Oil Rate
STB/d

Edwards
Sweet Unit
Hanson 311
Dullnig 511
Greenlow
Joseph 311
hoff
Wiatrek

Gas Rate
[j SCFD

904
1182
1538
1353
607
1317
683
857

350
1323
1512
1224
386
1200
391
682

Answer the following questions:


1.

What is the range of field development cost per barrel if we assume 6 MS(:F z I STB. lithe requirement is that
F& D cost should be less than S25/barrel, is that criterion satisfied?

2.

EOG currently has 520,000 acres of leased acreage in the oil window. What will be the range of total estimated
investment needed to drill and complete all of the wells?

3.

If we assume that in ground gas reserves are worth S1/MSCF and in-ground oil reserves are worth S40/S1B,
how much is EOGs oil window acreage worth?

Casc Stssdy Solutfon 1-2

1.

F&DCosts
We can calculate both the pessimistic and optimistic F & I) costs by using the following equations:

5 x iO + 120 x 6,000
= $16.61BBL
460,000 x 0.75
8 x 10 6 + 140 x 6,000
Pessimistic F & D Costs = ___________________ - $29.5/BBL
400,000 x 0.75
Optimistic F & D Costs =

In calculating F & L) Costs, we have to consider both leasing and drilling and completions costs. We divided by
net reserves to account for royal interest. The average cost is S23/bbl which is less than our threshold
requirement of $25/bbl. I Iowever, the range of F & 1) costs also indicates that there is some risk involved in
drilling these wells based on our Criterion.
2.

Investment Needed
As with F & 1) Costs, we can also calculate the pessimistic and optimistic ranges. These costs do not include
leasing costs since the land has already been leased. We consider both the van.itlollC in the spacing, as well as the
uncertainties in the costs of drilling and completion. It is possible that, over time, these costs will come down as
the technology of drilling and completion improves.

Optimistic Investment =

520,000
140

Pessimistic Investment =

520,000
8 x 106 = $ 34.7 billion
120 x

5 x 106 = $18.6 billion

The FOG wcbsite EOC 2011) uses a number of 10 to 15 billion dollars of investment. This probably assumes
improvement in the drilling md COMPIC6011 costs.

24

Mohan Kelkar, Ph.D., J. D.

3.

Worth of In-Ground Oil and Gas Reserves


Using the well data provided, we can calculate the percent of gas present based on a 6 MSCF equivalence. The
table below shows these calculations. We divided the gas rate by 6 and calculated the percent of gas present as the
total equivalent oil production. The average of all these wells is 12%.
that is, out of the total reserves produced
from a well. 880/s will he produced as oil and 12% produced as gas. This number is consistent with the website.

Well Name

Gas Rate
MSCFD

Oil Rate
STB/d

Edwards
Sweet Unit
Hanson 311
Dullnig 511
Cireenlow
Joseph 311
Hoff
Wiatrek

904
1,182
1,538
1,353
607
1,317
683
857

350
1,323
1,512
1,224
386
1,200
391
682

% Gas
(6 MSCF eq)

0.061
0.157
0.141
0.131
0.096
0.132
0.087
0.117

Using this information, we can calculate the following values:


Optimistic
Gas/well, MSCF
Oil/well, SFB
Total Gas (BCF)
Total Oil (SIMSTB)
S (billions)

248,400
303,600
1,076
1,316
53.70

Pessimistic
216,000
264,000
802
981
40.03

In the table above, we assumed that 12i/ of the FUR is produced as gas and 88% of the FUR is produced as oil.
For the optimistic scenario, we considered smaller spacing and higher FUR per well and for the pessimistic
scenario, we considered larger spacing and lower EUR per well. By multiplying per well data with the total
number of wells in 320,000 acres, we can calculate total gas and oil. The total FUR reported by FOG Resources
is 900 MMSTB equivalent, which is slightly less than predicted in this table. This may be due to different spacing
assumptions. Based on the optimistic and pessimistic scenarios, the in-ground oil and gas resources are worth
anywhere from S40 billion to S54 billion. liiesc values are calculated by multiplying gas FUR by S1/MSCF and
oil FUR by $40/bbl.
Problem 1-3
Classify each of the following costs as fixed or variable:
Materials required for maintenance
Direct labor
Supplies
Utilities
Property taxes
Administrative salaries
Insurance
Pumping costs
Interest on borrowed capital

Economic Evaluation in the Petroleum Industry


Chapter 1 - Economic Principles

25

Problem 14
An oil company is considering a routine core analysis to be done from on outside lab. The outside lab charges $20
per core plus $1 per core for shipping and handling. The manager of the core lab at the oil company contends
that costs associated with the equipment are approximately $101core the cast of material is $21care and the
cast of direct labor is $51care. Therefore, he contends that the care study should be done in-house. Why?
The company has conducted its economic study and has observed that, based on the overhead cast allocation,
of lab space is $41core and the overhead costs are $31core. The company thinks that it can use the space

the cast

more efficiently.
Discuss why the core analysis should be done outside. What is the correct perspective in economic analysis?
Problem 1-5
An oil company is thinking of buying a computer. Because of the advancements in the technology, the computer
price depreciates at a rate of 25% per year. The maintenance and the upkeep costs increase gradually. The cast of
the computer is $5,000 and the maintenance and the upkeep costs in the first year are $700 with an increase in
the cost at a rate of 10% per year. What strategy should the company adopt to maximize the computer benefit?
Assume that due to advances in technology, it is worth buying a new computer when the yearly costs start rising
after reaching a minimum.
Problem 1-6
An operator is considering two options to improve the production from an oil well. Option 1 requires that the well
be stimulated at a cast of $10,000 with an increase in production of S bbls/day for a one-year period. Option 2
requires the well be fractured at a cast of $50,000 with an increase in production of 15 bbls/day for a one-year
period. Option 3 is to continue to produce under present conditions. If the oil price is assumed to be $201bbl,
which option should be chosen?

off by
Based on prior experience, the operator knows that the incremental production after stimulation can be
off by 10%. How will this analysis affect the decision

5% and the incremental production after fracturing can be


in the previous paragraph?
77IThWA

An oil company is considering buying a compressor. Depending upon the horsepower, the cost of the compressor
will vary. The four options the company is looking at are:
Option

Initial Cost
Annual Benefit

$100,000
$40,000
$20,000

$180,000

$250,000
$75,000

$300,000

Annual Operating Costs

$60,000
$30,000

$30,000

$90,000
$40,000

Assume that the unused portion of the money can be invested at a rate of 15%. That is, if we assume that the
company has $300,000 to invest, and if the company chooses Option A, then the remaining $200,000 can be
invested at a rate

of 15%.

Which option should the company choose based an net annual benefit analysis?

26

Mohan Kelkar, Ph.D.. 1.0.

Problem 1-8

An oil company is interested in drilling in fill wells to accelerate production from a field. As more wells are drilled,
the production will increase; however, the incremental production will become smaller and smaller as more wells
are drilled. Based on the analysis of a nearby field, the company derives the following equations:
B = 400,0001 - 10,0001 2
C = 100,0001
where B is the total benefit (in dollars) received as a result of I infihl wells drilled and C is the cost (in dollars) of
drilling I wells. To optimize the profit, how many wells should be drilled? What is the maximum profit the
company can receive?
Problem 1-9
A service company offers its employee two options. Either the company will provide him with a company car, or if
the employee chooses to use his own car (which he intends to buy), provide him with a mileage rote of
$0.211mile. Assume that the employee drives the car 15,000 miles per year for business purposes. Assume further
that the new personal car the employee is going to buy will cost him $20,000. The employee will use his own car
for personal purposes for 10,000 miles. If the car depreciates per year at a rote equal to,

+ os)
where p is the price of the car at the beginning of the year and m is the mileage driven during a given year, which
option should the employee select in the first year? In which year should the employee switch to the other option?
Problem 1-10
An oil company hired a consultant to study the improvement of an oilfield. The consultant charged $10,000 and
recommended improvements which would cost the company $100,000 to be implemented. An in-house study,
costing two days of on engineers time at a rote of $3001day, revealed that the some improvements could be
done using on alternative scheme at a cost of $105,000. Which option should the company choose?
Problem 1-11
A drilling company is considering two alternative scenarios of drilling mud to drill a well. Alternative one will use
on oil-based mud at a cost of $0.31gallon; however, due to environmental regulations and concerns, the cast of
disposal it is much higher. We can calculate the cost to be fixed at $10,000 plus $0.11gallon for each gallon of
mud used. The second alternative is to use a water-based mud. Due to the addition of expensive components, the
cast of the water-based mud is $0.41gallon; however, the disposal casts are $5,000 plus $0.051gallon. Knowing
these costs, at what volume of drilling mud will both methods result in the some costs? Under what conditions
will you prefer one method over the other?
Problem 1-12
A service company wants to expand its business. An internal study indicates that one way to improve the business
is to reduce the charges for a certain logging technique. For that technique, it costs the company $5,000 to log
the well and the company charges $10,000. Currently, the company has 200 customers. The study indicates that
for every 10% decrease in the charged costs, the number of customers can be increased by 150. What is the
optimum price the company should charge to maximize the benefits? What is the maximum benefit the company
will receive?

at
Economic Evaluation in the Petroleum Industry
Chapter 1 - Economic Principles

opt

27

Problem 1-13
An oil company is contemplating drilling a horizontal well at a cast of $400,000. The chance that the well will be
successful is 30%. If successful the well will produce 500,000 bbls of oil. The company has an option of conducting
a detailed 3-D seismic survey at on additional cast of $400,000. By evaluating the seismic data a well can be
better located and, hence, the chance of success will be improved to 50%. If the net profit per barrel of oil is
expected to be $3 in terms of present worth, should the company collect the seismic data?

An oil company implemented a waterflood on a marginal field. The cost of implementation was $1 million.
Additionally, the injection costs were a fixed at $5,000 per month plus $0.41bbl of injected water. Currently, 6,000
bbls of water per day is being injected. Each barrel of injected water results in 0.1 bbl of incremental oil. After
deducting all of the expenses excluding the injection costs, the net benefit received per barrel of oil is $6.50. If
after implementation, the all price in the market plunged resulting in the net benefit per barrel of oilfrom $6.50
to $5.50, should we continue to woterflood the reservoir? Assume that the change in the price is expected to be
long-term. If we decide to continue, how much profit would we make at the new price?
Problem 1-15
Two oil companies owning equal operating interest in a property agree to sign a contract with the mineral owner
to provide the mineral owner 15% royalty interest. Create a table showing the working and net revenue interests
of oil the properties.
Problem 1-16
Chesapeake Energy, owner of a substantial leasing interest in !-laynesville shale, agreed to sell some of its interest
to Plains Exploration and Production Company. Chesapeake originally owned 100% working interest and 80% NRI.
Chesapeake sold half of its interest to Plains during the transaction. However, the agreement had a clause which
required that Plains pay for 50% of WI of Chesapeake until it paid out a certain amount of money (i.e., Plains paid
for its own WI plus 505v. of Chesapeakes interest until a certain amount of cash was paid). What were the WI and
NRlfor Chesapeake and Plains during that period?
Problem 1-17
An oil company (Company A) leased land with 100% WI and 75% 1VRI with the mineral owner receiving 15%
royalty and another oil company (Company B) receiving 106 of the override royalty interest. Company A decided
to sell Company B 40% of its working interest (and proportionate NRI). In return, it secured 2% override royalty
from Company B. After the transaction, what were the WI and NRI of all the three parties?
Problem 1-18

An exploration and production company paid about $17,000 per acre in leasing costs. It expects that it can drill a
gas well on 40 acre spacing with a drilling and completion cost of $5 million. The company expects to recover
about 4 BCF of gas (net to the company) in EUR. If the companys threshold requirement is that it cannot exceed F
& D costs of more than $21MSCF, should it develop the ploy?
Problem 1-19
In the Woodford Cana ploy, the typical cost of drilling and completing a well is $4 million. The average leasing
costs are about $1,500 per acre. The standard spacing of a typical horizontal well is 80 acres. The well produces
30 STB/MMSCF of condensate throughout the depletion phase. If the gas EUR (net to the company) is 2.7 BCF,
what is the gas equivalent FUR if we assume 6 MSCF 1 STB? How much will it be if we assume 15 MSCF 1 STB?
How will the F & D Cost change depending on the equivalent assumption?

28

Mohan Kelkar, Ph.D., J.D.

Problem 1-20
In an oil shale play, a company expects to have a success rote of 90% (the rest being unproductive) in completing
the wells. It has acquired 100,000 net acres of land at a cost of $6,000 per acre. The cost of drilling and
completing the well is $6 million. The well is expected to have an EUR of 220,000 barrels of oil with 1 BCF of gas.
Assume the royalty interest to be 25%. The normal spacing of a well is 120 acres, If the company intends to
develop the field, what will be the F & 0 cast per well? Assume 10 MSCF 1 STB to calculate equivalent oil
production. The cost has to be less than $25 per barrel to be economical. Does the field satisfy this criterion?
Problem 1-21
An exploration and production company is producing a gas field by drilling one well per section (640 acres).
Although there is some variation in the performance, the average EUR per well is about 2 BCF. The royalty
interest is 25%. The total acreage the company has is 64,000 acres. The company wants to sell this property to
another company for $400 million. In addition, it would like 10% override royalty. It is expected that the field can
be developed on 80 acre spacing. In addition, an average of about 1 BCF per well still remains to be produced
from the producing wells. The cost of drilling and completion is $3 million, If you are working for another
company and your criterion is to buy property if F & 0 costs are less than $1.50/MSCF, would you buy this
property?

OIL AND GAS RESERVES


Companies are valuable because of their assets. These assets typically constitute building, equipment,
manufacturing facilities, good will, people, long-term contracts, etc. For oil and gas companies, the main
asset is what is underground. It is not the buildings that provide value to a typical oil company; it is really
the future potential of oil and gas production that makes the company valuable. The common method
of defining this future potential is oil and gas reserves. By no means do oil and gas reserves represent
the precise value of an oil company. For one, the reserves do not tell us how quickly that oil and gas can
be produced. The reserves also do not tell us the cost of producing the oil and gas. However, oil and gas
reserves are an important measure of a companys worth and understanding how those reserves are
reported is extremely important to anyone working in the oil industry.
It is important to distinguish between reserves and what is in place. Many times companies will report
oil in place (OIP) or gas in place (GIP). Sometimes, these numbers are reported as OOIP (original oil in
place) or OGIP (original gas in place). Typical units of QUIP and OGIP are barrels (or STB - standard
barrels) and SCF (standard cubic feet) respectively. These numbers represent the estimate of how much
oil and gas was originally present in the reservoir. Because of uncertainties, these numbers are only
estimates. However, the quantity that is produced is always smaller than what is present. Reserves
represent what can be economically produced from what is originally present. The recovery factor (RF)
can vary widely. Recovery factor represents the percentage of QUIP or OGIP that can be produced from
the reservoir. In extreme cases, it is possible that a reservoir containing a large amount of hydrocarbons
may have a recovery factor of zero, which means that the reserves are non-existent. The reasons for the
recovery factor being zero could be many, including technical difficulties (no current technology),
economic difficulty (price of commodity too low), or market difficulty (no current market available).
Nevertheless, it is important to understand that QUIP or OGIP may not tell us anything about the oil and
gas production potential of a company.
Many documents are available which define reserves. Individual countries have their own rules and
regulations regarding how the reserves are defined. Instead of providing alternate definitions of the
reserves, we will follow the document published by SPE (Society of Petroleum Engineers 2007). The
Petroleum Resources Management System (PRMS) (Society of Petroleum Engineers 2007) provides
Economic Evaluation in the Petroleum Industry
Chapter 1 - Economic Principles

29

definition of reserves under various conditions. These definitions are not tied to any specific country;
instead, they are based on opinions of people who have a wealth of experience in defining reserves. The
document has gone through many review processes and is the most robust available for defining the
reserves.
The goal of this section is not to make a person an expert in understanding the reserves. Instead, the
goal is to introduce the concept and provide the necessary rationale so that the reader can understand
why certain reserves are defined in a particular way.
PRMS defines petroleum resources in much broader terms than reserves. The

Figure 1-2 shows these

categories.
!KODtCflON

conc_Eyr
T1

W
1

PROSPECMT

2
..i n

.-

Rartp ofUncmd1ny

Figure 1-2: Hydrocarbon Resources (Society of Petroleum Engineers 2007)


In Figure 1-2, hydrocarbon resources are divided into three categories: Reserves, Contingent Resources
and Prospective Resources. As shown in this graph, the y axis represents the commerciality; whereas,
the x axis represents the uncertainty associated with those resources. The top left corner (Proved
Reserves) represents the hydrocarbons we are most confident of producing and bottom right corner
(high estimate of prospective resources), hydrocarbons we are least confident of producing. Let us
examine the definitions of these categories as given in the PRMS.

RESERVES are those quantities of petroleum anticipated to be commercially recoverable by application of


development projects to known accumulations from a given date forward under defined conditions.
Reserves must further satisfy four criteria: they must be discovered, recoverable, commercial, and
remaining (as of the evaluation dote) based on the development project(s) applied.

30

Mohan Kelkar, Ph.D., J.D.

According to this definition, reserves represent what is commercially recoverable in the future based on
already discovered accumulations; for example, a gas field that is produced by ten wells under current
conditions. We can reasonably predict how much those wells can produce in the future based on their
past performance. Or we can consider an oil field which is producing under depletion. What that field
can produce under water flooding conditions is also reserves. However, a potential prospect, where not
a single well has been drilled, cannot be considered regarding reserves.

CONTINGENT RESOURCES are those quantities of petroleum estimated, as of a given date, to be


potentially recoverable from known accumulations, but the applied project(s) are not yet considered
mature enough for commercial development due to one or more contingencies. Contingent resources
may include, for example, projects for which there are currently no viable markets, or where commercial
recovery is dependent on technology under development, or where evaluation of the accumulation is
insufficient to clearly assess commerciality.
According to this definition, like reserves, contingent resources also are discovered resources (i.e., well
or wells have already been drilled in the field). However, without overcoming a certain important
limitation, we cannot produce from it under current conditions. An example would be the discovery of a
large gas field on a remote island that cannot be produced without assurance that the LNG (liquefied
natural gas) produced from it can be sold to an end user. Another example would be the discovery of an
off-shore, tight oil, reservoir that cannot be produced without development of an efficient, economically
viable, fracturing technique.

PROSPECTIVE RESOURCES are those quantities of petroleum estimated, as of a given date, to be


potentially recoverable from undiscovered accumulations by application of future development projects.
Prospective resources have both an associated chance of discovery and a chance of development.
According to this definition, prospective resources represent undiscovered accumulations. An example
would be a claim that in Alaska there are many fields containing as much as 10 billion barrels based on
geological assessment. Since no well has been drilled, there is an uncertainty associated with discovery.
In addition, even if it is discovered, there is no guarantee that it can be commercially produced
(uncertainty associated with development).
Examining these definitions, as we go from reserves to prospective resources, the uncertainty
associated with commerciality increases. However, within each of these categories, there is also an
uncertainty with respect to the percentage of hydrocarbons that can be produced (uncertainty with
respect to recovery factor). A certain percentage of hydrocarbons can be easy to produce within the
reservoir, whereas, additional recovery may require significant effort resulting in additional
uncertainties.
Going from contingent resources to reserves requires an establishment of commerciality. According to
PRMS, the following factors are to be considered to establish the commerciality:

Evidence to support a reasonable timetable for development.


A reasonable assessment of the future economics of such development projects meeting defined
investment and operating criteria.
A reasonable expectation that there will be a market for all or at least the expected sales
quantities of production required to justify development.

Economic Evaluation in the petroleum Industry


Chapter 1 Economic Principles

31

Evidence that the necessary production and transportation facilities are available or can be
made available.
Evidence that legal, contractual, environmental and other social and economic concerns will
allow for the actual implementation of the recovery project being evaluated.
Briefly, to categorize something as reserves requires that hydrocarbons will be produced within a
reasonable period after discovery. A reasonable period is, typically, less than five years; however, there
will be circumstances under which that period could be longer. For example, a company that has
discovered a giant field in deep water may require more than five years before beginning production
due to technical challenges; however, it has made a commitment to build the off-shore platform and has
started drilling the development wells. Then the company can claim the reserves associated with that
field.

DETERMINISTIC VS. PROBABILISTIC RESERVES


In defining reserves, we can use two methodologies. Although seemingly exclusive of each other,
these methods can be made consistent with each other. One underlying principle to remember
before defining the reserves is that there is always uncertainty with respect to reserves. Unless a
well or reservoir is abandoned, we truly do not know how much hydrocarbons are produced from it.
Until we reach abandonment, there is always some uncertainty with respect to how much
hydrocarbons will ultimately be produced from a reservoir. The uncertainty is much bigger in the
initial stages of development and, as more production data are collected and more is known about
the reservoir, the uncertainty will decrease. In defining the reserves, this uncertainty has to be
conveyed irrespective of the type of methodology used in calculating reserves.
Deterministic methods, as the name indicates, represent a single value to define the reserves.
However, in reality, to convey the uncertainties associated with reserves, deterministic methods will
report low, best and high estimates of the reserves. Low indicates a conservative estimate, best
indicates a best guess, and high indicates an optimistic estimate.
In probabilistic methods, instead of reporting a single value, a range of possible values are reported
for reserves along with the associated probabilities. Depending on how exhaustive the work is, it is
possible to have a continuous distribution of reserves. There is an implicit relationship between
probabilistic reserves and deterministic reserves. The low estimate corresponds to the 10th
10th
percentile value in the distribution function. The
percentile represents a value that is less than
1h
at least 10% of the values. The best estimate corresponds to the 50
percentile which represents a
value which is greater than 50% of the values in the overall distribution. The high estimate
901h
corresponds to the
percentile value, which represents a value greater than 90% of the values in
the overall distribution. In other words, if we know the overall distribution of reserves, it is easy to
define deterministic reserves. Deterministic reserves are a sub-set of probabilistic reserves which
represent a much more exhaustive definition of the reserves. It is not always possible to create
probabilistic distribution of the reserves; however, unless the reservoir is very mature, we should
expect to see the low, best and high estimates. We also realize that the difference between low,
best and high estimates will decrease as the reservoir production maturity increases. This is also
true with probabilistic estimates. The difference in the possible range of reserves will decrease as
the reservoir matures.

32

Mohan Kelkar, Ph.D., J.D.

CATEGORY OF RESERVES
Depending on the uncertainty associated with the reserves, we can define different categories of
the reserves.

PROVED RESERVES
According to PRMS, proved reserves are those quantities of petroleum, which by analysis of

geoscience and engineering data can be estimated with reasonable certainty to be commercially
recoverable, from a given date forward, from known reservoirs and under defined economic
conditions, operating methods, and government regulations.
Proved reserves represent the most important category of reserves. These are the numbers
reported by oil companies for public consumption. These are the numbers which are typically
accepted by government agencies. The key word in the definition of proved reserves is
"reasonable certainty." Although reasonable certainty is not defined explicitly, implicit in this
definition is high confidence. It is meant to be understood that the operator, with more than
90% confidence, can state that these are the reserves that can be produced. By nature, this is a
very conservative estimate. Also, these reserves need to be reported under defined economic
conditions, operating methods and government regulations. Typically what that means is that
no speculation is allowed in defining proved reserves. If we can only produce reserves if the oil
price reaches $150 per barrel, then those are not considered proved reserves if the current price
of oil is $100 per barrel. The same is true of the government regulations and operating methods
under which these reserves will need to be reported. If the regulations are expected to change
in the future or if new technology can change the way the field will be operated, without
proving it, we can only report the reserves based on existing government regulations and
existing operating methods.
If using determining methods, proved reserves represent the low estimate. If using probabilistic
10th
percentile (also called 1P) reserves. That is, there
methods, proved reserves represent the
should be a 90% probability that these reserves can be produced. An important theme in stating
proved reserves is high confidence and a conservative view. If a company reports proved
reserves correctly, it implicitly requires that those reserves will grow with time since the number
should represent the most conservative estimate.
According to PRMS, the area of the reservoir which is considered as proved includes (1) the area

delineated by drilling and defined by fluid contacts, if any, and (2) adjacent undrilled portions of
the reservoir that can reasonably be judged as continuous with it and commercially productive
on the basis of available geoscience and engineering data. Again, the theme is conservative
estimation; if a well is drilled in a reservoir, the lowest known hydrocarbon (LKH) contact will
represent the lowest part up to which hydrocarbons are located unless proven otherwise. It is
possible that oil and gas may be below the known contact, but unless convincing proof exists,
the conservative estimate requires that the LKH is assumed to be the depth up to which
hydrocarbons are located. The same thing can be said about areal distribution of reservoir. If

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Chapter 1 Economic Principles
-

33

few wells are drilled in the field, without substantial and convincing information, the area
around the existing wells, which is assumed to be commercially productive, is limited.
Proved reserves are further divided into sub-categories.

Proved, developed, producing (PDP) reserves represent the reserves with the most
confidence. These reserves are expected to be recovered from producing intervals within
wells that are currently open. These reserves continue to be produced without any
significant investment except for proper maintenance.
DEVELOPED, NON-PRODUCING, RESERVES (PDNP)
Proved, developed, non-producing (PDNP) reserves represent the reserves which can be
produced with very little investment compared to drilling a new well. For example, intervals
that are open but are not producing under current conditions, behind the pipe reserves that
are known but will require perforation of that interval, and pipeline connection to a newly
completed well where the available market is well established. The key to defining PDNP is
that the well has already been drilled and, with very little investment, the reserves can be
produced. If, by installing a compressor, we can increase the reserves and the cost of
compression is small compared to drilling a new well, it can be categorized as PDNP
reserves.
UNDEVELOPED RESERVES (PUD)
Proved, undeveloped reserves (PUD) represent the reserves known to exist but will require
substantial investment. These are the reserves that are expected to be recovered in the
future through large investments. Examples of PUDs include those from (1) new wells on
undrilled acreage in known accumulations, (2) deepening existing wells to a different (but
known) reservoir, (3) infill wells that will increase recovery, or (4) where a relatively large
expenditure (e.g., when compared to the cost f drilling a new well) is required to (a)
recomplete an existing well or (b) install production or transportation facilities for primary
or improved recovery projects. Examining these examples, the key is the large expenditure.
For example, if a well is drilled and a shallower formation needs to be perforated, it is
cheaper and, hence, can be considered PDNP; whereas, a deeper formation needs to be
perforated; it would be considered PUD since the well will need to be deepened before the
new interval can be perforated. This will require significant investment compared to
completing a shallower interval.

PROBABLE RESERVES
Probable Reserves are those additional Reserves which analysis of geoscience and engineering
data indicate are less likely to be recovered than Proved Reserves but more certain to be
recovered than Possible Reserves. As can be seen from this definition, the uncertainty is much
higher for probable reserves compared to proved reserves. A well which is currently producing

34

Mohan Kelkar.. Ph.D.. J.D.

can have both proved and probable reserves associated with it. Probable reserves represent
higher value than proved reserves but with less confidence or more uncertainty. If deterministic
definition is used, probable and proved reserves represent the best estimate of reserves. If
50th
probabilistic definition is used, probable and proved reserves represent
percentile reserves
(also called 2P). If we understand that proved reserves represent 10 th percentile reserves, then
50th
10th
and
percentile values. The key in
probable reserves represent the difference between
defining probable reserves is the degree of uncertainty. There is an equal likelihood that these
reserves can be produced or not produced. For example, if a new oil reservoir is discovered and
the recovery factor in all of the analogous reservoirs is at least 10%, then 10% of OOIP would
represent proved reserves. However, if fifty percent of the analogous reservoirs show 20%
recovery factor, then probable and proved reserves would be 20% of OOIP.

POSSIBLE RESERVES

Possible reserves are those additional reserves which analysis of geoscience and engineering
data indicate are less likely to be recoverable than probable reserves. This definition indicates
even more uncertainty than probable reserves. If we are using the deterministic reserves
definition, possible plus probable plus proved reserves indicate a high estimate of the reserves.
If we are using the probabilistic reserves definition, possible plus probable plus proved (also
goth percentile reserves. That is, there is only a 10% probability that these
called 3P) represent
90th and 50th
reserves can be recovered. For a probabilistic definition, the difference between
percentile represents possible reserves. An example of these reserves includes water flooding
on an existing oil reservoir when no analog for water flood exists. The reservoir properties of the
existing reservoir are substantially different from the water floods where data are available.
Without a pilot flood, significant laboratory data and any other evidence, the incremental
recovery from water flood is speculative and, therefore, should be categorized as possible
reserves. Another example is drilling spacing. Currently a field is being developed on 80 acre
spacing but there is a remote possibility that the field can be developed eventually on 20 acre
spacing, which means we might have an opportunity to drill more wells. However, without a
pilot project and government approval in the field, 20 acre spacing is speculative; hence,
reserves to 20 acre spacing can be considered as possible reserves.

CATEGORY OF CONTINGENT RESOURCES


Contingent resources have already been discovered; however, because of significant constraint
(economic, technical, etc.), these resources cannot be produced; therefore, the category of
contingent resources is very similar to reserves. Instead of 1P, 2P and 3P, we can consider 1C, 2C
10th
percentile of contingent resource, 2C represents the 50th
and 3C, where 1C represents the
90th
percentile of contingent resource. If
percentile of contingent resource and 3C represents the
the contingency is removed, 1C, 2C and 3C should directly translate to 1P, 2P and 3P respectively.

Economic Evaluation in the Petroleum Industry


Chapter 1 Economic Principles

35

ESTIMATION OF RESERVES
Estimation of reserves is beyond the scope of this book. However, we will briefly describe different
methodologies used in estimating reserves.

VOLUMETRIC ANALYSIS
During the appraisal and initial development phases, volumetric analysis is the most commonly
used method. The main advantage of the volumetric method is that it does not require any
production data. Volumetric analysis requires that we have an idea about the reservoir
dimensions. Knowing the dimensions we can calculate the volume of the reservoir and, by using
appropriate petrophysical properties such as porosity and saturation, we can calculate the
hydrocarbons in place. Then, using an analogous reservoir, we can estimate recovery factor.
Knowing the recovery factor and volume of hydrocarbons, we can calculate the reserves.

MATERIAL BALANCE
Material balance technique can only be used after the reservoir starts producing hydrocarbons.
Material balance is a simple technique and assumes a uniform reservoir without any variations
in reservoir properties, such as pressure. However, if the assumptions are satisfied, material
balance can provide hydrocarbons in place. This is similar to volumetric analysis, except that
since the method is based on hydrocarbons produced, it is more reliable than volumetric
analysis. Once hydrocarbons in place are calculated, by knowing the recovery factor, we can
calculate the reserves.

RESERVOIR SIMULATION
Reservoir simulation is a more sophisticated technique than material balance. Simulation
accounts for variations in physical properties of the rock as a function of space and time. It can
rigorously account for various scenarios and complex physical processes. It is an advanced
material balance technique. The technique can be used without any historical production data;
however, the technique becomes more reliable if historical production data are available. By
using reservoir simulation, we can match the historical production data and then predict the
future performance. Knowing the economic limit, simulation can predict how much
hydrocarbons will ultimately be produced. Unlike material balance, we do not need the recovery
factor since simulation is able to predict rate versus time until we reach abandonment. In
addition to predicting the remaining reserves, it can also predict rate versus time, which can be
valuable for economic evaluation. Reservoir simulation is more valuable than material balance
technique if properly used. It is important to understand that just because simulation
methodology is more complex, it does not necessarily mean that it reduces the uncertainties in
future prediction compared to material balance technique.

36

Mohan Kelkar, Ph.D., J. D.

RATE - TIME ANALYSIS


The rate-time analysis method also requires production data. It is a method by which production
data are plotted as a function of time and, using the historical trend, a curve is fitted to the past
data and is extrapolated to predict future performance. Assuming that the trend is correctly
predicted, we can assess future performance. Knowing the economic limit, we can calculate the
remaining reserves. Similar to reservoir simulation, rate-time analysis can also predict the future
rate as a function of time. As with any other method, when more production data are available,
this technique becomes more reliable. Although it is possible to use this method for the entire
field, normally, the method is used for individual wells to predict the reserves for that well.
There are other techniques that may also be used to calculate the reserves; however, the
techniques above are the most common.

RESERVES AND THE TRUE WORTH OF A COMPANY


Without question, assigning the right reserves to a particular project is important. Proved reserves
provide the most conservative estimate; therefore, in most countries, these are the reserves that
are reported for public consumption. It is assumed that an average person may not be able to
distinguish between different types of reserves that are assigned different levels of uncertainties.
However, when a company reports proved reserves, it implies more than 90% certainty that these
hydrocarbons can be produced. So an average investor can count on production of at least these
reserves with an expectation that, in most likelihood, more hydrocarbons will eventually be
produced.
A relevant question to ask is if this is the best estimate of companys worth. We need to understand
two caveats in evaluating reserves. One, the reserves may not represent the net value of
hydrocarbons since reserves do not include the cost of producing them. When proved reserves are
reported, they represent the amount of hydrocarbons that can be produced in commercial quantity;
however, they do not tell us the cost of production. Clearly, if the production cost for producing a
barrel of oil is $10 for one operator versus $20 for another operator, although both operators are
reporting the same reserves, the one with the smaller cost of operation represents better worth of
the reserves since it will make more profit from selling the oil. Secondly is the timing. By examining
the reserves, we do not know when these reserves will be produced. The worth of these reserves is
clearly tied to when the reserves are produced. As we will see later in this chapter, the earlier we
produce these reserves, the more valuable they become. For example, if a company reports
reserves from a gas well equal to 2 BCF by assuming production from that well to be over sixty years
and the well is expected to produce 1.4 BCE over the first thirty years, economic evaluation indicates
that 0.6 BCF of gas produced after thirty years does not have any significant value. This means that
reserves by themselves may not tell us the whole story without knowing when they will be
produced.
Suffice it to say that reserves provide valuable information about the worth of the company;
however, it will be more valuable if, in addition to knowing the reserves, we also know the cost of
producing them, as well as the timing of producing those reserves.

Economic Evaluation in the Petroleum Industry


Chapter 1 - Economic Principles

37

Example 1-10
A company is producing from ten existing wells on 160 acre spacing. Using the rate-time analysis, the remaining reserves
are calculated. They add up to 8 BCF. Based on the analysis of all of these wells, the average EUR for each well is 1.5 BCF.
A local government entity has already approved 80 acre spacing in the same reservoir for other operators and they are
reporting the production from 80 acre spacing to be similar to 160 acre spacing wells. There is also a speculation that
government entity may allow 40 acre spacing for this reservoir. However, no one knows for sure. It is also rumored that
another operator in the same reservoir is using a different fracturing technique, which increases the EUR by 50% but, at
this time, no service company is providing this service and there is no reported information. For internal purposes, the
company needs to determine the reserves for this area. Provide the total reserves and assign an appropriate category for
these reserves.
Solution 1-10
We can divide the reserves into proved and contingent resources in this case.
Proved Developed and Producing (PDP) Reserves
Since production data from all ten wells is available, we are reasonably certain how much remaining gas can be
produced from these wells using rate-time analysis. Therefore, PDP reserves are 8 BCF. We are assuming that a
conservative estimate is used in determining the remaining reserves from these wells.
Proved and Undeveloped (PUD) Reserves
We are assuming that the reservoir is reasonably continuous around the 10 wells already drilled. That is, the properties
observed in the existing wells will be similar to wells that will be drilled on 80 acre spacing. If 80 acre spacing is already
approved in this reservoir, we may expect that similar spacing will also be approved in this field. If the operator is able to
drill 80 acre spacing wells, it will double the well count compared to 160 acre spacing. If the conservative estimate of
EUR for each of the ten wells is 1.5 BCF and if we know that the EUR from 80 acre spacing is not different from 160 acre
spacing (based on observations in other part of the reservoir), we can report 1.5 BCE times 10 as equal to 15 BCF as PUD
reserves.
Please note that the range of estimate observed in an individual well is not the same as the range observed in a group of
wells. That is, if for an individual well the range of possible EUR is from 1.0 BCF (low value) to 3.0 BCE (high value) with
1.5 BCE as the best estimate, it does not mean that the range of 10 wells drilled will be 10 BCE (low value), 15 BCE (best
estimate) and 30 BCF (high value). Instead, the range of uncertainty for the ten wells would be narrower than would be
calculated by just adding the numbers. Why? We will discuss this in more detail later in Chapter 4 - Economic
Uncertainty.
Contingent Resources

Contingent resources represent discovered resources which cannot be produced because of some contingency. If 40
acre spacing is approved, the well count would quadruple compared to the current number of wells. That is, additional
20 wells (compared to 80 acre spacing) can be drilled in the field. We do not know if those wells will produce the same
amount of gas as 80 acre spacing; however, assuming that is the case, 20 times 1.5 BCE would result is 30 BCF of most
likely contingent resources. If indeed a better technology is available and we can increase the EUR by 50%, on the high
side of contingent resources, we would be able to produce 45 BCF of gas from 40 acre spacing wells. - -

Example 1-11
An off-shore oil field is discovered and is currently approved for development. The development wells are being drilled
and production platform has been ordered. It will be another four years before the field will start producing. The OOIP is
estimated to be 800 million barrels. Based on the simulation results as well as comparison with analogs from similar oil
fields, the primary depletion recovery factor can be as low as 6% to as high as 20% with the best estimate being 12%.
Currently, additional slots for potential water injection wells are provided for on the production platform; however, no
wells are currently planned for. No laboratory results have been collected, nor has detailed simulation been done.
Examination of analog reservoirs indicates that it is possible to double the reserves if water flooding is properly

38

Mohan Kelkar, Ph.D., J. D.

0
0
0
0
I
I

implemented and natural aquifer provides a weak support. The company would like to start the production and examine
the data before making a decision about when and if water injection should be implemented.
Explain different reserves categories based on this information.

Solution 1-11
Proved Reserves
Since the field is already under development, the proved reserves would be 6% of 800 million barrels which is equal to
48 million barrels. During the development phase, these reserves remain as proved undeveloped (PUD). However, once
the wells are drilled and if the company is waiting for pipeline connection which requires a small investment compared
to drilling the wells, these reserves would move into proved, developed, non-producing (PDNP). Once the production
starts, they would become proved, developed and producing (POP).
Probable Reserves
Probable plus proved reserves would be equal to 12% of 800 million barrels which is equal to 96 million barrels. By
subtracting proved reserves, probable reserves would 48 million barrels.
Possible Reserves
Possible plus probable plus proved would be 20% of 800 million barrels which is equal to 160 million barrels. Subtracting
96 million barrels would result in 64 million barrels of possible reserves.
Contingent Resources
Water flooding is a common process applied to many oil reservoirs. Therefore, the process is not new and technical
challenges are easy to overcome. However, we will need to add the additional reserves into contingent resources
because those resources depend on one important condition: support from an underlying aquifer which is not known
until production begins. If we assume that we can double the reserves using water flood, our low estimate of recovery
factor will be 12%, high estimate of recovery factor will be 40% and the best estimate will be 24%. Subtracting reserves
from our calculations, our low estimate of contingent resources will be 48 million barrels, high estimate will be 160
million barrels and the best estimate will be 96 million barrels.
If the company eventually determines that aquifer support is limited and based on detailed lab and simulation studies,
water flooding is economically feasible and approves the development, the contingent resources will be shifted into
reserves category.
.-

Case Srzdv 1-3

This case study is largely adopted from "Guidelines for Application of the Petroleum Resources Management System"

(Sosie

of Pr/ia/earn Engineers 2011).

An oil field was discovered about nineteen years ago. After two years of appraisal followed by three years of development, the
field has been producing for fourteen years. The field has been under peripheral water flood. Based on a detailed reservoir
study, a multi-disciplinary team built a reservoir model and matched the historical data using a detailed flow simulation study.
Case Study Figure 1-4 shows the history match result for the most likely (best estimate) scenario. .\lthough only one figure is
shown for the history match, two other scenarios were also run for conducting history matching which involves different
amounts of oil in place. Case Study Table 1-1 shows some of the details about the history matched results from the three
models. lhc field, to date, has produced 399 million barrels of oil. After history matching the results, the model was run in the
future to understand a "do nothing" option (l\Vl); that is, continuing the water flood operations as they stand. Additionally, a
peripheral water flood option with artificial lift using a submersible pump (P\yF with ESP) was also run. The third option
considered was conducting CO2 miscible displacement. All three scenarios were run and results were estimated to determine
how much additional oil can be produced.

Economic Evaluation in the Petroleum Industry


Chapter 1 - Economic Principles

39

Caw Study .Inigure 1-4? Hi/tory match and future prediction fur the most likely scena rio
case Study Table 1-i: Swnnaary of oil recoveries under three scenarios

Bases and Estimates by Reserves Category


Low
Best
High
Measured and Estimated Parameters

Estimate

Estimate

Estimate

Original Oil in Place (MMSTB)


Original Gas in Place BSCF

1,434
367.7

1,525
434.6

1,739
545.0

Cumulative Production so far


Oil (MMSTB)
Gas (BSCF)

399
227.4

399
227.4

399
227.4

Recoverable hydrocarbons under PWF 5


Oil (MMSTB)
Gas (BS(F)

573.4
326.8

686.3
391.2

869.3
495.5

Recoverable I lydrocatbons under PWF with ESP*


Oil (MMSTB)
Gas (BSCF)

645.1
367.7

762.5
434.6

9562
545

Recoverable I -lydrocarbons under (102 Flood


Oil (MMSTB)
Gas (BS(F)

716.8
386.1

915.0

1217.1
626.8

478.1

The 7% incremental oil recovery based on ESP is well supported by several nearby analog fields which showed incremental
recoveries of as high as 9% of 00W. The economics of I SP is very attractive and the company has already made a
commitment to implement I This project is expected to he implemented in four years and the investment is expected to be
substantial.
The CO2 flooding project showed an incremental recovery of 18%. lhccc were two CO2 pilots running in analogous fields.
lloth pilots indicated recovery efficiencies exceeding 21% of incremental recovery. The project economics of C() 2 flooding is
also positive. Currently, delivery of the CO2 is somewhat in doubt since construction of the CO 2 pipeline is not finished and
the pipeline company has yet to commit to building the pipelmc. ;\dditionally, the company suspects that the laws and rides
regarding CO, sequestration may change resulting in potential positive impact. In the report describing the results of (02

AN
40

Mohcin Kelkar, Ph.D., J.D.

p
p
p
p

flood study there was a note stating that "these estimates should be reviewed periodically to confirm whether these
impediments still exist and appropriate development decision should be made accordingly."
Using this information, categorize all of the reserves and explain your reasoning. Calculate equivalent oil recovery by
Consorting gas production using 6 MSCF1S1B. Report SIB and RIBI. separately.
Case Stm tv Solution 1-3

The recovery of oil in this case can be categorized as:


Proved. Developed and Producing- QP D P) : These reserves represent the remaining reserves that can be produced using water
injection. No significant investment is expected. These calculations are done only for a low (most conservative) estimate.
Proved and Undeveloped (PUD): These reserves represent the remaining reserves that can he produced through water
injection and f.SP combination. Once ESPs are implemented, these reserves can he moved to the PDP category.
Probable: These reserves represent the difference between best case and low case scenario under water flood with FSP option.
Possible: These reserves represent the difference between the high estimate and the best case scenario under water flood with
an ESP option.
Contingent Resources: Incremental recovery based on CO2 flood will be represented by contingent resources since these
resources cannot be recovered by overcoming a significant contingency. The low, best and high estimates will be categorized as
IC, 2C and 3C estimates respectively.
Case Study Table 1-2summariscs there results:
Case Study lSblc 12 AsnountufRemaining Resaut car and tin i.e Respective Cats 50t!OS

Category

Oil
(MMSTB)

Gas

Combined

(BCF) (MMBOE)

Proved
Proved, developed, producing
Proved, undeveloped

174.4
71.7

99.4
40.9

191.0
78.5

Probable

117.4

66.9

128.55

Possible

193.7

110.4

212.1

71.7
152.5
260.9

18.4
43.5
81.8

74.8
159.7

Contingent Resources
IC
2C
3C

274.5

Note that, in calculating contingent resources, we calculated the difference between oil and Was recovered under CO2 flooding
and under an US!2 option for each scenario. That is, the difference under the low estimate scenario represents IC reserves, the
difference under the best ease scenario represents 2C reserves and the difference under the high ease scenario represents 3C
reserves. lhis is because the entire CO2 flooding process is contingent upon satisfying certain conditions. If the conditions are
satisfied, the IC should move into proved reserves, 2C should move Into probable reserves and 3C should move into possible
reserves. By calculating the contingent resources as explained, this will happen logically.
Problem 1-22
After drilling a single well and testing it for production, a company predicts the low estimate
of recoverable oil to be
30,000 barrels (with a GOR of 2,000 SCF/STB), the best estimate of recoverable oil to be 50,000 barrels (with a GOR of
2,500 SCF/STB) and high estimate of 100,000 barrels (with GOR of 3,000 SCF/STB). Categorize these reserves separately
as oil and gas. If we define 6 MSCF ISTB, re-write the reserves in terms of oil equivalent

Economic Evaluation in the Petroleum Industry


Chapter 1 - Economic Principles

41

A gas field is being currently developed on 80 acre spacing. It began development on 640 acre spacing with an average
FUR of 2 BCF. However, over time, the government entity overseeing this particular area granted the spacing to be
reduced to 80 acre spacing A plot of FUR versus spacing indicates a declining trend That is every time the well is drilled
on a smaller spacing the FUR is slightly less than the wells drilled on a larger spacing There has been some dispute
among operators but a 15/ decline in FUR is observable every time the spacing is halved if the spacing goes from 640 to
320 acres the FUR of wells drilled on 320 acre spacing is about 15% lower than the EUR of wells drilled on 640 acre
spacing. An operator has a lease interest over 3,200 acres which is producing at 80 acre spacing. Assume the royalty
interest to be 20%. If the government agency grants 40 acre spacing in this field, how much additional reserves can the
company book? How would the reserves be categorized? Assume that, for the wells producing on 80 acre spacing, an
average of 0.5 BCF of gas per well still remains to be produced.
Problem 1-24

Problem Figure 1-1 shows the progression of a reservoir. Initially, well A was drilled and tested. It produced at a high
enough rate to be economical. The lowest known oil (LKO) was established from the log data. The volumetric analysis
indicated 200 million barrels of oil in place based on LKO. The recovery factor in this type of reservoirs varies from 10% to
25%. Seismic analysis indicated that the oil contact could be much lower than shown in the well. If seismic analysis is to
be believed, the oil in place will be as much as 500 million barrels of oil. Assuming that field development is approved
based on this well, categorize all of the reserves.
Eventually, well B was drilled and entered the water zone. Based on the gradients in both oil and water, a new oil-water
contact was established at a different depth. This resulted in oil in place of 430 million barrels of oil. How would the
reserves change based on this information?

Well A

Well B

Problem Figure 1-1: Cross section of on oilfield

42

Mohan Kelkar, Ph.D., J. D.

Problem 125
A newly discovered oil field indicated original oil in place of 30 million barrels (with expected produced cumulative GOR
of
800 SCF/STB). This was based on volumetric analysis. The recovery factor was expected to be in the range of 10% to 20%
with the most likely value of 14%. How would the reserves be reported under these conditions?
The field started producing and, after one year of production, the material balance technique was applied. Based on the
decline in reservoir pressure, the initial oil in place was revised to be 20 million barrels. The GOR remained unchanged. If
the field has already produced I million barrels of oil by the end of one year, how will the reserves be reported at this
point? Assume that the recovery factor has not changed.
The field can be subjected to water flood. There are some analog reservoirs which have indicated mixed success in
indicating an incremental recovery between 8% and 15% of the original oil in place with the best estimate equal to 10%.
However, the company has not done any detailed analysis of the cores, nor has it studied the water flood feasibility in
detail. May be in another year, the company will start examining the feasibility of water flood and based on the
evaluation, it may be approved. How would the reserves based on water flood characterized?

SIMPLE ECONOMIC METHODS


When economic projects are evaluated, we need to have the ability to decide which one is the best
project or the best alternative if several alternatives are available in one particular project. Many
sophisticated techniques are available to determine the best possible solution. Some of these
techniques are discussed in Chapter 2 - Economic Methods. Here we consider two simple methods
which are commonly used in the industry. We will also explain the rationale for using these methods.
Before we consider these two methods, let us consider two possibilities when decisions are made. We
can consider a possibility when the amount of investment needed for different alternatives is small
compared to the overall budget that we will select the best alternative without worrying if the company
has enough money; for example, if a company is considering the possibility of producing an oil well
under natural conditions, installing a rod pump, installing a submersible pump or a gas lift. If the cost of
all scenarios is insignificant compared to the capital commitment of the company, all four scenarios will
be evaluated and the best one will be selected. It is assumed that sufficient funds are available for
selecting the optimal solution. These alternatives are called mutually exclusive alternatives because if
the company selects one alternative, it will have to reject all others. That is, if the company selects a gas
lift option for an oil well, it has automatically eliminated the do nothing, rod pump and submersible
pump options.
On the other hand, if a company is considering multiple projects with different amounts of investment
needed and the investment amount is significant, it is possible that the company may have to pick and
choose between those projects based on the amount of money available. For example, if a company is
looking into development of three off-shore projects and has money to develop only two then, using an
appropriate economic criterion, it will have to decide which two should be selected and which one will
be rejected. These projects are considered independent since, by selecting one, the company does not
have to reject the other except for monetary constraints.

Economic Evaluation in the Petroleum Industry


Chapter 1 - Economic Principles

43

PAYBACK PERIOD
Payback (or payout) period method is one of the simplest methods used in economic evaluation. It is
the time it takes to recover the investment. Despite its simplicity, the method is extremely useful
under certain conditions.
Consider a small oil company with limited working capital. If a geologist enters the office and offers
a new prospect, the main consideration for the companys CEO is how long the money will be tied
up before it can be re-invested. If the time is very long, even though the project is very attractive
and can make a significant profit, the CEO will reject it. For small companies, many times liquidity is
more important than profitability. If the initial investment can be recovered quickly, anything
beyond that is profit and the same money is put to other use. It is not the only criterion the
company will use, but will definitely be one of the important ones.
Even bigger companies will sometimes sell an asset that has long-term potential but has a very long
payback period. This type of monetizing is quite common so that the money can be deployed in
other assets that have faster turn-around time in terms of recovering investment. For example, in
2009, Devon Energy announced its intention to sell its offshore assets in the Gulf of Mexico and
Brazil so that the proceeds could be invested in North American assets (Devon Energy 2009). The
main reason for the sale of these assets was the long horizon over which those off-shore assets will
be developed. This means that a lot of money will be tied up for a long time without any potential
revenue. In contrast, North American assets are quickly developed and, therefore, quick revenue is
gained from it. This is an example where liquidity (quick payback) triumphs over potential
profitability.
In addition to working capital or liquidity problems, the payback period can also be valuable when
contractual obligations or political uncertainty makes it difficult to plan for a long-term, optimal
project. If a company is operating an oil field and the lease on the oil field expires in five years, the
payback period is an important consideration to ensure that the initial investment is recovered.
Payback period is definitely not a criterion if profitability ofthe project is important. A project that
recovers cash quickly but terminates after that would look more attractive using payback period
criterion compared to a project which generates cash over a long period of time but has a significant
lead time. Therefore, in evaluating a project, both payback period and some profitability criterion
should be considered in making an appropriate decision about the investment.
Example 1-12
An oil well is currently producing at a rate of 20 barrels per day. A service company claims that the well, after stimulation
at a cost of $50,000, will produce an incremental amount of 7 barrels/day. Using an internal program, the service
company provides you with the following table of old versus new (after stimulation) rates. What is the payback period
and what is the profit? Assume that net benefit from each barrel is $80. Assume that an average of 30.4 days exists in
each month.

44

Mohan Kelkar, Ph.D., ID.

Old rate
b/d

Month

New Rate
b/d

20

27

19.2

25.2

18.4

23.6

17.7

22.0

17.0

20.5

16.3

19.2

15.7

17.9

15.0

16.7

14.4

15.6

13.9

14.6

10

13.3

13.6

11

12.8

12.8

12

12.3

12.3

13

11.8

11.8

14

11.3

11.3

15

10.8

10.8

Solution 1-12
Using the table above, we can construct the following table.

Old rate
Month

b/d

New Rate
b/d

D oil per
month

0 revenue

Cumulative

per month

Revenue

20

27

212.8

17,024

17,024

19.2

25.2

182.9

14,636

31,660

18.4

23.6

155.7

12,456

44,116

17.7

22.0

130.9

10,468

54,584

17.0

20.5

108.2

8,658

63,242

16.3

19.2

87.7

7,013

70,255

15.7

17.9

69.0

5,519

75,774

15.0

16.7

52.1

4,165

79,939

14.4

15.6

36.7

2,940

82,878

13.9

14.6

22.9

1,833

84,711

10

13.3

13.6

10.5

836

85,548

11

12.8

12.8

85,548

12

12.3

12.3

85,548

13

11.8

11.8

85,548

14

11.3

11.3

85,548

15

10.8

10.8

85,548

Note that after 10 months, the rates match; therefore, there is no incremental revenue from stimulation. The revenue
per month is calculated by multiplying incremental oil by $80/barrel. The last column, cumulative revenue, is just the
addition of revenue from the previous column. In month three, cumulative revenue exceeds the $50,000 investment;
therefore, the payback period is 4 months (starting with month 0). The profit from the project is $85,548 - $50,000 =
$35,548.

Economic Evaluation in the Petroleum Industry


Chapter 1 - Economic Principles

45

PROFIT-TO-INVESTMENT RATIO
Another important economic method extremely useful in evaluating independent projects is profitto-investment ratio (PIR or P1). This is simply a ratio of profit generated from a project to total
investment needed. PIR provides us with the information about which project gives us the "biggest
bang for the buck". If, for example, we are considering two projects, one requiring a $100
investment and the other requiring a $500 investment, and both projects generate a profit of $500,
the project with the $100 investment is much more valuable than the project requiring a $500
investment although both of them generate the same profit. This is because, if we can generate a
$500 profit with only a $100 investment, the remaining $400 (which would have been required had
we selected the other alternative) could be invested elsewhere.
When dealing with limited capital and multiple projects to consider, PIR is a method we can use to
rank these projects so that proper selection, which will maximize the profits, can be made.
Example 1-13
Consider an extension of Example 1-12. The same well can also be hydraulically fractured at a cost of $300,000. The
production profile after fracturing versus stimulation is provided in the table below.

Month

Old rate
b/d

Stimulation
New Rate
b/d

Fracturing
New Rate
b/d

20

27

50.0

19.2

25.2

45.0

18.4

23.6

40.5

17.7

22.0

36.5

17.0

20.5

32.8
29.5

16.3

19.2

15.7

17.9

26.6

15.0

16.7

23.9
21.5

14.4

15.6

13.9

14.6

19.4

10

133

13.6,

17.4

11

12.8

12.8

15.7

12

12.3

12.3

14.1

13

11.8

11.8

12.7

14

11.3

11.3

11.4

15

10.8

10.8

10.8

Using this information, determine the profit from each of the options. If the company has enough money to either
fracture or stimulate every well, what is the best option? If the company can invest up to $600,000 and there are more
than 20 wells in the field, what is the best option? Assume the net oil revenue to be $80/barrel of oil and 30.4 days in
each month.
Solution 1-13

Using the information provided, we can construct the following table.

46

Mohan Kelkar, Ph.D., J.D.

Month

Old rate
b/d

Stimulation
New Rate
b/d

Stimulation L
Fracturing LI
Fracturing
New Rate b/d revenue per month revenue per month

20

27

50.0 $

17,024

72,960

19.

25.2

45.0

14,636

62,746

18.4

23.6

40.5

12,456

36.5

10,468

53,669
$
$ 45,613

17.7

22.0

17.0

20.5

$
32.8 $

8,658

38,470

16.3

19.2

29.5

7,013

32,144

15.7

17.9

26.6

5,519

26,550

15.0

16.7

23.9

4,165

21,610

14.4

15.6

21.5

2,940

17,256

13.9

14.6

19.4

1,833

13,425

10

13.3

13.6

17.4

836

10,062

11

12.8

12.8

15.7

7,115

12

12.3

12.3

14.1

4,541

13

11.8

11.8

12.7

2,299

14

11.3

11.3

11.4

352

15

10.8

10.8

10.8

85,548

$ 408,813

In this table, we have calculated the revenue from each of the options. Incidentally, the payback period for the fracturing
option is six months; slightly greater than stimulation option. However, four months versus six months shows a very
small difference and is not be an important consideration in making a decision about which method to choose.
The profit from stimulation is $35,548 per well; whereas, the profit from fracturing is $108,813 per well. If we assume
that the table above represents an average, typical well, then it is always better to fracture the well than stimulate the
well since the overall profit will be maximized by fracturing every well.
If the company has only limited funds, we will need to calculate the PIR for each option:
PIR for stimulation

= 35,548
50,000

= 0.71; whereas, PIR for fracturing si

=108,813
300,000

= 0.36.

Therefore, we should select stimulation over fracturing.


Examining it differently, we can reach the same conclusion. If we have $600,000, we can either stimulate 12 wells or
fracture two wells. Therefore, the overall profit after stimulation will be 12 x 35,548 = $426,572; whereas, overall profit
after fracturing will be 2 x 108,813 = $217,626. If we want to maximize profit, stimulation is a better choice.
This example clearly shows how decisions can differ depending on a companys availability of funds. PIR is an important
criterion when a company is strapped for cash.

Economic Evaluation in the Petroleum Industry


Chapter 1 - Economic Principles

47

case Study 1-4


In 2003, California Electric Utility (CET) decided to promote savings of electric energy to oil producers in the state of
California. Working through P1TC (Petroleum Technology Transfer Council), C EU contacted several operators and
promoted various strategies to reduce electric consumption. As an incentive to use new, more efficient technology, CPU also
made a cash contribution toward implementation of this new technology. After a year-long effort, the following data were
collected from various alternatives;
I. Pump-off Controller (POC)
Most of the wells in California use rod beam pump artificial lift equipment. Rod pumps are operated more efficiently if
they operate with a full pump. POCs optimize the well run time so that the well operates periodically and with full pump.
POCs sense when the well is full and optimize the pumping system. During the program, POCs were installed on 42 wells
that were operated by 3 different operators with the following results;
Operator #1 Operator # 2 Operator # 3
Number of Wells
Gross Production b/d)
Oil Production (bid)
Cost (5)
Incentive by CEU (5)
Annual Average Savings (KWh/yr)
Cost of Energy (S/Kwh)
2.

27
N/A
N/A
26,199
13,100
391,207
0.080

10
623
104
129,775
64,888
822,915
0.080

3
180
26
13,000
6,500
74,720
0.115

Premium Ffficient and Downsizing Motors (PFDM)


PEDMs are 2% to 8% more efficient than standard motors. Replacing standard motors is a common practice in many
industries. I lowever, in the oil industry, motors are typically run until they fall and are replaced with an existing motor on
hand. By using state-of-the-art software, a motor could be optimized fora particular application at the oil well. It is also
possible to optimize oil production at the same time. Two producers installed PEDMs on 21 wells with the following
results;
Operator # 4 Operator # 5

Number of Wells
Gross Production (b/d)
Oil Production (b/d)
Cost (S)
Incentive by CPU (S)
Annual Average Savings (KWh/yr)
Cost of Energy (S/Kwh)
3.

11
661
N/A
405.738
166,000
3,194.047
0.080

10
17,500
400
701,294
265,380
5,019,790
0.080

Circuit Rider Controllers (CRC)


CRCs have three main components; surge suppression, capacitance, and line noise filtration. It isolates the motor or
circuit from receiving or dispersing transient surges while reducing harmonics. In addition, CRCs filter out AC line noise
problems, resulting in a much cleaner filtered AC current. Installing CRC allows for a better voltage/current balance,
increases voltage at the motor, and improves power factor.
In addition, line loss is reduced. One producer installed CRC on 25 wells with the following result;
Operator # 6
Number of Wells
(,toss Production (b/d)
Oil Ploduction b/d)
Cost (5)
liicenrivc by (ldJ (S)
,\nno;d .\vcragc Savings (KWh/yr)
Cost of I inergy (S/ K,vh)

48

25
N /\
N/A
37.704
18.852
1.389.000
0080

Mohan Kelkar, Ph.D., J.D.

4. KOBE Systems
The KOBE system utilize ,-, production fluid as the power transfer medium instead of steel rod as used in traditional rod
beam pumps. The working fluid is transmitted from a surface unit via surface piping to actuate a standard rod type pump
in the well. The working fluid is cyclically applied and relieved at the surface unit to create pumping action in the well. A
major drawback of the KOBE system is the large electrical requirements associated with the inefficiencies of the fluid
piping system. The application of the KOBE system involved 43 wells with the following results. It should be noted that,
in addition to reduced power requirements, the actual production increased and pump failures were reduced.
Operator # 7
Number of Wells
Gross Production (b/d)
Oil Production b/d)
Project Cost (S)
Reduction in annual Oper Fxp ($)
Incremental rev due to addl. Prod (S)
Incentive by CEU (5)
Annual average savings KWh/yr
Cost of energy (5/kWh)

43
960
530
1,448,351
547,500
173,900
212,375
2,644,046
0.073

Using this information, calculate the following for each of the four options. If multiple operators are involved, do the
calculations for individual operators, as well as on an average basis.
Calculate the time it takes to recover the initial investment with and without CEU contributions.
Assuming that the annual benefit in each project will continue for 4 years, calculate the profit from each alternative with
and without CEU contributions.
1 Based on the evaluation of each of the four alternatives, which alternative is the best based on profit per unit investment?
Would your answer be different if we selected the best alternative as the one which takes the least amount of time to
recover the investment? For part 3, assume that CPU contributions are zero.

1.
2.

(Sac Study Solution 1-4

1.

Pump-off Controllers (PO(


Operator #1

Operator # 2

Operator #3

Number of Wells
Gross Production (b/d)
Oil Production (b/d)
Cost (S)
Incentive by (i1U (S)
Annual Average Savings (KWIi/?i)
Cost of Energy (S/Kwh)

27
N/A
N/A
26,199
13,100
391,207
0.080

3
180
26
13,000
6,500
74,720
0.115

10
623
104
129,775
64,888
822,915
0.080

Payout Period (w/ Incentive), mo.


Payout Period (w/o Incentive), urn.
Profit (w/ Incentive), $
Profit (w/o Incentive), $

5.0
10.0
112,087
98,987

9.1
18.2
27,871
21,371

11.8
23.7
198,446
133,558

Profit Per Unit Cost (win Incentive)

3.78

1.64

1.03

Sample calculations:
Payout period w/o incentive) = (26,199 )/(391,207x 0.080) x 12 = 10 months
Payout period (w/ incentive) = (26199 - 13,100)/(391.207x 0.080) x 12 = 5 months
Profit (w/o incentive) = 4091,207xO.03 26.199 = S98,987
Profit w/ incentive) = 4x391,207x0.08 26,199 + 13,100 = $112,087
Profit per unit cost (w/o incentive) - 98,987/261,199 = 3.7$

2.

PI C11141111

)lS (Fl d)3l)


I f6cient and Downsizing Motors

Economic Evaluation in the petroleum Industry


Chapter 1 - Economic Principles

Total
40

168,974
84,488
1,288,842
0.0917
8.6
17.2
388,089
303,601
1.80

Operator
Number of Wells
Gross Production (b/d)
Oil Production (b/d)
Cost (5)
Incentive by CI1J (5)
Annual Average Savings (K\Vh/yr)
Cost of Energy (S/Kwh)

Operator

10
17,500
400
701,294
265,380
5,019,790
0.080

11.3
19.1

13.0
21.0
1,170,419
905,039
1.29

782,357
616,357
1.52

Total
21

107,032
431,380
8,213,837
0.0800
12.3
20.2
1,952,776
1,521,396
1.37

Circuit Ride Controllers (CRC)


Operator
Number of Wells
Gross Production (b/d)
Oil Production (b/d)
Cost (5)
Incentive by CEU (5)
Annual Average Savings KWh/vr
Cost of Energy (S/Kwh)
Payout Period (w/ Incentive), mo.
Payout Period (w/o Incentive), mo.
Profit (w/ Incentive), $
Profit (w/o Incentive), $
Profit Per Unit Cost (w/o Incentive)

4.

11
661
N/A
405,738
166,000
3,194,047
0080

Payout Period (w/ Incentive), mo.


Payout Period (w/o Incentive), mo.
Profit (wI Incentive), $
Profit (w/o Incentive), $
Profit Per Unit Cost (w/o Incentive)
3.

25
N/A
N/A
37,704
18,852
1,389,000
0.080
2.0
4.1

425,628
406,776
10.79

KOBE Systems
Operator
Number of Wells
Gross Production (b/d)
Oil Production (b/d)
Project Cost (5)
Reduction in Annual Oper Exp (S)
Incremental Rev Due to Addl. Prod (S)
Incentive byCEU (5)
Annual Average Savings (K\Xh/\ r)
Cost of Energy (S/kWh)
Payout Period (w/ Incentive), mo.
Payout Period (w/o Incentive), mo.
Profit (w/ Incentive), $
Profit (w/o Incentive), $
Profit Per Unit Cost (win Incentive)

7
43
960
530

1,448,351
547,500
173,900
212,375
2,644,046
0.073
16.2
19.0
2,421,685
2,209,310
1.53

Comparing the results of all four options, CRC is the best option in tcirns of both payback period and profit per unit Cost. The
other three options are very similar if you compare the payback pc nod or the profit per unit cost (P1 R).

50

Mohan Ke/kar, Ph.D., J.D.

Problem 1-26
The initiation of o waterflood project will require an initial investment of $2 million. It is expected that the project will
generate additional revenues of $700,000 in the first year followed by a decline of 10% per year. Calculate the payback
period.
-Problem 1-27
You have $1,000 to invest and have the following potential projects in mind. To maximize your benefit, which projects
should be selected?
Project

Cost

Net Benefit

1
2
3
4

300
400
300
200
400
300
500
200

80
160
105
50
100
90
125
40

5
6
7
8

Problem 1-28
After investing $100,000 in drilling and development costs, it is expected that in the first year net income will be $50,000
declining at a rote of 10% per year over the next five years. Calculate the payback period. What is the profit-toinvestment (PIR)for this project?

Consider the following three alternatives for a project. Based on the payback period method, which alternative should be
selected?
Year

0
1
2
3
4

-200
50
50
50
50

-100
32
32
32
32

-100
42
42
42
42

Problem 1-30
The following two alternatives are considered for a project. Based on a payback period method, which alternative would
be selected?
Year

0
1
2
3
4
5
6
7
8

-100
-200
-100
50
150
300
300
300
200

-300
100
150
100
50
0
0
0
0

Would the answer be different if the PIR method is used?


Economic Evaluation in the Petroleum Industry
Chapter 1 - Economic Principles

51

Problem 1-31
A company is considering two alternatives to improve production from a well. The cash flow
given below:

Year

0
1
2
3
4
5

-10,000
2,000
2,000
5,000
5,000
5,000

-30,000
12,000
12,000
12,000
8,000
6,000

5,000

of these two alternatives is

Which alternative should be selected?

TIME VALUE OF MONEY


In any decision-making process, we have to account for the benefits and costs of a project. In a typical
project, the costs occur at the beginning of the project and the benefits accrue over a period of time. For
example, installation of a waterflood project results in benefits in terms of additional oil recovery over
several years. However, to install waterflood, we may have to incur significant costs at the present time.
This money has to come from the internal capital of a corporation or from a lending institute. Either
way, we will lose the opportunity to invest the money somewhere else or we will have to pay interest to
the lending institution. That is, instead of investing the money in a waterilooding project, we could have
earned interest from the bank by investing that money in the bank or, if we borrowed the money to
invest in this project, we have to pay interest on the borrowed amount. This lost opportunity
(opportunity cost) or the interest payment has to be accounted for in our cost benefit analysis. One way
to do this is through the understanding of the time value of money.
Money is a valuable commodity. People will pay you to use your money, whereas you will have to pay
someone to use their money. The cost of money is established and measured by an
interest rate. An
interest rate is periodically applied and added to the amount of money borrowed (the principal) over a
specific period of time. For example, depositing $100 in the bank for one year may generate an interest
of $6 at the end of the year. That is, the bank has paid you 6% interest to use your money. In the same
vein, the bank will turn around and lend that money to another individual and charge 10% interest. The
borrower will have to pay back $110 at the end of one year. This means that your $100 today is
equivalent to $106 to you one year from now because of the interest earned on the principal. With the
same token, $100 lent by the bank is equivalent $110 to the bank one year from now. This principal is
called a theory of equivalence (Newman, Engineering Economic Analysis 1991) (Stermole and Stermole
1986) (Park 1993).

THEORY OF EQUIVALENCE
Money is a valuable commodity and it has earning power. We need to establish a method to
compare the money collected at different times. For example, if you have the option of receiving

52

Mohan Kelkar, Ph.D., J.D.

$100 today or $110 one year from now, which would you prefer? The answer to this question
depends on what you would do with $100 if you received today. If you invest $100 in the bank at 5%
interest rate, you will only earn $5 in one year, leaving you with $105. Obviously, $105 is less than
the $110 you would receive if you had selected the other option; therefore, you should choose the
option to receive $110 in one year.
On the other hand, if you received a hot tip on a particular stock that is expected to grow at a rate of
25% in the first year, by investing in that stock, you can get $125 one year from now. Therefore, you
would prefer to get $100 today rather than $110 one year from now.
Only if you receive a 10% interest rate on your $100 investment will you earn $110 one year from
now. Whether you receive $100 today or $110 in one year, it will not make any difference to you. In
other words, $100 today is equivalent to $110 one year from now if you can earn a 10% interest rate
on your investment.
This example illustrates the theory of economic equivalence. When cash flows can be traded for one
another in the financial world, those cash flows are considered equivalent to each other. In the
example above, at a 10% interest rate, $100 today is equivalent to $110 one year from now. By the
same token, at a 25% interest rate, $100 today is equivalent to $125 one year from now. Studying
these examples illustrates one fundamental aspect of the economic equivalence. It depends on the
interest rate earned. The equivalent amounts will be different for different interest rates.
The economic equivalence is also affected by time. Consider the extension of the previous example.
If someone offers you $100 today, $110 one year from now, or $121 two years from now, which
would you prefer? As before, it depends on what you can do with the $100 you will have today. If
you invest it at a 5% interest rate, after one year you will have:

$ioo+sioo(os)= $105
After two years, you will have:

$ios+sios(os)=$i 10.25
Since $110.25 is less than $121, you should choose to receive $121 two years from today. On the
other hand, if you can earn a 25% interest rate, you will have, after one year:

$100+$100(0.25)=$125
After two years:

$125+ $125(0.25)= $156.25


This amount is greater than $121; therefore, you should choose to receive $100 today rather than
$121 two years from now.
Only if you earn a 10% interest rate, after one year you will have:

Economic Evaluation in the Petroleum Industry


Chapter 1 - Economic Principles

53

$ioo+sioo(i)=

$110

After two years, you will have,


s110+s110(1)= $121
At a 10% interest rate, whether you choose to receive $100 today, $110 one year from now or $121
two years from now, it will not make a difference. That is, $121 two years from now is equivalent to
$100 today at 10% interest rate. This enforces another factor which affects the principle of
equivalence - time. $100 today is equivalent to $110 one year from now and $121 two years from
now at 10% interest rate; $100 today is equivalent to $125 one year from now, and $156.25 two
years from now at 25% interest rate. Notice that equivalence is affected by both the time and the
interest rate.
Think about why this principle is so important. When conducting the cost benefit analysis of any
project, if the benefits are received in the future, we cannot directly compare the present costs to
the future benefits unless we can convert the future benefits to equivalent present benefits; or,
alternatively, we will have to convert the present cost to equivalent future costs.

EQUIVALENCE RELATIONSHIPS
In typical economic analysis, cash flows occur in many different ways. The benefit may occur at the
end of the useful life of a project (i.e., withdrawing the principal and all accumulated interest at the
end of five years from a bank), or the benefits may be received periodically during the life of the
project (i.e., opening a restaurant and receiving profit each day). Before we can consider whether
the investment made in a given project is justified in light of future benefits, we need to establish
systematic procedures for relating monies collected at different times to some common frame of
reference. Only then can we compare them correctly. We use the theory of equivalence for this
purpose.
To understand the theory of equivalence in a more rigorous way, we need to establish certain
relationships starting with some basic parameters. We can define these parameters as:

P = present sum of money


F = future sum of money
A = end of period cash payment or receipt
= interest rate per period
n = number of periods
In establishing the relationships between the various types of cash flows, we will begin with the
simplest type of relationship; a relationship between the present sum of money and the future sum
of money. Then, we will follow it with much more involved and complex relationships.

54

Mohan Kelkar, PhD., iD,

The cash flow diagram for establishing the relationship between the present sum and the future
sum can be drawn as:

Let us assume that the present sum P is invested at an interest rate of i per period for one
period. The amount collected after one period will be:

P+Pi=P(1+i)
If we continue to invest the new principal, P(1 + i), for another period, we will have, after the
end of two periods,

P(1 + i) + iP(1 + i) = P(1 + i)(1 + i) = P(1 + i) 2


Notice that the exponent of (1 + i) term is equal to the number of periods the principal is
invested.
Extending this analysis, after periods, the sum colletted is equal to P(1 +
therefore, the future sum after periods as:

F = P(1 + i)-

i). We can write,

Equation 1-2

Since, in this equation, we increased the principal for each period (compounded) by the
accumulated interest, this method is called the compounding interest method. Equation
1-2
establishes a relationship between the future sum of money and the present sum of money.
Equation 1-2 can also be written as:

P = ( 1+)11

Equation 13

This relationship allows us to calculate the present sum if the future sum is known. The
following examples illustrate the application of these equations.

Economic Evaluation in the Petroleum Industry


Chapter 1 - Economic Principles

55

Example 1-14
If you need $10,000 after 5 years, how much should you invest today at an interest rate of 10%?
Solution 1-14
Given:

F = $10,000, n = 5 years, t = 10%

Find:

Using Equation 1-3,


F
= (1 +

$10,000

j)fl =

Ti + 0.1)5= $6,209

You need to invest $6,209 today.

Example 1-15
If you invest $4,000 in a bank at an interest rate of 6.25% per year, how much money will you have at the end of
three years?
Solution 1-15
Given:

P = $4,000, n = 3 years, i = 6.25%

Find:

FF

Using Equation 1-2,


F = P(1 + i)

= 4,000(1 + 0.0625) = $4,798

You will have $4,798 after three years.

56

Mohan Kelkar, Ph.D., J.D.

Example 1-16
If you want to invest $3,000 at an interest rate of 7%, how long will it take to double the initial investment?

Solution 1-16
Given:

P = $3,000, F = $6,000, I = 7%

Find:

Using Equation 1-2,


6,000 = 3,000(1 +.07)(1 + .07 1 = 2
Taking log on both sides
nlog(1 + .07) = log(2)
- log(2)
- Iog(1.07)
= 10.2 years
The amount will double in 10.2 years. It is interesting to note that in economics, there is a famous rule called the
Rule of 72. It says that if you divide 72 by the interest rate in percentage, you can calculate the number of years
needed to double the money. In our example, dividing 72 by 7 will result in 10.3 years which is close to the actual
answer.

RELATIONSHIP BETWEEN A AND F


Let us extend the previous relationships to a case where a payment is made at the end of each
period. We want to calculate the future value of these payments at the end of the total period.
A cash flow diagram for this arrangement is shown in Figure 1-4.

1 "1
Figure 1-4: Periodic payments
This case is similar to the periodic investment in a bank at a fixed interest rate for a certain
period followed by a total withdrawal at the end of that period.

Economic Evaluation in the Petroleum Industry


Chapter 1 - Economic Principles

57

___

(n-2)
4
(n-i)
Figure 1-5: Accumulation of interest for periodic payments
Considering that for the first payment, we earned interest for (n - 1) periods (see Equation 12), and for the last payment we earned no interest, using Equation 1-2, we can write,

F = A(1 + j)fl_l + A(1 + Ofl_2 + + A

Equation 1-4

Multiplying Equation 1-4 by (1 + i),

F(1 + i) = A(1 + j)fl + A(1 + i)

1 + + A(1 + i)

Equation 1-5

Subtracting Equation 1-4 from Equation 1-5 and rearranging, we obtain,

F(1+i)F=Fi=A[(1+i)-1]
Therefore,

F = A [ ( 1h

Equation 1-6

We can rewrite Equation 1-6 as,

A=F

Equation 1-7

Equation 1-6 and Equation 1-7 establish the relationships between A and F.

58

Mohan Kelkcir, Ph, D., ID,

Example 1-17
If you deposit $10,000 at the end of each year, how much would you accumulate at the end of five years at an
interest rate of 6%?
Solution 1-17
Given:

A = $10,000, n = 5 years, i = 6%

Find:

Using Equation 1-6,

F = A [(1 + in -

$10,000 [(1 + 0.06) s-

=1

ii

0.06

= $56,371
You would have $56,371 at the end of five years.

Example 1-18
If you need $100,000 at the end of ten years for a college education, how much should you invest at the end of each
year at an interest rate of 8%?

Solution 1-18
Given:

F = $100,000, n = 10 years, i = 8%

Find:

Using Equation 1-7,

A =F

1(1 +

$100,000

M.0

1(1

+ 0.08)10 -

11

= $6,903
You should invest $6,903 at the end of each year to receive $100,000 at the end of ten years.

Example 1-19
You intend to invest $1,000 per year in mutual funds. If the average annual yield from this fund is expected to be
12%, how long will it take before you will accumulate $15,000 in your account?

Solution 1-19
Given:

A = $1,000, F = $ 15,000, i = 12%

Find:

Using Equation 1-6,


P - (1 + j)n 1

Economic Evaluation in the Petroleum Industry


Chapter 1 - Economic Principles

59

(1 + i) Th = 1 +
Substituting,

(1+i)=1+.12x 15,000
=2.8
1,000
nlog(1 +.12) = Iog(2,8)
Therefore,

n = 9.1 years
It will take approximately 9.1 years before $15,000 will be accumulated.

Example 1-20
After graduating from college, Betty plans, in 5 years, to buy a house worth $150,000 with a 20% down payment.
Bettys father gives her $10,000 as a graduation gift. If Betty invests that money at a 6% interest rate, how much
additional annual savings will she have to invest at the same interest rate to accumulate the desired 20% down
payment at the end of five years?
Solution 1-20
Given:

F = 20% of $150,000, P = $10,000, i = 6%, n = 5 years

Find:

In this example, Betty is investing $10,000 at the beginning of year 1 plus additional annual investments to get
$30,000 at the end of five years. The cash flow diagram can be drawn as shown in Example Figure 1-2.

F = $30,000

IF

Ilr

AAAAA
$10,000
Example Figure 1-2: Cash flow diagram for Example 1-20
The first step is to can calculate the future value (F1 ) of $10,000 after five years.
Using Equation 1-2,

F1 = P(1 + i)- = 10,000(1 + .06)


= $13,382
The remaining future value has to be the result of annual investments. We can calculate the remaining future value.

F2 = 30,000 + 13,382 = $16,618


Using Equation 1-7,

60

Mohon Kelkar, Ph.D., J.D.

I
I
A = F t(l+iflh1
_
0.06
- 16,618
= $2,948

I
I
I

Therefore, Betty needs to invest $2,948 at the end of each year.

I RELATIONSHIP BETWEEN A AND P


Let us extend the relationship one step further by relating the present value to the periodic
payments. As shown in Figure 1-6, we want to calculate the present value of future periodic
payments.

Figure 1-6: Relationship between P and A


From Equation 1-6, we know that

FP(1+i)
From Equation 1-6, we know that

F - A (1+i)-1

Substituting Equation 1-2 in Equation 1-6, we can write,

P(1+i)=A

(1+i)-1

Simplifying,

P - A

Equation 1-8

Equation 1-8 can also be written as:

Economic Evaluation in the Petroleum Industry


Chapter 1 - Economic Principles

61

A = P

i(i+i) I
{(1+)fl_1i

Equation 1-9

Equation 1-8 and Equation 1-9 establish the relationship between the periodic payment (A) and
the present worth (P).
Example 1-21
If you take a home improvement loan of $10,000 to be paid over a five year period, what will be the yearly payment
if the interest rate is 12% per year?

Solution 1-21
Given:

P = $10,000, n = 5 years, i = 12%

Find:

Using Equation 1-9,

i(1+i)
A = P [ + j)fl
[(1

-1
.12(1 +.12) 5

= (1 + .12) - 1
= $2,774
The yearly payment will be $2,774.

Example 1-22
If you want to invest sufficient money in the bank so that, at an interest rate of 8%, you will receive $20,000 per year
for the next 10 years, how much should you invest in the bank?

Solution 1-22
Given:

A = $20,000, n = 10 years, i = 8%

Find:

Using Equation 1-8,

P =A

[(1

+ j)fl

- 1]

i(1+i) J
(1 +.08)0 1

= $20,000 [.08(1 +.08)10


= $134,202
You will have to invest $134,202 today to earn $20,000 per year for the next ten years.

Example 1-23

Able borrows $1,000 from a loan shark. In return, the loan shark demands that Able pay $100 per month for one
year. What is the monthly interest rate the loan shark is charging?

Solution 1-23
Given:

62

P = $1,000, A = $100 per month, n = 12 months

Mohan Kelkar, Ph.D., J.D.

Find:
Notice that the periodic payment and the period are given in terms of monthly units.
Using Equation 1-8,
[(1

P=I
A

+ jY -

ii

i(1+i)1 j

Substituting
1,000(1

+ 012

-1

i(1+i)12

=10

There is no explicit solution for i. By trial-and-error,


For

P
1=1%

P
= 2.9%

I Therefore, the interest rate charged

-10.01

is 2.9% per month.

Example 1-24
Betty buys a new computer at a price of $10,000. Betty expects that the use of the computer should result in an
annual income of $2,500. If Betty wants to earn at least a 15% return on her investment, at what price will the
computer have to be sold after 4 years?

Solution 1-24

Given:

P = $10,000, A = $2,500, i = 15%, n = 4 years

Find:

Salvage value (resale price) of the computer

We can draw a cash flow diagram for this example as shown in Example Figure 1-3.

Economic Evaluation in the Petroleum Industry


Chapter 1 - Economic Principles

63

F=?
A = $2,500

P = $10,000
Example Figure 1-3: Cash flow diagram for Example 1-24
Using Equation 1-8, we can calculate the present value of periodic payments as:

P1=A

(1 + j) - 1
i(l+i)

Substituting

P1

(1 + .15) - 1
= 2,500 .15(1 + .15)
= $7,137

The remaining present investment will have to be recovered by the future resale price.
The remaining present investment is
= 10,000 - 7,137 = $2,863
Using Equation 1-2,

F = P(1 + j)"
= 2,863(1 +.15)4
= $5,007
The computer will need to be sold at a price of $5,007 at the end of 4 years.

In solving these and other examples and problems, please remember that the units of periodic
payment, interest rate per period and the number of periods have to be consistent. For
example, if the payment is per month, then the number of periods has to be in months and the
interest rate has to be defined per month. Similarly, if the payment is per year, the interest rate
has to be defined per year and the number of periods has to be in years.

GEOMETRIC GRADIENT PAYMENT

In the previous section, we developed the relationships when the periodic payment is constant.
However, it is possible that instead of being constant, the payment can change as a function of time.
For arbitrary changes in payment, there is no analytical solution. However, for some simplified
cases, an analytical solution is available. One case that has practical implications in the oil industry is

64

Mohan Kelkar, PhD., 1.0.

geometric gradient assumption. Geometric gradient assumes that, instead of being constant, the
payment is changing by a constant percentage. This is useful in the petroleum industry because, in
many instances, we assume that production from a field or from a well is declining by a constant
percentage. If we want to capture future production, we can use a geometric gradient series. As
with production, while doing an economic evaluation, we may assume that the price of the
commodity (either oil or gas) is increasing by a constant percentage. This assumption can also be
incorporated using a geometric gradient series. The relationship between the changing payment and
the future sum is shown in Figure 1-7.

ni

12

A(l+g)
A(1 +g)

u-I

A(1 +g)
Figure 1-7: Geometric gradient series

In this case, we assume that the periodic payment changes by a constant percentage every period. If
payment A is made at the end of the first period, it will change to A(1 + g) at the end of the second
period where .g is a constant fraction. For the last period,.n, the payment is A(1 + g)fl_l. Knowing
that the interest earned on the first payment is for (n - 1) years, and no interest is earned on the
last payment, we can write the equation for the future sum as,

F = A(1

+ 0_

+ A(1 + g)(l + ofl_2 + + A(1 + g)--1

Equation 1-10

(1+1)

Multiplying the Equation 1-10 by -----3, we get,

F(1+9)
=A

(1+O
(1+g)

+ A(1

+ 0-

+ A(1 + 0(1 + ) n2

Equation i-Il

Subtracting Equation 1-10 from Equation 1-11, we obtain,

(1+i)

(1+g)

F=A

(1+i

(1+g)

A(1+i)

Simplifying,

Economic Evaluation in the Petroleum Industry


Chapter 1 - Economic Principles

65

Equation 1-12

(i-g)

This equation is applicable only if i

g. If i = g, Equation 1-10 simplifies to,

Adding,

F = nA(1 + j

Equation 1-13

Knowing the relationship between F and P, Equation 1-2, we can write:

F = P(1 + j)fl

Equation 1-2

Substituting Equation 1-2 in Equation 1-12 and rearranging,

P =-

1+9)1
4- Ft - ((i+0Th1

Equation 1-14

(ig) I

Similarly, for i = g, Equation 1-2 can be substituted in Equation 1-13. Therefore,

P(1 +

j)fl

= nA(1 + j)fl_l

and,
nA
(1+i)

Equation 1-15

P = --

Example 1-25
If you invest $10,000 in the first year with a 10% increase in each subsequent year, how much money would be
accumulated at the end of ten years at an interest rate of 8%?

Solution 1-25
Given:

A = $10,000, p = 10%, 1 = 8%, n = 10 years

Find:

Using Equation 1-12,

F=---f(i+i)-(1+g)}
=

( - 9)
10,000
(1.08-1) [(1 +.08)0 - ( 1 + .1) 10 1 = $ 217,410

After ten years, you would collect $217,410.

1-26
If, as an employer, you guarantee one of your employees an initial salary of $20,000 per year and an annual increase of

M
.

Mohan Kelkar, Ph.D., J.D.

at least 6% for the next five years, what is the minimum amount of money you need to set aside at an interest rate of 7%
to cover the cost of the employees salary? If the interest rate is 6%, how much more needs to be set aside?

Solution 1-26
Given:

A = $20,000, p = 6%, j = 7%, n = 5 years.

Find:

Using Equation 1-12,

(1+g)

P=(j_g) 1(l+i)
20,000

1
(.07
.06) -

(1+.06) 1
(1+.07) = $91,727

At a 7% interest rate, $91,727 has to be set aside to cover the cost of the employees salary.
If the interest rate is 6%, i = p. Therefore, using Equation 1-15,

nA
(1+i)
5 x 20,000

= (1 + .06)

= $94,340

Therefore, at an interest rate of 6%, an additional $2,621 ($94,340 - $91,719) has to be set aside.

Example 1-27
Able pays $500,000 for a producing oil field that generates a profit of $10,000 in the first month. The field profit is
expected to decline at a rate of 1.0% per month. If Able expects to get a rate of return of
1.25% per month on his
investment, at what minimum price will he have to sell the field after 10 years of production?

Solution 1-27
Given:

A = $10,000/month, p= -1%, i = 1.25%, n = 120 months.

Find:

P, salvage value

First calculate the present sum of all future profits for a ten year period.
Using Equation 1-14,
A

(1+y)l
I
(1+i)j
1
10,000
(1 - .01) 120
1+0125 j=$414478
C0125+.01)[1

(ig)

Ii

Since Able paid $500,000 for the property, the balance has to come out of the salvage value after 10 years.
balance at present = 500,000 414,478
= $85,522
However, we need to calculate the future value of this balance. Using Equation 1-2,

Economic Evaluation in the Petroleum Industry


Chapter 1 - Economic Principles

67

F = P(1 + j)n
= 85,522(1 +.0125) 120
= $379,736
Able will have to sell the oil field for $379,736 after 10 years.

Example 1-28
In the oil industry, a rule commonly used to evaluate oil property is to multiply daily production (in STB/d) by one
thousand times the price of oil to determine the present worth of the field. How can this rule be justified based on the
geometric gradient series?
Solution 1-28
Equation 1-12 can be simplified for a large value of n. We can write P as:

A
P =

The reason for this simplification is that the second term in the bracket goes to zero when a fraction less than one is
taken to a higher power. As is common, because of the risk involved in the oil business, if we assume that the rate of
return you want to earn on an investment is 25% (i = 25%), and a typical decline of a field is 10% (p = 10%), we
can write the equation above as:
daily production x 365 x $/STB
(0.25+0.1)

daily production x

$
STB

x 1,000

Since the interest rate is per year, we also need to use production per year. That is why we multiply by 365. We can use
this equation to calculate worth of an oil field. For example, if the field is producing 50 bbl/d and the oil price is $30/bbl,
then the field is worth 50 x 1000 x 80 = $4,000,000. Please note that this is a simplified form and not every field
depletes at a rate of 10%. It is also true that the net revenue from a barrel of oil is not the price of oil. We have to
account for production costs as well as royalty interest. However, this is a good approximation that works well in many
situations.

Example 1-29
Following is a newspaper article about Anadarko Corporation selling its Louisiana assets to EXCO Corporation in 2006.
The oil price was trading around $50/barrel at that time. Assume 6MScF 1STB:
"Anadarko Petroleum Corp. has confirmed it has agreed to sell two gas fields in Louisiana to EXCO Resources. Inc. for $1.6
billion in cash. .... The company said it agreed to sell its Vernon and Ansley fields, located in Jackson Parish, Louisiana, to
EXCO, which is focused on acquiring and developing onshore North American oil and natural gas properties. The fields
produced 192 million cubic feet equivalent per day from about 350 wells on 66,000 net acres as of November 1, according
to Anadorko."
How does our rule compare to the actual purchase price?
Solution 1-29
Using the equivalence, we can calculate 192 million SCF = 32,000 STB. Using our rule, the present worth of property
would be 32,000 x 50 x 1000 = $1.6 billion. This is consistent with the price EXCO paid for the property.
(Size Study 1-5

Gas wells start loading when the gas flow rate is not high enough to remove the liquids accumulated in the tubing Several
solutions are used to minimize liquid loading. lhesc solutions include: (1) injection of chemicals (surfactants) to create a stable
foam so that the foam can he produced to the surface; (2) changing the tubing size; (3) gas lift by injecting additional gas, and
(4) plunger lift which does not allow the liquid fall back while liquid is being lifted to the surface. For marginal wells, gas lift is

Mohan Kelkar, P/iD., J.D.

not economically viable; therefore, techniques commonly used include plunger lift or use of capillary strings to inject chemical
downhole to lift the liquid.
Traditional plunger lift requires shut in time for the plunger to fall hack to bottom and to allow for bottomhole pressure to
build. This thut-in time results in lost production and forces liquids back into the formation. Chevron is testing a new plunger
(called Pacemaker) which has several advantages over conventional plunger lift. The Pacemaker plunger operates as two
interdependent pieces a cylinder and a ball (Case Study Figure 1-5) - each of which fall separately and are designed to do so
against a significant gas flow rate. Once the cylinder reaches the bottom, it encounters the ball, which seals off the cavity in the
cylinder. Gas is now forced to travel around the cylinder. The gas velocity around the cylinder results in a drag force, causing
the cylinder and ball to return to surface, thus acting like a piston. Once on surface, a rod in the lubricator separates the ball
from the cylinder, allowing the ball to fall back to the bottom.

cam Study- 1 u re 1-5 Different sacss anJ (ESteeM/s of two-piece f/eu-through plungers

Only 5-10 seconds of shut-in time per cycle is required. This minimizes production fluctuations and means less interference
for wells sharing the same facilities and/or compression. The longer flow period means more production, and liquids are not
forced back into the formation. Stabilized production allows liquids to be produced as opposed to accumulating in the nearweilbore area, reducing the relative gas permeability.
Pacemaker has some limitations. Since this plunger system is driven by gas velocity, it works best at low wellhead pressures.
With 80 to 100 psi of flowing tubing pressure, the plunger system performs best when unloaded gas rates exceed 150 to 200
Mcfd. Very high liquid rates impede the balls fall and can result in the cylinder catching the ball prior to reaching bottom.
Wellborc restrictions, tubing set too high or excessive sand production will prevent optimum performance. Finally, those
involved must understand that the cit/ica/Jartor is gas velosatj, ii 01 pressure as Will) 0 csnientionalp/uqger 1fi ys/ern. Training as to how to
set the controller, troubleshoot and optimize is critical.
An example of application of Pacemaker plunger lift is shown in a South Texas well that originally was operated by capillary
string through which chemicals were injected. A capillary string subsequently began producing more condensate and became
more difficult and expensive to operate (Case Study Figure 1-6). The Pacemaker plunger system was installed in October
2002. Production increased and become more consistent, producing an incremental 40 Mcfd. Based on the evaluation, the
incremental production is declining at a rate of 1 1/o per month. Prior chemical costs of $1,740 per month have now been
eliminated. The cost of Pacemaker is $6,000. Assume the net price of gas to be S3/MSCF. Assume the life of the well to be 5
years after installation.

Economic Evaluation in the Petroleum Industry


Chapter 1 - Economic Principles

69

500

---

ji",

QU

M r ,

i
-

t 111

FTP

i1

13-l&v-02
0L02
Case St nlj Pagure 1-6: South Texas example: capithay srrlsag vs. Pacemaker

Auqll2

27-Auj02

22-5tp-02

cc-02

Case Study Figure 1-7 compares the results of standard plunger lift with Pacemaker. The results are from West Texas gas
field where the production increased by 1,200 MSCFD for 10 wells after installing Pacemaker plunger lift. Again the cost is
S6,000 per installation and the net price of gas is assumed to be S3/MSCF. Assume the average life of wells to be 5 years.
&litJO
13,500

3,000
2.500
2.000
1.500
1.000
0
U)tiys
Case Study FIgure 1- 7 Wear Texas field test: normaliaedproductkan fi,im all wells

As an engineer working for Chevron, you are asked to evaluate the performance of Pacemaker against capillary string as well as
conventional plunger lift. Using the information above:
1.

Calculate the present value of incremental revenue by installing Pacemaker compared to capillary string. What is the
net profit? Assume interest rate to be 15% per year.

2.

Continuing the first part, if the Pacemaker will have to be replaced after 3 years, how would the economics change?
Assume that capillary string will not have to he replaced and continued to be used for 5 years.

3.

Compare the effectiveness of Pacemaker compared to conventional plunger lift on an average well basis using the
West Texas information.

4.

1 low will the economics in Part 3 change if the Pacemaker has to be replaced after 2 years

Case Studj Solution 1-5

C a pillary String Replacement


For the first part, we can use the equation for geometric gradient series. Since we know the decline of a well to he 1%/month,
we also need to define the interest rate per month. It would he 15/12 = 1.25% per month. Incremental production is 40
MSCIO). We will assume 30.4 days in each month. Using this assumption, we can calculate the present value of future
o.venues as:

70

Mohan Kelkar, Ph.D., J.D.

PVprod

(1 -0.01)60
40 x 30.4 x 3
(00125 + 001) 1 - (1 + 0.0125)60 = $120,033

Note that is equal to -0.01. Ihc number of years over which this is valid is 5 years or 60 months. In addition, we also save
the Cost of chemicals. Ihe cost savings can be written as:

I
I

PVc6em

savings

(l+0.0125) -1
1,740 0.0125(1 + 0.0125)60 = $73,140

Combining the two and subtracting $6,000 which is the plunger cost, we can calculate the profit as 120,033 + 73,140 6,000
= $187,173.
Even if we have to replace the plunger after three years, the cost will he 6,0001(1+0.0125) 36 $3,836. Ibis is the present value
of the costs after three years. Subtracting this from the profit, we still make $183,337 profit.
Conventional Plunger
We can calculate the present value of incremental gas as:

(1+.012 5)60 1

PVprod = 1,200 X 30.4 X 3 0.0125(1 + .0125)60 = $4,600,265

I
I
I
I
I

Subtracting the cost of 10 plungers, profit = 4,600,265 - 60,000 - $4,540,265. Even if we have to replace the plunger after two
)ears, the additional cost will be 60,000/(1+0.0125) 24 . Subtracting it, we still make S4,495,733 profit.
Overall, Pacemaker is a good investment for this project.

---.
NOMINAL AND EFFECTIVE INTEREST RATES

.. ....................................................

In the previous section, we were careful to define the periodic payments that were based on certain
periods, and the interest rate that is also defined based on per period. Although many examples we
considered were based on annual payments (yearly payments), we also considered some examples
in which payments were made at shorter intervals (months). As long as we defined our interest rate
consistently with the payment period, we do not have.to make any special adjustments to our
economic analysis. The equations developed in the previous sections can easily be adapted to
shorter durations as long as the periodic payment and the interest rate per period is defined for the
some period.

In practice, however, the interest rates are rarely defined for a period shorter than one year. If you
invest money in the bank or if you borrow money from a lending institution, the interest is, typically,
- defined on an annual basis. However, depending on how frequently the payments are paid, the
effective interest rate could be different than the annual interest rate charged. Consider a simple
example to illustrate this concept.
Esampie 1-30
$1,000 is invested in the bank at a rate of 12% per year. The bank statement declares, "the interest is compounded
monthly based on the average daily balance during that month." How much money will you accumulate at the end of
one year?

Solution 1-30

Economic Evaluation in the Petroleum Industry


Chapter 1 - Economic Principles

71

The interest rate is equal to 12% per year. Since the interest is compounded monthly, we need to calculate the monthly
interest rate.
-. 12%/year - 12 months/year -

1%/month

The average daily balance (in the absence of any withdrawals or deposits) will be the principal plus the accumulated
interest from the previous months. For example, at the end of the first month, the interest will be:
1,000 x .01 = $10
Therefore, we will accumulate $1000 + $10 = $1010 in the account. In the second month, the interest will be:
1,010 X.01 = $10.10
Therefore, at the end of the second month, the total accumulated will be:
1,010 + 10.1 = $1,020.10
In general, we are simply compounding the principal each month by the designated interest rate. We use Equation 1-2,

F = P(1

+ j)n

In this example, P = $1,000, i = 1%/month, n = 1 year = 12 months.


Substituting,

F = 1,000(1 +.01)12 = $1,126.80


Therefore, we will accumulate $1,126.80 by the end of the one-year period.
Instead of accumulating the interest monthly, if the interest is accumulated at the end of the year, we will receive,

F = 1,000(1 +.12) 1 = $ 1,120.00


The two amounts are not equal. By compounding the interest more frequently, we accumulate more money. We can
define an equivalent yearly rote that will give us the same amount of money as the monthly compounding. For example,
if we assume that our interest rate is 12.68%, and the interest is compounded at the end of each year, at the end of one
year, we will accumulate,

F = 1,000(1 + .01268)1 = $1,126.80


This is exactly the same amount we will receive if the interest is 12% per year, but is compounded monthly.
12.68% in this example, therefore, is the effective interest rate, and 12% is the nominal interest rate.

This brings us to the definitions of nominal and effective interest rates. The nominal interest rate is
the interest rate advertised, typically, on an annual basis. Most of the banks or lending institutions
will use the annual interest rate to advertise the attractiveness of the loan or the interest
accumulated on the principal. The nominal interest rate need not be defined on an annual basis,
although it is the most common method. Nominal interest rate for any period can be calculated
using the following equation,
nominal interest rate per period=

72

nominal annual interest rate


number of periods in one year

E quat ion

Mohan Kelkar, Ph.D., J.D.

For example, if the nominal interest rate per year is 6%, we can calculate the nominal interest rate
per quarter as,

6%

- - - 1.5% per quarter


4
In the example above, 4 in the denominator represents four quarters per year. The nominal interest
rate per month will be calculated as,
6%
2
= -j-1

= 0.5% per month

I
The effective interest rate is the actual interest rate paid based on the number of compounding subperiods as well as any other hidden charges. More often than not, the effective interest rate will be
higher than the nominal interest rate. However, in some cases, the reverse may be true. Consider
that if you pay off a credit card balance as soon as it is accumulated, you pay no interest. That is, the
effective interest rate is zero, whereas the nominal interest rate charged may be higher. The
number of compounding sub-periods (we define them as M) represent the number of times the
interest is compounded within the period for which the nominal interest rate is defined. Note that
the nominal interest rate is equal to the effective interest rate if the number of compounding subperiods is equal to one.

I
I
I
I
I
I
I
I
I

Let us consider the development of the relationship between the nominal and the effective interest
rate. If we define,

j = nominal interest rate per period


M = number of compounding sub-periods
Using Equation 1-14, we can calculate the nominal interest rate per sub-period as,

I
M
If we invest principal P for one period (M sub-periods), we can calculate the future value of the
principal as, using Equation 1-2,

Equation 1-15

F = P (i + j

If we want to define the effective interest rate, i, we need to accumulate the same future value at
this interest rate by compounding it only once during that period. That is,

F = P(1

+ 01

Equation 1-16

Equating Equation 1-15 and Equation 1-16,

1 + = (

Economic Evaluation in the petroleum Industry


Chapter 1 - Economic Principles

i +)M

or
= (1+

Equation 1-17

-1

Equation 1-17 defines the relationship between the effective interest rate per period, i, and the
nominal interest rate per period,]. Note that if compounding sub-periods, M, is equal to one, then,
= (1 + j)1 -

Equation

1-18

Let us consider some examples illustrating the applications of these equations.


Example 1-31
A bank advertises in a newspaper: Invest a minimum of $5,000 today in a CD (certificate of Deposit) account at an
interest rate of 8.5% per year and receive an effective yield of 8.87% per year by compounding the interest daily." Do
you believe that this statement is accurate?
Solution 1-31
Given:

j = 8.5% per year, M = 365 (365 sub-periods in one year)

Find:

Using Equation 1-17,


/ +)365
.085
I = (1
= 8.87%

The effective interest rate is 8.87%. Therefore, the statement is accurate.


Example 1-32
A credit card agreement states, "The finance charge will be calculated on a monthly basis based on the Average Daily
Balance." Further, it states that the finance charge is "135% which is an ANNUAL PERCENTAGE RATE OF 21%." Is this an
accurate statement?
Solution 1-32
The finance charge is calculated on a monthly basis. If we assume that the nominal interest rate per year is 21%, then the
monthly nominal interest rate is, using Equation 1-14,
21
= = 1.75%

Therefore, the statement in the credit card is accurate to the extent that 21% is the nominal annual percentage rate.
However, the interest is compounded monthly; therefore, M is equal to 12. Using Equation 1-17,

= (i +)M

+ 0.21)
= 23.14%

74

Mohon Kelkcxr, Ph.D., J.D.

The effective interest rate is 23.14%, which is much greater than the 21% advertised.
We, therefore, can say that the statement in the agreement is misleading because it does not specify whether the
interest is nominal or effective.

In defining the time value of money, we should use the effective interest rate rather than the
nominal interest rate in our computations. The effective interest rate is the actual interest rate
charged to the principal. In applying any of the equations we learned in the previous section, it
should be remembered that the units for many of the terms should be consistent. The determining
factor in most instances is the periodic payment. The interest rate used in any calculation should be
the effective interest rate per period (period defined based on the periodic payment) and the
number of periods should be defined in a consistent unit as the periodic payment. For example, if
the periodic payment is per month, then the effective interest rate should be per month, and the
number of periods should be in months.
Example 1-33
Able borrows $50,000 for a lending institution for building a house. The lending institution charges 8% per year nominal
interest rate compounded daily. If Able intends to pay the loan back in 10 years, what is his monthly payment?

Solution 1-33
Given:

P = $50,000, j = 8% per year compounded daily, n = 10 years

Find:

A per month

In this example, the payment needs to be calculated per month. Therefore, we need to define the effective interest rate
per month as well as the number of periods in months. Using Equation 1-14,

nominal interest rate per month = -

8%

j-- =

0.6667%

The number of sub-periods per month = 30.4 days/month. Using Equation 1-17,

.006667

304

=( i+ 30.4 )

= .6688% per month


The number of periods - 10 years - 10 x 12 - 120 months. Using Equation 1-9,
F i(1+i)"

A=Pl

[(1

+O -1 j

006688(1 + .006688) 120 1


00 [
+ (1
.006688)
- 1 j
= $607.30

= ]so

The monthly payment will be $607.30.

Example 1-34
A department store advertises on September

1a,

"Buy now and dont make the first payment until January 31 at 0%
31a,
interest. At the bottom of the advertisement, in small print, the advertisement states, After January
the interest
will be charged at 18% annual rate compounded daily."

Economic Evaluation in the Petroleum Industry


Chapter 1 - Economic Principles

75

If you buy a computer for $2,500 on September 1, and pay it off on January
paid?

31st

what effective interest rate have you

281h
You make twelve consecutive monthly
Instead of paying on January 31, you make the first payment on February
payments; how much is your monthly payment? What is the effective interest rate charged to you?

Solution 1-34
Part I:

Payment on January 3l

t
31st
The payment and the
Since the interest charged until January 31 is 0%, the payment will be $2,500 on January
borrowed amount is the same (by purchasing the computer and not paying for it, you are borrowing $2,500 from the
store!), therefore, the effective interest rate is zero.
Part II: Constant monthly payments starting at the end of February
In this case, the interest will not start accumulating until the first day of February. In other words, whether we bought
the computer on January 31st or September 1st, the loan amount will be the same: $2,500. We, therefore, can calculate
the monthly payment on $2,500 using the appropriate monthly effective interest rate. Using Equation 1 14,
-

nominal interest rate per month

18%
= 1.5%
j-=

For daily compounding, M = 30.4 days. Using Equation 1-17,

01S ) m
=(i~-) 1
= .0151% per month
Using Equation 1 9, for n = 12,
-

A =P

i(1 + i)
(1 +i)-1
[.0151(1 + .01S1) 12

= 2500[ (1 +.0151) 12
= $229.21

-,

You will have to make a monthly payment of $229.21 for 12 months to pay off the $2,500 loan.
January 31), you did not pay any interest. After
To calculate the effective rate, note that for five months (September 1
that, over a 12 month period, you paid an interest rate of 1.51% per month. The effective rate should be somewhere
-

between.
If we define the effective interest rate = e per month, we can write that the interest on the $2,500 loan should have
31st
the future value of the loan should be, using Equation 1-2,
accumulated at that rate. Therefore, on January

F = P(1 + O
= 2,500(1 + te) 5
This will be the new principal that should be paid off in twelve months. So, using Equation 1 9, we can write our monthly
payment as,
-

No
76

Mohan Kelkar, Ph.D., J D.


.

No

i(l+i)1

[_
=P (1 + n - 1

A = 2,500(1 + e)

j(1 + ie) 12

[( 1 + je)12 il

We already know that our monthly payment is $229.21. Therefore, we need to find the value of i, so that the right side
of the above equation is equal to $229.21. By trial and error,
for

ie=1% A=$233.40
i,=.85% A$229.50

That is, the effective interest rate is 0.85% per month. This is less than the nominal interest rate.

In some instances, we can simplify our relationship between the nominal and the effective interest
rate if the compounding is continuous. Recall that,

i = (i +)M 1

Equation l-17

represents the relationship between the effective and the nominal interest rate. If M is very large
(continuous compounding), we can write,

= 11m 7n .large (i + j ) m - 1 = e 1

Equation 1-19

-1

where i = the effective interest rate per period and is the nominal interest rate per period. This
equation represents the relationship between the nominal and the effective interest rate for
continuous compounding.
Example 1-35
If the nominal interest rate is 16% per year, calculate the effective interest rate if,
a.
b.

The interest is compounded quarterly.


The interest is compounded monthly.
The interest is compounded daily.
C.
d. The interest is compounded continuously.

Solution 1-35
Given:

j= 16% per year

Find:

i for various compounding periods

Using Equation 1-17,

= (i +)M

a.

Quarterly compounding,
0.16
1=16.98%

Economic Evaluation in the Petroleum Industry


Chapter 1 - Economic Principles

77

b. Monthly compounding,
0.16\12

C.

1=17.23%

Daily compounding,
0.16

365
1=17.35%

d. Continuous compounding, using Equation 1-19,


= e - 1
= e 0 16 - 1 = 17.35%

Notice that the effective interest rate increases as the compounding sub-periods becomes decrease. However, there is
practically no difference between daily compounding and continuous compounding. (The difference is at the third
decimal point). Unless the nominal interest rate is very large (in practice, not very likely), there is no difference between
the daily compounding and continuous compounding.
Case Study 1-6

The Wail Street Journal (Wall Street Journal 2009) reports that during Britains boom, easy credit helped Eduardo lreneo pile
up 1,750 (52,848) in bank debt. When the boom turned to bust in 2007, the banks cut him off and he turned to a loan shark,
an illicit credit source that is gaining popularity.
According to Mr. Ireneos testimony in a recent court case, Mr. Irenco went to a south London loan shark in April 2007,
seeking money to send to family members in the Philippines after his bank refused to lend him any more money. A friend
introduced him to Greg Dc Guzman, a fellow Filipino immigrant to the U.K. who sat him down at his kitchen table and
scribbled an agreement on a sheet emblazoned with his logo - a mouse in a hat next to the words "General Speedy." He
would give Mr. Ireneo 1,500 in exchange for 1,950 to be paid over six months. Mr. lreneo signed the paper but never
received a copy. After making three monthly payments of 325, he called Mr. Dc Guzman in October 2007 to say he was
having difficulty keeping up and wanted to reduce his monthly payment, he told the court. Mr. Dc Guzman agreed, saying Mr.
Irenco could pay 100 a month for an additional 13 months. Mr. lreneo kept paying, and in June 2008 (after 9 payments)
phoned to say lie wanted to pay the remaining balance. But Mr. Dc Guzman told him he still owed
1,950, saying that what he
had paid until then was interest only.
Calculate:
1.
2.

3.

What is the initial effective monthly interest rate Mr. Irenco agreed to pay in April 2007?
After making three payments of 325, Mc lreneo paid 100 for additional nine months. Assuming that the loan
would be retired at that point, what is effective monthly interest rate Mr. lrcneo would have paid?
After making all the payments, if Mr. Dc Guzman believes that Mr. Ireneo still owes him additional 1,950, what is
the monthly effective interest rate he is expecting to charge to Mr. lrcneo?

Case Study Solution 1-6

Initial Agreement
We need to solve the following equation
1,500 = 325

(1 +
i(1

06

-1

+ 06

ihrough trial-and-error, the effective interest rate is 8% per month


Second \crccmcnt
lhis would include three payments of 325 and nine payments of 100. Notice that in the equation below, we consider the fact
that the 100 payments started after three months.

78

Mohan Ke/kor, Ph.D., i.D.

1,500 = 325 [

____
+

i)3

(1

+O -1

+100 i(1 +

012

Using a trial and error, the effective interest rate i 5% per month.

Third irccicit
\Xe need to solve the following equation.
[(1 + ) 3
1,500=325l
[

i(1+i)3

11
J

+1001 1(1 +

i) 9

i(1+i)12

11
1,950
I
j+(1+.)12

Through trial-and-error, the effective interest rate is 14% per month.


Problem 1-32
If you invest $1,000 in a five year band paying 8.5% interest annually, how much will you get back after five years?
Problem 1-33
If $5,000 is invested in a bank today followed by $3,000 after three years, how much money will be accumulated at the
end of six years if the interest rate is 6%?
Problem 1-34
To receive $2,000 three years from now, how much should you invest in the bank at a rate of 7%?
Problem 1-35
You need to have $7,500 seven years from today. If you currently have $5,000, at what rate should you invest to receive
the needed amount?
Problem 1-36
Able has invested $2, 000 in the bank at a rate of 6%. If Able needs $4,500 after five years, how much money does he need
to save and deposit after three years to receive the needed amount?
Problem 1-37
If you want to double your investment at an interest rate of 10%, how long will it take?
Problem 1-38
If you invest $1,000 today at an interest rate of 8%, how long will it take before the amount becomes $1,500?
Problem 1-39
Betty purchased 50 shores of stock at a price of $30 each. After five years, she sold the stock, after deducting the
commission, at a price of $65 each. What was the interest rate Betty earned on her investment?
Problem 1-40
If you need $5,000 five years from now, how much in yearly deposits should you make at an interest rote of 5%?
Problem 1-41
How much money will be accumulated in the bank if $1,000 is deposited each year for ten years at on interest rote of 8%?
Economic Evaluation in the Petroleum Industry
Chapter 1 - Economic Principles

Problem 1-42
Able invested $5,000 per year in a bank for three years at an interest rate of 6% At the end of three years the interest
rate changed from 6% to 8%. If Able continues to invest the money for another six years, how much money is
accumulated at the end of that period?
Problem 143

If a Betty invests $2,000 per year in an IRA (Individual Retirement Account) and, at the end of 30 years, receives $250,000
in cash, what annual interest rate did Betty receive?
Problem 1-44
Baker wants to buy an expensive piano that costs $20,000.
long will it take before he can purchase the piano?

If he invests $3,000 per year at on interest rate of 7%, how

Problem 1-45
After investing $1,000 per year for the first five years, a person decided to invest $2,000 per year for the next five years. If
the interest rate is 8%, how much money will be accumulated at the end often years?
Problem 1-46
To buy a house, Able took a loon

of $50,000 at an interest rate of 12% for a period of 15 years. What will be the yearly

payment?
Problem 1-47
A car dealer advertises a down payment of $250 with a monthly payment of $250 for five years (60 months) for a new
car. If the interest rate charged is 1% per month, what is the price of the car?
Problem 1-48

If you have $100,000 and would like to invest it so that you will receive $25,000 per year over the next ten years, at what
interest rate should the money be invested?
Problem 1-49
A magazine provides two subscription options. You can pay $250 now for a five-year subscription, or you can make an
annual payment of $65 at the end of each year for the next five years. If you can invest the money at an interest rote of
10%forfive years, which option should you choose?
Problem 1-50
When buying a car for $10,000, Baker agreed to pay a yearly payment
off the loon?

of $2,000. At an interest rate of 8%, how long will

it take to pay

Problem 1-51
A TV worth $500 is purchased on a monthly installment plan. After making a cash payment of $50, what will be the
monthly installment if the interest rote is 1% per month and the loon is to be paid off in one year?

80

Mahan Kelkar, Ph.D., J.D.

Problem 1-52
Carson purchases a stereo from a distributor. The stereo is worth $2,000. The distributor asks Carson not to make a
payment for the first 12 months. If Carson will have to make twelve equal payments during the second year to pay off the
stereo what will be the payment? Assume the interest rate to be 1% per month and the interest is accumulated during
the first year when no payment is mode.

MWOM
Dawn buys a new boat for $20,000. With a 20% down payment, she is going to pay for the boot with monthly payments
over a five year period. The interest rote is 0.8% per month. After making payments for 2 years (24 payments), Able offers
Down $11,500 for the boot. If Down can pay off the remaining loan balance without penalty, will she make a profit by
selling the boot? If so, how much?
Hint: Calculate the remaining principal balance at the end of 2 years based an the remaining payments.
Problem 1-54
A person invests $3,000 in 0401K mutualfund account in the first year followed by a 5% increase per year over the next
thirty years. If on overage yield on the mutual fund account is 11%, how much money will she collect at the end of thirty
years?
Problem 1-55
You are interested in saving money for your daughters education. After twelve years, when your daughter turns 18, the
college tuition plus other expenses are expected to be $100,000 in the first year, rising at an 8% rate during each of the
remaining three years. If you can invest a fixed sum per year over the next twelve years at an interest rote of 8%, how
much money should you be investing to cover your daughters college costs?
Problem 1-56
Concerned about medicol insurance costs, you wont to purchase a life insurance policy that will cover the medical
insurance costs of your family in case of your death. The current family medical insurance is $500 per year and is
expected to rise at a rote of 13% per year. If you wont to pay for the next twenty years of medical insurance and the life
insurance money con be safely invested at a rate of 6.8%, how much life insurance should you purchase?
Problem 1-57
An oilfield is currently producing at a rate of 100,000 bbls per year. The net revenue received from the field is $111bbl.
The field is expected to decline at a rate of 10% per year over the next eight years before becoming uneconomical. If the
revenues earned are invested at a rote of 8%, how much money will the oil company have at the end of eight years?
Problem 1-58
If a Betty invests $2,000 per year with on 8% increase during each subsequent year for the next ten years at an interest
rate of 6%, how much will she accumulate? How much of a fixed sum of money will she have to invest per year over the
next ten years to receive the some future sum? How will the fixed sum of money per year change if the interest rate is 8%
instead of 6%?
Problem 1-59
A gas field is currently producing 1.2 BCE per year. The net revenue earned from the field is $0.61MSCF. The field is
expected to decline at a rate of 12% over the next eight years before production will cease. If the interest rote is 15%, how
much will you be willing to pay to buy this gas field?

Economic Evaluation in the Petroleum Industry


Chapter 1 - Economic Principles

81

Problem 1-60
Four years from now, Carson would like to buy a nice diamond ring for $10,000 for his wife for their 25th wedding
anniversary. He can save $2,000 this year with a 5% increase per year over the next three years What is the minimum
interest rote he needs to earn to have $10,000 at the end of four years?
Problem 1-61
Able has $200,000 to invest at the age of 65. He wants to earn $20,000 at the end of the first year followed by a 4%
increase in each year to account for inflation over the next 20 years. What is the minimum interest rate Able is required
to earn on his investment?
Problem 1-62
If the effective interest rate is 20% and the money is compounded continuously, what is the nominal interest rate?

If a loan company charges you $10 per month for every $100 you borrow, what is the nominal yearly interest rate? What
is the effective interest rate per year?

A petroleum engineer wants to buy a house. If she can afford to pay $10,000 as a down payment and can afford to pay
$1,000 as a monthly payment at a 12% interest rate compounded monthly for a 30-year period, what is the maximum
price of house she can afford?
Problem 1-65
A small company wants to borrow $100,000 from the bank. The bank charges a 12% nominal interest rate, compounded
monthly, and 2% of the loan as a loan origination fee to be paid in cash. What is the effective interest rate? Assume the
loan is paid over a five-year period. Calculate the part of the payments that go toward the principal and interest for the
first and the last payments.

If you invest $100 per month over a five-year period, how much money will be accumulated at the end of the five years if
-

the nominal interest rate is 8% compounded continuously?


Problem 1-67

If you require $30,000 per year for living expenses for the next twenty years, how much should you invest today? Assume
that the interest earned would be 9% to be compounded continuously.
Problem 1-68
A credit card company offers an instant credit scheme. if you withdraw money on the credit card, the company will
charge you a minimum $5 processing charge if the withdrawal is less than $200, and charge 2.5% of your total
withdrawal if the withdrawal is greater than $200. in addition, the company will charge a 19% interest rote, compounded
daily, on payment of the cash withdrawal plus any charges.
If you withdraw $100 and pay it over a three-month period, what is the monthly payment? What is the effective
interest rate?
If you withdraw $1,000 and pay it over a twelve-month period, what is the monthly payment? What is the
effective interest rate?

82

Mohan Kelkor, Ph.D., J.D.

Problem 1-69
A new credit card advertises a low annual interest rate of 12% to be compounded continuously. The card charges an
annual membership of $100. If you wish to purchase a sofa worth $2,000 to be paid over a one-year period, what will be
your monthly payment? What will be the effective interest rate on the payment? If another credit card offers an 18%
annual interest rate compounded monthly with no membership fee, would you prefer this credit card over the previous
one? Why?

WORKS CITED
Brush, R. M., and S. S. Marsden. Journal of Petroleum Technology, February 1982: 433-439.
Campbell, J. M. et al. Analysis and Management of Petroleum Investments: Risk, Taxes and Time. Norman,
Oklahoma: CPS Publishing Company, 1987.
Chang, et al. Successful Field Pilot of In-Depth Colloidal Dispersion Gel (CDG) Technology in Daqing Oil Field." SPE
Improved Oil Recovery Symposium. Tulsa: Society of Petroleum Engineers, 2004.
Chesapeake Energy. Investor Presentation. Chesapeake Energy. July 2011. www.chk.com .
Davis, L. F. Journal of Petroleum Technology, May 1968: 467-474.
DeGarmo, E. P., W. G. Sullivan, and J.A. Bontadelli. Engineering Economy. 9th Edition. New York, New York:
MacMillan Publishing Company, 1993.
Devon Energy. Summary Annual Report. 2009. www.dvn.com .
EOG. Investor Presentation. EOG Resources. June 2011. www.E0GResources.com .
Ikoku, C. U. Economic Analysis and Investment Decisions. New York, New York: John Wiley, 1985.
Newman, D. G. Engineering Economic Analysis. San Jose, California: Engineering Press, 1991.
-. Engineering Economic Analysis. San Jose, California: Engineering Press, 1991.
Park, C. S. Contemporary Engineering Economics. Reading, Massachusetts: Addison-Wesley Publishing Company,
1993.
Society of Petroleum Engineers. Guidelines for Application of the Petroleum Resources Management System. 2011.
www.spe.org .
-. Petroleum Resources Management System. 2007. www.spe.org .
Steiner, H. M. Engineering Economic Principles. New York, New York: McGraw-Hill, 1992.
Stermole, F. J., and J. M. Stermole. Economic Evaluation and Investment Decision Methods. Golden, Colorado:
Investment Evaluation Corporation, 1986.
Wall Street Journal. September 1, 2009.

Economic Evaluation in the Petroleum Industry


Chapter 1 - Economic Principles

83

R
-VMZ 1

In this chapter, we will discuss a variety of methods used for evaluating the economic feasibility of
petroleum projects. The foundation for these methods was laid in Chapter 1 - Economic Principles when
we discussed the importance of the time value of money and its impact on cash flow. In this chapter, we
will formalize those concepts through various methods and illustrate the application of these methods
by numerous examples.
As discussed in Chapter 1, in decision making, we typically encounter two types of projects; those where
we have to make a decision among mutually exclusive alternatives, and those where we have to make a
decision about selecting the appropriate independent projects.
In this chapter we will concentrate on the selection of an alternative among mutually exclusive
alternatives. We will only cursorily examine independent projects.
In simple terms, mutually exclusive alternatives are exclusive of each other. By selecting one alternative,
we will automatically eliminate the other alternatives. In the petroleum industry, in many instances you
will deal with projects where only one alternative will be selected after evaluating several alternatives.
For example,
Selection of a contractor to conduct a 3-D seismic survey for an exploration venture.
Selection of a drilling contractor to drill a well.
Selection of a service company to conduct log surveys.
Selection of a pumping unit to improve production.
Evaluation of an infill drilling option to increase production.
Selection of a compressor to increase the gas production.
In all of these, we can select only one of the alternatives being considered. Once a particular alternative
is selected, the other alternatives are automatically eliminated from further consideration.
Throughout this chapter, we will use a minimum rate of return (MROR) to evaluate the attractiveness of
various alternatives. The choice of MROR is very critical in evaluating the alternatives. In simple terms,
the MROR is the minimum rate required by a corporation or an individual to make the project attractive.
For example, if you borrow money from a bank at an interest rate of 10% per year to invest in a drilling
venture, the MROR is 10%. This is because, if the project does not yield at least a 10% return on the
investment, you will be a net loser. If the project earns a 15% return, then after paying 10% interest to
the bank, you make money. If the project only earns a 5% return, you will have to pay out of your own
pocket to cover the interest payment to the bank. If the project earns 10%, then there is no net gain or
loss. Therefore, 10% becomes the minimum acceptable rate.
tl

MROR is sometimes called the cost of capital. The computation of the cost of capital for a corporation is
much more complex than the previous example due to the varied sources of capital. The discussion
about MROR calculation is beyond the scope of this book. We will assume that this information is
provided to us. Any alternative that does not satisfy the MROR criteria will be automatically rejected.

Economic Evaluation in the Petroleum Industry


Chapter 2 - Economic Methods

Ideally, when evaluating mutually exclusive alternatives, we prefer the economic criterion possess the
following characteristics:
It should be suitable for ranking various alternatives.
It should reflect the cost of capital.
It should incorporate uncertainties in our assumptions.
It should reflect the goals and objectives of the corporation.
In practice, no single criterion will be able to satisfy these characteristics. Sometimes, multiple criteria
may be appropriate. We will defer the discussion related to uncertainties to Chapter 4. Regarding the
fourth bullet, we will assume that our goal will always be to minimize cost or to maximize profit or
benefit. We will not consider other objectives in our analysis.
Many economic criteria are available in the literature. We will only concentrate on the ones which are
most commonly used. These include present value (PV) analysis and its cousin, annual value (AV)
analysis, rate of return (ROR) method and profit to investment (PIR) ratio. We have already discussed
payback period and PIR. The only difference in this chapter is that we will consider the impact of time
value of money on PIR. 1
L)

frff

Ji4.L

PRESENT VALUE ANALYSIS


Present value (PV) or worth analysis evaluates projects based on the financial position of various
alternatives at the present time. This technique accounts for the time value of money and provides a
way of comparing various alternatives with the same frame of reference. If the project has a fixed
output, the objective should be to minimize the present worth of costs. As discussed in the previous
chapter, if the project has a fixed input, the objective should be to maximize the present worth of
benefits and, if the project has neither fixed input nor output, the objective should be to maximize the
difference between the present worth of benefits and present worth of costs. Let us illustrate these
three alternatives through various examples.
Example 2-1
A company is considering two alternatives to satisfy its photocopying requirements. The cost of each machine is shown below:

Initial cost
Annual Cost

(a)

(b)

$10,000
$1,000

$8,000
$1,400

The annual cost includes the replacement and maintenance costs. If both machines have a life of five years and the minimum
rate of return (MROR) is 10%, which project should be selected?

Solution 2-1
Both alternatives will perform the same functions, i.e., they offer the same output. Therefore, our objective should be to
minimize the cost.
For alternative (a),

PV

= $10,000 + $1,000

1(1 +
[.1(1~1) 5 ]

= $13,791

Mohan Kelkar, Ph.D., J D.


.

For alternative (b),

PV,,),, = $8,000 + $1,400

= $13,307

Comparing the present worth costs of the two alternatives, alternative (b) should be selected.

Example 2-2
A proposal calls for an investment of $100,000 in drilling a new well. It is expected that the production will generate revenue
of $30,000 per year for six years. At the end of six years, the production equipment can be sold for $10,000. Another proposal
requires a $100,000 investment. It will generate $50,000 in the first year followed by 8% decline in each year. The life of the
project will be six years. There is no salvage (remaining) value associated with the proposal. If the minimum rate of return is
12%, which project should be selected?
Solution 2-2
We have a fixed amount of investment. Our objective should be to maximize our output or to maximize the present value of
benefits received after the fixed investment.
For the first proposal,

PVbene fl

(1 +.12) 6 - 1
10,000
= 30,000 .12(1 + .12)6 + (1 + .12)6 $128,408

For the second proposal,


50,000

(1 -.08)6

PVbenefl = (.12 + .08) 1 - (1 + .12)6 = $173,200


Comparing the PVb ene fits for both proposals, the second proposal should be selected.

Example 2-3
A company is considering two alternative computer models to satisfy its computer needs. Due to their differing powers, the
benefits received by both the computers are different. Based on the work projections, the company thinks that either of the
computers can be used to their fullest potential. If the minimum rate of return is 10%, which computer should the company
select?
Initial Cost
Annual Benefit
Life, Years
Salvage Value

(a)

(b)

$4,500
$1,500
5
$600

$3,200
$1,000
5
$300

Solution 2-3
The salvage value indicates the price received if the computer is sold after five years. Since neither the costs, nor the benefits
are fixed, we need to select an alternative that maximizes the difference between the benefits and costs. We can define the
difference as,
NPV = PVh,fit - PV 0

Equation 2-1

where NPV is the net present value of the alternative.


For alternative (a),

Economic Evaluation in the Petroleum Industry


Chapter 2 - Economic Methods

NPV=$1,500I

[(1. + .i) - lj
600
+ (1 + .1) 4,500 = $1,559
.1(1 + .1)

For alternative (b),


[(1. + .i) - lj
300
[.1(1 + .1)
+ (1 + .1)

NPV = $1,000 I

3,200 = $777

Based on the comparison of the two alternatives, (a) should be selected.


(se .Study 2-1
You work for JLF Production Company as a production engineer and are responsible for 16 gas wells in western Oklahoma.
Currently the wells are on plunger lift and are managed by a pumper on a daily basis. They have an expected life of three years at
which time the wells will be abandoned. The average daily production for the past month for each well is 136 MSCF.
Autoplunger, Inc. has approached you with a method of remotely monitoring the wells. The automation device consists of a special
flow meter that is able to connect to an Autoplunger, Inc. server remotely using a cellular phone. The data can then be monitored by
you using the internet.
Autoplunger claims that the systcm can reduce down time associated with well problems and, therefore, prevent lost production due
to down time. From previous wells production history, they claim that by installing the system they can increase production initially
by 10% over the base and it will decline at 11% per month. The base decline is 10% per mouth. The installation of the flow meter
and transmitter equipment costs $3,000 per well for the first 4 wells and $1,000 for each additional well thereafter and the monthly
maintenance fee is $80 per month per well. Currently you pay the pumper $125 per well per month to monitor the wells- If the
automation system is installed the pumper will no longer be needed on a daily basis, but he will be needed as problems occur. lie
requires a $25 fee per visit. It is expected that initially the required visits will be 0.5 per well per month, but will increase
exponentially to 2 visits per well per month at the end of the wells life, that is in month 0 there will be 0.5 visits required and in
month 36 there will be 2 visits required.
Perform an economic analysis using a MROR of 1 5%/year over the life of the wells to determine the minimum number of
automation units to install for gas prices of S1.50/mcf, S2.50/mtf and $3.00/mef. We need to make the project viable. Assume that
the initial (year 0) average monthly production is last months average production and the production decline is 10%/month.
Consider the problem starting with 4 installations and go up to 16 using an increment of four.
case Swdr Solution 24

Many variations exist in this case study. We will show the detailed calculations for one scenario and then summarize the other
scenarios in the table following these calculations.
Scenario: 16 wells with ps price of SI .50/MSCF
Total Cost of Equipment = 3,000 x 4 + 1,000 x 12 = $24,000
(1 + 0.0125)36 - 1
Cost of Maintenance = 80 x 16 x
. 0125(1 + 0.0125)361 = $36,924
[0
To calculate the visiting Ice, we realize that the number of visits Start at 0.5 per month and reach 2 visits per month at the end of 36
months period. Therefore, we can calculate the rate at which the visits arc increasing by knowing that.
2 = 0.5(1 + rate)36
Solving for the rate, the visits are increasing at a rate of 3.9% per month.
Cost of Visits =

25 x 0.5 x 16 [
(1+0.03
9)36
1
0.0125 - 0.039 - (1 + 0.0125)3 6

$11,583

lhc current cost for using the pumper is:

Mohan Kelkar, Ph.D., J.D.

to

(1+0.0125) 36 - 1
Current Cost of pumpers = 125 x 16 x 00125>< (1 + 0.0125)361 = $56,694
These costs will bc saved
lherefore, the net increase in present costs = 24,000+36,924+11,58356,694$14,813
As a result of autoplunger, the production will improve by I0 0/s from the original value but it will decline at a higher rate compared
to the previous case- Production revenue can he explained by geometric gradient. Therefore, net present value of benefits is given
by:
PV Benefits

136x30.4x 16x 1.50x(1+0.1)


(0.0125 + 0.11)
1 - (1 + 0.0125)
NPV = PVbenetts - PV rosi

136x30.4x16x1.50[
1-0.1 36
(0.0125 + 0.1)
[ - (125)

$13,121

= 13,121 - 14,813 = -$1,692

This means that the project is not feasible under these conditions. We have done similar calculations for other scenarios in the
following tables.
Gas Price = $1.50 per MSCF
Wells Equip.
4$
8$
12 S
16 $

Cost Monthly
12,000 S
16,000 $
20,000 S
24,000 S

Fee Visiting
9,231 S
18,462 S
27,693 $
36,925 S

Fee Pumper Costs


PV Costs PV Benefit NPV
2,896 S
14,424 $
9,703 S
3,280 S (6,423)
5,792 S
28,847 $ 11,407 S
6,561 S (4,846)
8,687 S
43,271 $ 13,110 S
9,841 S (3,269)
11,583 S
57,695 S 14,813 S
13,121 S (1,692)

Gas Price = $2.00 per MSCF


Wells Equip.
4S
8S
12 S
16 S

Cost Monthly
12,000 S
16,000 S
20,000 S
24,000 5

Fee Visiting
9,231 S
18,462 S
27,693 S
36,925 S

Fee Pumper Costs


PV
2,896 $
14,424 S
5,792 S
28,847 S
8,687 S
43,271 S
11,583 S
57,695 S

Costs PV Benefit NPV


9,703 S
4,374 S (5,330)
11,407 5
8,747 S (2,659)
13,110 S
13,121 S
ii
14,813 S
17,495 S
2,682

Gas Price = $2.50 per MSCF

Wells Equip.
4 S
8S
12 S
16 $

Cost Monthly
12,000 S
16,000 S
20,000 S
24,000 S

Fee Visiting
9,231 $
18,462 S
27,693 $
36,925 S

Fee Pumper Costs


PV Costs PV Benefit NPV
2,896 $
14,424 S
9,703 S
5,467 S (4,236)
5,792 S
28,847 S
11,407 S
10,934 S
(472)
8,687 S
43,271 S 13,110 $
16,401 $
3,291
11,583 S
57.695 S 14,813 $
21,868 S
7,055

Fxamining these numbers, we can see that for a gas price of S1.50/MSCF, the project is not feasible under any scenario. For the gas
Price of $2.00/$ISCF, the project breaks even if we adapt it for 12 wells and for gas price of S2.50/MS( -F, the project is profitable if
we adapt it for at least 12 wells.
Case Study 2-2
Adapted from: http://ww\vbpcom/genericarrielc.dQc43cgnild=201

2968&contcnt1ri7046356)

lit) America acquired approximately 90,000 net acres of leasehold and producing properties in the Woodford shale in ( )khihoinas
Arkoma basin from Chesapeake Fncrgy Corporation. BP paid $1.75 billion dollars for this acquisition. The current gross production
from the area is approxiniatclv 50 lMSCF/day. lie relevant information about Woodford Shale is provided below:

Economic Evaluation in the Petroleum Industry


Chapter 2-Economic Methods

Statistical Data about Woodford Shale

Gas in Place/640 acre


Recovery Factor
Initial Production (MMSCFD)
Average Well Cost (Drill, Complete, and Facilities)
Typical Well Spacing
Royalty Interest
No. of days to complete and begin well production

40 to 120 BCF
SO%
3 to 6
$6 to $8 million
80 acres
25%
90 days

A. Assuming S6,000/MSCFID to $10,000/MSCFD, how much did BP America pay for the right to drill the wells? Assume that
only 80,000 net acres are available for drilling.
B. Using 80 acre spacing and assuming that only 80,000 net acres are available for drilling (other parts are already drilled), using
the average well cost range, what is the possible range of field and development (F& D) cost?
C. Assuming that for a project of this kind to be feasible, the cost of in place reserves has to be less than $3/MSCl, do you think
that BP America made a good deal? Note that BP America has only access to new reserves from 80,000 acres.
D. A typical production profile from the best and the worst well in Woodford Shale is available. The profiles are provided below:

Year

Worst

2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18

1,095
383
249
212
191
172
154
139
125
113
101
91
82
74
66
60
54
48

Best
(MMSCF/Year)

2,190
767
498
423
381
343
309
278
250
225
203
182
164
148
133
120
108
97

Using these production profiles, calculate the N1V at 15% (assume monthly compounding) using the worst of the scenario and
the best of the scenario. Note that for the worst case, you should consider everything (e.g, drilling costs) to be the worst.
Assume the range of gas price to be S6/MSCF to S9/MSCF held constant. Assume that the operating costs per mouth per well
to be In the range of 54,000 to $6,000. Do not forget to subtract royalty interest in your calculations.
E. Assume that the NPV you have calculated per well represents the present value of that well at the time the well was started to
drill. BP America believes that it will secure 10 to 20 drilling rigs to initiate the development of the field. If we assume that 10
drilling rigs are running, then we will be able to complete 40 wells per year assuming a 90 day period for beginning production
for each well. Again, consider the worst and the best case scenarios based on renting 10 to 20 drilling rigs. Using the NIV
values from the previous section, calculate the NIT for the whole project using a 15 0/s MROR (continuous compounding. For
this part, remember that you will accumulate 10 to 20 wells NPV every 3 mouths until all the wells are drilled.
F. Based on your evaluation, is this a good deal for LIP? Why?
(7

\.

,cc

.olution 2-2

\mount paid per acre for right to drill wells


We can examine both a pessimistic and an optimistic case to determine the amount paid for the right to drill. To achieve this,
first we need to calculate how much lIly paid fur the existing production.
Net Production = 50 MMSCFD x 0.75 = 37.5 MMSCID

Mohan Kelkar, Ph.D., J. D.

This is based on 25/s royalty interest. Depending on the amount paid for existing production, BP paid between 37,500 x
S6,000/MSCFD -. $225 million and 37,500 x 510,000/1NTSC D = $375 million.
The balance will be paid for the right to drill at undrilled locations within 80,000 net acres. Since the total amount paid is 1,750
million dollars, the balance will be between $1,375 million and $1525 million. Dividing that amount by 80,000 acres, BP paid
between $17,188 and $19,063 per acre for the right to drill the wells.
B.

F and D Costs
Assuming 80 acre spacing, the amount of gas in place is between 5 to 15 BCF per well. Assuming 50% recovery of the gas, the
amount of gas that can be recovered per well is between 2.5 and 7.5 13CR Knowing the cost of drilling and completion is
between 6 and 8 million dollars per well, we can calculate F & U costs.
Pessimistic F&D Costs =

Optimistic F&D Costs=

8 x 10 6 + 19,063 x 80 $5.08
2.5 <
< 0.75
= MSCF
6 x 106 x 17,188 x 80
= $1.31/MSCF
75 > 10 6 0.75

C.

Is it a good deal?
Under the optimistic scenario for F & 1) costs, it is a good deal; whereas, under the pessimistic scenario it is a bad deal. The
average of the t-wo (assuming equal likelihood) is S3.19/MSCF. This number is slightly greater than 53/MSCF; therefore, the
project is marginal.

D.

NPV of Individual well


The effective interest rate is -e 0

- 1 = 16.2%

Using the production data, the following table shows yearly revenues for the worst case and best ease scenarios. In calculating,
we assumed that, in the worst ease scenario, we had the highest cost of drilling and production as well as operations and the
worst production and lower price. For the best case scenario, we assume the smallest cost of drilling and completion and
operations, and the best production profile and the best price scenario. Using the net revenue at the end of each year, we
calculated the NPV for each scenario.

Year

Worst Case Scenario


Prod Revenue Op Costs Net Rev
MMSCF (MM $)

0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18

1095
383
249
212
191
172
154
139
125
113
101
91
82
74
66
60
54
48

-8.00
5.75
2.01
1.31
1.11
1.00
0.90
081
0.73
0.66
0.59
0.53
0.48
0.43
0.39
0.35
0.32
0.28
0.25

(MM $)

0.072
0.072
0.072
0.072
0.072
0.072
0.072
0.072
0.072
0.072
0.072
0.072
0.072
0.072
0.072
0.072
0.072
0.072

NPV = 1.51 MM $

S
S
S
S
S

Year

(MM $)

-8.00
5.68
1.94
124
1.04
0.93
0.83
0.74
0.66
0.58
0.52
046
0.41
0.36
0.32
0.27
0.24
0.21
018

0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18

Best Case Scenario


Prod Revenue Op Costs Net Rev
MMSCF (MM $) (MM $) (MM $)
-6.00
6.00
2190
14.78
0.048
14.73
767
5.18
0.048
5.13
498
3.36
0.048
3.31
423
2.86
0.048
2.81
381
2.57
0.048
232
343
2.32
0.048
2.27
309
2.09
0.048
2.04
278
1.88
0.048
1.83
250
1.69
0.048
1.64
225
1.52
0.048
1.47
203
1.37
0.048
1.32
182
123
0.048
1.18
164
1.11
0.048
1.06
148
1.00
0.048
0.95
133
0.90
0.048
085
120
0.81
0.048
076
108
0.73
0.048
0.68
97
0.65
0.048
0.61

NPV = 19.24 MM $

I nilur both the scenarios, the NPV is positiveEconomic Evaluation in the Petroleum Industry
Chapter 2 - Economic Methods

V. NPV of the Overall Pro j ect


In this calculation, we assume that we paid the upfront costs for leasing, and then, at the end of every 3 months, we started
collecting revenue based on the NOV of all the wells drilled. As a worst case scenario, we will start collecting $15.1 million at
the end of ever, 3 months. This is based on an assumption of 10 wells in each period (1.51 MM a 10). We will need to drill a
total of 80,000/80 - 1,000 wells. That is, it will be 100 periods of 10 wells each before all the wells are drilled. For the best
case, we will drill 20 wells in each period. It will take only 50 periods before all the wells are drilled. Each pet id is 3 monthsThe interest rate per period is 15/4 = 3.75%. Since the interest is compounded continuously, the effective interest rate per
period is = e 00375 1 = 3.82%/period.
NPV under the worst case scenario
= 1,525 + 15.1

(1 + 0.0382)100 - 1
0.0382 x (1 + 0.0382)100 = 1,139

million

NPV under the best case scenario


= 1,375 + 384.8

(1 + 0.0382) - 1
million
0.0382 x (1 + 0.0382) = 7,153

F. Is this a good investment?


Depending on which scenario is selected, the project can have positive or negative NPV. Knowing the uncertainties in these
calculations, we can examine the average of the two and find that the average value is 3,007 million. This is clearly a viable
project based on the assumptions we made.
It 15 worth remembering that, in addition to the uncertainties we considered, we should realize that there are other uncertainties
present in this project that we did not consider. Examples of these uncertainties include:
Drilling and completion efficiencies: BP may be able to improve the drilling and completion techniques over time
resulting in better completion at smaller cost and over a smaller period. This will allow to them to drill and complete the
wells over a shorter period using a smaller amount of money.
The rules and regulations of fracturing and completing wells can change over time making it difficult to dispose of
produced water and emit produced gas. This can increase the cost of drilling and completion.
The surplus gas from the shale play can depress the gas prices making it less attractive from a revenue perspective.
The actual spacing can become smaller based on the evaluation of the wells. This can result in higher recovery of gas as
well as more revenue over time.
Problem 2-1
A company is considering the following two alternatives for installing a compressor. The annual benefits
depend upon the horse-power.

Initial Investment
Annual Benefit
Life, Years
Salvage Value

$30,000
$8,000
10
$5,000

$70,000
$20,000
10
$10,000

of the compressor

Which alternative would you select lithe MROR is 12%? Use present worth analysis.

Problem 2-2
An oil company is considering building an off shore pipeline. Depending upon the pipeline, the cost
installation varies. Which of the three alternatives should the company choose?
B
A
C
Installation Cost
Annual Cost
Life, Years

$30
2
20

$20
4.5
20

of maintenance and the

$25
3
20

The numbers are in millions. Assume the MROR to be 10% and the salvage value to be zero.

Mohan Kelkar, Ph.D., J.D.

0
0
Problem 2-3
A prospect is expected to fetch $100,000 from oil revenues per year over the next eight years. The annual operating costs ore
estimated to be $10,000. The salvage value can be assumed to be zero. If the MROR is 15%, what is the maximum price you
are willing to pay for this property?

Problem 2-4
An oil company paid a consultant $10,000 to analyze various alternatives with respect to a producing property. Based on the
analysis, the consultant suggested the following scenarios. Which one should be selected?
Alternative
Do Nothing
5 In-Fill Wells
10 In-Fill Wells

Investment

Annual Benefit

Salvage Value

$0
200,000
400,000

$20,000

$10,000
25,000
40,000

60,000
100,000

If the MROR is 15%, which option should the company select? Assume the life of the project to be six years
Problem 2-5
A periodical having a cover price of $5.50 per magazine, published monthly, advertises 020% discount
subscribed on a yearly basis and a 30% discount off the cover price if subscribed for a two-year period.

off the cover price if

Assuming that you buy the magazine every month, which option is best? Assume the minimum rate of return to be 8%.
92POTTO"
"M.
Three alternatives are considered for installing a pipeline. The initial cost is less for a smaller diameter pipe; however, due to a
higher pressure drop, the pumping cost is higher for the some pipe. The costs are shown below:
Pipe Size/Inches

Cost Per BBL of Pumping

Construction Cost

2
3
4

$.031bbl
$.0251bbl
$.021bbl

$30,000
$50,000
$75,000

We can assume the useful life of the pipe to be 12 years with no salvage value. Assume also that the flow rate per year is
constant. Calculate the range of flow rates for which different pipe sizes will be the most beneficial. Assume the minimum rote
of return to be 10%.
Problem 2-7

of $427,000. The estimated annual benefits are $120,000 and the


estimated annual casts are $30,000. The costs are decreasing at a rate of $2,500 per year. If the life of the investment is 8
years, and the MROR is 15%, should the money be invested? Assume the salvage value to be zero.

An investment proposal calls for an initial investment

Problem 2-8
Consider the following four alternatives for a project. Calculate the NPV for each project. Which ones are acceptable if the
MROFI is 12%?
Period

Alternative 1

Alternative 2

Alternative 3

Alternative 4

0
I
2
3

-4,000
10,800
28,800
14,400

0
-4,500
1,500
3,000

4,000
-16,000
4,000
8,000

-6,000
-1,500
22,500
19 500
,

Economic Evaluation in the Petroleum Industry


Chapter 2

Economic Methods

Two producing properties are considered for a potential investment of $100,000. The first property will generate net revenue
of $3,000 in the first month with a 10% decline per year. The property is expected to be sold for $30,000 after S years. The
second property will generate revenue of $6,000 in the first month with an operating cost of $1,000. The revenues are
expected to decline at a rate of 15% per year and the operating costs are expected to increase at a rate of 5% per year. The
property can be disposed of at the remaining value of the property. Using five years as a basis, which property should be
purchased?

David and his wife decide to set a sum of money each year such that they can withdraw $30,000 per year perpetually after
retirement. If the interest rate is 10%, and they start saving money each year for 20 years before retirement, how much money
do they need to save every year?
Hint:

First calculate the PV of periodic payment received in perpetuity.

Problem 2-I1
Betty bought a producing property at a price of $190,000. The revenue received in the first year is $90,000 declining at 6% per
year. The operating costs are fixed at $15,000 per year. If after 5 years of operation. Carson offers Betty $85,000 for the
property, should Betty sell it? Assume the MROR to be 14%.

ANNUAL VALUE ANALYSIS


The difference between the present value analysis and the annual value (AV) analysis is that in the case
of PV analysis we compare the alternatives based on present value, whereas in the case of AV analysis,
we compare the alternatives based on the annual value. All the problems that can be solved by AV
analysis can be solved by PV analysis. However, AV analysis does possess certain advantages; the biggest
advantage being it is easier to explain to someone not familiar with economic analysis principles than
the PV analysis.
Specifically, some instances in which AV analysis is useful are (Park 1993) (Steiner 1992):
Financial Reporting: Most corporations report to their shareholders the companys performance
on an annual basis. It is much easier to present the annual cost or benefit of a project than the
net present value.
Cost/Unit Calculation: In comparing alternatives, it is easier to illustrate the benefit of one
method over the other by showing that a particular method costs less to produce one unit than
the other.
Example 2-4
Two alternatives are being considered for leasing a copier machine. The costs associated with both machines are given below:
Cost
Installation
Annual Maintenance
Life, Years
Salvage Value

Alternative I

vl
Alternative II

$2,000

$1,500

$800
5

$900

Which is the better alternative? Assume that the operating cost to make one copy is the same for both machines. The MROR =
10%.

10

Mohan Kelkar, Ph.D., J.D.

Solution 2-4
We can solve this example using PV analysis; however, it is more convenient to compare the annual costs associated with
each machine. The installation cost or the initial cost is called the capital cost. The annual equivalent of capital cost is called
capital recovery cost.
Alternative I
Using the equation,
i(1

+O

A=P (1+i)-1
capital recovery cost,A 2,000 [(

l+ .15 - 1

= $527
total annual cost = 800 + 527 = $1,327
.

Alternative II
1
capital recovery cost = 1,500

[(1 + .1),-

ij

= $395

Total annual cost = 900 + 395 = $1,295


Based on the annual costs, Alternative II is superior.
If we use present value analysis,
Alternative I

(PV)0

1(1
= 2,000 + 800 - 11 +
= $5,033

Alternative II

(PV) 0 . = 1,500 + 900 (1


10.1( 1 + 0.1) 11
= $4,911

I Since Alternative II has smaller costs than Alternative I, the second alternative should be selected.
Exom pIe 2-5
Two submersible pumps are being evaluated for an oil well. Both have the same capacity to produce liquid. The costs are
shown below:

Installation
Maintenance Per Year
Operating Costs (Utilities) Per Barrel

Pump I

Pump If

$15,000

$20,000

$5,000
$0.04

$6,000
$0.03

The well is expected to produce 2,000 barrels of fluid per day with a water oil ratio of 95. Which pump should be purchased?

Economic Evaluation in the Petroleum Industry


Chapter 2 - Economic Methods

11

Assume the life of both pumps to be 10 years. MROR = 15%.


Solution 2-5
In this example, it is much more illustrative to compare the cost of lifting one barrel of fluid using both the methods.
Total production per year,
= 2,000 x 365 = 730,000 bbls
Pump I
annual costs = capital recovery cost + maintenance costs + operating costs
(1 +.15)b0(. 152
= 15,000 (1 + .15)10 - 1 + 5,000 + 730,000 x 0.04
= $37,189
cost/bbl = 730,000
37,189 = $0.05 1/bbl

Pump II

annual costs = 20,000 [(1 + .15)10 - 1 j + 6,000 + 730,000 x 0.03


= $31,885
= $0.044/bbl
cost/bbl = 31,885
730,000
The cost per barrel of lifting is less for Pump II than Pump I. Therefore, Pump II should be selected. As stated before, this
comparison.
comparison is much more illustrative than the (PV) c
,, , t,

O.sscStudv2-3

As a new petroleum engineer working for Stetson Petroleum Corporation, you are in charge of evaluating the newly installed rodpump controllers (RPCs) which replaced the time clock in its East Linden field in East Texas. Fifteen wells are currently producing
from the field. The wells are about 10,000 ft. deep, producing 42 to 46 API gravity oil, with an average water cut of 30%.
In the past, Stetson had always relied on contract pumpers. Timers were utilized for intermittent operation and, unfortunately, the
pumpers could not evaluate the cyclical status of the wells during the single visit every 24 hours. lbev had to set the timer manually
based on a series of trial-and-error adjustments. During the trial-and-error period, sometimes some of the wells would pound the
fluid fora considerable period of time resulting in damage to the rod and pump. Another problem was wider-pumping the wells.
The pump efficiency at this depth was considerably impacted due to rod stretch. On certain wells, the times were set for as low as 3
hours per day. During the wells idle time, gas would break out of the fluid in the tubing and extra pump time would be required to
return the liquid level in the tubing to surface where production could be "put in the tank." lhis extra pump-up time was not
consistent and, combined with decreased pump efficiency due to pump wear over time, resulted in additional complication while
trying to estimate the time required to produce the well efficiently with a time clock.

l\vo years ago, Stetson hired eProduction (eP) Solutions to install RPCs. Ihe version installed in the held is shown in Case Study
Figure 2-1. Ihe installation cost for RPC for the whole field was $25,000. In addition, el charged S1.99 per well per day

12

Mohan Kelkor, Ph.D., J. D.

maintenance costs. These controllers were supposed to eliminate a lot of guessing. Rather than using trial-and-error for adjusting the
time clocks, RPC immediately shut down the pump and adjusted the idle time based on buffered data in the controller from past
Cycle times .
The to \car survey revealed that rod failure frequency and tubing repairs were reduced by installing RP(
In addition to reducing
the rod repair costs another savings -was elimination of the belts burn offs The belts would burn off the electric motor when the
well had a shallow rod part The RPC shut the well down on a low load limit which resulted in saving the belts For over two years
about 6 Per year repairs were eliminated savirigabout S3,500 per repair,
A major cost of production for Stetson was lifting cost. The average production from the well is 30 barrels of oil per day in addition
to water production. The cost per barrel of lifting was about $1.0/bbl of liquid production. By optimizing the well performance
using RFCs, the cost of lifting was reduced by about 30 0/s.
Using this information over the last two years and assuming that this will last for about 5 years total, do the following evaluations.
Assume the costs and saving on a monthly basis. The MROR is 15% per year compounded monthly.
a)

Using annual value (AV) analysis, calculate the monthly savings. Flow much are the savings per barrel of oil produced?

b)

In reality, the oil production rate is not constant. Instead, the initial rate of oil was 30 barrels per day. However, it is declining at
a rate of 10/0 per month. What would be the current monthly savings and saving per barrel of oil produced?

e) Stetson also operates the extension of Fast Linden field containing approximately the same number of wells and similar
production profiles. The only exception is that the rod pumps are better optimized in the extension of the field. Based on
talking to the field supervisor, you conclude that the rod repair savings will be three per year with an average saving of about
S2,700 per repair. In addition, the reduction in the lifting cost will be about 20% instead of 30%. All the other factors are
assumed to be same as in part (a). Will you recommend installation of RPC in the extension of the field?
Case Study Solution 2-3

A.

Constant oil production at 30 hhl/day


The initial cost is S25,000. We can convert it to capital recovery cost per month. The interest rate is 15% per year or 1.25% per
month.
0.0125 x 1.0125 60
capital recovery costs = 25,000(1.012560 - 1) j =
monthly maintenance costs = 1.99 x 30.4 x 15 = $907
3,500 x 6
rod pump savings per month =
= $1,750
12
30
electrical savings per month = (1 - 0 3) X 30.4 x 1 x 15 x 0.3 = $5,863
net savings per month = 5,863 + 1,750 - 907 595 = $6,111
6,111
net savings per barrel = 30
< 30.4 = $0.45/barrel

>s

This is a positive value and, hence, economically feasible project.


B.

Oil production dcclming 1 /o per month


In this case, we can calculate equivalent oil production per month by comparing geometric gradient series with constant
payment series.

F=A eq

(1+i)-1 =
(t g)

__[(1+i)n(1+gyi]

Comparing the future values for both constant payment and geometric gradient series, we can calculate a value of A which will
provide us svith the same future value as geometric gradient series. tJsing this equation, we can calculate equivalent oil
production per niuiiih.
30x30.4

0.0125

Aeq = (0.0125 + 0.01) (1.01250 - 0.9960) (1.012560 - 1) = 714 bbl/month


Economic Evaluation in the Petroleum Industry
Chapter 2- Economic Methods

13

All the other costs will remain the same except the electric savings costs:
714
electrical savings per month = (1 - 0,3) x 1 x 15 x 0.3 = $4,589
net savings per month = 4,589 + 1,750 - 907 - 595 = $4,837
4,837
net savings per barrel= 1----j- = $0.45/barrel
It is still an economically feasible project The reason that savings per barrel is the same as case (a) is because electrical savings
dominate the savings in our analysis. Since it is based on per barrel, savings do not change when calculated on a per barrel
basis.
C. Extension of East Linden Field
All the other costs and savings would remain the same except the following two items
2,700x3
= $675
12
30
electrical savings per month = - 0 3)
30.4 x 1 x 15 x 0.2 = $3,909

rod pump savings per month=

net savings per month = 3,909 + 675 - 907 - 595 = $3,081


3 081
net savings per barrel = 30 15 < 30.4 = $0.23/barrel
,

The savings are reduced by half compared to the previous case, but it is still an economically feasible project.
Problem 2-12
A company is considering two options for using a computer. It can buy o computer for $15,000 and use itforfive years with a
salvage value of $3,000, or it can lease the computer for an annual cost of $4,200. If the MROR is 12%, which is the better
option? Use the annual value method.
Problem 2-13
An oil company is considering buying a compressor at a cost of $60,000. The maintenance cost per year is estimated to be
$3,000. As a result of the compressor, on incremental production in the first month is estimated to be 30 MSCFD declining at a
rate of 10% per year. The operating cost is estimated to be $0.2 0/MSCF of gas. If the price of the gas is $2. 0/MSCF, should be
compressor be bought? What is the cost of producing the incremental gas per MSCF? Assume the life of the compressor to be
10 years and the MROR to be 12%. The salvage value is zero.
Problem 2-14
Able has the option of using either his car and claiming the cost on a mileage basis or to use a company owned car. He
purchased a new car at a cost of $15,000. He is expected to drive approximately 13,000 miles per year for business related
travel. The car, based on the personal mile and business miles estimate, will depreciate at orate of 25% per year.
The cost of scheduled maintenance per year is $150. The cost of registration is $100 per year. Other non-scheduled repairs and
maintenance will cost $50 in the first year increasing at a rate of $20 per year. The car is expected to give an average of 25
miles per gallon. Assume the gas price to be $1.00 per gallon. The parking and toll costs per year are $125. If the car is kept for
5 years, should Able claim the mileage cost? The mileage costs are $0.301mile. Assume the MROR to be 10%. The salvage value
at the end of 5 years is the un-depreciated value.
Problem 2-15
An oil company is considering two alternatives for routine core analysis. The cost of the machine is $100,000 and the annual
maintenance cost is $8,000. The cost of labor is $30,000 per year. The cost of supplies is $2.00 per core analyzed. The allocated
space will cost approximately $250 per month. If an outside lab charges $25 per care for routine analysis, how many cores
does the company need to analyze in-house so that it will make no difference whether the cores are analyzed using outside

14

Mohan Kelkar, Ph.D., J.D.

I
0

services or an in-house facility. The life of the equipment is 15 years with a salvage value of zero. The MROR is 8%.
Problem 2-16
An independent oil producer wants to buy well testing equipment to test individual wells. The cost of the equipment is $30,000
with a maintenance cost per year of $4,000. The life of the equipment is 7 years. An outside service using the same equipment
costs $2,500 per well test. The service also includes analysis of the well. If the data are analyzed in-house, the cost is an
additional $200 per well. If the producer estimates that it will conduct 15 well tests per year, should it buy the equipment?
Assume the salvage value to be zero. The MROR is 15%.

to
14

Problem 2-17
A cable company manufactures a particular type of cable for supporting tools in a well. It currently produces 20,000 units of
cable per year. The costs if produced in house, are:
Direct Materials
Direct Labor
Variable Overhead (Power)
Fixed Overhead (Light, Space)

I
I

$120,000
360,000
270,000
140,000

It is anticipated that the production will last for at least 5 years. The cost of material is expected to rise at a rate of 5% per
year, the direct labor is expected to increase at a rate of 6% per year, and the variable costs will rise at a rate of 3% per year.
The fixed overhead will remain fixed at the present level. Another cable company offers to sell the some cable at a rote of $50
per unit. If this offer is accepted, the space used currently can be used for manufacturing other types
of cable saving the
company $70,000 per year. In addition, the variable costs will be reduced by $10 per unit. If the MROR is 15%, should the cable
be manufactured in-house or outside?

RATE OF RETURN ANALYSIS


The rate of return analysis is probably the most popular criterion in economic analysis. Its popularity
stems from the ease with which a common person can understand the meaning of rate of return. Most
investment brochures will use rate of return on your investment as a criterion to show how good a given
investment opportunity is. It is much easier to understand that a project will provide a 20% return on
your investment" than "the project will result in a NPV of $5,000." Unfortunately, although simple to
understand, the technique has some major drawbacks. In this section, in addition to explaining how to
calculate the rate of return (ROR), we will discuss the advantages and disadvantages of this technique
(Park 1993) (Steiner 1992).
Rate of return has two definitions. One definition can be stated as "the interest rate earned on the
unpaid balance of a loan such that the payment schedule makes the unpaid balance equal to zero when
the final payment is made." Consider a simple example to illustrate this definition. Assume that you take
a loan of $1,000 from a bank at an interest rate of 10% for a period of four years. Every year, including
last year, you pay an interest of $100 to the bank. At the end of four years, you pay the principal amount
of $1,000. Therefore, at the end of four years the unpaid balance is zero. The rate of return for the bank
is (1,000/100=) 10%. Schematically, the cash flow is shown in Figure 2-1.

Economic Evaluation in the Petroleum Industry


Chapter 2 - Economic Methods

15

This definition can be turned around to state that the "rate of return is the interest rate earned on the
unrecovered investment such that the payment schedule makes the unrecovered investment equal to
zero at the end of the life of the investment. Using a similar example as before, let us assume that you
have invested $10,000 in the bank at an interest rate of 6% for five years. At the end of each year, you
withdraw $600 in interest and at the end of five years, you withdraw $10,000. The investment in the
bank at the end of five years is, therefore, zero. You can consider that the rate of return on the
investment is (600/10,000=) 6%. Schematically, the cash flow profile is shown in Figure 2-2.

Figure 2-2: Investment of .10,000 with a uniform receipt of interest


Mathematically, the rate of return (ROR) is defined as the rate at which net present worth (NPV) for a
given investment is equal to zero. In equation form, the rate at which,
"costs

"b enefit s=

Equation 2-2

is the rate of return.


In other words, the rate at which:

16

Mohan Kelkar, Ph.D., J.D.

Equation 2-3

NPV = 0

If we assume that the cash flow for a particular project is given by Aj where A1 represents the cash flow
in yearj, we can write the equation for NPV as,

A1
NPV A

O+(l + ) + ( l

A2
A
+ .) 2 ++(l + .)n

A
= J (1+0 1

iu.i4IflPr

If we define the rate R corresponding to the rate at which NPV is zero, we can write the equation for i
as,

A0

(1i)

A2
=0
+ (i+ i)2 + + (i+.)"

Equation 2-5

Observing Equation 2-5, we notice that the equation represents a polynomial in R which may result in n
possible solutions for tR which will satisfy Equation 2-5. In economic analysis, we are only interested in
real solutions. Although negative rate of return is a real value, we may not be interested in an
investment of negative rate of return. As a practical matter, we are searching for positive, real solutions
of this equation. In most instances, we will obtain only one positive, real solution which represents the
rate of return. This is shown in the following examples.
Example 2-6
Calculate the rate of return for the following cash flow.
Year

Cash Flow

-4,000

2,500

1,800

1,300

900

Solution 2-6
Using the cash flows, we can write the equation for NPV as,
2,500

NPV = 4,000 + (1 + .) + (

1,800
1,300
900
i)3 + (
1 + ) 2 + (1 +
1+ 0

Since this is a polynomial equation in i, we will have to solve it by trial-and-error,


i=15%
= 35%

NPV=904
NPV = 361

Since the value of NPV changes a sign between i = 15% and i = 35%, the rate of return should fall in between the two values. By
linear interpolation, we can write an approximate equation for the rate of return (ROR) as,

ROR i, + (

f ""
t - t+) tNPV-NPVJ

quatiot1 2-6

Where i and L respectively represent the trial values which resulted in positive and negative NPV values, and NPV+ and
-NPV_ represent the positive and the negative NPV values respectively. In our example,

Economic Evaluation in the Petroleum Industry


Chapter 2- Economic Methods

17

NPV = 904 NPV_ =

361
= 15% L = 35%

Therefore,
r 904
15 + (35-15) 904
+ 3611
29.3%

ROR

We can calculate the NPV at 29.3%.

NPV =

66.5

Although close to zero, we can try one more interpolation between 15% and 29.3%.
904

ROR

15 + (29.3 - 15) [904

+ 66.51

28.3%
NPV at233.% = 10.2

i_, the
We assume this value to be close enough to zero. You may note that the higher the difference between the i and
bigger the deviation between the true ROR and the interpolated value. Therefore, the interpolation may have to be carried out
- more than once to obtain a correct value of the ROR.

Example 2-7
By investing $10,000 in a project, you are promised that you will earn $2,700 per year for a period of six years. What is the ROR
for this investment?

Solution 2-7
Using Equation 2-2,

PVcosts - PV eneits = 0

That is,
[(1 + 06 - 11
10,000-2,7001
i(1-I-i)
j

For i=10%,
F(1
11
10,000 + 2700[01(1 + 0.1)6] = 1,759

For i=20%,
[(1 + 0.2)6 - 11
10,000 + 2700[o2(1
+0.2) 61

1,021

Using Equation 2-6,

r
ROR

10 + (20 10)

1,759

1,021 - 1,759]

For 16.3%, NPV = -129

18

Mohan Kelkar, Ph.D., lU

Doing interpolation one more time,


1,759

ROR 10 + (

16.3 - 10) [1,759 + 1291

15.8%
At
= 15.8%

NPV = 1.7 0

Therefore, the rate of return is 15.8%.

The examples above show that the ROR calculation has to be done by trial-and-error. With the advent of
software programs, this problem can be easily solved by using standard functions available in
spreadsheet programs. One easy way to guess the initial value of ROR is by knowing that if the initial
investment is equal to the salvage value, the ROR can be calculated as,

ROR =

periodic payment

Equation 2-7

initial investment

Using Equation 2-7, if the salvage value is less than the initial investment,

ROR <

periodic payment

Equation 2-8

initial investment

On the other hand, if the salvage value is greater than the initial investment,

ROR >

periodic payment

Equation 2-9

initial investment

Equations 2-7 through 2-9 are applicable only if the investment is made at the beginning of the project
and the periodic payments are equal to each other.
Example 2-8
As an investment, you bought a house for $50,000. If you can rent the house for $800 per month, and can sell the house for
$70,000 at the end often years, what is the ROR on your investment?

Solution 2-8
In this problem, using Equation 2-9, the salvage value ($70,000) is greater than the initial cost ($50,000). Therefore,
800
ROR>

50,000

= 0.016/month

Let us assume the ROR to be .017/month. Using Equation 2-2,


PVcosts - P17 115 = 0

70,000
50,000-800 1(1 + .017)120_lI (1
= $93 0
017(1 + .017)120 - + .017 ) 120
where 120 is the number of months in which the rent is collected. Therefore, the ROR is 1.7%/month, or 20.4%/year

Economic Evaluation in the Petroleum Industry


Chapter 2 - Economic Methods

19

As shown in the example above, by using the correct initial guess, we did not have to use too many trialand-error methods to find a solution. A similar equation can be developed for geometric series as
explained in the example below.
Example 2-9
A proposal calls for an investment of $25,000 in an oil property that will result in an initial income of $6,000 per year declining
at a rate of 8% per year over the next twenty years. What is the rate of return? Assume the salvage value to be zero.

In this example we have a geometric series.


Given:

A= $6,000, n= 20 years, g= -0.08

Using the equation for geometric series,

NPV=

A
(ig)

f1+1
9\
1 l----1 1-25,000= 0
\1+ tJ j

For a geometric series with negativeg, with long life, as a rule, the initial guess of ROR can be used as equal to,
initial guess =

first periodic payment


initial investment

Equation 2-10

+g

In this problem,

initial guess = 6,000- 0.08 = 0.16


25,000
Using the initial guess,
6,000 [
1NPV=(16+08)[1_(l+16) j_25000=$242
After one additional trial-and-error, the ROR = 15.7%.

As stated before, the ROR technique is probably the most used technique in economic analysis. It is easy
to understand. Since everyone understands the interest rate, rate of return is equated to return on
investment in terms of an interest rate that would be earned. Intuitively, when comparing two
investments, one fetching a higher ROR is always more attractive.
In a corporate structure, to evaluate the feasibility of a project, we need to compare the ROR to the
minimum rate of return (MROR). If the ROR>MROR, the project is selected; if the ROR<MROR, the
project will be rejected.
Example 2-10
An oil property is on sale for a value of $100,000. It was observed that the property will result in an annual net income of
$30,000 in the first year followed by a decline of 10% per year. If the property will have to be abandoned after 10 years with a
salvage value of $10,000, should property be purchased if the MROR is 20%?

Solution 2-18
A= $30,000 with a decline of 10% (p = -0.1), initial investment = $100,000, salvage value = $10,000,

n= 10 years

20

Mohan Kelkar, PhD., J.D.

Using the expression for geometric gradient series,

NPV=

30,000 1 - (1+0) n}
Ii
100,000=
(ig)[

1+i

10,000
(1+i)

Using Equation 2-10, we can start with an initial guess of

30,000

=0.1 = 0.2

For,
= 0.2 NPV = 4,016
= 0.15 NPV = 12,129
By linear interpolation,
12,129
= 0.15 + (.2 + .15) (12,129 + 4,016)
ROR = 0.1875
Assuming that the ROB is correct, it is compared with the MROR. Since 18.75% < 20%, the project should be

The procedure is slightly more involved when two alternatives are being considered. In addition to
comparing the ROR to the MROR for individual alternatives, we also have to carry out an incremental
analysis. This procedure is illustrated in the following example.

The following two alternatives are considered for a project,

Initial Investment
Annual Benefit
Life, Years
Salvage Value

(a)

(b)

$50,000
$25,000
5
$50,000

$500,000
$125,000
5
$500,000

If the MROR is 20%, which alternative should be selected?


Solution 2-11
The first step is to estimate the ROR of the individual alternatives and compare the ROR with the MROR. If the ROB is less than
the MROR, the alternative(s) should be rejected.
In this example, since the salvage value is equal to the initial investment, using Equation 2-7,
25,000
= 50%
RORa =S0,000
125,000
RORb
= 25%
= 500,000
Since the ROR ( > MROR and ROR 1, > MROR, both alternatives satisfy the feasibility criterion.
Intuitively, since ROR 1 > R0R 5 , one may be inclined to select (a) over (b), but notice that the initial investment for both
alternatives is not the same One of the drawbacks of the ROB analysis isits inability to account for the investment amount. In

Economic Evaluation in the Petroleum Industry


Chapter 2 - Economic Methods

21

$500,000 to
considering the two alternatives with a different investment amount, our implicit assumption is that we have
invest; otherwise, we would not consider alternative (b). Therefore, if we choose alternative (a), we have to assume that the
remaining $450,000 will have to be invested at MROR. To properly account for the investment, we need to conduct
incremental analysis. That is, to find out by investing an additional (incremental) $450,000 in alternative (b), what incremental
benefits are received? Subtracting values related to alternative (a) from alternative (b), we obtain,

(b)-(a)
$450,000
$100,000

Investment
Annual Benefit
Life, years
Salvage Value

5
$450,000

For incremental investment, we can calculate the ROR by Equation

AROR b_ a =

2-7 (since investment = salvage value),

100,000
450,000 =

22.2%

This number indicates that the ROR on incremental investment is 22.2% that is greater than the MROR. In other words, by
investing an additional $450,000, we will earn a ROR of 22.2%. On the other hand, if we do not invest an additional $450,000 in
alternative (b), we will earn only MROR on that additional amount. Therefore, it is more attractive to invest the additional
$450,000 in alternative (b). That is, to select alternative (b) over (a).
This analysis can be easily confirmed by calculating the NPV for both the alternatives at MROR.
For alternative (a),

(NPV) a =

25,000

[(1

+ .2)

11

50,000
-

50,000

500,000

+ (1 +.2)

.2(1 + .2)

= $44,859
For alternative (b),

(NPV)b =

125,000

[(1 +.2) 5
[

.2(1+.2)5

11,

50,000
(1

+ .2)1

= $74,765
Since (NPV)b > (NPV)
incremental analysis.

a,

alternative (b) should be chosen. This is consistent with the answer we obtained from the

To generalize, if two alternatives requiring different amounts of investment need to be compared, we


should carry out an incremental analysis. If AROR>MROR, we should select an alternative requiring a
larger investment. If tROR:~ MROR, we should select an alternative requiring a smaller investment.
The procedure can be easily extended when considering more than two alternatives. Briefly, the
stepwise procedure for incremental analysis can be stated as:
a.

Calculate the ROR for each alternative. If ROR>MROR, assume that the alternative is feasible and
retain it for further incremental analysis. If the ROR<MROR, remove tle alternative from further
analysis.

b.

Take two alternatives requiring the smallest investments. Calculate the ROR on the incremental
investment by subtracting the smaller investment from the larger investment. We denote the
ROR on incremental analysis as LXROR. If AROR~!MROR, select the alternative requiring the

22

Mohan Kelkcir, Ph.D., J D.


.

larger investment; if AROR<MROR, select the alternative requiring the smaller investment.
Remove the rejected alternative from further analysis.
c.

Take the remaining alternative and compare it with the alternative requiring the next largest
investment. Calculate the incremental ROR. If AROR ~: MROR, select the alternative requiring the
larger investment; if LROR<MROR, select the alternative requiring the smaller investment.
Remove the rejected alternative from further analysis.

Repeat step (c) until only one alternative remains.


Example 2-12
The following three alternatives are considered for a project. If MROR is 15%, select the appropriate alternative.

Initial Investment
Annual Benefit
Life, Years
Salvage Value

p
0
p
p

(a)

(b)

(c)

$1,000
$300
10
$1,000

$3,000
$1,000
10

$6,000
$1,800
10

$3,000

$6,000

Solution 2-12
Using Equation 2 7,
-

ROR a =
ROR b =
ROR C =

300
1,000
1,000

3,000
1,800
6,000

= 30%
= 33.33%
= 30%

Since ROR for all of the alternatives is greater than the MROR, all are feasible. In step (b) take the two alternatives requiring the
smallest investments.
In this example, we will consider alternatives (a) and (b) for incremental analysis,
(b)-(a)
Investment

$2,000

Annual Benefit
Life, Years
Salvage Value

$700
10
$2,000

Therefore,

1\ROR ba =

700
2,000

= 35%

Since ARORb_ a > MROR, select (b) over (a). Eliminate alternative (a) from further analysis.
In the next step (step c), compare (b) with the remaining alternative (c). For incremental analysis,
(c)-(b)

I
I
I
I
I
I
I

Investment
Annual Benefit
Life, years
Salvage Value

$3,000
$800
10
$3,000

Economic Evaluation in the Petroleum Industry


Chapter 2- Economic Methods

23

Therefore,

LIROR C _ b =

800
000 = 26.67%
3, -

Since AROR C _b > MROR, select (c) over (b). After eliminating (b), we are left with only alternative (c). This will be our choice.

To summarize the economic criterion applied for the rate of return analysis for a single project: if the
ROR>MROR, the project is selected; if the ROR<MROR, the project is rejected. For a project having
multiple alternatives, an incremental analysis needs to be conducted so long as there is a difference in
the cash flow profiles of two projects. Only after applying the incremental analysis is the solution
consistent with the NPV analysis.
In addition to the requirement of incremental analysis, the ROR analysis method has another drawback.
This method works well when a given alternative requires an initial investment that is followed by future
benefits. For this type of alternative, the cash flow profile can be shown as negative cash flow in the first
year followed by positive cash flow in future years. For example, if we consider an investment of $1,000
that will result in a $300 annual benefit for the next six years with a $500 salvage value at the end of six
years, the cash profile can be written as,

Year

Cash Flow

-1,000
300
300
300
300
300
300+500

1
2
3
4
5
6

In this profile, there is only one sign change in cash profile between years 0 and 1. Such a profile is
amenable to conventional ROR analysis.
Note that the ROR calculation requires solving a polynomial of i. We calculate the value of i for which
the NPV is zero. For economic analysis, we are only interested in obtaining positive, real values of i for
which the NPV is equal to zero. When there is only one sign change in the cash flow profile, as shown
above, we can only obtain one or zero positive solutions.
In some instances, however, the sign changes more than once in a cash flow profile. Under these
circumstances, we may obtain more than one real ROR. The rule of signs for polynomial solution states
that the number of real solutions between -1 and Oo is never greater than the number of sign changes.
That is, if we have two sign changes, we may obtain a maximum of two rates of return values between 100% and oo. In practice, a typical cash profile includes initial investment followed by positive cash flow.
Since this type of cash flow has only one sign change, only one rational value of ROR can be obtained.
However, there are practical situations where it is possible to obtain multiple solutions. Under those
conditions, the ROR technique is not very useful.

24

Mohan Kelkar, PhD., J. D,

Example 2-13
An in-fill drilling project is being considered for an existing oil field to accelerate oil recovery. The following two scenarios,
based on two alternatives (no in-fill drilling versus in-fill drilling) are predicted. Which alternative would you select?

Year

Alternative A
(no drilling)

Alternative B
(in-fill drilling)

0
1
2
3
4
5
6

0
30
20
18
14
10
6

-20
60
40
6
4
2
0

The numbers are in millions. Assume that MROR is 20%.

Solution 2-13
The first step in ROR analysis is to compare individual RORs for each alternative with the MROR. For alternative A, there is no
sign change in the cash flow profile. Therefore, the ROR for alternative A is . For alternative B, ROR can be shown to be
greater than 20% (the ROR for alternative B is 260%). Therefore, both alternatives satisfy the requirement that the ROR be
greater than the MROR.
The next step is to conduct the incremental analysis. The cash flow profile for incremental values can be written as,
Year

B-A

0
1
2
3
4
5
6

-20
30
20
-12
-10
-8
-6

The cash flow profile shows more than one sign change. This indicates the possibility of more than one positive ROR solution.
NPV for any interest rate can be calculated as,

30

20

12

10

NPV= _ 20+ (l+) + (l+)2(l


_ + .) a(l
_ + .) 4(l + ) s(l
_ + )6
Example Figure 2-1 shows a plot of NPV as a function oft,

Economic Evaluation in the Petroleum Industry


Chapter 2 - Economic Methods

25

$3

$2
U)

> $0
EL

0.3

0.6 0.7 08

($3)

Example Figure 2-1: Plot of NPV vs. ifor Example 2-13


As stated before, the ROB is the rate at which the NPV is equal to zero. Based on Example Figure 2-1, two L\ RORs are possible;
11% and 72%. If we assume /X ROR to be 11%, then alternative A (the alternative requiring a smaller investment) should be
selected (i ROR<MROR). If we assume A ROR to be 72%, then alternative B (an alternative requiring a larger investment)
should be selected (\ ROR>MROR). Obviously, our answer changes depending upon the selected value of L ROR. When faced
with this issue, ROR cannot resolve the correct answer. We have to use NPV analysis to come up with a correct answer. As
Example Figure 2-1 shows, the NPV value at 20% MROR is positive. This means that drilling wells is a better option than not
drilling since the NIPV represents the difference of the two.
One easy way to confirm this analysis is to calculate the NIPV at the MROR (=20%) for incremental cash flow,

NP iT 02 + (1

30
20
+.2) + (1 +.2)2

10
(1+.2)4

12
(1+.2)3

8
6
(1+.2)s (1+.2)6

= 1.9
Since NPV is positive, alternative B should be selected. This is the same answer predicted in the previous paragraph.

Case Study 2-4

Cimarex is one of the major operators in the Woodford play in Oklahoma. Cimarcx has net 94,000 acres in western Oklahoma for
which they paid an average of $700 per acre for the leasing fee. The infrastructure is excellent and with better fracturing and
completion technology, Cimarex has improved the performance of the well significantly. The map of well locations is shown below.

Eiornt

.,
,,a

a,

* a.

a,

a
*1

n.
*

*
4,

a,
a,

s,,,

jc

26

Mohan Kelkar, Ph.D., J.D.

All the wells drilled are horizontal, typically on 160 acre spacing, and are about 4,300 feet long with multistage fracturing. Fhcre is a
potential for 80 acre spacing in the future which will increase the production significantly. The cost of drilling and completing a
typical wcll is about S7.2 million.
Cimarex has approximately 50% Net Revenue Interest (34R1) in each well (after subtracting royalty costs). The operating costs are
assumed to be about 85,000 per month for first year followed by about $s,OOO per month for the rest of the life of the well. In
addition to producing gas, the wells typically also produce some condensate. Although the condensate rate varies widely, about 20
SFB/MMSCF is a good approximation.
A typical rate profile ofawell is shown below.

Year
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30

Gp, MMSCF
1,046,0
6147
471.1
393
3423
306.1
2787
257.1
239.5
224.8
218.2
205.1
192.8
181.2
170.4
160.1
150.5
141.5
133
125
117.5
110.5
103.8
97.6
91.8
86.2
81.1
76.2
71.6
67.3

Assume, as a baseline, the price of gas to be S5/MSCF and the price of oil to be S70/bbl. We have arbitrarily cut off the production
after 30 years, but it is possible that, based on the economic cut-off, the well can produce for 60 years. Assume that, starting after 30
years, yearly production reduces by 5.8% every year until one reaches 60 years.
A.

Assuming the life of the well to be 30 vs. 60 years, what is the EUR expected from this well? how much of a percentage increase
will you get by assuming 60 years of life?
B. Assuming 30 vs. 60 years, what is the field and development cost per MSCIi? Do not forget to include the leasing costs as part
of the initial investment. Is there a big difference between the two? iiow much difference will it make if we assume 160 acre vs.
80 acre spacing?
C. What is the RfR for 30 vs. 60 years of life? Assume 160 acre spacing. Assume the MR(.)R for Cimarex is 10%.
D According to the \ice President of Cimacx, Field and Development Cost per MSCP is one of the most worthless pieces of
information an investor can get. She ROR is much more valuable information according to him. Do you agree with his
statement? Why or why not?
Ii. Keeping the oil price flat at $70/hhl, if we assume that price of gas is 53/1\ISCEi, would the well still remain economical based on
R( )R analysis? Use 30 year life only.
E,\twhat price of gas, the ROR would exceed 100%_1 Do you believe that this price of gas is reasonable or iicliieval,le? Use 30
year life only.

Economic Evaluation in the Petroleum Industry


Chapter - Economic Methods

27

Case Study 5Iution 24


1. EUR and F & 1) Costs

To calculate F & D Costs, we first need to determine EUR for 30 years production and 60 years production. Since the well
produces condensate, we also will need to convert STB into 5CC by using I SIB z 6 MSCF.
By summing the total gas production over thirty years, we obtain 6,755 MMSCF of cumulative production. Using 20
bbl/MMSCU, we can calculate equivalent gas production as

6,755xZOX6
=1,000

= 811 MMSCF. I hcrefore, net equivalent production

is 0.8 (6,755 + 811) = 6,052 MMSCF. We can calculate F & D Costs as:

700 x 160 + 7.2 x


=
6,052 x 10

106

$1.21/MSCF

If the spacing is 80 acre spacing instead of 160 acre spacing, the only cost that would change in the above equation is leasing
costs. It would be 700 x 80 instead of 700 x 160, The F & 1) Costs for 80 acre spacing would he 51.20/MSCF.
If the production continues for more than sixty years, based on a 5.85s decline every year beyond 30 years, we can calculate the
production profile for the remaining thirty years as follows. Starting at 30 years, we multiplied production from the previous year
by 0.942 to get the result.
Year

.
.

..

..

31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53

54
55
56
57
58
59
60

Gp, MMSCF

63.4
59.7
56.3
53.0
49.9
47.0
44.3
41.7
39.3
37.0
34.9
32.9
31.0
29.2
27.5
25.9
24.4
23.0
21.6
20.4
19.2
18.1
17.0
16.0
15.1
14.2
13.4
12.6
11.9
11.2

Additional production for the remaining thirty years is 1,020 MMSCF gas ciiuivalcnt assuming the same condensate ratio. The
net production is 0.8( 7 ,565 I,020) = 6,868 i\IMSCI. Therefore, F & 1) Costs based on sixty years production For 160 acre
spacing is:

700 x 160 + 7.2 x 10 6


= $1.061MSCF
6,868x103

By assuming I\tinstead of thirty years, we reduced the I & I) Costs by about 14%. The FUR has changed from 6,052
MMSCI to 6,868 1 \1S( 1. I Ins represents 14% increase In the I UR value based on 60 years production compared to 30 years

28

Mohan Kelkar, Ph.D., J.D.

production.

5
0
5
S

2.

Rate of Return Calculations


The following table is constructed based on 30 years production. The net revenue is calculated for both the gas price of
S5/SISCP as wdll as S3/MSCE The net revenue is determined by assuming S70/bbl of condensate, and 0.8 NR1. We subtracted
the operating costs from the gross revenue to calculate the net revenue.

Gas

Price

$5/MSCF

$3/MSCF

Net Revenue

Net Revenue

0
Year

. . . .
.

$
e

O
5

Gp, MMSCF

STB

Op Costs

. .
.

$
S
5
S.
5
S..
5
S.

(7,312,000)

(7,312,000

1,046.00

20,920

60,000

5,295,520

3,621,920

614.7

12,294

36,000

3,111,264

2,127,744

471.1

9,422

36,000

2,376,032

1,622,272

393

7,860

36,000

1,976,160

1,347,360

342.3

6,846

36,000

1,716,576

1,168,896

306.1

6,122

36,000

1,521,232

1,041,472

278.7

5,574

36,000

1,390,944

945,024

257.1

5,142

36,000

1,280,352

868,992

239.5

4,790

36,000

1,190,240

807,040

10

224.8

4,496

36,000

1,114,976

755,296

11

218.2

4,364

36,000

1,081,184

732,064

12

205.1

4,102

36,000

1,014,112

685,952

13

192.8

3,856

36,000

951,136

642,656

14

181.2

3,624

36,000

891,744

601,824

15

170.4

3,408

36,000

836.448

563,808

16

160,1

3,202

36,000

7 83,712

527,552

17

1503

3,310

36,000

734,560

493,760

18

141.5

2,830

36,000

688,480

462,080

19

133

2,660

36,000

644,960

432,160

20

125

2,500

36,000

604,000

404,000

21

117.5

2,350

36,000

565,600

377,600

22

110.5

2,210

36,000

529,760

352,960

23

103.8

2,076

36,000

395.456

329,376

24

97.6

1,952

36,000

462,712

307,552

25

91.8

1,836

36,000

434,016

287,136

26

86.2

1,724

36,000

405,344

267,424

27

81.1

1,622

36,000

379,232

249,472

28

76.2

1,524

36,000

354,144

232,224

29

71.6

1,432

36,000

330.592

236,032

30

67.3

1,346

36,000

308,576

200,896

The initial investment in year zero includes both the cost of drilling and completion is well as leasing costs. It could also be
argued that the cost of leasing isa"sunk cost" and should not be included in the costs for evaluating individual wells. The cash
flow profile has only one sign change and, hence, only one feasible value of R( )R. The R( )R caribc calculated by any trial-anderror method by determining the rate at which NPV is 7cm. In RXCI 1., a function IRR can be used to calculate the R( )R. The
rate of return for S5/MSCI" price is 43% whereas the ROR for S3/1NISL" price is 24/s. based on 6IROR of 10%, under both
scenarios, the project is feasible.
If, instead of a 30 year life, one assumes a 60 year life, a similar table its contructcd above can be constructed for 60 years. The
net rcvcilue would continue for another 30 yeats; however, the ROR of the pluject for a gas pi ice of S5/MSCF is still 43% and
the ROR for a gas price of S3/SISCI is still 24%.

Economic Evaluation in the Petroleum Industry


Chapter 2 Economic Methods

29

3.

ROR versus F & D Costs


lhere is an important difference between ROR and F & I) Costs, as is illustrated in this Case Study. ROR accounts for future
discounting of revenue; hence, even though the life of the well is extended beyond thirty years, the revenues generated beyond
thirty years do not contribute to the ROR value. A similar observation can be made if NPV is calculated. ftc NPV will not be
different if we assume 30 years versus 60 years life since the production at later stages of life of the well is highly discounted and
does not contribute to the present value of the well. In contrast, RUR or F & D Costs do not account for the discounting of the
reserves or revenues. lherefore, the longer the well is expected to produce, the larger the EUR will he and the F & I) Costs will
be smaller. By extending the life of the well based on certain, arbitrary, economic limits, it is easy to manipulate the F& I) Costs
as well as CUR; however, ROR and NPV of the well will not be affected by the extension of the life of the well. hence, the
ROR is a much more robust measure of the wells economic feasibility than CUR or F & D Costs. This is especially true for
shale wells, which tend to have quick, early decline followed by potentially a long life with a slow decline at the end.

4.

100% Rate of Return


Using the table above, through trial-and error we can determine the price of gas, which will provide us with I00% ROR. lhe
price of the gas has to be 510/tsISCF. Historically, the price of gas has reached S10/MSCF; therefore, it is possible that the gas
price can reach $I0/MSCF in the future. however, based on current conditions, it appears unlikely.

Before we close the discussion about rate of return analysis, it is worth repeating an important
distinction between NPV and ROR. NPV is an absolute measure of the profitability of the project;
whereas, ROR is a relative measure of the profitability of the project. A large NPV means more profit
from the project. A large ROR means relative to investment, the project is economically attractive. This
is one of the reasons NIPV is a much more appropriate measure when comparing mutually exclusive
alternatives. If our goat is to maximize profit, then the alternative that provides the maximum value of
NPV is the most appropriate. In contrast, as we have seen in this section, the largest ROR may not
indicate the best mutually exclusive alternative without conducting incremental analysis. However, the
disadvantage of ROR is also a big benefit when we are comparing alternatives that are independent.
Since ROR is a measure of profitability relative to investment, the highest ROR among many
independent projects tells us which project will provide the biggest bang for the buck. By ranking various
projects according to ROR, we can make a decision about the order in which various projects should be
selected. This can be important when the budget is tight and we do not have enough money to invest in
all of the projects. The following example illustrates the usefulness of ROR under these conditions.
Example 2-14
A company is considering multiple independent projects for potential investments. The company currently has $70,000 to
invest and the MROR of the company is 10%. Which projects should the company consider for investment?
Project
A
B
C
0
E

Initial Investment
$50,000
$20,000
$30,000
$70,000
$40,000

Annual Benefit
$14,500
$5,500
$9,500
$21,000
$12,500

Life
5
5
5
5
5

Solution 2-14
Knowing the life of the project, the annual benefit, and initial investment, we can calculate both the ROR and NPV of the
project. The following table shows the ranking of the projects based on both the ROR and NPV.

30

Mohan Kelkar, Ph.D., J.D.

Project

ROR

Ranking

NPV

Ranking

A
B
C
D
E

14%
12%
18%

4
5
1
3
2

$4,966
$849
$6,012

4
5
3

$9,607
$7,385

1
2

15%
17%

The ranking based on ROR (the highest being the best) and the ranking based on NPV are different. If we only have a $70,000
budget, based on the ranking of NPV, we will select project D and that will use up the $70,000 and, hence, we cannot select any
other project. Based on ROR, we will select C and E and that will use up the $70,000. The selection of C and E is the correct
choice since the summation of NPV for C and E adds to $13,397 which is better than $9,607 for project D. Since ROR is based on
relative benefit, it favors projects that bring in more profit relative to investment. When limited capital is an important
consideration, ROR provides us the correct ranking because it tells us the order in which we need to select projects that will
maximize the profit.
--

----

--

This topic is not as simple as illustrated in this example. We will add more detail in the next section.
Problem 2-18
An investment proposal promises to pay $1,000 per year for the next ten years if you invest $5,000 today. Assume the salvage
value to be zero. What is the rate of return on your investment?
Problem 2-19
A proposalfor drilling on oil well states that if you invest $25,000 in the project, you will own 33% of the working interest (pay
33% of the operating costs) and will receive 25% of the revenue interest (receive 25% of the revenues). If the operating costs in
the first year are expected to be $20,000, rising at a rote of 5%, and the revenues are expected to be $70,000, declining at a rate
of 8%, should you invest in this project? Considering the risks involved in the project, you want to receive at least 25% MROR.
Use the ROR analysis. Assume the life of the project to be five years.
Problem 2-20
An oil company is considering a proposal to automate a plant to reduce the labor costs and increase the efficiency
of the
producing field. It has an option of completely automating or partially automating the field. The cash flows from both the
alternatives are shown below.
Alternative
Full Automation
Partial Automation

Investment

Annual Benefit

$4,000,000

$1,150,000

$1,500,000

$500,000

Assume the life of the project to be seven years and the salvage value to be zero. If the MROR is 20%, which alternative should
be selected? If the MROR is 15%, does the answer change? Use the ROR analysis.
Problem 2-21
A company is considering four alternatives for copying machines. The costs and the annual benefits are shown below:

Cost
Annual Benefit

$6,000

$5,000
$500

$10,000
$1,800

$8,000
$1,300

$900

Assume the salvage value to be zero, life of each machine to be ten years and the MROR to be 6%. Which alternative should the
company choose? Use the ROR analysis.

Economic Evaluation in the Petroleum Industry


Chapter 2 - Economic Methods

31

Problem 2-22
Able bought 50 shares of stock in an oil company at a price of $20 per shore. After holding the stock for 10 years, he sold it for
$45 per share. For the first 5 years, he received an annual dividend of $1.50 per share; for the last five years, he received a
dividend of $0.50 per share per year. What is the rate of return on his investment?

Problem 2-23
Consider an investment in a gas producing property. After investing $70,000, annual revenue of $36,600 is expected with annual
expenses of $22,000 per year.
If the life of the project is 8 years with a salvage value of zero, what is the rate of return?
If the annual expenses increase at a rote of 7% per year, but the revenues are constant, what is the rate

of return?

At what rate in the above option would the annual revenues have to increase so that the rate of return is the same as in the first
option?
Problem 2-24
Consider the following two mutually exclusive investments.
Period

II

0
1
2
3

-30,000
15,000
15,000
15,000

-40,000
16,000
30,000
10,000

Using the ROR analysis, select the appropriate alternative

if the MROR is 10%.

Problem 2-25
A company is considering buying workstation computers for internal use. Model I costs $27,000 and Model I! costs $39,000.
Bath models are expected to provide the some service. Due to the increasing power of computers, these machines will be traded
in after four years of service. Model I can be traded in for $13,500 versus Model II which can be traded in for $17,000. If the
MROR is 1091o, which model should be selected?
Problem 2-26
Consider the following four, mutually exclusive projects.
Period

0
1
2

-2,000
1,800
1,000
200
100

-4,000
1,800
1,800
1,800
1,800

-2,400

3
4

-1,500
900
750
750
150

800
800
800
800

OW

If the MROR is 12%, which project should be selected?

32

Mohan Kelkar, Ph.D., J.D.

Problem 2-27
The following three mutually exclusive alternatives are presented for a project. If the MROR is 13%, select the appropriate
alternative.

Period

II

Ill

0
1
2
3

-150
45
75
120

-450
150
150
150

-300
1230
-1674
756

300

Problem 2-28
An oil field is currently under consideration for in-fill drilling. The net revenues for two alternatives are shown below. Which
option will you select?

Year

No Drilling

In-Fill Drilling

0
1
2
3
4
5
6

0
600,000
475,000
400,000
325,000
260,000
130,000

-1,170,000
1,900,000
900,000
440,000
100,000
0
0

Assume the MROR to be 18%.


Problem 2-29
An oil producing property was expected to make a profit throughout its lifetime. Unfortunately, due to fluctuations in oil prices
the property resulted in the following cash flow. What is the rate of return on the investment?

Year

Cash Flow

0
1
2
3
4
5
6

-$100,000
70,000
55,000
-35,000
-10,000
30,000
20,000

If the MROR is 1096, based on NPV analysis, was this a profitable investment?
Problem 2-30
An oil field is under consideration for a potential in-fill drilling project. The feasibility study indicates that without in-fill drilling,
the field will generate net revenues of $200,000 over the next year and will continue to generate additional revenues over
twenty-five years declining at a rate of 8%. If we invest $1 million in in-fill drilling, the field will generate net revenue of
$580,000 over the next year and will continue to generate revenues over an additional six years declining at a rate of 10%. For
what range of RORs is the in-fill drilling a suitable alternative? Assume the salvage value to be negligible. Assume the MROR to
be 15%.
Problem 2-31
An oil well is currently producing 10 bbl/day under natural flow. The analysis of the inflow performance curve reveals that
installing an electrical submersible pump at a cost of $50,000 will increase the production to 18 bbl/day. It is expected that,
Economic Evaluation in the Petroleum Industry
Chapter 2- Economic Methods

33

under natural flow (active water drive), production will continue at the some rate over a period of 15 years. If we use an
electrical submersible pump, production will continue only for eight years. If we assume that the net revenue under natural flow
conditions is $131bbl and the net revenue with electrical submersible pump is $12.301bbl, which option is preferable? Assume
the MROR to be 15%.
Problem 2-32
A producing gas property is currently receiving total revenues of $2,000 per month. The revenues are expected to decline at a
of 4% per year. If you offer $60,000 for
rate of 6% per year. The operating costs are $600 per month and will increase at a rate
this property, what is the rote of return on your investment? Assume the salvage value to be zero.
Problem 2-33

of $1 million and will


You are considering two properties for a potential investment. The first property requires on investment
result in $60,000 in net revenues in the first month followed by a decline of 9% per year over the next ten years. The second
property requires an investment of $3 million and will result in $220,000 in net revenues in the first month followed by a decline
of 40% per year over the next ten years. Assume continuous compounding. If the MROR is 15%, which investment should you
select? Use incremental analysis.
PROFIT TO INVESTMENT RATIO
We discussed the PIR in Chapter 1. The only difference in this chapter is that we will account for time
value of money in defining it. Profit to investment ratio (PIR) is the ratio of the NPV at MROR to the
present value of out of pocket investment. We can write it as,

PIR

NPV
Pvcosts

Equation 2-11

This number is an indication of the efficiency of the investment. In other words, PIR is the amount of
money earned per dollar invested. Similar to ROR, PIR is also a measure of the profit relative to
investment. If we are interested in evaluating projects that are mutually exclusive, PIR does not add any
value compared to NPV. This is because once we determine the NPV of all the mutually exclusive
alternatives, we already know which alternative is the best alternative. Also, similar to ROR, to make an
appropriate selection we will have to conduct incremental analysis. For a project to be feasible, the PIR
has to be greater than zero. The following examples illustrate the application.
Example 2-I5
The following two alternatives are considered for a project. Based on the PIR analysis, select the best alternative.

Initial Investment
Annual Benefit
Life, Years
Salvage Value

(a)

(b)

$10,000
$3,000
5
$8,000

$20,000
$7,000
5
$3,000

Assume the MROR to be 10%.

34

Mohan Kelkar, Ph.D., J.D.

I
0
S

So lution 2-15

+ .i) -

ii
8,000
b0
339
[(1.1(1+.1) 1+(1+1)5O0O_$6
3,000
+ .1) s- ii
NPVb = 7 000

.1(1+.1) J+(1+1)s_2O O O O_$ 8 398


6,339
NPVa
PIRa
= 0.6339 > 0
= Pvcos = 10,000
3,398
NPVb
= 0.4199> 0
PIRb =
PVCOStSb = 20,000
NPVa

3000

Although PIRa > PlR, we need not select (a) unless we carry out one additional calculation. As shown in the NPV calculation,
alternative (b) is a better alternative; however, we will have to do incremental analysis to arrive at the correct conclusion.

PIR

NPVa NPV b
PVinVeStMeDtb PVinvestment

8,398 - 6,339
20,000 - 10,000 =

0.2059> 0

Since LXPIR > 0, an alternative with a higher investment should be selected (i.e., we should select (b) over (a)). If LXPIR < 0, an
alternative requiring a smaller investment should be selected.

Like ROR analysis, the criteria for the selection of an alternative depend on the value of APIR. The above
example illustrates the application of incremental analysis when only two alternatives are involved. The
analysis can be easily extended when more than two alternatives are involved. Rather than discussing
the method, what is important to understand is that the PIR does not add any value compared to NPV
analysis when selecting mutually exclusive alternatives. However, just like ROR, when capital constraints
are important, the PIR can provide a much better approach in making the correct selection of
independent projects. See the Example 2-16.
Example 2-15
We have $50,000 to invest. We are considering four possible projects in which to invest. The information with respect to each
project is provided below. Which projects should be selected? Assume the MROR to be 10%.
Initial Cost
$10,000
$20,000
$30,000
$50,000

Project
A
B
C
D

Annual Benefit
$3,000
$5,500
$8,500
$13,000

Life, Years
5
5
5
5

Salvage Value
$1,000
$6,000
$10,000
$15,000

Solution 2-15
We will have to calculate PIR for each of the projects.
Project A
[(1 +.1) 5 - U

1,000
+.1), j +
.1(1
NPV
1,993
PIRA == 10,000 0.1993
NPV = 3000[

- 10,000 = 1,993

Economic Evaluation in the Petroleum Industry


Chapter 2 Economic Methods

35

Project B

5 - ii
6,000
NPV = 5,500 [(1
+.1)
.1(1+.1)
1+(1+1)5_204575
00 O=
4,575
PIRH = 20,000 = 0.2287

Project C

30,000 = 12,222
NPV = 8,500 [(1 + .i)5 - 11+
1(1 T.155 ] + (1 T.15 5
12,222
PIRc = 30,000 = 0.4074

Project 0

f(i +.1) 5- 11

NPV = 13,0001

15,000

.1(1 + .1) j + (1 + .i) - 50,000 = 8,594


8,594
PIRD = 50,000 = 0.1719
All of the projects satisfy the minimum criterion that PIR>0. Based on the analysis, we can rank the projects as,
Cumulative

Project

PIR

Investment

Investment

C
B
A

.4074
.2287
.1993
.1719

30,00
20,000
10,000

30,000
50,000
60,000
110,000

50,000

The table above shows the investment required for each alternative and the cumulative investment required if we select the
projects in the same order. It is obvious that after selecting C and B, we have exhausted our limited budget. Therefore, we will
select only B and C projects. If we had $60,000, we should have selected A, B and C. Our selection is only limited by the
budgetary constraints; not by the selection of a particular project. In principal, we can select any combination of projects so
long as the budget constraints are satisfied. In this particular case, by combining projects C and B our NPV is $12,222 + $4,575 =
$16,797. This is the maximum value we can achieve with the existing budget constraint.
For this particular problem we selected the projects so that our cumulative investment matched precisely with the budget
requirements of the projects. There was no residual budget remaining after the selection. In some instances, where the
projects are ranked so that if we select i projects, our cumulative investment is less than the total budget, and if we select
(i + 1) projects, the cumulative investment is greater than the total budget, we may require a trial-and-error procedure to
select the appropriate combination.
Let us consider the above example, except we will assume that the salvage value for project B is $4,000 instead of $6,000. Then
for project B,

[(1 + .1) 5- 11
4,000
NPV = 5,500 [ .11 + .1) + (1 + .1) - 20,000 = 3,333
3,333
PIR0 = 20,000 = 0.1667

If we rank the projects,

36

Mohan Kelkar, Ph.D., J.D.

Project

PIR

Investment

Cumulative Investment

C
A

.4074
.1993
.1719
.1667

30,000
10,000
50,000
20,000

30,000
40,000
90,000
110,000

we realize that we can select projects C and A for a cumulative investment of $40,000. This investment is less than the total
budget, $50,000, we currently have. On the other hand, if we add project 0, it will result in $90,000, which exceeds our
budgetary limits.
If such a case arises, we do not have a systematic way of obtaining a solution to maximize our net benefit - NPV.
If we consider only projects C and A, our total net benefit is,

NPVtotai = NPVc + NPVA


= 12,222 + 1,993 = $14,215
However, with this combination, the remaining $10,000 ($50,000 -$40,000), un-invested budget can only earn the MROR. That
is, the NPV of the remaining $10,000 in budget is 0. To utilize $50,000, if we select only project 0, the NPVD is $8,594. This
amount is smaller than the combination of C and A. Therefore, we will have to reject the selection of D. Another alternative is
to select C and B, which satisfies the budgetary requirement as well. If we select C and B, the net present value is,
NPVtota i = NPVc + NPVa
12,222 + 3,333 = $15,555
This is better than selecting C and A, which results in a NPV of $14,215.
The only way we can obtain the correct combination of C and B is through trial-and-error. Other sophisticated methods such as
linear programming may be used to achieve this result. These methods allow for maximization of a given function (NPV) with
external constraints. The discussion of these methods is beyond the scope of this book.
In practice, operating companies will use a combination of the methods to determine the feasibility of a project. For example, it
may use a criterion that the payback period is less than three years and the PIR should exceed 1.5. If both conditions are
satisfied, then it accounts for liquidity criterion as well as limited budget criterion.
Problem 2-34
A project has three possible alternatives:
Alternative

Investment

Annual Benefit

Salvage Value

A
B

$3,000
$2,500

$1,200

$800
$700
$600

$1,000
$600
$100

If the MROR is 10%, use PIR analysis to choose the correct alternative. Assume the useful life to be five years.
Problem 2-35
Consider four alternatives for the project. Assume the salvage value to be zero and the MROR td be 10%. Using PIR analysis,
which alternative will you select? Assume the life of the project to be five years.
Alternative

Investment

Annual Benefit

A
B
C
D

$15,000

$3,750
$2,750

$10,000
$3,000
$18,000

$900
$4,750

Economic Evaluation in the Petroleum Industry


Chap ter 2 - Economic Methods

37

Problem 2-36
A newly discovered oil field needs to be developed. The expected costs ore: $20 million in the first year, $80 million each in
second and the third years and $150 million in the fourth year. The net income will be $110 million in the fifth year declining at a
rate of 8/ per year. If the producing life of the project is 15 years is the project feasible? Assume the MROR to be 20% Use the
PIR method.
Problem 2-37
The following seven projects are being considered for possible investment. If $360,000 is available for investment, which
projects should be selected? All numbers given are in thousands.
A

Project

150
210

Investment

Pljb ene fi ts

140
190

C
100
126

70
110

120
152

50
64

140
200

Problem 2-38
The following alternatives are considered for potential investment. If the available investment is $2,600, which projects should
be selected? Assume the MROR to be 10%.
Project
1
2
3
4
5
6
7
8
9

Cost Annual Benefit Useful Life, Years Salvage Value


400
800
200
400
400
400
1,200
1,200
200

96
160
140
90
80
72
340
192
28

10
10
2
5
10
10
5
10
10

0
0
0
400
400
400
0
400
200

Use the method of a common denominator to adjust for varying useful lives. Use the PIR technique.

WORKS CITED
DeGarmo, E. P., W. G. Sullivan, and J. A. Bontadelli.

Engineering Economy. New York, New York:

Park, C. S. Contemporary Engineering Economics. Reading, Massachusetts: Addison-Wesley Publishing


Company, 1993.
Steiner, H. M. Engineering Economic Principles. New York, New York: McGraw-Hill, 1992.
MacMillan Publishing Company, 1993.

ADDITIONAL CASE STUDIES


Case Ssdv 2-5

IJassi Rmel field in Algeria is developed using mostly horizontalwells. The field is at a depth of approximately 5,000 ft., and is
overlain by gas cap at the top and underlain by aquifer at the bottom. The gross thickness of oil rim varies between 25 to 40 feet. To
prevent gas or water coning, the best solution is to develop the field using horizontal wells.
As a reservoir engineer working on the field, you are undertaking a performance of a new horizontal well - well I IRZ09 - which is
going to he drilled, the wcil has been drilled using inverted high angle technique as shown in Case Study Figure 2-2. this technique
involves drilling the entire oil column at a high angle and then turning the wellbore hack up through the reservoir at an angle
exceeding 90 . lhe actual path of the well is shown in Case Study Figure 2-2 along with oil-water and nil-gas contacts. We need to
complete this well. the company is going to case this hole, and asarcservoir engineer, your job is to figure out the optimal well

38

Mohan Kelkar, Ph.D., J. 0.

HRZO9 Path

550

01

Dsiancs is

653

750

000

000

the Fast tract the Well head, m

Case Study Figuse 2-2 Actual well path

The three perforation strategies you can use are: 1) perforating only slanted zone, 2) perforating both slanted and horizontal zones,
and 3) perforating only horizontal zone A possible completion with completion in both slanted and horizontal zones is shown in
Case Study Figure 2-3.

Case Study Jiure 23: Possible corupletton in both sdantcd and horizoneilpomotis

The cost of drilling the well is S million dollars, and the cost of perforation for all the three options is $1.3 million. The cost of
transportation is S1.2 per barrel of oil. Assume that the net revenue per b"Irrel of oil is S25. Assume further that the expected rate of
return on the investment is 15". . \isumc that the gas produced has to be flared. The cost of lost revenue is $0.2/idS( :i. lie
following data ate provided for all the three options:
Economic Evaluation in the Petroleum Industry
Chapter 2 - Economic Methods

39

Np (Mbbls)
Slanted
Horizontal
275.06
171.92
275.06
171.92
275.06
171.92
172.39
242.57
132.65
134.52
78.93
92.11
50.64
66.88
35.53
50.64
26.38
40.32
20.11
33.33
27.32
15.1
11.47
22.74
8.03
19.49

Year

1
2
3
4
5
6
7
8
9
10
11
12
13

GOR (SCF/STB)

Slanted
2,808
5,054
6,177
8,984
12,353
14,599
16,845
19,091
20,776
21,899
23,022
23,583
24,145

Horizontal
1,685
5,054
6,177
14,599
21,337
25,829
29,198
32,567
34,252
36,498
38,744
42,113
47,728

Both

275.06
275.06
275.06
268.58
148.92
77.21
49.49
33.43
22.17
13.6
8.6
5.73
4.39

Both

2,246
5,054
8,423
17,407
23,583
25,829
26,391
27,514
30,321
35,375
40,428
47,166
52,781

Choose the best option. Will your answer be different if the previous wells have been completed in horizontal portion
Cast Swdv 2-4

Cobra Oil Company operates five wells on the \7 ogtsberger lease in Texas. Vogtsbergcr field, originally drilled in the 1940s, comprises
numerous wells completed in several different zones. One of the wells produces from a depth of 5,200 ft and averages about 8.2
bopd and 35 bwpd, with 4 Mcfd of natural gas.
The well was experiencing downhole gas locking, which resulted in an inefficient lifting operation. To cure this problem, Cobra Oil
Company hired Ecometer Inc., a company that specializes in well diagnostic problems. An acoustic depth measurement indicated that
the liquid level was 148 ft. over the pump when the well was producing at stabilized conditions (continuous pumping). Casing
pressure increased by about 0.1 psi per minute when the casing valves were closed, indicating that free gas was being produced and
flowing up through the annular liquid. To determine stabilized conditions, a dynamometer test was run without shutting down the
pumping unit. It showed that pump fihlage was 27% (Case Study Figure 2-4). Traveling and standing valve tests verified that the
pump was in good condition.
,enscs PRItiSI
i
VT k

ux

455ib

5urtsee card

b:d rod ps,scr


Pocrccc

2.ttp
5I5

._\_....,/

rpcztp

P oertd

Tod csmior r

1 en Pur s5i
ritetx

LttP

i-kr

siis C.Cpni

hsr up
card

4b r9

nirC

btgpsi

ci

C
t-ir- rarirr. ir.

Case Sturlv Isze 2-4: I)r-naxnoincler reading in dicathig 27c flhJage

40

Mohan Kelkar, Ph.D., J. D.

Poor downhole gas separation occurs when a high liquid level is present above the pump and the pump does not fill with liquid on
the upstroke. In this case, the pump was set at 5,173 ft., which is above the formation. The completion is open hole (4-3/4 in) below
the 5-1/2-in. casing from 5,235 to 5,247 ft. 1 he well was shut down for 10 minutes, then restarted with the same result low pump
fil]age. liven after a 20 minute shut down, poor fillage continued. As is often the case, the "poor boy" gas separator was not working
effectively.
The producing bottomhole pressure was about 94 psi, but the reservoir pressure was unknown. To evaluate reservoir characteristics,
Cobra performed an acoustic liquid-level pressure buildup test, allowing the well to be shut in for five days. Pressure buildup tests
using computerized acoustic liquid level equipment are cost efficient, since the rods and pumps do not need to be pulled
a primary
impediment to running a conventional pressure bomb. The result of this shut-in was loss of production for 5 days, plus an additional
$1,000 for well test evaluation and data collection.
Although the well pressure did not stabilize, reservoir pressure (p5) was in excess of 1,000 psi, according to pressure buildup data.
This data also showed that the well did not have skin damage, meaning re-stimulation was not necessary. permeability also was low.
Furthermore, the data showed that calculated liquid flow into the wdllbore after shut in was only about 10 bpd of liquid, considerably
less than the wells production (Case Study Figure 2-5). Low liquid flow into the wdllbore may indicate that some cross flow occurs
in the formation. This suggests that the pump should probably be set as low as possible in the well.

-10

WO-11: 1WOCTA8

6 40

25

"
75

icc

125

Tirn5hr
6hr Stczdr JYguxr 2-5: Llllcoiatcdl7cjssld aJie.r-ulow
The high reservoir pressure (pt) indicated that, even after the gas interference problem was solved, very little additionalproduction
would be obtained. Therefore, before doing any further work, Cobra knew that the primary benefits of the project would come from
reduced electrical and maintenance costs resulting from less run time and better equipment loading. .\ substantial increase in
production was not expected.
The rods and tubing were pulled and the pump serviced. In addition, a worn pull tube was replaced. It had probably deteriorated
from the continuous "pounding" of the plunger when the pump was 20% to 50 0/s filled with liquid. The pump also had two standing
valves, but only one was used when the pump was run back into the well. A tubing anchor was in the well when it was pulled, but it
had a broken spring and was not run back into the well. As rerun, the tubing string consisted of 167 joints of 2-3/8-in, tubing, a
seating nipple and a 2-3/8-in. collar-size gas separator that was six feet long. The bottom of the gas separator was placed 3 ft. from
the bottom of the well in the middle of the producing formation.
A solid-state percentage timer, low voltage transformer and relay were installed in the motor panel. The goal was to reduce the
amount of run time, since the 24-hour pump capacity exceeded the wells producing capacity. The three items were purchased for
Si 10. In addition the work over rig for one day cost S1,000.
After pumping the well overnight, the liquid level was at the seating nipple, 166.9 joints from the surface. Without shutting down the
pumping unit, a dvnamoinctcr test was conducted. with the pump card showing about 30% fillage. With the liquid level at the pump
and partial punip tillage occurring, the gas separator was operating efficiently. The well was shut-down for time minutes, then
restarted and run for about ten minutes.
The first 36 strokes indicated full pump fillage (Case Study Figure 2-6, stroke 2 of 60). lhe next seven strokes showed that the well
was iximig pumped down and, from stroke 43 to the final stroke 60, pump fillagc was relatively stablest around 35%. The collar-size
go separator was working
king effectively. A percentage 11111C r a as installed and set to run one third of the time.

Economic Evaluation in the Petroleum Industry


Chapter 2 Economic Methods

41

14

it"

14
;

Surf aes card


irrir.
5c;/1

:i
Slcx C

th

GPM
J

ed

)dc( F

kacp

do. crl:c

fkirlplr .doC

EX,
Pp pceric, a,

Case StuJy Isorc 2-6: dtS


us cc and dow nhole cards showthg pump d!Js,gc attic

Sc

ke 2

Liquid level and dynamometer tests were important for diagnosing well problems, but it was necessary to review the downhole
equipment to get the full picture. The pressure buildup analysis helped determine whether the well needed to be re-stimulated, and
what production level to expect.
The beam pump now operates five minutes on and ten minutes off, with a full pump until near the end of the on cycle. While there
has been only a slight increase in oil, w
ater and natural gas production, the overall electrical eciency
efficiency
was improved from 35% to
($203 per month). With smoother operation and
59O/ Power costs are approximately $108 per month, about half of the earlier level
less stress on equipment, maintenance Costs are expected to decrease by about S25 per month. Assume the oil price to be S25 per
barrel and the price of gas to be S5/MSCF.
As a newly hired production engineer for Cobra, you are asked to evaluate the cost effectiveness of the diagnosis and implementation.
You are asked to find the answers to the following questions:
How long did it take to recover the initial investment? Assume that period has to be less than 3 years to make it viable.
Ignore interest rate.
b) If we expect that in the subsequent wells, we do not have to conduct well tests, how long will it take to recover the initial
investment? Ignore the interest rate.
If we expect to see the savings Over five year period for this well, what is the present value of future benefits assuming an
C)
interest rate of 15%? What is the profit at present conditions? Use tile original conditions as in (1).
d) If, in addition to electricity savings, we also can obtain an incremental production of 5% over the original production, what
will the present value of future benefits and profit at present conditions? Use 15% interest rate.
a)

Case Study

5,7

Renco Energy, Inc., a small independent in Tulsa, OK, operates several stripper well leases throughout northeastern Oklahoma. As is
typical with stripper well leases, profit margins are thin and often nonexistent if leases contain problem wells. In many cases, high
costs can be attributed to high water production with its associated operating costs. In managing its leases, Renco identified five
problem wells that needed something different done to restore or improve profitability.
While looking for solutions, Renco began exploring whether the balanced oil recovery system BORS Lift, manufactured by loops
lechnohigy Iiccnsing, would be helpful. Fquipnient is quite different from a conventional rod pumping unit. From a mechanical
standpoint, oil is lifted to the surface in a flexible tube (having appropriate valves and bottom weight) with a nylon strap
(Case Study
Figure 2-7).

42

Mohan Kelkar, Ph.D., i.D.

At the surface, the strap is wound/unwound on a reel. As the full tube arrives at the surface, a sensor tells the tube valve to open,
dumping the fluids into a small holding tank. The Current design does not capture casing head gas, thus losing potential gas revenues.
small transfer pump with a level controller periodically transfers fluids from the holding tank into the well flowline.
wellsite computer controls both the depth from which fluid is lifted and the number of cycles per hour. These parameters,
determined in the pre-installation analysis, can (and often need to) be adjusted at the wellhead - a simple matter. By achieving a
balance, the system removes oil at a rate that corresponds to the natural migration of oil through the formation.
Not all wells are amenable to this system. To determine if a well is a candidate, Toups requires information about porosity, water
saturation and permeability, in addition to standard well data (depth, perforations, oil / water / gas production, drive mechanism, oil
and water gravities). Typically, well logs are analyzed and permeability estimated from the nearest available core or regional
experience. As a final screening test, Toups logs the wellbore (preferably after a 3-day shut-in period) to determine fluid level and oilwater contact within the weilbore. If adequate oil entry is not occurring, wells are not good candidates.

0
O

Renco had several problem wells. Renco drilled and completed the Keefer 8 in the Bartlesville sand at about 1,400 ft. and Peru sand
at about 950 ft. There had been an old watcrulood, but not in the area where Keefer 8 was drilled. For more than a year (except for a
few instances after well work when it would produce 9 bopd for several days), the well produced essentially all water at around 80
bwpd, if one chose to pump that much.
The Ogelsby #1 is on a single-well lease and produces from the Peru sand at about 950 ft. The well could produce at 80%, or higher,
water cut. But since the lease does not have a saltwater disposal well, water must he hauled at a cost of $600 per 80-bbl tank of oil
sold ($7.50 per bbl oil sold). Operations were uneconomic, but to hold the lease, the well was operated on a time clock, producing for
two, 15-mm periods a day. Production averaged about 0.5 bopd.
Renco operates four wells on the Comstock lease. ftc Comstock I produces from the Wayside sand at about 500 ft. Sand
production, with its associated mechanical and well service needs, was a real problem in the Comstock 1. Pulling frequency was
excessive, often being only days (or weeks apart). Well servicing costs were excessive - averaging over $1,000 per month. With
production of only 3.5 bopd, the lease was unprofitable if the problems associated with sand production could not he solved. In fact,
the well had been inactive for a couple of months when the BORS system was installed.
The operator installed B( )RS units on two Bartlesville completions on the Cominonwcalth lease. Prior to installation, one of the wells
produced about 3 bopd plus 70 l.wpd, which is marginally economic. The second well produced a trace of oil plus 70 bwpd, but they
could not "keep ahead" of the water production. Like the Keefer 8, the phlcni for the second well was obvious - try something or
plug the well.
Renco installed I3ORS unit on several wells. Results from 5 wells are available in Case Study Table 2-1.

Economic Evaluation in the Petroleum Industry


Chapter 2 - Economic Methods

43

Case Study Table 2-1: Composite results ofaltemthve ardficlal life system

Production
bopd/bwpd
Time
system has
been
installed,
months

Before

Oglesby 1 Peru
sand

After

Reduction in
power cost,
S/month

Reduction in
operating cost,
s/month

0/80

6.0/3.0

65

700

0.5/3.0

2.7/trace

60

Essentially eliminated water


hauling costs and increased oil
production

Comstock 1
rylcr A)
Wayside sand

3.5/trace

3.5/trace

60

1,000

Unit has operated trouble-free


with no well service cots

Commonwealth
lease

little/70

7/trace

40

500

Too Bartlesville
comolctions

trace/70

4/trace

40

500

Well
Keefer 8
Bartlesville
Peru sands

&

General Comments
Unprofitable "water well
converted to profitable
producer

Essentially eliminated water


production, converting too
unprofitable wells to profitable
producers

The improved artificial system is still work in progress. Equipment frequently breaks down and some of the parts have to be replaced.
On an average, the cost of maintenance per unit is $2,400 per year spread over the year. Also, not every well has been successful.
Based on Toups experience with other wells, about 80% of the wells will benefit from such installation.
As a petroleum engineer working for Renco, you are assigned to investigate the feasibility of BORS so that the same type of system
can be installed in other wells. Assume that the average response from a successful well can be determined from averaging the
responses from the table above. Assume that the price of oil is S25/barrel and the life of a well operating under given conditions to
be three years. Answer the following questions:
a)
b)
c)

What is the payback period for this new installation? Calculate discounted payback.
What is the NPV if the ?s[ROR is 15% per year?
Should Renco purchase the unit or lease it?

Cc Study 2-8
In most reservoirs, after the oil is produced through primary depletion, the next stage is to use water flooding to produce more oil.
Significant quantities of oil still remain in the reservoir after water flood. Therefore, other tertiary oil recovery processes can be used
to receiver additional oil from such reservoirs.
One of such experiment was conducted in David Pool in L]oydminstcr, Alberta, Canada. David Pool was first depleted using primary
recovery, followed by water injection, and then ultimately a tertiary recovery process, called alkalinc-surfactant polymer (ASP)
flooding. Between 1987 and 1997, David Pool was subjected to ASP, and was closely monitored for oil recovery from tertiary oil
recovery. Case Study Figure 2-8 shows the size of the Pool. Notice that ASP flood was only applied to part of the field. The North,
South and West parts of the pool were only water flooded.

44

Mohan Ke/kar, Ph.D., J.D.

Produed
wtli
Mkdl-1ndtiuitr
ifljItCtfl

Viue-

tw

J
L

Qiwid

lO

Afk,li

\-,
-South

Case Study Fiure 2-8; Pa aid Pool oetpav isopa oh

\Ve are going to evaluate the ASP flood in the middle part of the reservoir. The pore volume (P\) of the ASP flooded area is 12.5
million barrels. The oil in place (OOIP) in that area is 9.4 million barrels at standard conditions. The chemical flood - ASP flood required that we design a mixture of chemicals - to be injected in the reservoir, so that we can displace additional oil from the
reservoir. After spending in 1986 about $150,000 for laboratory and reservoir studies, the oil company determined that the best
combination of the chemicals is 1% by weight Na2CO3 sJkah), 0.2% by weight Petrostep B-100 (surfactant) and 600 mg/Litre
Alcoflood Pusher 1000 F (polymer. The company also determined that 0.3 1V of chemical (ASP) slug needs to be injected in the
reservoir for succcssful,\SP flood, and that slug will be followed by 0.2 PV of 400 mg/Litre Alcoflood Pusher polymer slug. The cost
Of Na2CO3 was S0.06/lb, the cost of surfactant was $1.00/lb and the cost of polymer was $0.90/lb. Assume that the density of ASP
and polymer slug is 62.4 lb/ft. Assume that 0.1 PV of ASP slug was injected in 1987, 0.2 P NI of ASP slug was injected in 1988 and
0.2 PV of post-flush, polymer only, slug was injected in 1989. The operating cost was $3.50 per barrel of oil produced. To initiate the
ASP flood, additional 12 wells were drilled and completed in 1986 at a cost of $300,000 per well. Since the chemicals in ASP plants
are sensitive to salinity of injected water, a special softening plant was built in 1986 to soften the water. In addition, special separation
facility to account for emulsion of oil-water had to be built. The total incremental cost of facilities was S1.1 million. The incremental
production and the price per barrel of oil is provided below. The field was assumed to reach economic limit at the end of 1997. The
price reflects an average price received for the oil during that year - which can be used to calculate the gross revenue during that year.
Price

Year

Oil
Mbbl

($/hbl)

1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997

0
113
259
290
275
249
216
193
169
127
69
16

18.1
12.65
15.94
1788
13.72
15.69
13.98
12.94
14.35
18.12
16.91

Economic Evaluation in the Petroleum Industry


Chapter 2

Economic Methods

45

Using the numbers above, calculate the payback period and the NPV of the project if the MROR is 15%. Also calculate ROR for the
project. is the project economical?
Fast forward to current conditions. As a reservoir engineer, working for an oil company, you are investigating ASP flood to be
implemented in present year. Assume that the production profile starting next year, will be similar to above table, except that year
1987 and onwards will change to next year and onwards. The cost structure has changed though. You have already spent $280,000 on
the lab study which has determined that 035 1/V of chemical slug needs to be injected in the reservoir for successful ASP flood, and
that slug will be followed by 0.2 PV of 400 mg/Litre Alcoflood Pusher polymer slug. The cost of NO2CO3 is $0.08/lb, the cost of
surfactant is Si.50/lb and the cost of polymer is S1.05/lb. Assume that the density of ASP and polymer slug is 62.4 lb/ft 5 . Assume
that 01 PV of ASP slug will be injected next year, 0.25 PV of ASP slug will be injected in year after and 0.2 PV of post.-flush, polymer
only, slug will be injected in the third year. The operating cost will he S5.00 per barrel. To initiate the ASP flood, an additional 12
wells will have to he drilled and completed at a cost of $600,000 per well. That can be accomplished this year. The plant for softening
the water and the cost of separation combined will be $1.6 million which will have to be spent this year. For economic calculation
purposes, we will assume that the price of oil next year will he $40 per barrel and will remain steady throughout the life of the project.
Calculate the payout period. Calculate NPV if MROR is 20/s per year. What is the cost of chemical per incremental barrel of oil? Is
the project feasible? If to account for uncertainty, we assume that only half of the projected incremental oil is produced every year,
how will the economics be affected?
Case Stud 2-9

Granite Wash is a formation at a depth of more than 12,000 ft. It is located in the Western part of Oklahoma. The permeability is less
than 0.001 md and the well will not typically produce without fracturing it. After the success of horizontal wells in Barnett Shale
(another very tight formation), operators are exploring the possibility of using horizontal wells to exploit Granite Wash formation, in
the last few years, some operators have drilled the horizontal wells with some success. As a production engineer, your job is to
evaluate the efficacy of both the vertical and horizontal wells and recommend your boss which type of well is a better option. The
vertical wells have been used in this formation for a very long time and typical production data from the best vertical well is shown
below. Assume that the production from a vertical well can be as low as 33% of the given data. With limited production data available
from horizontal wells, the production profile is estimated based on decline curve analysis. This is the data from the worst horizontal
well. Assume that the production data from a horizontal well can be as high as 100% above the worst horizontal well. Production
data for water is not provided; however, most wells will produce significant quantities of water over the life of the well. The
condensate production for both the vertical and horizontal wells can vary between 30 STB/IVIMSCF to about 70 STB/M1\ISCF. Most
wells produce naturally for the first yean lloevever, starting in the second year, compressor will have to be installed to reduce the well
head pressure, and starting third year, gas lift need to be installed to lift both the condensate and water. The economic parameters are
provided as below:
\ertical well drilling and completion costs: S2.2 million to S2.8 million
horizontal well drilling and completion costs: S6.2 million to $8.8 million
Cost of operating vertical well: In year 1, S1,000/month; starting year 2, the well will have to be fitted with a compressor
increasing the operating cost to S6,000/month. In year 3, to lift the liquids, we will have to install gas lift ($70,000. In addition,
the cost of operation will increase to Si 1,000/month (due to compression required for artificial lift plus compression at the well
site
Cost of operating horizontal well: In year I, S 1,300/month; starting year 2, the well will have to be fitted with a compressor
increasing the operating cost to S7,000/month. In year 3, to lift the liquids, we will have to install gas lift S70,000. In addition,
the cost of operation will increase to S12,500/month (due to compression required for artificial lift plus compression at the well
site)
Price of gas: $5/MSCF (constant over the entire period) to S5/MSCI 5 in the first year escalating at 2%/year
Price of condensate: S60/SIB (constant over the entire period) to S60/STB in the first year escalating at 2%/year
Assume that the abandonment cost is negligible. The MROR is 15% per year compounded daily.
Evaluate the data using this information. Use various economic parameters (NPV, bR, PIR, payback, etc.) to determine which one
is the best option. Calculate the pessimistic and optimistic development costs for both the options. Evaluate the risks involved in
choosing one or the other option. I Iltunatcly, what do you think is the best option and why?
Year
2
3
3
6

46

Vertical Well
MSCF
800,199
319,642
186,869
127,682
95,014
74,645

Horizontal Well
MSCF
1324,946
445,137
262,388
175,438
137.830
109.383

Mohan Kelkar, Ph.D., J.D.

7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24

25

60,866
51,003
43,639
17,958
33,458
29,817
26,819
24,313
22,191
20,373
18,802
17,432
16,228
15,162
14,214
13,365
12,601
11,911
11,284

84,100
69,519
63,520
57,992
49,054
39,978
34,705
29,088
26,776
22,952
21,161
22,992
21,936
21,093
21,882
24,029
15,638
19,756
18,611

Cjse Study 2-JO


CamWest, Inc., an independent based in Denver, Colorado, and McKinney, Texas, operates more than 120 oil wells in Lander,

Wyoming. These wells are located in a remote region that is difficult to reach due to the rough terrain and harsh winter climate. To
better manage its waterflood and oil production activities, CamWest installed web-based pump-off controllers.

For CamWest, like many producers, electrical and well pulling costs are a significant part of the total lease operating expense. In
remote areas, operations with manual data retrieval and site inspection complicate things further. historically, the companys pumpoff controls were activated based on pre-set timing mechanisms not linked to changing well fluid levels. Furthermore, unit failures
were primarily discovered by inspecting each individual well throug h field visits. Many of these breakdowns were the direct result of
over-pumping
m (fluid pound), leading to premature pump or rod failures. As a result, the company experienced higher expenditures
and lost production revenue.
To minimize electricity costs, lower repair expenditures and optimize production, Cam West implemented a wireless, electronic pumpoff controller (POC) that could be monitored and controlled via the Internet. Aunion Technologies, Inc., a Dallas-based provider of
turnkey, web-based telemetry services for oil and gas Producers and gas gatherers, provided and installed pump-off control R1Us and
a spread-spectrum wireless communication network. The company provides Internet monitoring and support services that include
POC software applications within an application service provider (ASP) format. The first 10 POCs were installed in November 2000.
By March 2001,49 POCs had been installed with 51 units being in place at the end of May 2001. That is, out of the total of 59 units
installed, 51 were operational by May 2001.
CamWcst utilizes Aurions vebite to monitor fluid level, production and pump-off controller activity, and to control load limits,
stroke and load references to activate the pump-off Control. The wehsitc (Case Study Figure 29) also allows both management and
field operations personnel to access various pump-off control reports, such as morning, event and runtime reports; analyze trending
and dynagraph card graphics; and allow multiple users to comment on-line about well maintenance issues. Additionally, the website
allows users to respond iriOre quickly to equipment problems and production interruption through the receipt of POC data about
four times per day.

Economic Evaluation in the Petroleum Industry


Chapter 2 - Economic Methods

47

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Case Study Figure 2-9: An on-line "Morning Report" provides operator persoiatiel the most recent opera dog di to from all
weh-basedpurnp -off controllers. Personnel can access the report fivm any loco iion with Internet access.

By using the pump-off control RTV unit and web software, the operator, CamWest, reduced actual electricity usage by maximizing
pumping activity during periods of high fluid levels, while eliminating pumping during periods of low fluid levels. Additionally, peak
electricity demand usage was reduced by decreasing the rate of pumping activity during peak period.
As a new engineer just hired by CamWest, your job is to present the cost effectiveness of these lOCs to upper management. The
cost of installation of each POC is S2,500. In addition, Aurion Technology charges $5.99 per month fee for service and monitoring
per well. The production at the time of installation per well was 20 bbl/day, and it is declining at a rate of 15% per year. Based on the
evaluation of the data, electricity costs have dropped from an average of $1.20/bbl of oil to about S1.04/bbl of oil. In addition,
CamWest expects that additional economic value can be received through production optimization, and by reducing rod and well
repair expenditures. Although no firm data is available to you, you can assume an average additional savings of S500 per year per well
through reduction in rod and repair expenses and production optimization. Assuming MROR of 20%, calculate:
a)
b)

Payback period in months by discounting the cash flow


NP\ if we assume that the well will produce for 4 years.

What will be the NPV if the $500 savings per year does not materialize ,
case Smdy 2-fl

Silver Pines Energy Corporation operates the Sun T1 I and Stuart City Fields in LaSalle Counts, Texas. The leases have 32 wells
producing either sour gas from Edwards lame at about 11,000 ft. deep or Sweet gas from Olmos gas sand at a depth of 7,500 ft. Both
formations arc tight and, as production matured, the wells began loading water. Silver Pines started using soap sticks to keep the wells
unloaded. The soap sticks reduced the interfacial tension between water and gas and, hence, reduce the loading velocity required to
lift the water. The soap sticks were launched by a gauger each day. I lowever, Silver Pines discovered that the soap sticks launched by
the gauger would not keep the wells unloaded for a full 24 hours. Production was being lost, and more frequent visits by a contract
gauger is not an economic option.
&J Oilfield and Electric Service (J&J) approached Silver Pines to propose a solution. J&J had-just invented in automatic soap
launcher as shown in Case Study Figure 2-10.

48

Mohan Kelkar, Ph.D., J.D.

a
a

Sen dyFi,c

uromdlie soap Ia all chr

The cost of installing the soap launcher is about S5,000 per well- Once the launcher is installed, one soap stick could be launched by
gauger during his daily rounds, and two additional soap sticks will be automatically launched at 8 hour intervals. The cost of additional
soap sticks is about $6 per day, per well. Installation of these launchers takes just a few hours, and if not successful, can be reinstalled at other well at an additional cost of SI ,000 per well. j&J claims that the launchers are reliable. If any of the launcher breaks
down, it can be fixed at an average cost of $500 per repair. J&J claims 90i/o reliability for the launcher per year. That is, 90% of the
installed launchers will not breakdown during a year.
J &J also claims that the launchers increase the production for 90% of the wells. If the launcher is unsuccessful on a well, we can
assume that we will not get any incremental production. The same launcher can be used for another well at a cost of S -1,000.
As an example of the success enjoyed by J&) Launehers,J&J provided the following information:

Well

1
2
3
4

Gas Production
MSCFD
After
Before

18
83
17
120

70
120
135
185

These installations took place about four months ago, and J&J claims that the production increase has sustained over this period.
As an engineer working for Silver Pines, you are in charge of evaluating the efficacy of installing launchers at the well Site. You
assume that the average performance of a well will be consistent with what has been reported by J&J in their field experience.
however, you also know that the production from the wells is declining at a rate of about 15% per year. You can assume that the
incremental production will also decline at about the same rate.
Assume that the price of gas is S2/MS( l and the MROR to he 15% per year. Assume that you will install the launcher on 10 gas
wells at a time, followed by another ten wells after 3 months, till the installation is complete on all the thirty-two wells. If the
installation is not successful in one of the wells, we will reinstall the launcher on another well, thus saving the cost of bu
Ing a new
launcher and spending only SI ,000 for reinstallation.
Assume that the last two wells, where the installation will be done after 9 months, will be successful. l)o your calculations on a
monthly basis.
a)
b)
e

Assuming the life of the wells to be live years, is It worth iiistalllng the launcher?
What is the cost of thc launcher (installation plus operation) per \lS( F of gas produced?
If the gas price changes to SI /i\ISCP, how will the N lV change?

Economic Evaluation in the Petroleum Industry


Chapter 2 Economic Methods

Case Mudt 22

Citation Oil and Gas Corporation operates \Xasioger Unit of Bemis Scbutts Oil Field in the State of Kansas, The location of the wells
is shown in Case Study Figure 2-11.

CITATION OIL AND GAS CORP.

Wasinger Unit
Bemis Shutts Field
Ellis Co.. Kansas

Commingled Arbuckle Producers


31111990
TopekaILkC Producers
31111990
Unit Boundary

EI2Sec.21
r

TIIS
RI8W

17SWD

14

+
12

18

18

19

Case Stvclv Figure 211: Well locations

Several wells in the Unit were either temporarily abandoned, or


cost of water disposal is about S0.12 per barrel.

were about to be abandoned because of large water production. The

ITORCO, Inc., a service company specialized in polymer gel treatment, suggested to Citation that by treating the well with polymer
gel, the overall water production could he reduced. This will increase the oil production and hence extend the life of the well. The
cost of polymer treatment is roughly S135,000 per well. This includes the cost of polymer gel treatment, rig costs, stimulation, down
time, frac trucks, prep time and change in artificial lift equipment.
Depending on the type of job, the cost could be as low as S60,000 and as high as S200,000. Citation gave contract to TIORCO, Inc to
treat well # I in 1997. This well is shown in Case Study Figure 2-11. Prior to November 1997, when well I was treated, the Unit was
producing about 42 barrels of oil declining at 6.5% per year. The WOR was 70 and increasing at a rate of 9.5% per year. Economic
cut-off calculations indicated that when the tXOR reaches a value of 100, it is uneconomical to produce oil from the Unit.
Well I was treated in November of 1997. The well was not producing at that time. The production increased from 42 to 100 barrels
from the Unit. The unit \VOR decreased to 55. Since that time WOR has increased at a rate of 9.5 0/a per year, however, the oil
production has declined at a rate of 31% per year.
a) I low much are the remaining reserves without treatment?
I low much incremental production will you expect from Well # 1? One measure of success is the cost per incremental
h
barrel. You prefer to keep it below S3/bbl.
c) At what point you will abandon the Unit based on W( )R value?
d) What is the rate of return on your investment?
c) If wells 2, 3, 4, 5 and l2 arc candidates for gel treatment, will you recommend gel treatment for those wells?
If you want to be conservative, and assume that the incremental production from a well will go to 75 b/d, will you
t)
recommend it? Assume that \X( )R xvill decrease to 55.

50

Mohan Kelkar, Ph.D., J.D.

Do the calculations on a monthly basis. Assume MROR to he 20%.


Assume the net revenue per barrel of oil to he S11; however, assume that this does not include the Cost of water disposal. For oil
production declining at a fixed percentage, we can assume exponential decline. For this tvpc of decline the oil rate at any given time is
calculated as:
q0 q0te_t

where D is the declining rate and q01 is the initial rate. Integrating rate w.r.t, time, we can calculate hydrocarbons produced when the
rate has declined to q by using the equation:
N

_q0gq0

(.rssc Stride 2-13

Parallel Petroleum Corporation (NASDAQ: PLLL) on September 151, 2009 announced that it has entered into a definitive agreement
for the Company to be acquired by an affiliate of Apollo Global Management, LLC, a leading global alternative asset manager, in a
transaction valued at approximately S483 million, including the assumption or repayment of approximately $351 million of net
indebtedness. The agreement was unanimously approved by Parallels Board of Directors.
Commenting on the transaction, Sam Oh, Partner at Apollo, said, AVc believe Parallels high-quality assets and its outstanding
management team will he a positive addition to our investment portfolio and we look forward to working with the Company."
Larry Oldham, Parallels President and Chief Executive Officer commented, "Apollos interest in the Company is a clear recognition
of the attractiveness of Parallel, its business plan and the success that has been achieved Apollo has a strong track record of growing
businesses. Under its ownership, Parallel will be better capitalized to execute its current business plan and develop new opportunities
for growth."
Your job is to evaluate this transaction to see who got a good deal out of it. Most of the information I am providing is taken from a
second quarter 2009 presentation provided by Parallel Petroleum. Here we summarize all the properties operated by Parallel. In the
table below, we provide the name, net production either in MSCFD (1000s of cubic feet per day) or STB/D (barrels per day), the
remaining proved reserves (oil and gas remaining in the ground but vet to be produced) in BCF (lxIO 9 Cubic feet) or MMSTBO
(millions of barrels), and the upside potential in each of the field.
Parallels Properties
Net Daily
Production

Reserves

Barnett Shale Project

10,344 MSCII)

19.5 BCF

New Mexico Wolfcamp

10,152 MS(FD

22.4 BCF

606 STB/D

4.1 M1\lBO

Property

Upside

Gas
Additional infill wells potential
31) seismic being collected - additional well locations
otcntial

AR
Permian Basin of West Texas

Carm-ann San Andres

303 SIB/I)

5.4 MMBO

30 MMBOE gross potential based on analog; additional CO2


flood potential
lnfill and step out drilling

I larris San Andres

412 SIB/I)

5.5 tiNillO

Infill and step out drilling; \vaterflrioding potential

Fullerton San Andres

1,421 5Th/I)

3.2 tIMI-IO

Immature warcrflood

Diamond NI Canyon Reef

Diamond NI Shallow

104 SIB/I)

1.0 NIMBO

Infill Potential

Oilier Pcrmian Basin

220 SlB/l)

1.6 NINIBO

lnfill potential

On Shore Gulf Coast

262 S. ..I-I/I)

2.2 MMBO

Infill well potential

P specific interest ainnng all these prnperiics is Bai ileir Shale production. In February of 2009, Bir:i]ld entered into
an agreement
with Chesapeake. Parallel currently has pi )tcnfi:Il 2-I0 li ciii ins where the wells can he drilled. tin flu nina xlv. due to linv gas prices and
Economic Evaluation in the Petroleum Industry
Chapter 2 - Economic Methods

51

prior commitments, Parallel did not have money to contribute its portion of the drilling and operating costs. Parallel has 35% working
interest in these wells and Chesapeake has 65%. That is, Parallel has to pay for 35% of the drilling, completion and the operating
costs. Instead, Chesapeake will "carry" Parallels interest in these wells. That is, Chesapeake will drill these wells by paying for all the
costs for drilling, completion and production. As a penalty, Chesapeake will recover ISOb/o of the drilling and completion costs from
the net revenue before Parallel is allowed to "back in" with 17.5% of the working interest. For example, if the cost of drilling and
completion is $1 million, and each year the net revenue is S250,000, then Chesapeake will have to be paid $1.5 million before Parallel
would receive anything. That is, it will take six years before Parallel can back in with 17.5% interest. At that point, Parallel will start
receiving 17.5% of the net revenue.
The cost of drilling and completing a typical Barnett well is about S3.2 million. The operating cost of a well is about S4,000 per
month. Assume a 20 year life for a well. According to Chesapeakes website, the production profile for a t)pical Barnett Shale well is
provided and it is reproduced below: The production provided is for each year.
Year BCF
1
0.650
2
0.228
3
0.164
0.140
4
0.129
5
6
0.119
7
0.109
0.100
8
0.092
9
10
0.085
11
0.078
12
0.072
13
0.066
14
0.061
15
0.056
16
0.052
0.047
17
0.044
18
19
0.040
0.037
20

Assume that royalty interest is 25%. For gas prices, assume S3.50 for the first year and S4.50 for the rest of the years, held flat.
Using this information, answer the following questions:
a)
b)

c
d)

e)

1)

Using a purchase price of S483 million, and using S70/barrcl oil price, what was the conversion factor for price
equivalence between MSCF1) to barrels per day? Use the standard rule to calculate equivalent barrels of oil.
Using the same conversion factor, convert all the gas reserves into equivalent oil reserves and assume S20/barrel in the
ground price and calculate the worth of the reserves. Is this price higher or lower than what Apollo paid? Knowing
what Apollo paid, how much did Apollo pay for an equivalent barrel in the ground?
Using the information about Barnett Shale well, determine the NP\T for each well from both Chesapeake and Parallels
perspectives. Assume that the nominal interest rate is 15% per year compounded continuously.
, ,-.
Assume that Chesapeake is planning to drill 30 wells each year so that it will take eight years to drill all of the well
Knowing the N 1 3 \7 for each well, how much is the present worth to Parallel for all those horizontal wells which will be
drilled in the future? For convenience, assume that the NP\T for the first set of 30 wells will be collected at the
beginning of year 2011. You need to know present worth of these wells for Parallel at the beginning of year 2010.
Using Part 1, do you think that Parallel received any compensation from Apollo for these horizontal \VClls?
If, on a long-term basis, you believe that the gas price on a MSCF basis is going to be 1/15 of the price of barrel of oil,
hew much will you pay for the property based on current production if you expect the (ill price to remain steady at
S70/barrel? I low much will you pay based on reserves if you par S20/barrel in the ground?
In making this deal, under what conditions would Apollo get the worst end of thebargain? I/oiler what conditions
would Parallel get the worst end of the bargain?

1)o you believe that Apollo paid anything to Parallel for upside potential?

52

Mohan Ke/kar, Ph.D., J.D.

This chapter covers the importance of taxes and contract agreements on decision making in the oil and
gas industry. Although taxes, in general, are not unique to the oil and gas industry, certain rules and
regulations related to taxes are uniquely applicable to the upstream industry. Complicating the impact
of taxes is the type of contract signed between the operator and mineral owner.
In the Basic Tax Structure section, basic tax concepts are explained in a simplified manner. These
concepts are common to any industry and are not necessarily restricted to the oil and gas industry.
Understanding of these basic concepts is important before other complicated tax consequences are
considered. The two concepts that are discussed in this section are depreciation and income taxes.
Depreciation relates to deduction of part of the durable equipment costs from potential taxes; whereas,
income taxes relate to part of the income received by the government. Both concepts are further
explained through multiple examples.
In the Domestic Agreements section, the effect of domestic (U.S.) agreements on overall cash flow
analysis is discussed in detail. These agreements are signed between the mineral owner and oil
company. Due to the terms of the agreements and the overriding tax laws, the cash flow analysis may
be significantly affected. In the Chapter 1, we discussed basic terminology in the oil and gas industry.
Additional terms are explained in this chapter. In the second part, the concept of depletion is discussed.
Similar to depreciation, depletion is also a tax benefit provided to oil companies. Depletion relates to
deduction of costs associated with locating hydrocarbons. Although used in the United States, it is rarely
used in other countries. In the third part, the effect of income taxes is discussed for domestic contracts.
In the International Contracts section, international agreements, signed between governments or their
national oil companies and international oil companies, are discussed. International agreements are
becoming more common. After a brief history and discussion of the purpose of these international
agreements, three common types of agreements - concession, production sharing, and service - are
explained. The host country government exerts a progressively larger amount control as we move from
the concession agreement to the service agreement. The tax consequences of these agreements are
presented in general terms. Although the specific agreements signed can vary from country to country,
we do not cover the impact of specific agreements on economic analysis. Instead, we cover only the
basic concepts of the different types of agreements. The sources cited in this chapter provide greater
detail.
The Summary section, we will review the concepts discussed in this chapter. It also highlights the
similarities and differences between the various agreements.
BASIC TAX STRUCTURE
In this section, we discuss two important concepts common to most types of tax analysis. The only
requirement is that the business invests in durable (lasting more than one year) goods. For an industry
exclusively service, requiring no investment in durable goods, the concept of depreciation may not be
relevant. Otherwise, an understanding of depreciation and income taxes is, predominately, a universal
requirement for proper economic evaluation of any project.

Economic Evaluation in the Petroleum Industry


Chapter 3- Economic Analysis

DEPRECIATION
Depreciation, in the literal sense, means a decrease in value. For example, if you buy a car today,
one year from today, the same car cannot be sold at the same price. The value of the car is
depreciated. As time goes by, the price of the car will depreciate further. In economic analysis,
depreciation has a different meaning. Realizing that the existence of a corporation is perpetual,
depreciation is treated as a replacement cost. That is, if you buy a piece of equipment that has a
useful life greater than one year, the assumption is that you will have to replace that piece of the
equipment at the end of its useful life. Therefore, some money has to be set aside during the useful
life so that the equipment can be replaced. This yearly replacement cost is called depreciation; it is
an allocation of the cost of the equipment spread over its useful life. The government allows the
corporation to set aside this money for future replacement without taxing it.
Although the depreciation is most commonly used for durable equipment, it is also used for other
properties. To generalize, a property can be depreciated if it satisfies the following characteristics
(Newman, 1991):
It must be used in business or production of income.
It must have a life longer than one year.
It must be something that wears out, decays, becomes obsolete or loses value from natural
causes.
These characteristics are most appropriate for equipment; however, they may also be applied to
buildings, patents and copyrights.
Investment in such property is called capitalized cost. In production operations, this cost will include
the cost of casing, piping, tank batteries, pumps, compressors, buildings, etc. Considering that these
costs are incurred over tangible items, they are sometimes called tangible costs. Costs related to
patents and copyrights are intangible costs; however, they still need to be capitalized. In contrast,
the costs incurred for regular maintenance, upkeep, utilities, and labor costs, are considered
operating costs and can be deducted from the operating revenue in the same year for tax purposes.
Although the distinction between capitalized costs and operating costs is clear in most instances,
sometimes the distinction is difficult to achieve. In the context of the petroleum industry, a good
example would be the costs associated with drilling a well. These include (Campbell, 1987):
Costs related to agreements with drilling contractors.
Surveys related to the location of a well.
Road costs and dirt work related to well location.
Rig transportation and set up costs.
Fuel, water, and drilling mud costs.
Labor costs including supervisors, well site geologists, and the testing of well.
Stimulation costs.
Cementing costs (does not include casing).
Surface damage costs.

Mohan Kelkar, Ph.D., J.D.

Since the drilling costs are incurred before production begins, they cannot be considered operating
costs. On the other hand, the costs for labor, utilities, drilling mud, and rig rental cannot be
considered tangible costs. How to treat these costs is indeed a legislative decision. The industry calls
these costs intangible drilling costs (IDC). Different countries have different rules with respect to
categorizing IDC.
Before we can understand the different methods for calculating the depreciation, we need to
understand some basic definitions.
COST BASIS
Cost basis represents the cost of acquiring a property. This is the total cost that will be
capitalized over the life of the property. This cost includes the cost of the property and all other
incidental expenses such as installation, freight, and site preparation.

BOOK VALUE (BK)


Book value is cumulative depreciation subtracted from the cost basis of the property. In year k,
the book value can be defined as,

Bk = cost basis -

Equation 31

where Dj is the depreciation in yearj. The amount depreciated each year will depend upon the
method used.
SALVAGE VALUE
Salvage value is the price obtained from the sale of a property at the end of its useful life. In
many instances, for tax purposes, this is assumed to be zero.
REPAIR COSTS
Repair costs are the costs related to keeping the property in ordinary, efficient operating
condition.
CAPITALIZED COSTS
Capitalized costs pertaining to the existing property are costs related to alterations, additions, or
improvements that increase propertys useful life or value or make it adaptable for a different
use.
The distinction between repair costs and capitalized costs for an existing property is useful
because repair costs can be deducted as operating costs; whereas, capitalized costs will have to
be depreciated. This difference can have significant tax consequences, as we will examine in the
Domestic Agreements section.

Economic Evaluation in the Petroleum Industry


Chapter 3- Economicflnalysis

USEFUL LIFE
Useful life is the time over which the property is kept in productive use.
TAX LIFE
Tax life is the period of time over which depreciation is calculated to offset taxable income. This
period is usually shorter than the useful life of the property. It is determined by the tax code of a
particular country depending on the type of property. For example, in the United States the tax
life can be as short as three years for taxi cabs and race horses, and as long as 31.5 years for
non-residential real estate.
Some popular methods of estimating the cost of depreciation are discussed below.

Example 3-1
An oil company ordered a new submersible pump for improving production from an old well. The pump costs $20,000. The
company will have to pay 7% sales tax on the pump. Additionally, the shipping cost is $300, and the installation cost is $1,000.
What is the cost basis for the pump?
Solution 3-1
In calculating the cost basis (any cost associated with the purchase), shipping, installation and site preparation should be
included. Therefore, the cost basis for the pump is,
Cost of Pump
Sales Tax (7%)
Shipping Cost
Installation Cost

$20,000
$1,400
$300
$1,000

Cost Basis

$22,700

In calculating cost basis, it is critical that all costs, including some non-monetary transactions, are included. One example of a
non-monetary transaction is the trade-in benefit. If you trade in an oil pump for a new pump so that the cost of the new pump is
$18,000, the cost basis will not be reduced by $2,000. Since the trade-in value is considered to be $2,000, it will be added in the
cost basis as a separate item.

STRAIGHT-LINE DEPRECIATION
Straight-line depreciation is one of the easiest methods of estimating depreciation.
Mathematically, the depreciation is calculated as:

Dk

(B0 - S)

Equation 3-2

where Dk is the depreciation in year k, B0 is the cost basis, S is the salvage value at the end of
tax life, and n is the number of years of tax life.
Alternately, depreciation can also be calculated as,
Bk_ 1

n-k+1

Equation 3-3

Mohan Ke/kar, Ph.D., J.D.

where Bk_i is the book value at the end of period k - 1. Both equations will give the same
result. The book value is calculated using Equation 3-1.
A common term, S. in Equation 3-2 and Equation 3-3, is difficult to estimate at the beginning of
taxable life for some properties. Many tax codes simplify the calculations by assuming that the
salvage value is zero at the end of tax life.
Example 3-2
Consider a piece of equipment purchased for $5,000. If the tax life is five years, and the salvage value is zero, calculate the
depreciation schedule over the five year period.
Solution 3-2
Using Equation 3-2,

Dk =

B0 S

= (5,000) = $1,000

Therefore, the depreciation schedule can be written as,

Year

Depreciation

Book Value at the


Beginning of the Year

1
2
3
4

1,000
1,000
1,000
1,000
1,000

5,000
4,000
3,000
2,000
1,000

Using Equation 3-3, we could reach the same result. For example, in year 2, the book value at the end of year 1 is $4,000;
therefore, depreciation is,

B1 S

4,000

DECLINING BALANCE DEPRECIATION


The declining balance method allows depreciation at a faster rate than the straight-line method.
The amount of depreciation in each year is a certain percentage of the book value at the end of
the previous year. This percentage is constant throughout the tax life of the property and is
usually defined as the ratio of declining balance rate to tax life. For example, if the declining
balance rate is 200% and the tax life of the property is five years, then the percentage of the
book value used as depreciation is 200%/5=40% per year. If we denote this percentage change
in fraction as R, we can calculate the depreciation in year k as,

if

Dk = RB k _ l

Equation 3-4

where the book value at the end of year k can be calculated as,

BkBO_>IDk
k=1
B0(1 - R)k

Equation 3-5

0
Economic Evaluation in the Petroleum Industry
Chapter - Economic Analysis

Substituting Equation 3-5 in Equation 3-4, we can calculate the depreciation in year

Dk = RB 0 (1 - R)
where

k as,

Lciuii4ii

B0 is the cost basis.

The declining balance rate can vary between 100% and 200% (double declining balance); the
most common value being 200%.
Example 3-3
Using the same information as in Equation 3-2, and using the double declining balance method, estimate the depreciation
schedule.
Solution 3-3
For year one, depreciation is calculated as (using Equation 3-6),

where R is 200%/5 = 40%, and B0 = $ 5,000.


Substituting,
= 0.4 x 5,000 = $2,000
The book value at the end of year 1 can be calculated using Equation 3-5,
131 =B0 (1 - R) 1
= 5,000(1 - 0.4) = $3,000
Similarly, for year two,

D2 = RB0 (1 .- R) 2
= 0.4(5,000)(1 - 0.4)
= $1,200
Or, using Equation 3-4,

D2 = RB e _ 1
= 0.4(3,000)
= $1,200
The book value is,
13 2

= ( 5,000)(1 - 0.4)
= $1,800

Calculations can be repeated for other years as well, as shown in the table below:
Year

1
2
3
4
5

Book Value

5,000
3,000
1,800
1,080
648
Total

Deprecation
2,000
1,200
720
432
259
$4,611

After five years, the total amount of depreciation allowed is $4,611, which is not equal to the cost of the equipment. This is one

Mohan Kelkar, Ph 0., J.D.

of the major disadvantages of the declining balance method. That is, the cost of the equipment cannot be recovered fully over
the tax life. Only over long periods of time can the total cost be fully recovered.

SUM-OF-YEARS DIGITS DEPRECIATION


The sum-of-years digits depreciation method also results in a larger depreciation at the
beginning of a useful life than the straight-line depreciation method. It is not a very common
method. To calculate the depreciation using this method, we first need to know the sum-ofyears digits. This sum represents the sum of all the years in a tax life. For example, if n is the tax
life of a property, the sum is calculated as,

sum = 1 +2+3+...+n

Equation 3-7

Alternately, we can also calculate the sum as,

sum =

n (n+ 1)
2

Equation 3-8

Depreciation in year k can be calculated as,


remaining tax life at the beginning of period k

Dk =

sum

(B

s)

Equation 3-9

We can write Equation 3-9 as,


n- k+1
Dk

n(n+1)

(B0 - S)

- 2(n-k+1)
n(n+1)

(B0 - S)

Equation 3-10

Book value can be calculated using Equation 3-1.


Example 3-4
Using the same information as in Equation 3-2, calculate the depreciation schedule using sum-of-years digits depletion.
Solution 3-4
Using Equation 3-10, depreciation in year 1 can be calculated as,
2(5 - 1+1)
=

(5)(6)

(5,000) = $1,667

For year two,

D2 =

2(5-2+ 1)

( 5)(6)

(5,000) = $1,333

The book value after year two is,

B2 =

B0

- Dk

= 5,000 - (1,667 + 1,333)


= 2,000

Economic Evaluation in the Petroleum Industry


Chapter 3- Economic Analysis

Similar calculations can be done for other years.


Year

Book Value

1
2
3
4
5

1,667
1,333
1,000
667
333

Total Depreciation

3,333
2,000
1,000
333
0

$5,000

Unlike the declining balance method, the sum-of-years digits method allows the depreciation of the entire cost of an asset.

DECLINING BALANCE AND STRAIGHT-LINE DEPRECIATION

(i.e., not being able to


recover the entire cost of an asset) and, at the same time, allow for rapid depreciation as
calculated by the declining balance method, a combination of declining balance and a straightline method is used. This method allows the calculation of depreciation using both the declining
balance and the straight-line methods and allows for switching from one method to another
when one method predicts a higher depreciation.

To remove the major disadvantage of the declining balance method

Recall that straight-line depreciation is calculated as,


D

- Bk_I

Equation 3-3

k - nk+1

and the declining balance depreciation is calculated as,


Dk = RBk_ l

Equation 3-4

For each year, we compute the depreciation using both methods and choose the value that is
higher. If

RB k1 >

Equation 3-11

i-:i

we select the declining balance method. If

RB k _ l <

Equation 3-12

we select the straight-line method.


If we assume that the salvage value is zero, we can simplify Equation3-12 to write,

R<

1
nk+1

1
I?

ork>n+1----

Equation 3-13

Equation 3-13 provides a condition for switching to a straight-line method. For example, if
5, and R = 0.4, k > 3.5 to switch to a straight-line method. That is, we will switch in year 4
to a straight-line method. The following example illustrates the technique.

n=

Mohan Kelkar, Ph.D., J.D.

Example 3-5
Using the same information as in Example 3-2, calculate the depreciation schedule using the combination (double declining and
straight-line) method. Assume double declining balance (DDB).

Solution 3-5

Year

1
2
3
4
5

Depreciation
(Declining Balance)
2,000
1,200
720
432
216

Depreciation

Book Value

Selected

(Straight-line)

At The End

Depreciation

3,000
1,800
1,080
540

2,000
1,200
720
540
540

1,000
750
600
540
540

For example, for year one, for the declining balance method,R = = 0.4. Using Equation 3-4,

D1 = RB0 = 0.4 x 5,000 = $2,000


For straight-line method, using Equation 3-3,

B0
n-1+1

5,000
-= $1,000

Since 2,000>1,000, we should select the declining balance method; therefore, the book value at the end of year 1 will be,

5,000 + 2,000 = $3,000


For year two, depreciation using the declining balance method,

D2 = RB 1 = 0.4 x 3,000 = $1,200


and depreciation using a straight-line method,

113

B1
3,000
==$
4
n-2+1

750

As before, we select the declining balance method.


Using Equation 3-13, we expect to switch after 3 years. In year 4, depreciation using the declining balance method,

/14 = RB3 = 0.4 x 1,080 = $432


and depreciation using the straight-line method,

114

B3
1,080
= $540
4+1=

Depreciation using the straight-line method is higher; therefore, the straight-line method should be selected.
Problem 3-1
A pump for injecting water costs $10,000. If the salvage value is assumed to be zero, calculate the depreciation schedule using
the following methods if the useful life is five years.
Straight-line depreciation
Sum-of-years digits depreciation
Double declining balance (DDB) depreciation

Economic Evaluation in the Petroleum Industry


Chapter 3- Economic Analysis

DDB depreciation with switch to a straight-line depreciation


Problem 3-2
A hauling truck costs $12,500. If the useful life is three years and the salvage value
depreciation schedule using:

of the truck is $2,000, calculate the

Straight-line depreciation
DDB depreciation
DDB depreciation with switch to a straight-line depreciation.
Problem 3-3
Tubing for a well costs $20,000. If the life of the tubing is seven years and the salvage value is zero, calculate the depreciation
schedule using:
Straight-line depreciation.
DDB depreciation.
DDB depreciation with switch to a straight-line depreciation.
Calculate the year in which you will switch to a straight-line method and verify your answer with Equation 3-x.
21Y1I
A drilling company purchased a new drilling rig for $5 million. The tax life is seven years, and the depreciation is to be calculated
using the double declining balance method. After three years, due to relatively limited use, the company sold the rig for $2
million. Based on the depreciation schedule, did the company earn any taxable income after three years? If so, how much?
Problem 3-5
An oil company bought a new workstation for $100,000. The workstation is to be depreciated over a five year period using a
DDB/straight-line combination method. After four years, because of advances in computing, the company traded in the old
machine for a new machine. With trade in, the new workstation costs $100,000; without a trade in, the value is $115,000.
Calculate the depreciation for a new machine assuming five years useful tax life. Calculate the taxable income, if any, for the oil
company after four years due to trade-in.
Problem 3-6
A computer was purchased for $10,000 at the beginning of 1991. It was depreciated using the straight-line method assuming a
tax life of 5 years. In early 1994, $5,000 was spent to significantly upgrade and improve the performance
of the computer.
Assuming that depreciation begins in the same year as capital expenditure, and the tax life of the upgraded expenditure is also
five years, calculate the depreciation in years 1994, 1995, and 1996.
Problem 3-7
An oil company bought a gas oil separator for $80,000. The sales tax is 85v., the delivery cost is $500, and the site preparation
required another $1,000. The maintenance insurance for the compressor was offered at $1,000 per year. If the tax life of the
compressor is seven years, and is to be depreciated using a combination DDB and straight-line method, calculate the
depreciation schedule.
Problem 3-8
Tubing for a new oil well was purchased for $50,000. Assuming a salvage value of zero and a tax life of seven years, calculate
the depreciation schedule using the sum-of-years digits method. If, after five years, the well needs to be shut in and the tubing
can be sold for $10,000, what is the taxable income for the company, if any?

10

Mohan Kelkar, Ph.D., J.D.

INCOME TAXES (PARK, 1993) (DEGARMO, SULLIVAN, & BONTADELU, 1993)


In general terms, taxes are a way by which authorities share part of the income of an individual or a
corporation. These authorities may be the federal government, individual states, local
municipalities, counties and school districts. Taxing income can take several forms; the most
common being income tax that is levied on the difference between the gross revenue and allowed
deductions for tax purposes. Other types of taxes include property taxes that are based on the value
of real estate; sales taxes based on the price of goods; luxury taxes based on items that are not
considered necessities; entertainment taxes based on entertainment expenses; and value added
taxes based on the difference in the value of goods as they pass from one party to another. There
may be other types of taxes not included here.
In this section, we will concentrate on income taxes which, in most instances, are levied by either
federal or central government and local or state governments. The laws governing the calculations
of income tax are extremely complex and replete with exceptions. Therefore, rather than
considering the details of the tax laws in various countries, we will focus on the basic principles of
tax laws common in most instances.
The first principle of income tax is that it is assessed based on taxable income. Taxable income is the
difference between gross income or gross revenue and allowable deductions according to tax laws.
Logical tax deductions are operating costs or other expenses associated with operating a business.
Other tax deductions typically included are depreciation and interest payments.
The second principle common to most income tax laws is that the rates at which the tax applied
tends to be progressive. That is, the tax rates are lowest when the taxable income is the least. As the
taxable income increases, the tax rate also increases.
In most economic evaluations, we need to use the marginal tax rate for calculations. Marginal tax
rate represents the tax rate applied to the last dollar earned in the taxable income. For example, if
the corporation has earned $30,000 last year and expects to add another $10,000 in taxable income
with the addition of a new project, it is reasonable to assume a marginal tax rate of 15% (which is,
for example, based on the tax rate paid by a corporation for $30,000 of income); however, if the
corporation earned $1,000,000 last year and is considering a new project with a potential additional
taxable income of $500,000, it is better to use a marginal tax rate as the tax rate applicable beyond
the $1,000,000 income.
In the Basic Tax Structure section, we only need to understand these two principles. The following
examples use these concepts.
TAX COMPUTATIONS
Taxable income is calculated by subtracting the allowable deductions from gross revenue. In
mathematical terms,
taxable income = gross revenue tax deductions

Economic Evaluation in the Petroleum Industry


Chapter Economic Analysis

Equation 3.-14

11

Most common deductions include operating costs, depreciation, overhead costs and other
related expenses; therefore, we can write,
taxable income = gross revenue - operating costs
related expenses - depreciation

FARMITWIMMy

Once the taxable income is calculated, the income tax is calculated using the applicable marginal
tax rate. That is,
income tax = taxable income x tax rate
To calculate net revenue, we need to subtract the actual expenses from the gross revenue.
These expenses do not include depreciation or other deductions that are only deducted for tax
purposes. Net revenue is calculated as,
net revenue = gross revenue - operating costs - related expenses - tax

Equation 3-17

If we use the following notations:

A = gross revenue in year]


Oj = operating costs in year]

D1 = depreciation (or tax deductions) in year]


T = marginal tax rate
E = other related expenses in year]
we can write taxable income as,
= A1 - - - Dj
we can write the income tax as,

=T(A0

1 E 1 Dj)

7IptIj

and we can write the equation for net revenue as,

_A0
net revenue = (1 -

1 ET(A
1 OE
1 Di)
T)(A - - E) + TD 1

Equation 3-20 can be repeated for all years in which a project is in operation.
Example 3-6
A company wishes to purchase a workstation for $15,000. This will save the company $5,000 in outside computing costs. The
maintenance agreement calls for a payment of $800 per year for the machine. Assume that the useful life of the machine is five
years. Assume further that a straight-line depreciation is allowed over a five year period. If the marginal income tax rate is 28%,
calculate the NPV of this investment with a MROR of 15%.

Solution 3-6

12

Mohan Kelkc,r, Ph.D., J.D.

Sample calculation for year one,


gross revenue (savings) = 5,000
Using Equation 3-15,
taxable income = gross revenue - operating costs - depreciation
= 5,000 - 800 - 3,000
= $1,200

Using Equation 3-16,


tax = taxable income x tax rate
1,200 x 0.28
= $336
Using Equation 3-17,
net revenue = gross revenue - operating costs - taxes
= 5,000 - 800- 336
= $3,864
In these calculations, we assumed a straight-line depreciation. Therefore,
15000
depreciation =5
= $3,000 per year
The following table lists the calculations for other years.
Gross

Year Income
0
-15,000
1
5,000
2
5,000
3
5,000
4
5,000
5,000
5

Net

Taxable

Income
1,200
1,200
1,200
1,200
1,200

Tax
336
336
336
336
336

Revnue
-15,000
3,864
3,864
3,864
3,864
3,864

We are assuming that all of the income is collected at the end of the year,
NPV

3,864
3,864
3,864
3,864
= -15,000 + (1 + .15) + (1 + .15)2 + Ti + .15)3+
- (1+.15) +
= -$2,047

3,864

Since the NIPV is negative, the project is not feasible.


Alternately, if we use Equation 3-20, we can write the net revenue equation as,
net revenue = (1 - T)(A 1 - - E) + TD
Substituting,
= (1 - 0.28)(5,000 - 800) + 0.28 x 3,000
= $3,864
Since the revenue is constant each year, we can write,

Economic Evaluation in the Petroleum Industry

Chapter

- Economic Analysis

13

NPV = PVbenefits - PVosts


-

[(1 + .15)
.3 864{ 15(1

+ .15) 5

15,000

= $2,047
We get the same answer as before.
Example 37
A gas well is expected to produce at an exponential decline rate based on the adjacent producing wells. Per initial testing, the
following production profile is predicted over the next five years. The total capitalized cost for this well was $2,000,000.
Operating costs per year are $600,000 and are expected to increase at a rate of 5% per year. Assume that gas is sold at a rate of
$1.75/MSCF, and all money is collected at the end of each year. Assume that the local tax is 7% of the gross revenue. Assume
that the capitalized cost is depreciated over a five year period using a combination method (declining balance and straightline). Assume that depletion costs are negligible. Using this information, calculate the ROR for this investment. If the minimum
ROR is 20%, is this investment feasible?

Year

Production Profile
Production, MSCF
1,561,515
1,134,922
823,531
597,688
434,578

1
2
3
4
5

Solution 3-7
The following table illustrates the results over a five year period. Sample calculations are shown below.

Year
1
2
3
4
5

Production,
MSCF
1,561,515
1,134,922
823,531
597,688
434,578

Gross
Revenue ($)
2,732,651
1,986,114
1,441,179
1,045,954
760,512

Operating
Costs ($)
600,000
630,000
661,500
694,575
729,304

Local*
Tax ($)
191,286
139,028
100,883
73,217
53,236

*Loca l tax may be treated as other expenses since these taxes are assessed based on the gross revenue, and not taxable
income.
For year one,
revenue = production x price
= 1,561,515 x $1.75
= $2,732,651
local tax = revenue x .07
= $2,732,651 x.07
= $191,286
Depreciation
Year
1
2
3
4
5

14

($)
800,000
480,000
288,000
216,000
216,000

Taxable
Income ($)
1,141,365
737,086
390,796
62,162
-238,028

Tax ($)
319,582
206,384
109,423
17,405
-66,648

Net
Revenue ($)
1,621,783
1,010,702
569,373
260,757
44,620

Mohon Kelkor, Ph.D., J,D.

For year one,


Using Equation 3-4,
2
2
depreciation = x 2,000,000
= $800,000
Using Equation 3-15,
taxable income = revenue - operating costs - local tax - depreciation
= 2,732,651 - 600,000 - 191,286 - 800,000
= $1,141,365
Using Equation 3-16,
tax = taxable income x tax rate
= 1,141,365 x .28
= $319,582
Using Equation 3-17,
net revenue = revenue - operatingcosts - localtax - incometax
= 2,732,651-600.000-191.286-319582
= $1,621,783
Note that for the last year, the taxable income is negative. As a result, the tax is also negative. Therefore,
net revenue = 760,512 - 729,304 - 53,236 - (-66,648)
= $44,620
The reason we use negative tax is because of the assumption that this is one of several projects the company is involved in and,
as a result, the loss in this project will result in a reduction in profit in other ventures and, thus, result in an overall lower tax
payment by the negative amount. To calculate the ROR,
0 = PVcos - PVbenefits
1,621,783 1,010,702 569,373 260,757 44,620
0=-2,000,000+
+
(1j)
(1+i)2 +(1.)3+(li)4+(1)s
Through trial-and-error, i = ROR = 38.3%. Since ROR>MROR, the project is feasible.

EFFECT OF DEPRECIATION SCHEDULE


As shown in the previous section, depreciation plays a major role in net revenue calculations. In
this section, we will investigate the impact of the depreciation schedule on the after-tax analysis
of a project. Recall Equation 3-20 which states that the net revenue is,
Equation 3-28
That is, we receive an "additional" net revenue of TD1 as a result of the depreciation deduction.
This additional revenue is collected over the life of the project. If we assume that the tax life of
the asset is n, then we can calculate the present value of the additional future revenues as,
Dj
TV
___

J=1 (1+1)1

Economic Evaluation in the Petroleum Industry


Chapter - Economic Analysis

Equation 3-21

15

Where i is the effective interest rate. This is the benefit we will receive as a result of the capital
expenditure B0 . Therefore, after tax consideration, the net cost associated with that asset is,

WEEMSEM

net cost = B0 - TYi


(i+t)J

Obviously, the smaller the net cost, the better off the corporation. This net cost will depend on
the depreciation schedule. Examining Equation 3-22, one can see that more accelerated the
depreciation; the smaller the net cost. Time value of money of earlier depreciation is much
more valuable than later depreciation. This means an accelerated depreciation is more valuable
than straight-line depreciation. It also means that an item depreciated over a shorter period will
reduce more of the net cost than an item depreciated over a longer period. If the item is
depreciated over one year, there is no difference between capitalized cost and operating cost
since both costs will be deducted in the same year in which they are incurred.
Example 3-8
A water pump at a cost of $90,000 is to be used in a waterflooding operation. The additional water injected, because of the
pump, is expected to result in incremental production of 8,000 bbls of oil in year 1, decreasing at 8% per year. Additionally,
initial costs include reperforation and acidization of some of the wells which will cost an additional $70,000. The operating
costs, as a result of the new pump, are expected to be $7.50 per additional barrel of oil. If the oil price is assumed to be $18/bbl
and the life of the project is expected to be 10 years, calculate the NPV of this project. Assume the MROR to be 15%. Use both
the straight-line depreciation and DDB depreciation methods. The marginal tax rate is 34%. Assume the salvage value to be
zero. Compare the results between straight-line and DDB depreciation methods.

Solution 3-8
Straight-line Depreciation
The following table shows all of the computations. In performing these calculations, we assumed that $90,000 was expended at
the beginning and all the revenues are collected at the end of the year. $70,000 acidization and re-perforation costs were
considered operating costs; hence, they were deducted at the end of the first year along with the operating costs. It is possible
that a different convention may be used to define the expenses and revenues. For example, one of the most common
conventions used is the half-year convention where all numbers are defined in the middle of the year.

Year

0
1
2
3
4
5
6
7
8
9
10

Production

8,000
7,360
6,771
6,230
5,731
5,273
4,851
4,463
4,106
3,777

Gross

Operating

Revenue

Costs

-90,000
144,000
132,480
121,882
112,131
103,161
94,908
87,315
80,330
73,904
67,991

Taxable
Depreciation

130,000
55,200
50,784
46,721
42,984
39,545
36,381
33,471
30,793
28,330

12,857
12,857
12,857
12,857
12,857
12,857
12,857
12,857

Income

1,143
64,423
58,241
52,553
47,320
42,506
38,077
46,859
43,111
39,661

Net
Tax

Revenue

389
21,904
19,802
17,868
16,089
14,452
12,946
15,932
14,658
13,485

-90,000
13,611
55,376
51,296
47,542
44,088
40,911
37,988
30,927
28,453
26,176

Calculations are carried out using previously described methods. The NPV for this operation can be calculated as,

NPV

16

13,611

26,176

= -90,000 + (1 + .1s + + (1 + .15) 0


= $103,175

Mohan Kelkar, Ph.D., J.D.

I
I
I
I
I
I
I
I
I

Since the NPV is positive, the project is feasible.


Double Declining Balance Depreciation (DDB)
The following table shows all the computations.

Year
0
1

Production

2
3

8,000
7,360
6,771

4
5
6
7
8
9
10

6,230
5,731
5,273
4,851
4,463
4,106
3,777

Gross
Revenue

Operating
Costs

Depreciation

130,000
55,200
50,784

25,714
18,367
13,120

46,721
42,984
39,545
36,381
33,471

9,371
6,694
4,781
3,415

-90,000
144,000
132,480
121,882
112,131
103,161
94,908
87,315
80,330
73,904
67,991

Taxable
Income
-11,714
58,913
57,978
56,039
53,483
50,582
47,519
46,859
43,111
39,661

30,793
28,330

Tax
3,983
20,030
19,713
19,053
18,184
17,198
16,156
15,932
14,658
13,485

Net
Revenue
-90,000
17,983
57,250
51,385
46,357
41,993
38,165
34,778
30,927
28,453
26,176

The only difference between this table and the previous table is the amount of depreciation per year. The NPV can be
calculated as,

NPV = - - 90,000 + 17,983 + +


(1 + .15)

26,177
(1 + .15) 10

= $104,338
The difference between the two NPV values is equal to
= 104,338 - 103,175 = $1,163
This additional NPV using the 0D13 method is a result of accelerated depreciation. Instead of depreciating, if the cost of the
pump is allowed to be expensed in the first year, the NPV will be $142,686. This improvement is due to recovering all of the tax
benefit of depreciation in the first year.

Many companies will maintain separate accounting books; one for tax purposes and one for
balance sheets. For tax purposes, the company will use the most favorable depreciation
schedule available that will maximize the tax benefit. For balance sheets, the company will use a
depreciation schedule that allows for the smallest depreciation possible each year. This
apparent dichotomy serves two purposes. By using the quicker depreciation schedule for tax
purposes, the company can improve the net revenue as shown in the previous example. At the
same time, by using a slower depreciation schedule for balance sheet purposes, the company
can show that the asset base of the company is not reduced significantly over the year. The
asset base is the cumulative book value in the previous year minus the depreciation. If the
depreciation is smaller, the asset base will be larger providing the shareholder with a larger
equity base. To account for the differences between the two methods, a company will report
differed taxes in its balance sheet. These differed taxes represent the difference between what
the company had would have to pay if it had used a slower depreciation versus what it is paying
due to accelerated depreciation. In mathematical terms, the differed taxes are:

I
I
I
I
I

T (Daccj - D s t tine.)

Economic Evaluation in the Petroleum Industry


Chapter 3 - Economic Analysis

Equation

17

Where Daccj represents the accelerated depreciation amount used for tax purposes versus

Ds t.iinej represents a slower depreciation used for asset base purposes. In

Equation 3-8,

depreciation in year 1 using DDB is $25,714, whereas, depreciation using the straight-line
method is $12,857. For a marginal tax rate of 0.34, the differed taxes will be,
0.34(25,714 - 12,857) = $4,371
This is the exact difference in the net revenue in the first year using different depreciation
schedules. Most corporations, in their annual and quarterly financial reports, include a line item
for differed taxes. These are the taxes resulting from different depreciation schemes.
EFFECT OF BORROWED MONEY
Most tax laws allow a deduction for an interest payment on borrowed money. The interest
payment is considered the cost of operating a business; hence, it is considered an operating
cost. Because of the deduction of interest rate, the effective interest paid by the corporation is
equal to (1 - T)I where T is the marginal tax rate and I is the interest rate on the loan. As long
as (1 - T)I is less than the MROR, a corporation can borrow money and "leverage" its own
investment and make additional NPV. The following example illustrates the benefit.
Example 3-9
A potential prospect has been shown to an oil company. It will require the oil company to invest $2,000,000 to install a
compressor in a gas field. The compressor can be depreciated over a seven-year period using a combination of DDB and the
straight-line method. After installing, the gas field is expected to initially produce an incremental gas of 600 MSCFD declining at
10% per year. Beyond ten years, there will not be any incremental production. Assume the gas price to be $4/MSCF with 12%
of the revenue for the royalty payment and about $0.50/MSCF in operating costs. The company uses 15% as a hurdle rate
(MROR). The company has enough cash to invest in this project; however, using its other assets, it can borrow the entire
amount at a 6% interest rate and redeploy the money elsewhere. The marginal tax rate is 35%. Which is the better choice?
Assume that the money is borrowed over a ten year period. At what interest rate will it not make a difference if the company
borrows money or invests its own capital?
Solution 3-9
We can solve this problem by first assuming that the oil company used its own money. The table below shows the summary of
the calculations.

Year

Production

Gross

Operating

(MMSCF)

Revenue

Costs

1
2
3
4
5
6
7
8
9
10

219
197
177
160
144
129
116
105
94
85

-2,000,000
876,000
788,400
709,560
638,604
574,744
517,269
465,542
418,988
377,089
339,380

214,620
193,158
173,842
156,458
140,812
126,731
114,058
102,652
92,387
83,148

Taxable
Depreciation

571,429
408,163
291,545
208,247
173,539
173,539
173,539

Income

89,951
187,079
244,173
273,899
260,393
216,999
177,946
316,336
284,702
256,232

Net
Tax

31,483
65,478
85,460
95,865
91,137
75,950
62,281
110,718
99,646
89,681

Revenue
-2,000,000
629,897
529,764
450,257
386,181
342,794
314,588
289,203
205,618
185,057
166,551

Production is calculated by multiplying the daily rate by 365 and diving by 1,000. Operating costs include both royalty payment
and operating costs. The net present value at 15% is $41,371. The project is barely economical.

18

Mohan Kelkar, Ph.D., J.D.

If the oil company borrows $2,000,000 at 6% interest, no money from its own pocket is invested. Instead, the company will
have to make a payment on the borrowed amount. The yearly payment is

[0.06(1 + 0.06) 10

= 2,000,000 [(1 + 0.06)10 - i.j = $

271,736

This payment is split into an interest part and a principal part. The portion going toward principal is calculated as

Principalk+l = (l+-k

This represents the principal payment for (k+l)t period. The balance would go toward interest. For

example, in year 2, we can state

Principa12 = (1 2

101

= $ 160,840. Therefore, the interest payment in year 2 will be

=271,376 - 160,840 = $110,896. These amounts change over time as the interest payment decreases and principal payment
increases. The functions to calculate the interest payment and principal payment are available in standard spreadsheet
program. The following table shows the details of the calculations.

Year

0
1
2
3
4
5
6
7
8
9
10

Production

Gross

Operating

(MMSCF)

Revenue

Costs

0
876,000
788,400
709,560
638,604
574,744
517,269
465,542
418,988
377,089

219
197
177
160
144
129
116
105
94
85

339,380

214,620
193,158
173,842
156,458
140,812
126,731
114,058
102,652
92,387
83,148

Depreciation

571,429
408,163
291,545
208,247
173,539
173,539
173,539

Interest

Taxable

Payment

Income

120,000
110,896
101,245
91,016
80,173
68,679
56,496
43,581
29,892
15,381

-30,049
76,183
142,927
182,883
180,220
148,320
121,450
272,755
254,810
240,851

Net
Tax

-10,517
26,664
50,025
64,009
63,077
51,912
42,508
95,464
89,184
84,298

Revenue
0
400,161
296,842
213,957
146,401
99,119
66,890
37,241
-50,864
-76,217
-99,802

The NPV for this scenario is $826,043. In effect, by borrowing money, a marginal project became very attractive.
For example, for year two,
taxable income
net revenue

=
=
=
=
=

gross revenue - operating costs - depreciation - interest payment


788,400 - 193,158-408,163 - 110,896 = 76,183
gross revenue - operating costs - interest payment - tax - principal payment
788,400 - 193,158- 110,896 - 26,664- 160,840
$296,842

Note that the principal payment has to be deducted from the net revenue since it is an actual expense. The only difference is
that it is deducted after taxes are calculated. To calculate the interest rate at which it will not make any difference, we can use
trial-and-error. In the table below, an interest rate of 23.1% was paid on the borrowed amount. The NPV for this project is
$41,371; the same as when no money was borrowed. This interest is also calculated by noting that (1-0.35) x 0.231 = 0.15. 0.35
is the marginal tax rate and 15% is the hurdle rate. The higher the marginal interest rate the company pays, the higher the
interest rate it can borrow and improve the NPV of the project.

Year

0
1
2
3
4
5
6
7
8
9
10

Production

Gross

Operating

(MMSCF)

Revenue

Costs

219
197
177
160
144
129
116
105
94
85

0
876,000
788,400
709,560
638,604
574,744
517,269
465,542
418,988
377,089
339,380

214,620
193,158
173,842
156,458
140,812
126,731
114,058
102,652
92,387
83,148

Economic Evaluation in the Petroleum Industry


Chapter - Economic Analysis

Depreciation
571,429
408,163
291,545
208,247
173,539
173,539
173,539

Interest
Payment
461,540
446,271
427,479
404,350
375,881
340,848
297,728
244,656
179,337
98,945

Taxable

Net

Income

Tax

-371,589
-259,193
-183,307
-130,451
-115,491
-123,849

-130,056
-90,717
-64,157
-45,658
-40,422
-43,347
-41,924
25,088
26,878
55,051

-119,782
71,680
105,365
157,287

Revenue
0
263,732
158,255
72,171
100
-53,351
-93,819
-134,296
-236,456
-279,879
-326,522

19

Borrowing is useful and leverages the project and improves the NPV as this example illustrates.
Case Study 3

An article appeared in the paper (Wall Street Journal, 2009) about a federal program to stimulate the purchase of electric vehicles.
Golf carts which run on clectncity, qualify as electric vehicles. The federal credit provides from 54,200 to $5,500 for the purchase of
an electric vehicle, and when it is combined with similar incentive plan in many states the tax credits can almost pay the entire cost
of a golf cart Even in states that do not have their own tax rebate plans the federal credit is generous enough to pay for half or even
two-thirds of the as erage sticker price of i golf cart which typically ranges in price from $8,000 to $1 0,000. "The purchase of some
models could be absolutely free says Roger Caddis of Ada Electric Cars in Oklahoma Is that about the coolest thing youve ever
heard?"
\ golf cart boom followed an IRS (Internal Revenue Service which governs taxes in the 12 S) ruling that golf carts qualify for the
electric car credit is long as they are also road worthy. These qualifying golf carts are essentially the same as normal golf carts with the
addition of extra safety features, such as side and rearview mirrors and three-point seat belts. They typically go 15 to 25 miles per
hour.
In South Carolina, sales of these carts have been soaring as dealerships alert customers to the government tax rebate. The Golf Cart
Man" in the Villages of Lady Lake, Florida is running a banner online ad that declares: "GET A FREE GOLF CART or make S2,000
doing absolutely nothing!"
The Golf Cart Man is referring to his offer in which you can purchase the cart for $8,000, get a $5,300 tax credit off your years
income tax, lease it back for $100 a month for 27 months, at which point The Golf Cart Man will buy back the cart for $2,000. "This
means you own a free golf cart or made 82,000 cash doing absolutely nothing!!!"
Let us assume that you are interested in purchasing a golf cart for $8,000. You lease it to The Golf Cart Man for $100/monthAssume that The Golf Cart Man only pays you at the end of the year. Let us assume that you bought the car on January 1st, Since the
golf cart is car that you are using for investment, you can depreciate it over a three year period. Use a combination of double
declining/straight-line method. At the end of the first year (December 311, you -will be able to get a $5,300 tax credit. The tax credit
is not ordinary income. First calculate the tax owed in that year and then add $5,300 as a tax credit. For example, let us assume that
you calculate the tax to be paid as $2,000. If you are owed a tax credit of $5,000, then the tax liability is $3,000. That is, the
government will pay you 53,000 instead of you paying the government $2,000. If you return the car at the end of 27 months and
collect S2,000, what is the return on your investment (NPV) based on a 3 year project? Do your calculations based on the assumption
that the transaction occurs at the end of the year. That is, assume an income of S2,000 at the end of the third year. Instead of taking
$2,000. you decide to keep the cart. Every month, starting with the 27th month, you believe that you can save about $100/month by
utilizing the cart for your own use. However, The Golf Cart Man charges you a $50/month storage fee to store your cart at the golf
course. You intend to use the golf cart until it is six years old. At that point, you expect to sell it for about $500. Is it better to collect
S2,000 from The Golf Cart Man or keep the car for six years? Assume a marginal tax rate of 31%. Assume the MROR to be 15%.
Consider another scenario. You want to buy the cart but you do not have the cash. You approach The Golf Cart Man and he agrees
to lend you S8,000 at an interest rate of 15% per year. You will have to pay back the entire cost over a three year period on an annual
basis. If you decide to take on that offer, what will be your NPV under the first scenario described above?
Case Stud Solution 3.1

Option 1: Sell the cart after 27 months for 52,000


Here are the details:
Year

Gross Revenue

0
2
3

(8,000)
1,200
1,200
2,300

Depreciation

5,333
1,778
889

Taxable Income

(8,000)
(4,133)
(578)
1,411

Taxes

(6,581)
(179) ,.
437

Net Revenue

-3,000
7 1781
1,379
1,863

Notice that in year 1 taxes include a tax credit of 85,300. so the amount stated (6,581) is calculated as -4,133 x 0.31 - 5,300. The NP\T
for this option is $1,034.
)ptn in 2: Sell the car after six years
I Ieee are the details:

20

Mohan Kelkur, Ph.D., J.D.

Year

Gross Revenue

Depreciation

(8,000)
1,200
1,200
750
600
600
1,100

1
2
3
4
5
6

Taxable Income

Taxes

(8,000)
(4,133)
(578)
(139)
600
600
1,100

5,333
1,778
889

Net Revenue

8,000
7,781
1,379
793
414
414
759

(6,581)
(179)
43
186
186
341

The NPV for this scenario is $1,101, which is slightly better than Option I
Option 3: Similar to option 1 except that the money is borrowed at 15% interest

Here are the details:


Interest

Gross

Year
0
1
2
3

Revenue

Depreciation

1,200
1,200
2,300

Payment

5,333
1,778
889

1,200
854
457

Principal
Payment

2.304
2 1 649
3,047

Taxable

Income
(8,333)
(1,432)
954

Taxes

(6,953)
(444)
296

Net
Revenue

0
4,650
1,860
-1,500

In this case, S8,000 is borrowed; therefore, there is no initial investment. The borrowed money is returned over a three year period
using an interest rate of 15%. The interest payment is deducted for tax purposes. The NP for this option is $1,651. This is probably
the best of the available options.
Problem 3-9
An oil company is considering installing gas lift equipment on a well. The equipment will cost $60,000 which can be depreciated
using sum-of-years digits depreciation. The equipment has five years of useful life and a zero salvage value. it is expected that
the annual net benefit, as a result of installment will be $1 7,000 for the five year period. If the companys MROR is 12% after
taxes and the tax rate is 34%, should the company invest in this equipment?
Problem 3-10
An oil company is considering buying a compressor that costs $500,000. An alternative is to lease the compressor for $200,000
per year. The maintenance cost is $25,000 per year if the compressor is purchased. Assume that the compressor can be
depreciated using a DDB and straight-line combination depreciation method over a five year period. Further assume that the
income tax rate is 34%. At a MROR of 15%, which option is preferable? Would the answer be different if the MROR is 25%? Use
a five year period to complete the calculations.
Problem 3-11
A small operator has a total revenue of $1.5 million from gas production. Following are expenses for the company:
Labors $150,000
Materials = $70,000
Depreciation = $20Q,000
Operating expenses = $300,000
Royalty income from other investments = $32,000
Interest = $61,000
Proceeds from sales of old equipment with a book value of $30,000 = $65,000
What is the taxable income for the operator? If the tax rate is 34%, what is the net revenue received after income taxes? If the
state levies a 6% grass revenue tax on gas production, what is the net revenue? If the operator lost $100,000 in the previous
year and is allowed to carry forward the loss into the next year, what is the net revenue?

Economic Evaluation in the Petroleum Industry


Chapter 3 Economic Analysis

21

Problem 3-12
Clean Environmental Company started its operation with an initial investment of $2.5 million. Its primary target is oil well site
cleanups Out of $2.5 million $1.5 million is invested in equipment with a seven year life (DDB depreciation) The remaining $1
million are invested in start-up costs that can be depreciated over a five year period using the straight-line method The
company is expected to gross $1 million in revenues in year I with a projected increase of 10% per year over the next 10 years
The operating costs will be $150,000 in year one increasing at 10% per year. If the tax rate is 34% calculate the NPV of this
venture if the MROR is 15% If the company can deduct the start-up costs in the first year of operation and is allowed to carry
forward losses into future years, how will the NPV change?
Problem 3-13
An oil company is considering two options for the development of a project. It can continue to produce under existing conditions
or it can stimulate all of the wells to accelerate the production from the field. Proceeding under existing conditions will result in
the production of 150 bbl/d with a decline of 6% per yeorfor the next 10 years. The cost of production is $100,000 in fixed costs
plus $61bbl. If the stimulation project is undertaken, it will cost $20,000 per well. A total of 20 wells are operating in the field.
Production is expected to increase to 230 bbl/d, but is expected to decline at 10% per year over the next 10 years. The operating
cost structure will not change. The costs associated with stimulation can be considered as operating casts and can be deducted
in the same year. Assume that the company has other profitable operations such that the company can have "negative taxes"
from this project. If the marginal tax rote is 39% and the MROR is 12%, which option should the company choose? The price of
oil is $1 71bbl.
Problem 3-14
A promoter wants to drill a well in a yet-to-be explored area. The cost of drilling is expected to be $1 million. Other start-up
costs are expected to be $250,000. The equipment costs related to the well, if successful, will be $200,000. Based on the wells in
the nearby area, the well is expected to produce 5,000 MS CF/B. Production will decline at a rate of 10% per year. The well is
expected to produce at least for 15 years. Assume that the equipment cost con be depreciated over 7 years using a combination
of DDB and a straight-line method. A total cost of drilling of 70% can be deducted in year one and the rest over the next five
years with a straight-line depreciation. The other start-up costs are deducted over the life
of the well proportional to the
fractional gas produced each year. Assume that the total gas produced from the well is equal to 15 years of total production.
The operating cost of the field is $10,000 per year plus $0.15/Ms CF of gas production. If the marginal tax rate is 34% and if all
the money is invested by the promoter, what is the rate of return on this investment? If the promoter only invests 10% of the
required initial investment and 90% of the money is borrowed at 14% interest per year, what is the rate of return?Assume that
the interest payment is tax deductible. The price of gas is $1.75/MSCF1n the first year and is expected to increase at a rate of 3%
per year. Assume zero salvage value.
Problem 3-15
As part of restructuring, an oil company is proposing to automate port of the field operation. The cost of automation is
$230,000 and the equipment con be depreciated over a five year period using a combination of DDB and straight-line
of $120,000 per year over the next six years.
depreciation. Automation is expected to eliminate annual payroll expenses
Additionally, due to automation, production problems are expected to be detected earlier saving another $25,000 per year in
maintenance expenses. If the marginal tax rate is 39 01., and the MROR is 15%, should the company install the automation? If the
proposed field is expected to be sold to a potential buyer in three years, and the addition of automation can bring in an
additional $50,000 for the price of the field, will the decision be different?
Problem 3-16
A consulting company sends a newsletter to its clients updating them about recent events in the oil industry. Currently, the
newsletter is printed by an outside company at a cost of $15,500 per year. The cost is expected to increase over the next five
years at a rate of 6% per year. An alternative is to purchase a desktop publishing software package, a color laser printer, and a
high quality scanner. The cost of the software package is $3,000, a laser printer is $6,000, and a scanner is $4,000. All of this
equipment can be depreciated over five years using the straight-line method. The salvage value of the equipment is 15% of the
original equipment cost. An additional $3,000 per year will be spent on labor and material costs. If the marginal tax rote is 34%,
and the MROR is 12%, is it worth printing the newsletter in-house?

22

Mohan Kelkar, Ph.D., J.D.

Problem 3-17
An oil company is offered $3 million for a producing property based on an assessment of the property. The fair market value of
the surface property is $500,000. The fair market value of the equipment is $1 million. The remaining price goes toward the
hydrocarbons that will be produced in the future The company originally paid $200 000 for the surface property and $2 million
for the equipment. The equipment is already depreciated over ci five year period using the double declining balance method
assuming a seven year useful life The gain due to selling the surface property is taxable immediately as is the gain due to selling
the depreciated equipment five years ago. The field is currently producing at a rote of 60,000 bbls in the existing year with on
expected decline of 10% per year over the next ten years. The operating costs are $101bbl of oil. The tax rote is 34%. Assume the
salvage value of the equipment after 10 years is zero. If the oil price is expected to be $201bbl over the life of the field, should
the oil company sell the property at the expected rate of return of 20%? What is the minimum price at which the oil company
should expect to sell this property?
The buyer of the property can depreciate the equipment over a seven year period using a combination of DDB and straight-line
method. Further, by cutting some of the operating costs, the buyer can reduce the operating costs to $8.51bbl of oil. At the end
of 10 years, the buyer can sell the surface property for $1 million. The salvage value of the equipment will be zero. What is the
rate of return the buyer should expect from purchasing the property?

DOMESTIC AGREEMENTS
In the Basic Tax Structure section, we discussed the importance of depreciation and taxes on cash flow
analysis. In this section, we will discuss the importance of domestic operating agreements on cash flow
analysis. These agreements are specific to the U.S. Some of the details were provided in Chapter 1 and
will not be repeated here. To briefly review, a contract (called a tease) has to be signed between the
mineral owner and operators so that the operator will have the right to explore and produce from the
property (L. G. Mosburg, 1989). In return, the mineral owner receives royalty interest (cost-free
production or proceeds from cost-free production), and the operator receives the remaining interest
and has to pay all expenses (working interest). The operator and mineral owner typically pay the state a
percentage of production in the form of severance taxes. The lease, in most cases, can be held in
perpetuity if the operator can produce hydrocarbon in economic quantities (the operation is
economical), The operator will also pay a lease bonus to the mineral owner to entice him into signing
the lease.
Royalty payment and severance taxes are treated as operating expenses; therefore, from a tax
perspective, no unique treatment is needed. However, certain costs associated with oil and gas
exploration and production do require unique treatment. For example, leasehold costs and intangible
drilling costs (IDC). lDCs were explained in the Depreciation section. The rules regarding lDCs are also
complex and subject to many exceptions beyond the scope of this book. In general, for small,
independent operators, IDCs are may be deducted in the same year they are incurred; for large
operators,70% of the IDCs may be deducted in the same year they are incurred, and 30% of the costs
are depreciated over a five year period using the straight-line method. Capitalized costs are depreciated
using a combination of DDB and straight-line method. The specific rules are complex but, in general, in
the first year of operation, only a half year of depreciation is allowed and, in the last year, another half
of a year of depreciation is permitted. For example, if the taxable life is 3 years, the capitalized cost is
depreciated over 4 years with a half year on both ends and 2 years in between. Leasehold costs are
explained if the following section.

Economic Evaluation in the Petroleum Industry


Chapter 3 - Economic Analysis

23

LEASEHOLD COSTS
Leasehold costs include the lease bonus, costs related to the lease and property acquisitions such as
legal and administrative costs, assessment costs and most of the geological and geophysical costs.
Since these costs occur prior to production, they cannot be considered operating costs. Since these
costs do not result in tangible equipment, they cannot be considered capitalized costs. However, the
closest analog to leasehold costs is capitalized costs, because leasehold costs result in the
acquisition of minerals (instead of equipment). As with equipment, the value of minerals will
deplete over time until it reaches zero when the field is abandoned. Therefore, as with depreciation,
leasehold costs are deducted over the life of the field. The process of deduction is called depletion.
Only if the lease is terminated (e.g., dry hole), are the costs deducted in the same year. The
leasehold costs are depleted either through percentage depletion or cost depletion with few
restrictions. Both methods have a logical explanation as to how they work. The rules regarding the
specific application and eligibility for depletion are complex and beyond the scope of this book.
Remember that the percentage depletion option is normally afforded only to small, independent,
operators and they can choose between the two types of depletion. For large companies, only cost
depletion option is available.
DEPLETION
The costs (leasehold) associated with acquiring the right to drill a well, as well as the initial
assessment of feasibility to drill in a productive reservoir, is subjected to depletion. Depletion spans
the life of the reservoir.
The two most commonly used methods to recover the leasehold costs are cost depletion and
percentage depletion. Both methods have an underlying logic. If the discovery is greater than
expected, percentage depletion is the better option. The cost depletion method is strictly a recovery
of leasehold costs over the useful life of the reservoir. In contrast, percentage depletion is a tax
incentive, where part of the gross income is waived irrespective of the leasehold costs. Both
methods are discussed below.

COST DEPLETION
Cost depletion is based on the number of units produced in a given year. It can be written as,
_

depletion - ( L - D,)

Equation 3-24

) --)

where L is the leasehold cost, D C is the cumulative depletion up to a given year, u is the number
of units produced in a given year and R is the remaining reserves at the end of a given year.
Considering the uncertainties involved in estimating the remaining reserves, the value of the
remaining reserves, R, can change reflecting any new knowledge gained over the period of
production.
Example 310
Leasehold costs associated with finding a new field are $1 million, It is estimated that the field contains 200,000 bbls of
recoverable oil. Assuming that the field has produced 30,000 bbls in the first year, 27,000 bbls in the second year and
20,000 bbls in the third year, calculate the amount of depletion this period usingthe cost depletion method.

24

Mohcin Kelkcir, Ph.D., J. D.

Wo

Solution 3-10
Using Equation 3-24,

depletion = (L - D) (

U
T1 i)

For the first year,

depletion = (1,000,000) 30,000


00000)
= $150,000
where L = $1,000,000, u = 30,000 bbls and R = 200,000 - 30,000 = 170,000 bbls.
For the second year,
/ 27, 000 \
depletion = (1,000,000 - 150,000) (170000)
= $135,000
For the third year,

depletion = (1,000,000 - 150,000 135,000) 1

20,000 )
(143, 000

= $100,000
The amount will change over the production period. Eventually, the leasehold costs will be recovered by the end of the
production period. However, the method has the flexibility to account for reduction or increase in the remaining reserves.
For example, after the third year, based on evaluation of the production data, if we observe that the remaining reserves are
150,000 barrels instead of 123,000 barrels, the depletion in the third year can be calculated as:

depletion = (1,000,000 - 150,000 - 135,000)

20,000

+ 20,000)

= $84,117

PERCENTAGE DEPLETION
Unlike the cost depletion method, which allows recovery of the leasehold costs only, the
percentage depletion is calculated based on a certain percentage of gross income per year. The
idea of percentage depletion is analogous to depreciation of tangible property. Depreciation is a
certain percentage of the cost of the asset each year over the useful life of the asset. Percentage
depletion is a certain percentage of the diminished value of the producing property over the
producing life of a property. In the United States, for oil and gas properties, percentage
depletion is restricted to 15% of the gross revenues with the constraint that the amount should
not exceed 50% of the taxable income.
Exam ple 3-11
An oil property has a gross income of $500,000 per year. The deductible expenses excluding depletion are $380,000 per year.
Calculate the amount of depletion using the percentage depletion method.

0
0
0
0
0
0

Solution 3-11

Economic Evaluation in the Petroleum Industry


Chapter 3 - Economic Analysis

25

percentage depletion = 0.15 x 500,000


= $75,000
However, we need to check if it exceeds 50% of the taxable income,
taxable income before depletion = gross income - expenses
= 500,000 - 380,000
= $120,000
50% of taxable income = $60,000
Since $75,000 exceeds $60,000, the

allowed is

For a prospective oilfield, the leasehold costs ore estimated to be $60,000. The field is expected to produce 100,000 bbls? in the
first year with a decline of 12% per year. If the initial reserves are estimated to be 1 million bbls?, calculate the allowed cost
depletion for the first five years.
Problem 3-19
For a gas field currently in development leasehold costs are estimated to be $1 million. The field is estimated to produce 5
billion SCF of gas over its life. The field produced 700 million SCF in the first year and 650 million SCF the following year. After
two years, based on the field data, it was determined that the remaining reserves beyond two years of production are 3 billion
SCF as against 3.65 billion SCF as originally anticipated. If the field declines in production at a rate of 791 per year calculate the
allowed cost depletion for the first seven years of the production.
.

Problem 3-20
An oil company has a gross income of $500,000 for the year. Operating expenses, excluding depletion, are $420,000. If the
percentage depletion allowed is 15%, calculate the allowable percentage depletion.
Problem 3-21
A producing property is expected to generate $200,000 in the first year with operating expenses of $90,000. If revenues decline
at a rate of 10% and operating expenses increase at a rate of 4%, develop a percentage depletion schedule for the first five
years.
The leasehold costs for this property are $200,000.
produces 20,000 bbls in the first year with a decline
Compare it with the percentage depletion schedule.

If the original reserves are estimated to be 120,000 bbls and the well
of 10% per year, calculate the cost depletion schedule for the first 5 years.

ITAX CONSIDERATIONS
In calculating the taxable income for the purpose of tax assessment, we first need to calculate gross
revenue (or income). This income represents the total production multiplied by the sales price per
unit of production. Once the royalty interest is paid (percentage of gross revenue), the remaining
gross revenue is subject to production-related taxes.
Production related taxes are assessed by state and local governments. These taxes include
severance and ad valorem taxes. Severance taxes are assessed as a percentage of the remaining
gross revenue. The percentage varies from 0% to 35% for different states. Ad valorem taxes are
levied against the assessed value of the tangible equipment. The equipment is appraised and the tax
is assessed as a certain percentage of the appraised value.

26

Mohan Kelkar, Ph.D., J.D.

Mathematically, the taxable income can be calculated as,


taxable income before depletion = gross income - royalty payments
production related taxes
direct operating cost
amortization (of IDCs)
depreciation

Using the taxable income before depletion, for small producers, depletion is calculated using both
the methods of cost depletion and percentage depletion, and a higher of the two values is chosen.
For integrated oil companies, depletion is calculated using the method of cost depletion,
taxable income = taxable income before depletion
depletion
fl14DII1

Once the taxable income is calculated, the applicable federal tax is calculated using the appropriate
tax rate. Using the tax rate, the federal tax is calculated as,
federal tax = taxable income x tax rate

Equation 3-27

Once the federal tax is calculated, the net revenue after tax is calculated using,
net revenue = gross revenue - royalty payments - operating costs
production related taxes - federal taxes

WRT-THERIM
The following two examples illustrate the economic evaluation of a property, one owned by a small,
independent, producer and the other owned by a large oil company.
Example 3-12
A large oil company is interested in bidding on a prospect. The leasehold costs are expected to be $500,000. During the same
year, $1 million will be spent on intangible drilling costs and $1 million will be spent on tangible equipment. During the second
year, an additional $1 million will be spent on tangible equipment. Assume a useful equipment life of seven years. Depreciation
is carried using a combination of DDB and straight-line method. Production is expected to begin in the third year. Based on the
analysis of nearby wells and geophysical data, the initial production will be equivalent to 25,000 barrels in the first year and will
decline at a rate of 8% per year. Production is expected to last at least 12 years. Assume that the recoverable reserves are
estimated to be approximately 200,000 barrels. The oil price can be assumed to be $80/bbl during the entire production phase.
The royalty payment will be 12.5%; the severance tax rate is 7% and the income tax rate is 34%. The operating costs, including
the ad valorem tax, are expected to be $200,000, increasing at a rate of 4% per year. Assume the salvage value at the end of 12
years to be zero, calculate the net present value if the MROR is 15%. What is the RUR on this property?

Solution 3-12
The following table shows a summary of the calculations. Sample calculations follow.

Economic Evaluation in the Petroleum Industry


Chapter 3 - Economic Analysis

27

Gross

Costs

(2,500,000)

(1,000,000)

Royalty

Depreciation Depletion Amortization Income

Tax

Net

Taxable

Severance

Operating

Year Production Income

Tax

Revenue
(2,500,000)

700,000 (985,714) (335,143) (664,857)

285,714

25,000 2,000,000

200,000 250,000

122,500

489,796

63,258

60,000 814,446 276,912 1,150,588

23,000 1,840,000

208,000 230,000

112,300

349,854

58,197

60,000 821,249 279,225 1,010,075

21,160 1,692,800

216,320 211,600

103,684

249,896

53,541

60,000 797,759 271,238

889,958

19,467 1,557,376

224,973 194,672

95,389

190,893

49,258

60,000 742,191 252,345

789,997

17,910 1,432,786

233,972 179,098

87,758

173,539

45,317

60,000 653,102 222,055

709,903

16,477 1,318,163

243,331 164,770

80,737

173,539

41,692

614,094 208,792

620,533

15,159 1,212,710

253,064 151,589

74,278

86,769

38,357

608,653 206,942

526,837

13,946 1,115,693

263,186 139,462

68,336

35,288

609,421 207,203

437,506

10

12,830 1,026,438

273,714 128,305

62,869

32,465

529,085 179,889

381,661

11

11,804

944,323

284,662 118,040

57,840

29,868

453,912 154,330

329,450

12

10,860

868,777

296,049 108,597

53,213

27,478

383,440 130,370

280,549

9,991

799,275

307,891 99,909

48,956

25,280

317,239 107,861

234,658

13

Sample Calculations

For year one, there is no production. The gross income reflects $500,000 in leasehold costs, $1 million in tangible costs and $1
million in intangible costs (IDCs). 70% of the lDCs are deducted in the first year and the rest is amortized over five years using
straight-line depreciation.
0.3($1,000,000)
amortization =

= $60,000

Depreciation is calculated using a combination of DDB and straight-line method. The first million starts depreciating in the first
year, and the second million dollar starts depreciating in the second year. According to the accelerated cost recovery system
(ACRS), the depreciation will begin in the same year during which the equipment is placed in service. Since $1 million has been
spent on tangible items during this year, assuming a seven year useful life for equipment,

depreciation = ($1,000,000) = $285,714


taxable income = -amortization - depreciation
= -0.7(1,000,000) - 285,714
= $985,714
During this year, the company makes no revenue; therefore, taxable income includes only the costs that are allowed to be
deducted. Assuming that the company has several ongoing projects resulting in possible tax savings in other profitable projects
due to negative income for this property, we can calculate the tax paid as,
tax paid = taxable income x tax rate
= 0.34 x -985,714
= -$335,143
Therefore,
net revenue = gross revenue - royalty payment - operating costs - severance tax - tax paid
= -1000,000 + 335,143
-$664,857
-

For year three,

28

Mohan Kelkar, Ph.D., J.D.

WO

80
bbl
gross income = 25,000x $bbl
year
= $2,000,000
royalty = 0.125 x 2,000,000
= $250,000
severance tax = (gross income - royalty)state tax rate
= (2,000,000 - 250,000)(. 07)
= $122,500
For a large oil company, only the cost depletion option is allowed. Assuming that the cumulative oil production before
abandonment is 197,604 barrels (summation of the production over 12 years), using Equation 3-24,
"

cost depletion = ( L

- D)

(fi

25,000

= (500,000) (25,000 + 172,604)


= $63,258
Using Equation 3-25 and Equation 3-26,
taxable income = gross revenue - royalty payments - production related taxes - operating costs - depreciation
- amortization - depletion
= 2,000,000 250,000 - 122,500 - 2000,000 - 489,796 60,000 - 63,258
= $814,446
Using Equation 3-27,
federal tax = taxable income x tax rate
= 814,446 x 0.34
= $276,912
Using Equation 3-28,
net revenue = gross revenue - royalty - production related taxes - operating costs - federal tax
net revenue = 2,000,000 250,000 - 122,500 - 200,000 - 276,912
= $1,150,588
Similar calculations are carried out for other years. Production in each year is 0.92 times the production in the previous year;
whereas, the operating costs are 1.04 times the costs in the previous year.
The net present value at a 15% interest rate is calculated to be $450,130 and the rate of return is 19%. This indicates that the
project isfeasible.
-

Example 3-13
A small producer has spent $200,000 in leasehold costs on a potential gas prospect in year one. The producer needs to spend
$300,000 in intangible development costs and $500,000 in tangible costs in the second year before the well can be brought to
production. Based on geological, geophysical, and reservoir information, the well will produce 200,000 MSCF of gas in the first
year followed by a 15% decline per year over eight years before abandonment. In the lease, 12.5% royalty interest is awarded
to the mineral owner and a 2.5% override royalty is given to the geologist. All tangible items are assumed to have a useful life
of seven years. Assume that the total production from the well is expected to be approximately 1 BCE. Assume the gas price to
be $4.25/MSCF. The severance tax is levied at 7% and the federal tax is levied at 34%. The operating costs are expected to be
$80,000 during the producing life of the well. If the MROR is 20%, calculate the net present value of the project. What is the
ROR for this project?

Solution 3-13
The following table shows the summary of the calculations. The sample calculations follow.

Economic Evaluation in the Petroleum Industry

Chapter

- Economic Analysis

29

Income

Depletion

Severance

Production Gross Operating


Year (MMSF)

Costs Royalty

Tax

Depreciation Cost

Net

Taxable

Percentage Selected Income

Tax

(1 1 0001 000)

(1,000,000)

Revenue

200

850,000

380,000

127,500

50,575

142,857

39,043

74,534

74,534

74,534

25,342

566,583

170

722,500

80,000

108,375

42,989

102,041

21,447

108,375

108,375

280,720

95,445

395,691

145

614,125

80,000

92,119

36,540

72,886

3,091

92,119

92,119

240,461

81,757

323,709

123

522,006

80,000

78,301

31,059

52,062

78,301

78,301

202,283

68,776

263,870

104

443,705

80,000

66,556

26,400

43,385

66,556

66,556

160,809

54,675

216,074

89

377,150

80,000

56,572

22,440

43,385

56,572

56,572

118,180

40,181

177,956

75

320,577

80,000

48,087

19,074

43,385

48,087

48,087

81,945

27,861

145,555

64

272,491

80,000

40,874

16,213

40,874

40,874

94,530

32,140

103,263

80,000

34,743

13,781

34,743

34,743

68,351

23,239

79,854

6
7
8
9

54

231,617

Sample Calculations
The sample calculations are not repeated here since they are very similar to the previous example with two important
exceptions. The lDCs are deducted as operating costs in the first year; therefore, only in the first year are the operating costs
$380,000, which includes $300,000 in IDC5. The depletion is calculated using percentage depletion and cost depletion and the
highest value is selected. In our case, percentage depletion is selected in each year. The cost depletion is calculated in each
year by examining cumulative depletion in previous years. Therefore, after 3 years, since all the leasehold cost is depleted using
percentage depletion, no cost depletion exists. The NPV of the project is $451,131 and the rate of return is 33%. The project is
feasible. - -

Casc Study 3-2

In June 2008, Chesapeake (CHK) signed an agreement with Plains Exploration & Production Company (Plains) and formed a joint
venture. Your job is to evaluate from the Plains perspective. Here are the essential facts. Plains agreed to pay CHK $1.65 billion
dollars in cash for 20% working interest in CHKs leasehold in J-Taynesvillc shale. CHK has 80% NM in these leases. CHK had a net
leasehold of 550,000 net acres, which means Plains will hold about 110,000 net acres. In addition to $1.65 billion dollars in cash,
Plains agreed to pay 50% of CI-IKs 80% share of drilling costs until an additional $1.65 billion dollars is paid (i . e., for initial wells,
Plains will pay 60 1/6 of the drilling and completion costs until, based on CHKs share of 40%, all the funds are exhausted. For
example, if the cost of drilling is $1 million, Plains will pay $600,000 and CI-IK will pay S400,000. Plains CI-IK share is S400,000.
Therefore, Plains has to pay $400,000 for every well until the $1.65 billion is exhausted. After that, for every well, Plains share will be
only $200,000 (20%). The spacing of the wells is expected to be 80 acres.
It is assumed that it will take approximately 2 months to drill and complete a well. CIIK is expected to have 40 drilling rigs ready to
drill starting at the beginning of 2009. The royalty interest is 20% and the severance tax is 7%. The operating cost for these wells is
assumed to be $12,000 per month and will remain constant.
The cost of drilling and completion is from S6 million to $10 million. Assume that 30% of these costs are IDC and 70% are
capitalized expenses, which can be depreciated using a 7 year DDB/straight-line combination. The IDC costs are split so that 70% of
the lDCs are deducted in the first year and the remaining 30% are amortized over a five year period- Please note that Plains is eligible
to take the depreciation and IDC deduction for the expenses it paid. For the initial investment of S1.65 billion, assume that, based on
80 acres spacing, the leasehold bonus will be calculated as leasehold costs and, using cost depletion, deducted over the life of the well.
Assume that the gas price can vary from S5/MSCF to S7/MSCF held constant over the life of the well. The income tax rate is
assumed to be 35% k typical production profile for the best and worst well is provided below.

Year

1
2
3
5
6
5
9
10

30

Production (MMSCF/Yeai)
Worst
Best

4745
902
595
464
385
335
298
271
250
232

2555
485
320
250
207
180
161
146
134
125

Mohan Kelkar, Ph.D., J. D.

I. Assuming that Plains paid $1.65 billion up front, how much did Plains pay per acre?
Coot for Plains? Assume 80 acre sparing.
2. Assuming the ten year cumulative production represents the EUR, what is the 1 & U
If the cost needs to be less than S2/i4S( li, do you think that Plains made a good deal?
3. Assuming that the MROR is 15%, what is the NPV for Plains for the entire project based on the best and the worst ease
scenarios? Is it a good deal?
(se Study So/ursosa 32

1. Leasehold Costs per Acre

$
Acre

$1.65 x iO
110,000 = $

15,000/Acre

2. F&DCosts
The cumulative production for the best and the worst case scenarios is between 8.477 BCF and 4.56 BCF. Only 80% of the
production belongs to the operator; therefore, under the worst case scenario, F & D costs are:

F & D Costs=

80 x 15,000 + 10 x 10 6
= $ 3.1/MSCF
4.56 x 10 6
.a

Under the best case scenario, F & D Costs are:

F & D Costs

80 x 15,000 +6x 10 6
8.477 x 10 x 0.8 = $1.06/MSCF

The costs vary between S1.06/MSCF and S3.1/MSCF with an average of $2.1/MSCF. This number is slightly greater than
S2/MSCF and there is a lot of uncertainty in F & D costs making this project uneconomical.
3. Net Present Value per Well
To calculate the net present value of the well, we need to consider four scenarios. In one scenario, Plains will pay 60 1/0 of the
drilling costs but will only receive 20% of the production, and in another scenario, Plains will pay for 20% of the drilling costs
and get 20% of the production. We need to consider these scenarios under the best and worst cases.
Assuming 550,000 acre spacing, the total number of wells that can be drilled using 80 acre spacing is equal to 6,875. Using an
estimate of 40 drilling rigs, and assuming a period of 2 months to drill and complete each well, we can calculate how many 2
month periods it will take to drill the wells. It will be 172 periods or 28.7 years. Plains will have to contribute SO/s of CIIKs
drilling and completion costs until it exhausts S1.65 billion. SO% C1IKs contribution is equivalent to 40% of the drilling and
completion costs. Under the worst case scenario, Plains will contribute 40% of SlO million for each wells drilling and
completion costs. That will be S4 million. Under the best ease scenario, Plains will contribute S2.4 million toward CIIKs costs.
Please note that in addition to contributing toward Cl IKs 50% of drilling and completion costs, Plains will also be contributing
20% of its own drilling and completion costs. Under the worst ease scenario, we can calculate the number of periods required to
exhaust S1.65 billion.

1.65 x io

No. of periods for 60% contribution = 40 4 <

= 10 periods

For the best case scenario,


1.65 x 10 9

No. of periods for 60% contribution= 40 2.4 < 106 = 17 periods


That means under the worst case scenario, Plains will start contributing only 20% of drilling and completion costs starting in the
1 1 period; whereas, for the best case secnaiii. Plains will start contributing 20% of the costs starting in the 18I period.

Economic Evaluation in the Petroleum Industry


Chapter 3 - Economic Analysis

31

NPV

Year

Optimistic Case

Prod
MMSCF

60% Contribution

Gross
Revenue

(8MM)

0
2
3
4
5
6
7
8
9
10

-3.60
5.31
1701
0,67
0.52
0.43
0.38
0.33
0.30
0.28
0.26

4,745
902
595
464
385
335
298
271
250
232

Operating
Cost
($MM)

Severance
(8MM)

0.0288
0.0288
0.0288
0.0288
0.0288
0.0288
0.0288
00288
0.0288
0.0288

0,372
0.071
0.047
0.036
0.030
0.026
0.023
0.021
0.020
0.018

IDC

(8MM)
0.76
0.065
0.065
0.065
0.065
0.065

Net

Deprec.
(8MM)

Depletion
($MM)

Taxable
Income
($MM)

Taxes
($MM)

0.72
0.51
0.37
0.26
0.22
0.22
0.22

0.67
0.13
0.08
0.07
0.05
0.05
0.04
0.04
0.04
0.03

2.77
020
007
0.06
0.03
(0.01)
0.02
0.22
0.20
0.18

0.97
007
0.03
0.02
001
(0.00)
0.01
0.08
0.07
0.06

Revenue

(8MM)
-3.60
3.95
0.84
0.56
0.43
0.36
0.32
0.27
0.18
0.16
0.15

In the table above, royalty interest calculations are implicitly included in the gross revenue. The gross revenue - production x 0.2
x 0.8 x gas price. This includes the 20% share of Plains and 80% NRI. It is assumed that Plains will be allowed to depreciate its
own contribution to tangible costs. Depiction costs are the leasehold costs per well, which is 515,000 x 80 for 80 acre spacing.
The price of the gas is assumed to be S7/MS(-1. The NPV for this situation is S1.65 million.
NPV

Year
0
1
2
3
4
5
6
7
8
9
10

Pessimistic Case

Prod
MMSCF
2555
485
320
25))
207
180
161
146
134
125

60/s Contribution

Gross
Revenue

Operating
Cost

Severance

(8MM)

(8MM)

(8MM)

-6.00
2.04
0.39
026
0.20
0.17
0.14
0.13
0.12
0.11
0.10

0.0288
0.0288
0.0288
00238
0.0288
0.0288
0.0288
0.0288
0.0288
0.0288

0.143
0.027
0.018
01014
0.012
0.010
0.009
0.008
0.008
0.007

IDC
(8MM)

Deprec.
($MM)

Depletion
(8MM)

Taxable
Income
(8MM)

Taxes
(8MM)

1.26
0.108
0.108
0.108
0.108
0.108

1.2))
0.86
0.61
0.44
0.36
0.36
0.36

0.67
0.13
0.08
0.07
0.05
0705
0.04
0.04
0.04
0.03

(1.26)
(0.76)
(0.60)
(0.45)
(0.40)
(0.41)
(0.32)
0.04
0.04
0.03

(0.44)
(0.27)
(0.21)
(0.16)
(0.14)
(0.15)
(0.11)
0.01
0.01
0.01

Net
Revenue
(8MM)
-6.00
2.31
0.60
0.42
0.32
0.27
0.25
0.20
0.07
0.06
0.05

This procedure is similar to the previous case. The gas price is S5/MSCF. lhe NPV for this option is 5-2.71 million.
NPV - Optimistic Case - 20% Contribution

Year
0
1
2
3
4
5
6
7
8
9
10

Prod
MMSCF
4,745
902
595
464
385
335
298
271
251)
232

Gross
Revenue
(8MM)
-1.20
5.31
1.01
0.67
11.52
0.43
0.38
0.33
0.30
0.28
11.26

Operating
Cost
($MM)

Severance
($MM)

0.0288
0.0288
0.0288
0.0288
0.0288
0.0288
0.0288
0.0288
11.0288
0.0288

0.372
0.071
0.047
0.036
0.03))
07026
0.023
0.021
0.020
0.018

IDC

Deprec.

($MM)

(8MM)

0.25
0.022
0.022
07)22
0022
0022

0.24
0.17
0.12
0.09
(11)7
0.07
0.07

Depletion
($MM)
0.67
0.13
0.08
007
0705
0.05
0.04
0.04
11.04
((03

Taxable
Income

(8MM)
3.75
0.59
0.36
028
0.22
0.18
0.17
0.22
0.20
0.18

Taxes
(8MM)
1.31
0.21
0.13
010
0.08
0.06
0106
0.08
0.07
01)6

Net
Revenue
(8MM)
-1.20
3.60
0.70
0.46
0.36
0.29
0.26
0.22
0.18
0.16
0.15

The NP\T for this situation is S3.46 million.

32

Mohan Kelkar, Ph.D., J. D.

?.PV Pessimistic Ca s e

Year
0

20% Contribution

Prod
MMSCF

Gross
Revenue
($MM)

255
485
320
250
207
180
161
146
134
125

2.00
2.04
0.39
0.26
0.20
0.17
0.14
0.13
0.12
0.11
0.10

2
3
4
5
6
7
8
9
10

Operating
Cost

($MM)

Severance
($MM)

IDC
($MM)

Deprec.
($MM)

0,143
0.027
0.018
0.014
0.012
0010
0.009
0.008
0.008
0.007

0.42
0.036
0.036
0.036
0.036
0036

0.40
0.29
0.20
0.15
0.12
0.12
0.12

0.0288
0.0288
0,0288
0.0288
0.0288
0.0288
0.0288
0.0288
0.0288
0.0288

Depiction
($MM)

Taxable
Income
($MM)

Taxes
($MM)

Net
Revenue
($MM)

0.38
(0.12)
(0.11)
(0.09)
(0.09
(0.10)
(0.07)
0.04
0.04
0.03

0.13
(0.04)
(0.04)
(003)
(0.03)
(0.()3)
(0.03)
0.01
0.01
0.01

2.00
1.74
0.37
0.25
0.19
016
0.14
0.12
0.07
006
0.05

0.67
0.13
0.08
0.07
005
0.05
0.04
0.04
0.04
0.03

The NPV for this situation is S0.30 million.


Using this information for individual wells, we can calculate the NP\T of the overall project by assuming that 40 drilling rigs are
available and it takes 2 months to drill and complete each well. We will do these calculations based on a 2 month period. The
interest rate used will be 15/6 = 2.5% per period in our calculations. Recall that, in the pessimistic case scenario, Plains will have
to contribute 60% for 10 periods; whereas, it will have to contribute 60% for 17 periods under the optimistic scenario. Knowing
the NP\ under all situations, we can calculate NPV for the overall project.
NPV

Overall Project
NPV

NP\

-1,650

Pessimistic Scenario

+ 40 x (-2.71)

(1 +.025) 10 - 1 1
+ .025)101

0.025(1

+ 40 x (03)

[(1

025)162

t0.025(1

.025)162

-$2,128 million

- Overall Project - Optimistic Scenario


NPV = -1,650 + 40 x

(1 +.025) 17 - 1

(1.65) [0025(1 + .025)17] + 40

(1 +.02 S)155 - 1
(3.46) [0.025(1 + .025)155] = $4,671 million

Under the pessimistic scenario, Plains will lose 52.13 billion; whereas, under the optimistic scenario, Plains will make S4.67
billion. The average of the two is S1.271 billion, making the project economically feasible.
Considering that the price of gas plummeted in 2009 and continues to be low to this date makes this project less attractive. It is
possible that, with enhancement in drilling and completion technk1ucs, the cost of drilling and completion will go down and the
amount of gas produced per well may be increased. lhat is the only possible scenario that would make this project more attractive.
Problem 3-22
An oil company purchased a property for $2 million. Operating expenses are $1 million per year with an additional $31bbl
pumping cost. The well is estimated to produce 400,000 bbls in the first year with on annual decrease of 10% over the next five
years. In addition, the company has purchased oil field and pumping equipment for $3 million that is subject to a DDB and
straight-line combination depreciation method over a five year period. The oil percentage depletion allowance is 15% and the
local tax is expected to be 7%. If the income tax is levied at a rote of 34%, calculate the present worth of the project if the MROR
is 15%. Assume the price of the oil to be $201bbl. The life of the project is five years.
Problem 3-23

An oil company wants to dispose of a producing property. The property is currently producing 200,000 bbls/year and is expected
to decline at a rate of 10% per year. The oil price over the life of the project is assumed to be $20/bbl. The existing equipment on
the property is worth $300,000, which is subject to the DDB/straight-line method over a seven year period. Operating costs are
$51bbl. The royalty interest in the property is 118. Cost depletion is al/owed on the leasehold costs (purchase price-equipment
worth). If the remaining reserves are estimated to be $1 million and the tax rote is 34%, what is the minimum price you will be
willing to pay for the property? Assume the MROR to be 20% and the life of the property to be seven years.
If you are the seller and will have to pay a 28% tax on the proceeds and wont to recover the taxes in your soles price, at what
price will you be willing to sell the property if the MROR is 15%? Assume that the seller has $1 million remaining in the leasehold
Economic Evaluation in the Petroleum Industry
Chapter - Economic Analysis

33

cost basis Also the seller purchased the tangible property four years ago
over the last four years using the DDB/straight-line method

at price of $800,000. It has already been depreciated

Problem 3-24
What is the maximum price you (a large oil company) are willing to bid on an offshore property (excluding the lease bonus) if it
is estimated to cost $3 million to drill an exploratory well at the end of the first year and, if successful, another $4.5 million to
drill delineation wells at the end of the second year. The platform construction should be complete by the end of the third year
with a cost of $15 million. Drilling the remaining wells and installing production facilities will be done at the end of the fourth
year at a cost of $35 million. The production should commence at the beginning of the fifth year with initial production
estimated to be 2 million bbls in the fifth year. Based on nearby fields production will decline at a rate of 10% per year for the
next ten years. The operating costs are $71bbl and the sale price is $211bbl. Assume that 30% of the intangible drilling costs
need to be considered amortized costs and 705Y. can be expensed in the year production begins. The amortized costs are
amortized over a five year period using a straight-line method starting in the year IDC5 are incurred. The capitalized cost can be
depreciated over a ten year period using the ACRS system. Assume that intangible drilling costs in year one are $1.5 million, in
year two are $2.5 million, and in year four are $10 million. Assume that the recoverable oil is 13 million barrels. The income tax
rate is 3016, the royalty interest is 3116, and the MROR is 18%.

INTERNATIONAL CONTRACTS
This section discusses the implications of international contracts on economic evaluation. We introduce
the basic concepts of international contracts; however, each country adds its own criteria to these
contracts. We will not discuss the details of those criteria.
The oil business has always been a global business. Most international oil companies have searched for
oil wherever there are attractive targets. The key parameter is the cost of finding the oil. A country,
where that cost is small, attracts many suitors (Bertagne, 1992). In addition to the low cost of finding oil,
the international oil companies are also interested in favorable terms in the contract.
This section will discuss various contracts used between the host country and the international oil
companies to proceed with the exploration and development of potential hydrocarbon reserves. It is
important to remember that the objectives of the host country and the international oil company can
differ significantly. Most countries are afraid of exploitation, pollution, loss of national pride, and the
repetition of recent history at the hands of the western civilization (Bertagne, 1992). The host countries
like to be treated as equal and be part of the development of their own mineral resources so that it may
benefit the entire population of the host country. On the otherhand, the international oil companies are
afraid of varying tax rules, expropriation of oil and other assets, nationalization of a private companies,
and political uncertainties. The oil companies main interest is economical. They prefer to produce the
hydrocarbons in the most optimal way so they can maximize the benefits. To structure a contract
between these two parties that will create a win-win situation for both parties is a challenging task. The
solution is the various types of contracts that have evolved over the last thirty years that try to balance
the interest of both the host country and the international oil company.
In the first part of this section, we present the purpose of each of the parties involved in the contract so
that the understanding of the terms in the contracts becomes easy. In the next three sections we
illustrate the three types of contracts most commonly used: concession agreements, production sharing
contracts and service contracts. For host countries, concession agreements require the least
involvement; whereas, the service contracts require the most involvement. We will discuss the
advantages and disadvantages of these contracts and illustrate their application with several examples.

34

Mohan Kelkar, Ph.D., J.D.

OBJECTIVES
When a contract between a host country and an international oil company is signed, both parties
want to achieve certain objectives. Independent of the type of contract that is signed, both parties
try to satisfy most of their objectives. To understand the terms included in the contract, it is
important to consider the objectives of the parties involved.
OBJECTIVES OF THE HOST COUNTRY LML
i ske ll, 1984
The objectives of the host country can be divided into three broad categories; financial, political
and technical. Each of these objectives is described below.
FINANCIAL
The host country is ultimately interested in building a foreign exchange and capital base so
that the money can be invested in other capital-intensive projects. Unfortunately, to
develop this capital base requires an initial investment. Most exploration efforts involve
significant risk and capital investment. The host country may have only limited capital
resources that it may not want to tie in limited projects. By inviting an international oil
company to explore for and produce hydrocarbons, the host country can eliminate, or at
least minimize, the initial capital investment. It is also true that international oil companies
can get loans with more favorable terms than the developing country. If the project is
successful, by ensuring the appropriate terms in the contract, the host country can secure
significant financial benefits from the production of hydrocarbons. These benefits may be
reinvested in other projects of national interest.

Most developing countries have been previously colonized by Western countries. Awarding
contracts to international oil companies is a sensitive issue and involves national pride. To
overcome foreign dependence, the host countries prefer to maintain control over the
operations of the project, as well as the hydrocarbons produced as a result of the contract.
Instead of being passive beneficiaries, the host countries prefer to play an ctive role in the
field development so that the natural resources are optimally exploited to the countrys
benefit. Further, by controlling the hydrocarbon production, the country may be able to
influence desired foreign policy goals. It can also reduce imports and gain economic
efficiency.
TECHNICAL
Exploration of new areas requires increasingly sophisticated technologies which the host
country may not possess. By signing a contract with an international oil company, the host
country can benefit from the technical expertise within that company. Not only will this
reduce the risk in the exploration efforts, it will utilize the latest technology in the
development of the oil field.

Economic Evaluation in the Petroleum Industry


Chapter 3 - Economic Analysis

35

Additionally, the host country wants to gain technological independence so that, eventually,
future fields can be discovered using local talent and local companies.
Therefore, the host country prefers that the international oil companies hire a domestic
workforce, provide education grants and local R&D effort, and transfer technology to the
local talent. The companies also prefer local companies for the outside contracts.
The objectives of the host countries should be balanced by the objectives of the international
companies.
(OBJECTIVES OF INTERNATIONAL OIL COMPANIES
As with the host countries, the objectives of international oil companies can be described in
three broad categories: financial, operational and political.
FINANCIAL
International oil companies are incurring significant risks exploring for and producing
hydrocarbons from yet-to-be-explored areas. In return, the companies expect that they are
provided with a reasonable return commensurate with their risk. The companies want to
maximize their benefits with a minimum amount of cost. They also prefer that the initial
investment be recovered as quickly as possible (short payback period) in order to minimize
the impact of any political uncertainties. The companies also prefer that the revenue
generated be repatriated and their share of crude sold in the open world market.

International oil companies prefer to have operational control over the project. Rather than
sharing operational responsibilities with some bureaucratic agency, they prefer to operate
the field so as to preserve the economics. The international oil companies fear that by
sharing control with a host country or its wholly owned subsidiary, production decisions may
be made based on domestic political considerations rather than sound economics.
POLITICAL
International oil companies realize that their existence depends on the ability to explore for
and produce hydrocarbons from host countrys sovereign land. It is, therefore, important
that good working relationship be maintained with the host country and the local
community so that the company can secure additional concessions when awarded. The
company, therefore, is willing to spend resources on the development of local communities
as well as local talent.
On the other hand, the companies want to be careful as to what terms are agreed to in signing
the contract. The companies prefer not to set a precedent in one contract that can be used
against them in either the same country or in other countries. If the company gives in too much,
it will be subjected to similar demands in the future.

36

Mohan Kelkar, Ph.D., J.D.

As shown, the objectives of the two parties differ significantly. The types of contracts that are
signed between the parties reflect some objectives from both parties. We will discuss these
contracts in detail below.
TYPES OF CONTRACTS (BLINN, DUVAL, LELENCH, & PERTUZIO, 1986) (KATZ, 1992)
The three types of contracts most commonly used between a host country and an international oil
company are concession agreements, production sharing agreements and service contracts. In this
section, we will briefly describe each of these contracts highlighting their common features and the
fiscal impact of each of these contracts. Detailed economic evaluation of each of these contracts is
differed until the next section. It is important to note that none of these contracts is economically
inherently superior to the other types. By changing the individual terms of a particular contract, any
contract can be made more or less beneficial to the parties involved.
Although we will be discussing the contracts between the host country and an international oil
company, as a practical matter, a contract is typically signed between a nationalized oil company
and an international oil company. Creation of national oil company is helpful in separating the
financial benefits recovered from oil revenues. Also, by creating a company, it is easier to develop
technical expertise among the citizens of the country. It is also believed that a separate company
will be able to run more efficiently without the burden of imposing bureaucracy. Although separate,
these national companies have the same objectives as the host countries. Table 3-1 lists the
countries and their national oil companies. The most notable exceptions in this list are the United
States and the United Kingdom who do not have nationalized oil companies.
CONCESSION AGREEMENTS
A concession agreement is similar to the standard oil and gas lease signed between a mineral
owner and producer. In this agreement, the host country assigns to the international oil
company the rights to explore for and produce from a concession area. In return, the host
country receives royalty payments and income taxes from the proceeds. The host country may
also receive a signing bonus and other incentives, such as training of the domestic work force. In
this type of agreement, the host country does not usually participate in the day-to-day
operations of the field; however, the agreement may be modified to change that. This modified
contract is called a participation agreement.
PRODUCTION SHARING CONTRACTS
In this type of contract, the international oil company bears the cost and risk during the
exploration phase. However, if successful, the host country participates during the production
phase by paying for part of the costs and receiving part of the production based on the agreed
upon formula. In addition, the host country also receives income taxes on the international
companys profits.
SERVICE CONTRACTS
In service contracts, the international oil company acts as a service contractor. The host country
will invite the international oil company to provide certain services. This includes exploration of

Economic Evaluation in the Petroleum Industry


Chapter 3 - Economic Analysis

37

a new area as well as operation of the field. The international oil company in return will receive
fixed fees as well as fees based on barrels of oil produced. The contractor does not hold any
interest in the producing field. In that sense, the service contracts have the least control by the
international oil companies.

Table 34 National Oil Company Names in Various Countries (Allen & Seba, 1993)
Company
ADNOC
SONANGOL
SONATRACH
YPF
VPFB
Petrobras
Petro-Canada
ENAP
EcoPetrol
CEPE
EGPC
CPGTotaI
TOTAL
Pertamina
ONGC
NIOC
INOC
ENI
JNOC
KazMunaiGas
KOC
Petronas
Pemex
NNPC
Statoil
OGDC
PetroPeru
Trintoc
ANCAP
PDVSA

Country
Abu Dhabi
Angola
Algeria
Argentina
Bolivia
Brazil
Canada
Chile
Columbia
Ecuador
Egypt
France
France
Indonesia
India
Iran
Iraq
Italy
Japan
Kazakhstan
Kuwait
Malaysia
Mexico
Nigeria
Norway
Pakistan
Peru
Trinidad & Tobago
Ururguay
Venezuela

Table 3-2 lists the countries that have adopted a particular type of contract. The particular terms
of the contract vary significantly. In general, a country with less geologically promising regions is
more likely to set lenient terms to attract international investment. On the other hand, a
country with geologically promising regions can set stringent terms to leverage the benefit from
a successful venture.

38

Mohan Kelkar, Ph.D., J.D.

Table 32: Current Distribution of Exploration and Production Contract Types (Allen &
Seba, 1993)

Region

Concession
(Royalty/Income
Tax)

Production
Sharing

Risk Service

North
America

Canada
United States

Latin
America

Argentina
Bahamas

Bolivia
Guatemala

Brazil
Chile

Barbados
Belize
Costa Rica
Paraguay
Surinam
Trinidad

Guyana
Honduras
Panama
Uruguay

Columbia
Ecuador
Peru

Austria
Bulgaria

Albania

Europe

Denmark
France
Germany
Greece
Greenland
Ireland
Italy
Malta
Netherlands
Norway
Poland
Portugal
Spain
Sweden
Turkey
Africa

United Kingdom
Cameroon
Chad
Congo
Gambia
Ghana
Guinea Bissau
Mali
Morocco
Namibia
Niger
Nigeria
Senegal
Seychelles
Sierra Leone
Somalia

Economic Evaluation in the Petroleum Industry


Chapter 3 Economic Analysis

CIS
Romania
Yugoslavia
Hungary

Algeria
Angola
Benin
Burundi
Cote Dlvoire

Madagascar

Egypt
Eq. Guinea
Ethiopia
Gabon
Guinea
Mauritania
Kenya
Liberia
Libya
Mozambique

39

Concession
(Royalty/Income

Production

Tax)

Sharing

Region

South Africa
Tunisia

Sudan
Tanzania

Zaire

Togo
Zambia

Near

Israel

East

United Arab
EmirateS

Bahrain
Jordan
Oman

Risk Service

Qatar
Syria
Yemen
Far East
and
Australia

Philippines

Bangladesh
China
India
Indonesia

Australia
Brunei
Cambodia
Fiji
New Zealand
Pakistan
Papua New
Guinea
South Korea
Thailand

Laos
Malaysia
Mongolia
Myanmar
Nepal
Sri Lanka
Vietnam

Irrespective of the type of contract signed, there is enough flexibility within individual terms of
the contract to make it more or less attractive. In evaluating the economic impact of the
contract, the following economic considerations are very important.
HOST COUNTRYS NET SHARE
Depending on the terms of the contract, the net share of the host country can vary significantly
We can define the host countrys share as,
host countrys share = cash flow after costs - net revenue of contractor

where cash flow after costs is defined as,


cash flow after costs = gross revenue - project capital and operating costs

The net revenue of the contractor is the revenue received by the international oil company after
paying all royalties, taxes, and production to the host country; the net profit the contractor (the
company) will receive. As a percentage, we can calculate the host countrys share as,

host countrys share

40

= cash flow after costs

net revenue of contractor

cash flow after costs

Equation 3-31

Mohan Kelkar, Ph.D., ID.

I.

Equation 3-31 presents the percentage of the revenue after costs received by the host country.
The larger the share, the harder it is to make the project more economically favorable. Figure 31 presents the typical shares received by various countries. What is remarkable is that
approximately 90% of the countries receive more than 50% of the share. Also, another
noteworthy aspect of this graph is that the share of a host country does not depend on the type
of the contract. Ireland with the smallest share (25%) and Norway with the largest share (88%)
both have concession types of agreements. On the other hand, Guyana with a share of 51% and
Benin with a share of 88% both have production sharing types of agreements. These shares are
average shares calculated based on various scenarios. It is important that, before signing a
contract, this type of analysis is conducted to understand what share the host country will
receive under different scenarios.
Concession Agreement
n-rrm

rtnTh

enjiway

U(("fl

uTunisia
Senegal
Netherlands
Nigeria
rm Papua New Guinea
Cameroon
Poland
Somalia
Trinidad
___-1 Thailand
Morocco
Denmark
u Pakistan
Namibia
Greece
Greenland
Italy
Australia
Germany
U.S.A.
,,rnrrrrr
Portugal
New Zealand
-rn France
Spain
___________________
Argentina
Turkey
Paraguay
U.K.

10

20

30

40

50

60

70

80

90

100

Countrys Share

Economic Evaluation in the Petroleum Industry


Chapter 3- Economic Analysis

41

Production Sharing Contract

to Divoire
n

Panama
0

10

20

30

40

50

60

60

70

90

100

Countrys Share

Service Contract

Ecuador

Chile

Peru

Philippines

10

20

30

40

50

60

70

80

90

Countrys Share

Figure 3-1: Countrys share asafunction of the type of contract (Allinson, 1995)
ECONOMIC EFFICIENCY OF THE CONTRACT
An economically efficient contract will tax production from marginal fields very lightly, whereas,
it will heavily tax the most profitable fields. This efficiency is especially relevant when the
international oil company discovers marginal oil fields. If, for marginal oil fields, the host
countrys share does not change and the tax structure remains the same, these fields will be
very difficult to produce and cannot be economically justified. It is becoming increasingly
difficult to find giant oil fields. The focus is becoming more concentrated on small or marginal

42

Mohan Ke/kar, Ph.D., J.D.

fields. The host country will have to show some flexibility in contractual terms so that the small
fields may be developed in an economic efficient manner.

Efficient/"

0-

Inefficient

--

NPV before
countrys share

Figure 3-2 shows a plot of an economically efficient contract and an economically inefficient
contract. For economically efficient contracts, the NPV of cash flow before the host countrys
share is closely tied with the NPV of the host countrys share, the line passing through the origin.
For inefficient contracts, the NPV of cash flow before the host countrys share is positive;
however, the NPV after the host countrys share is negative. That is, by participating in this
contract, the host country prevented the development of the field, which would have been
developed without their participation. The inefficiency results from the terms of the contract
that relate to gross revenue or a certain level of production rather than the profitability of the
project. A common example is a royalty payment that is a percentage of the gross revenue and
ignores costs. Another example is a local tax that is levied based on the gross revenue. Marginal
projects are particularly affected by such terms of the contract.
TAX STRUCTURE
The overall tax structure can be progressive or regressive. Progressive tax structure involves
increasing share of the host country as the profitability of the project increases. When the
project is less profitable, the proportionate share of the host country is small as well. This type
of progressive structure also encourages development of marginal or small fields. Figure 3-3
shows schematically both progressive and regressive tax structures. In regressive structures, the
host countrys share increases as the profitability of the project gets smaller. A neutral fiscal
region is one where the host countrys share is not affected by the profitability of the project.

Economic Evaluation in the Petroleum Industry


Chapter - Economic Analysis

43

100%

75h
a)
cc
to
(O

50%

25%

0 0/c

Project Profitability

Figure 3-3: Progressive vs. regressive tax regime


In analyzing the economic impact of any project, the three sections above are important.
Analysis of these considerations will allow a proper evaluation of the projects under various
scenarios before reaching a final decision as to whether to invest money in a given project. In
the following sections, we will discuss these contracts in additional detail and evaluate their
economic impact.
CONCESSION AGREEMENTS
As stated before, in modern concession agreements, the host country has no direct involvement in
the management of day-to-day operations. In most instances, the host country will open up certain
areas for a sealed bidding process. The contracting companies compete for that area with incentives
including a signing bonus (up front) payment, royalties, and tax arrangements. If successful, the host
country will assign rights to the contracting company to explore for and develop certain areas in
return for a share of proceeds (royalty) and taxes. Although individual contracts vary, some common
features included in the concession agreement are:
The international oil company, solely at risk, has the exclusive right to explore for and
exploit petroleum reserves in the concession area. The company is also responsible for costs
associated with these rights.
The international oil company has a contractual obligation to supply part of the production
to the domestic market. Beyond that, the company can dispose of the remaining production
on the open market.
During the exploration phase, the company has to pay surface rentals to the host country.
The international oil company has to pay part of the gross revenue in kind or in cash.
The international oil company has to pay income tax on the taxable income.
The international oil company may have to pay a signing bonus and production bonus tied
to attaining a certain level of production.
The international oil company owns the equipment and installations used in the operations.
The contract will be in effect for a limited duration depending upon whether the exploration
is successful or not. For successful exploration, the contract may be in effect for 30 to 50
years.

44

Mohan Kelkar, Ph.D., J.D.

One main disadvantage of the concession agreement is that the host country has no control over
the operation of the field. Also, the citizens of the country may not get a chance to learn the
technical skills so that they can pursue an independent energy course. One way to overcome some
of these difficulties is to require in the contract that part of the proceeds should be obligated
towards technical training of the domestic workforce. Also, the host country can enforce a
requirement that the number of foreign nationals be restricted to a certain quantity that can be
reduced as the operation proceeds.
A modification of the concession agreement is a joint venture agreement. In a joint venture
agreement, the host country (or its fully owned national oil company) participates with the
international oil company in the exploration and development phases. In general, the international
oil company carries the host countrys interest through the exploration phase. If the exploration
effort is successful, the host country backs in with the pre-determined interest. The percentage of
the host country can vary greatly; as little as 5% or it can be as high as more than 50%. The
percentage may also be different during the exploration phase and the production phase.
Another modification of a joint venture agreement is the formation of a new operating company in a
host country that is co-owned by the international oil company and the host country. To retain
management control, the host country may own more than a 50% share. Even under this
modification, the international oil company has an obligation to carry the interest of the host
country during the exploration phase and, in some instances, the development phase.
The advantage of a joint venture agreement from the host countrys perspective is the management
control or, at least, the influence. Also, by participating in the day-to-day operations, the domestic
labor force can learn the practical side of the operation. This should help in the future when the
domestic oil company ventures out on its own. The schematic of the overall cash flow calculations
are shown in Figure 3-4 for standard concession agreements and joint venture agreements. The flow
diagram also shows sample calculations starting with 1,000 units of gross revenue. The shaded
portion indicates the host countrys share. At the bottom of the figure, the host countrys share is
calculated as a percentage of the revenue after deducting costs. As shown, depending on the tax
rate, royalty rate and participation percentage, the host countrys share may remain the same
irrespective of the type of contract.
The following example illustrates the application of royalty, as well as joint venture agreements.

I
I
I
Economic Evaluation in the Petroleum Industry
Chapter 3 - Economic Analysis

45

Concason Agreement

Joint VaitureAgriiait
Gross Revenue

Gross

$1,000

Less

Less

TaxabI
$650

Less

Equal To

NCflow
$325

Host Countrys Share

Host Countrys She

2 59 4%
800

Figure 3-4: Schematic of cash flow profile for concession agreements


Example 3-14
A royalty agreement is signed between an international oil company and a national oil company. The agreement calls for 20%
of the royalty interest on the gross income. The capitalized expenditure can be depreciated over a seven year period using a
double declining balance method with the remaining balance to be depreciated in year seven. Depreciation can only start after
production has started. IDCs and leasehold costs are recovered as soon as production has commenced (this is called cost
recovery). If the taxable income is negative, it is zeroed out and the balance is carried forward into the next year. The income
tax rate is 55% per year. The following data for the expected costs and production rates have been gathered:
Signing Bonus

$5 million in year zero

Capital expenditure:

$30 million in year one


$50 million in year two
$60 million in year three
$80 million in year four

46

Mohan Kelkar, Ph.D., J.D.

DC

$5 million in year 1
$8 million in year 2
$10 million in year 3

Initial production:

3 million barrels in the fifth year


5 million barrels from year 6 to 10
Start decline in year 11

Production decline rate:

18% per year

Years of production:

15 years

Operating costs:

$18 million in year five

Operating cost decline rate:

4% per year

Oil price:

$80 per barrel assumed constant

MROR:

20%/year

Examine the economic feasibility of the project.

Solution 3-14
The following table shows the detailed calculations:
Gross
Year

Operating 0

Production

Revenue

Costs

(MMSTB)

($MM)

($MM)

-500

-35.00

-58.00

-60.00

U Royalty 1
(SliM)

Cost

Taxable

Depreciation

Recovery

Income

(5MM)

($MM)

(5MM)

Net

Taxe

Revenue

MM)

(5MM)
-5.00

-35.00
-58.00

-60.00

-80.00

-80.00

3.00

240.00

18.001

48*1

62.86

5.00

400.00

17.28.

80.0

44.90

257.82

5.00

400.00

16.59

80.00

32.07

271,34

5.00

400.00

15.931

80.0

22.91

281.17

1164

149.43

5.00

400.00

15.290

80.10

16.36

288.35

1.59

146.12

10

5.00

400.00

14.68k

80.0

11.69

293.64

11

4.10

328.00

14.09

65.60

29.22

219.09

12

3.36

268.96

13.531

53,9

13

2.76

220.55

12.99

44*1

14

2.26

180,85

12.471

15

1.85

14830

16

1.52

17

1.25

18
19

28.00

83.14

41.73

128.27

1.80

160.92

149.24

154.17

16.50

143.82

120.50

127.81

201.64

11.90

90.74

163.45

89.90

73.55

36,7

132.21

7.72

59.50

11.97

29,66

106.67

58.67

48.00

121.60

11.49

24.2

85.79

4.19

38.61

9931

11.03

19*4

68.74

35.81

30.93

1.02

81.77

10.59

16.5

54,82

3.15

24.67

0.84

67.05

10.16

13.41

43.47

23.91

19.56

Sample calculations:
Years zero to four, the gross revenue is the expended amount and includes lease bonus, lDCs and tangible costs. Tangible costs
are depreciated starting year 5 with a double declining balance (DDB) method with a twist in that in year 7 the remaining
balance is depreciated. This is needed; otherwise, the operator will not be able to depreciate the total amount of capitalized
costs. IDCs and leasehold costs are treated differently than in domestic contracts. The total IDC and leasehold costs is equal to
$28 million. This amount can be deducted as soon as production begins with a caveat that the taxable income cannot be less
than zero. This means that if the taxable income is less than zero, only the cost recovery will be allowed up to the point that the
taxable income becomes zero. The balance for cost recovery is carried forward in subsequent years until all of the lDCs and
leasehold costs are deducted. This is a significant advantage over domestic contracts. Instead of spreading it out over the life of
the project, the leasehold costs are immediately recovered after production begins.
In year five,

Economic Evaluation in the Petroleum Industry


Chapter 3- Economic Analysis

47

gross revenue = $80 x 3 x 106 = $240 million


royalty = 0.2 x 240
= $48.0 million
depreciation = x (60 + 50 + 60 + 50)
= $62.86 million
taxable income = 240.0 - 18.0 - 48.0 - 62.86 - 28
= $83.64 million
tax = 83.64 x 0.55
= $45.73 million
net income = gross revenue - royalty - operating costs - tax
= 240.0 - 18.0- 48.0 - 62.86- 28
= $128.27 million
Using the last column of net income, the NPV of the company can be calculated to be $134.05 million. The shaded portion in
the table represents the contribution made to the host country. The host country collects the money in two different ways,
through taxes and through royalties. If we calculate the NPV of the royalty payment, it is equal to
$142.41 million and if we
calculate the NPV of taxes, it is equal to $252.97 million. Combining the total amount received by the host country divided by
the total amount received by the operator and the host country, the host countrys share is 75%. For a highly profitable project,
we expect the royalty payment (20%) and taxes (55%) will roughly add up to the host countrys share. For marginal projects,
this can make a difference and host countrys proportionate share would increase significantly.
Let us consider the previous data except we will assume that, under a pessimistic case, the production is half the original case
(i.e., 1.5 million barrels instead of 3 million barrels, etc.) Using those numbers, we can construct the following table:
Gross
Production Revenue
Year

(MMSTB)

($MM)

-5.00

-35.00

-58.00

-6000

-80.00

Operating

Cost

Costs Royalty. Depreciation Recovery


($MM)

($kIM)

($MM)

($MM)

Taxable

Net

Income

Taxe1

($MM)

MM)

0.10

-5.00

*00

-35.00

0.1

.(t)

-58.00

0.00

0.00

-60.00

,00

-80.00

78.00

4.73

95.99

0.0

1.50

120.00

18.00

2.50

200.00

17.28w

2.50

200.00

16.59

2.50

20000

15.93

2.50

200.00

15.290

10

2.50

200.00

14.68

11

2.05

164.00

12

1.68

13
14

($MM)

.00

0*0

Revenue

24*0
40.0

15.14

12.86

84.96

32.07

111.34 61.24

82.17

22.91

121.17

77.43

16.36

128.35

7*59

74.12

40.0

11.69

133.64

7.50

71.82

14.09

32.80

29.22

87.89

134.48

13.53

261

1.38

110.27

12.990

1.13

90.42

12.47_

15

0.93

74.15

11.97

16

0.76

60.80

1149

17

0.62

49.86

11.030

18

0.51

40.88

10.59 0

19

0.42

33.52

10.16

40.00

62.86
44.90

40.0
40*)

22.*)
18.8
N

14.83

12.16
9*7
8.8
N

6.70

6.64

48.34

94.06 5.73
4*.38

75.23

68.77
42.33
33.86

59.87 3.93

26.94

47.35

21.31

26.04

37.15 2.43

16.72

28.86

12.99

22.12
16.66

18.87
1.17
U

9.16

9.95
7.49

In this case, the cost recovery had to be split over two years because we could not subtract the entire $28 million in the first
year and make the taxable income not less than zero. The NPV of operator is $5.4 million, the PV of the royalty payment is
$71.21 million, the PV of taxes is $96.79 million, and the host countrys share is 97%. As you can see, it is conceivable that the
NJPV of the operator is negative, but the host countrys share can be positive because royalty payment is no matter whether the
taxable income is positive or negative. The more marginal the project, the more likely it is that the host countrys share will be
larger. In other words, this contract is both regressive and inefficient.

48

Mohan Kelkar, Ph.D., 1. D.

Example 3-15
A participation agreement is signed between the host country and an international oil company. The agreement calls for a 10%
royalty payment based on the gross revenue, 45% income tax rate and 30% participation by the host country. The agreement
further requires that the host country will not participate during the exploration and exploitation phases, and will be "carried"
by the contractor until production begins. The contractor will be allowed to recover 30% of the host countrys contribution to
all initial costs in the cost recovery phase. This is also true with lDCs and leasehold costs. Cost recovery is limited by the
requirement that taxable income cannot be less than zero. The capitalized expenditure can be depreciated using the double
declining balance method with the remaining balance depreciated in year seven. Assume the field data is the same as Example
3-14.

Solution 3-I5
The calculations are summarized in the following table.

Year

Gross

Operating

Cost

Taxable

Production

Revenue

Costs

Royalty

Depreciatio

Recovery

Income

Taxes

(MMSTP)

(5MM)

(5MM)

($r\4)

n (5MM)

($MM)

(5MM)

($Vl)

-5.00

-3500

0.1

Host Contry Contractor


U
i
Net Renue Net Revenue
15MM)

0.
U

0.41

8.41

(5MM)

0.0Q,

-5.00

.(100

-35.00

-58.00

&T

ac

0.0

-58.00

-60.00

8.00

0.00

0.001

-60.00

-80.00

01

3.00

240.00

18.00

24.1*

62.86

40.(Q

91.00

44.14

19.1*

0.0C

-80.00

*3.44

124.70

5.00

400.00

17.28

44.90

297.82

134.4

2.6r

146.09

5.00

400.00

16.59

40.00

32.07

311.34

*40.10

60.9*

142.32

5.00

400.00

15.93

40.(

22.91

321.17

44.S

5.00

400.00

15.29

40.1*

16.36

328.35

147.1*

*9.89

137.87

30

5.00

400.00

14.68 w

4041

11.69

333.64

501

58.5e

136.63

11

4.10

328.00

14.09

32.80

29.22

251.89

113.35

117.43

12

3.36

268.96

13.53

26.E

228.54

503*
377

13

2.76

220.55

12.99

22.41

18S.51

14

2.26

180.85

12.47

18.0

150.30

67.E

1.85

148.30

13.97

014.83

121.50

054.57

16

1.52

121.60

11.49

_121

97.95

17

1.25

99.71

11.03

9.41

78.71

35.41

18

1.02

81.77

10.59

63.00

28.3

19

0.84

67.05

10.16

50.18

U22.58

6.70

8141

15

139.68

*0.51

87.99
71.42

4.81

17.86

20.0*

46.78

16.1%

37.71

*2.99

30.30

0.4t

2426

8.2*

19.32

Sample calculations:
Years 0 through 4, the contractor will have to pick up all costs and carry the host countrys participation share (30%). Once
production begins, the contractor can recover the host countrys contribution through cost recovery. Unlike in the previous
case, the amount that can be recovered through cost recovery is the 30% contribution of the host country plus the contractors
contribution (70%) to (DC and leasehold costs. This can be calculated as:
cost recovery = 0.3 x (5 + 35 + 58 + 60 + 80) + 0.7 x (S + 23) = $91 million
As in the previous case, the contractor is only allowed to recover the costs until taxable income reaches zero.
For year five,
gross revenue = $80 x 3 x 106 = $ 240 million
royalty = 0.1 x 240 = $24 million
depreciation = x (60 + 50 + 60 + 50) = $62.86 million
taxable income = 240 - 18- 62.86- 91 - 24 + 0.7 x 50 = $44.14 million
tax = 44.14 x 0.45 = $19.86 million
net income(host country) = (240 - 18.0- 24.0 - 18.0 - 19.86)0.3 = $53.44 million
net income (contractor) = (240- 18.0- 24.0- 18.0-19.86)0.7_= $124.70 million

Economic Evaluation in the Petroleum Industry


Chapter 3- Economic Analysis

49

The key difference between a participation agreement and concession agreement is that host country receives a percentage of
the net revenue after taxes. The host country has three sources of income in this contract: royalty, taxes and after tax net
revenue.
We can calculate the PV of royalty ($71.21 million), PV of taxes ($227.62 million) and PV of after tax revenue ($113.50 million).
The contractors NPV is $117.09 million. The total revenue is $529.43 million.
We can calculate the host countrys share as,
412.33
=

529.43

=78%

The contractors share is 22%.


Similar to Example 3-14, let us assume that under a pessimistic scenario, production is 50% of the optimistic case. The following
table shows the calculations under that scenario.
Gross
Production Revenue
Year

(MMSTB)

($MM)

-5.00

-35.00

Operating
Costs

U
Cost
.
Royalty Oepreciatio Recovery

($MM)

($MJv1)

n I$MM)

($MM)

Taxable

Income

U
Taxes

($MM)

($JJ)

Host Contry Contractor


U
I
Net Rev1nue Net Revenue
$MM) i (5MM)

o.c
0.111

_S8.00

-60.00

U 0.00

-80.00

01

0.111

o.q

O.c
U 0.00

0.0f

-5.00

11110.00

-35.00

0.01

-58.00

0.0(1

0.0Q

0.1
U

-60.00
-80.00

1.50

120.00

18.00 U

1200

62.86

27.14

2.50

200.00

17.28

20.1

44.90

63.86

2.50

200.00

16.59

E20.00

32.07

131.34

U59.10

31.291

104.31

2.50

200.00

15.93

20.

22.91

141.17

.63.51

111

30.11

100.55

2.50

200.00

15.29

16.36

148.35

56.111

*9.39

97.95

10

2.50

200.00

14.68

20.1*
U20.q

11.63

153.64

69.3k

8.86

96.19

11

2.05

164.00

14.09

U16.40

29.22

104.29

04593

12

1.68

334.48

13.53

13.

307.51 111

48.

33

1.38

110.27

12.99 U

11.111

86.26 U

38.1*

14

1.13

90.42

12.47

U 9.1w

68.92 U

31.q

15

0.93

74.15

11.97

7.41

54.77

16

036

60.80

11.49

6.01

43.23

17

0.62

49.86

11.03 U

4.1*

3184 U

18

0,51

40.88

10.59

4.1w

26.21

19

0.42

3152

10.16

U 3.35

-U
53.96

20.01

U7.00

24.

24.64

63.00
138.44

25.9JI

86.58

IT71

59.13

*4.23

47.44
37.90

19.
15.31
U 117

9.00

9.041
73

30.12

5.58

18.61

23.78

14.41
3311

1100

The cost recovery was spread over two years due to limited cash flow in the first year. The PV of royalty is $35-6 million, PV of
taxes is $85.35 million and PV of the host countrys net revenue share is $60.05 million. The contractors NPV is $41.58 million.
The total revenue is $222.60 million. We can calculate the host countrys share as:
181.01
= 2 22.6

= 81%

Notice an important difference between the concession agreement and participation agreement. In the concession agreement,
as the project became marginal, the host countrys share increased from 75% to 97%. In the participation agreement, the host
countrys share increased from 78% to 81% as the project became marginal. The key difference is how the host country is
rewarded. In the concession agreement, the royalty payment forms a big part of the payment irrespective of the profitability of
the project. In the case of the participation agreement, the host country receives a small percentage of royalty but most of the
income comes from taxes and a percentage of net revenue. This means that if the project is not economically successful, the
host country will not receive significant benefit. This makes the participation agreement more efficient and less regressive than
the concession agreement.
Few countries in the world will go "straight up" in a participation agreement. That is, the host country will participate during
the exploration phase and pay for its share from the beginning. This makes the project more attractive for the contractor.

50

Mohan Kelkar, Ph.D., J.D.

Below we show the calculation under a "straight up" contract for the original case (optimistic). The only difference is that, from
year 0, the contractor only has to contribute 70% of the total costs and is able to recover 70% of IDC and leasehold costs after
production begins. The other numbers remain the same. Since the host country contributes from the beginning, the economics
are improved for the contractor.

Year

Cross

Operating

Production

Revenue

Costs

(MMSTB)

($MM)

($MM)

-3.50

-24.50

0
V

.. Deprectatio
Royalty
($Pj(\n)
n ($MM)

0.4
U 0.00

-56.00

0-cm

240.00

18.00

400.00

17.28

5.00

400.00

16.59

5.00

400.00

5.00

10

2459

($MM)

($MJv)

o
0.4

-42.00

5.00

($MM)

U
z Taxes

0.,

-40.60

3.00

Income

0.0

Taxable

0.t

Cost
Recovery

Host Country Contractor


U
U
Ne t Rev1nue Net Revenue

I$MM)
0.0Q

0.00

1
62.86

19.60

115.54 U

SI-99

($MM)
-350

0.00

-24.50

,o.cjd

-40.60

0.001

-4200

0.0q

-56.00

13.80

102.20

2.6f

146.09

60.991

142.32

44.90

297.82

040.00

32.07

311.34

140.10

15.93

40d

22.91

321.17

44.S

400.00

15.29 U

40.(,*

16.36

328.35 U

147.A

5.00

400.00

14.68

40.Q

11.69

333.64

150.4

11

4.10

328.00

14.09

32.80

29.22

251.89

113.35

12

3.36

268.96

13.53

_26.91

228.54

50.331
37,7

13

2.76

220.55

12.99

22.S

185.51

83.41

10.61

71,42

14

2.26

180.85

12.47

18.Q

150.30

676

42

57.86

15

1.85

148.30

11.97

114.83

121.50

154.67

20.041

46.78

16

1.52

121.60

11.49

12.:M

97.95

37

1.25

99.71

9.99

78.71

18

1.02

8137

10.59

8.1k

63.00

28.31

19

0.84

67.05

10.16

U 6.70

50.38

22.58

11.03 U

139.68
199.09

137,87
136.63

44.1
35.41

117.43
87.99

6.16

37.71

12.99

30.30

0.4c?

24.26

8.231

19.32

In this case, The PV of royalty is $71.21 million, PV of taxes is $240.54 million and PV of the host countrys net revenue share is
$109.63 million. The contractors NPV is $152.38 million. The total revenue is $573.75 million. We can calculate the host
countrys share as:

= 421.37
=73%
573.75
The contractors share has increased from 22% to 27%. This makes the contract more efficient than a "carried" contract.

............................................................
PRODUCTION SHARING CONTRACT
The production sharing contract was first signed between Pertamina (the national oil company of
Indonesia) and Mobil in 1966. Subsequently, production sharing contracts became extremely
popular among the non-OPEC countries. Today, it is the most widely used contract between host
countries and an international oil companies.
The basic difference between the production sharing contract and the concession agreement is the
extent of control exercised by the host country in the day-to-day operations. As a partner in the
operation of a field, the host country can monitor and participate in the decision making process. As
with the concession agreement, the host country will open up certain concession areas for bidding
purposes. The international oil company will bid on the concession and offer several incentives,
including the signing bonus and work program, to receive a contract. If successful, the host country
will sign a production sharing contract with the international oil company.
Some key features of a production sharing contract are:

Economic Evaluation in the Petroleum Industry


Chapter 3 - Economic Analysis

51

The international oil company, solely at risk, has the exclusive right to explore for and
exploit petroleum reserves in a concession area. The company is responsible for the
exploration costs associated with these rights.
If the exploration effort is successful, the international oil company is allowed to recover the
exploration costs from future production of the contract area.
Any production belongs to the host country.
After recovering the cost from the production proceeds, the balance of production is shared
on a pre-determined percentage split between the host country and the international oil
company.
The income of the international oil company is subject to income taxes.
Equipment and installations are the property of the host country. This can happen at the
onset of production or progressively in accordance with the approved schedule.
The main advantage of the production sharing contract is that the host country can develop its own
natural resources at no cost without losing managerial control of the overall operation. Further, by
acquiring equipment and installations, it can develop the necessary infrastructure for future
development. The host country can also benefit by having domestic personnel working directly with
personnel from the international oil company and gaining valuable experience.
The schematic of the overall cash flow calculations is shown in Figure 3-5 for a standard production
sharing contract. As shown, the contractor can recover the operating, capitalized (through
depreciation), and exploration costs from the gross revenue. The remaining revenue, called profit
oil, is split between the host country and the contractor based on the approved formula. This
formula may involve a volume-related sliding scale. The contractors share of profit oil is subject to
income taxes.
Some variations of this standard production sharing contract include assessment of royalty based on
the gross revenue before cost recovery, or the contractors share of profit oil is not subject to
income tax. These variations will change some of the calculations. Overall, though, the host
countrys share in a production sharing contract is rarely less than 50%.

52

Mohan Kelkar, Ph.D., J.D.

Gross Revenue
1000
Less
Operating, Capitalized and
Exploration Costs
(Cost Recovery)
400

Equal To
Profit Oil
600

Equal To
Contractors Share
300
Less

Lqnl to
Net Cash Flow
150

Host Countrys Share


450
--=75%
600

II

The following examples illustrate the application of a production sharing contract on the economic
evaluation of a project.
Example 3-16
A production sharing contract is signed between the host country and an international oil company. The contract calls for a
profit oil share of 60% with an income tax rate of 50% on taxable income. The capitalized costs are to be depreciated over a
seven year period using the double declining balance method with the balance to be depreciated in the seventh year. The
expected costs and other relevant parameters are stated below.
Signing Bonus
Capital expenditure:

$5 million in year zero


$30 million in year one
$50 million in year two
$60 million in year three
$80 million in year four

IDC

$5 million in year 1
$8 million in year 2
$10 million in year 3
3 million barrels in the fifth year
5 million barrels from year 6 to 10
Start decline in year 11

Initial production:

Economic Evaluation in the Petroleum Industry


Chapter - Economic Analysis

53

Production decline rate:


Years of production:
Operating costs:
Operating cost decline rate:
Oil price:
MROR:

18% per year


15 years
$18 million in year five
4% per year
$80 per barrel assumed constant
20%/year

Estimate the feasibility of the project.


Solution 3-16
The calculations are shown in the following table:
Host

Year

Operating

Cost

Production

Revenue

Costs

Depreciation

Recovery

Profit Oil

Shire

(MMSTB)

($MM)

($MM)

($MM)

($MM)

($MM)

($MM)

Contractor

Income

Taxes

Revenue

($MM)

($re1 )

($MM)

IS

Gross

Countrys.

-5.00

0(1

-35.00

0.00

-58.00

0.00

-60.00

acm

Taxable

Net

-80.00

0.0

-5.00

0.(

-35.00

0(1

-58.00

0.00

-60.00

0.00

-80.00

82.46 N

26.I

117.09

0(1

131.14

0 78. 69
U

44.90

337.82

IJ02.69

135.13

60.71

119.22

16.59

32.07

351.34 0

210-EM

140.54

0 63.24
U

109.37

400.00

15.93

22.91

361.17

216.71

144.47

65.01

102.36

400.00

15.29

16.36

36835

21.01

147.34

66.3

97.40
93.89

3.00

240.00

18.00

62.86

5.00

400.00

17.28

5.00

400.00

5.00

5.00

28.00

10

5.00

400.00

14.68

11.69

373.64

Q24.18

149.45

67.21

11

4.10

328.00

14.09

29.22

284.59

170.01

113.88

0 51.24
U

91.85

12

3.36

268.96

13.53

255.43

153.71

102.17

045.98

56.20

13

2.76

220.55

12.99

207.56

24.54

83.02

37JI

45.66

14

2.26

180,85

12.47

16838

IJ01.03

67.35

30.71

37.04

15

1.85

148.30

11.97

136.33 M

81.b

5453

0 24. 54

1.52

121.60

11.49

110.11

66(1

44.05

29.99

16

19.82

24.23

17

1.25

99.71

11.03

88.69

53.21

18

1.02

81.77

10.59

71.18

35.47

.42.71

19

0.84

67.05

10.16

56.88

34. A

15.919

19.51

28.47

12.71

15.66

22.75

M 10.24

12.51

Sample calculations:
The calculations are carried out with the constraint that the profit oil can never be less than zero. Similar to the concession
agreement, lDCs and leasehold costs are recovered through the cost recovery method. The total amount is $28 million.
For year five,
gross revenue = 3 x 106 x 80 = $240 million
DC and leasehold costs can be deducted in the first year of production as long as the profit oil is not less than zero.
profit oil = gross revenue from oil - operating costs - depreciation - cost recovery
= 240- 18- 62.86- 28
= $131.14 million
The depreciation is calculated by using the double declining balance method.

54

Mohan Kelkar, Ph.D., J.D.

host countrys share of profit oil = 0.6 x 131.14


= $78.69 million
taxable income = 0.4 x profit oil = $52.46 million
tax = 52.46 x 0.5 = $26.23 million
net income = gross income - operating costs - 0.6 x profit oil - taxes
240.0 - 18.0 - 78.69- 26.23
= $117.09 million
Net income represents revenue minus actual outlays. These outlays include 60% of the profit oil given to the host country. The
rest of the calculations are carried out in a similar fashion. The host country receives money in two ways in a production
sharing contract: a portion of the profit oil and taxes. In this example, the PV of the profit oil share is $361.41 million, PV of
taxes is $109.48 million and NPV of the contractor is $55.54 million. The host countrys share is,
470.89

-- 55.54 + 470.89 =89%


If we consider a pessimistic case where production is reduced by half, we see the following results:
Host

Year

Contractor

Gross

Operating

out?trys

Production

Revenue

Costs

Depreciation

Recovery

Profit Oil

Shire

Income

(MMSTB)

($MM)

($MM)

($MM)

($MM)

l$MMI

($MM)

($MM)

Cost

Taxable

Net
Taxes
($r*1)
U

o.

-5.00

-3500

000

-58.00

U 0.00

-60.00

-80.00

28.00

1.50

120.00

38.00

62.85

2.50

200.00

17.28

2.50

200.00

2.50

2.50

10

2.50

200.00

14.68

11.69

173.64

11

2.05

164.00

14.09

29.22

120.69 M

12

1.68

134.48

13.53

120.95

13

1.38

110.27

12.99

97.29

14

1.13

90.42

12.47

77.96

15

0.93

74.15

11.97

62.18 0

oe
0. cffi

-3500

0.0

-58.00

0.00
U

-500

-60.00

0.(

($MM)
U

adg

Revenue

0.00

-80.00

2.I

93.09

11.14

6.69

44.90

137.82

U 8269

16.59

32.07

151.35

gam

50.54

200.00

15.93

22.91

161.17

96.

64.47

200.00

15.29

16.36

168.35

1101.01

.
104.18

67.34

72.1

48.28
48.38 M

.24.19

24.19

38.92 M

19.!

19.46

33.18 U

15.4

15.59

24.87

12.44

12.44

72.1k
05837
U

.46.78
37.!

4.46

55.13 U

27.4

72.46

03027

62.34

.3123

55.14

33.ER

50.03

34.lj

46.41

0 24.14
K

53.36

69.45 U

36

0.76

60.80

11.49

49.31 U

17

0.62

49.86

1103

38.83

18

0.51

4088

10,59

30.30

19

0.42

33.52

10.16

23.36

29.8k

19.73

U
U

9.86

9.86

7.!

7.77

m 23.30

15.53 M

18.18

32.12

6.4

6.06

9.34

4.67

4.67

34.!

In this case, the PV of the host countrys share is $147.79 million and PV of taxes is $49.26 million, but the NPV of the
contractor is -$23.66 million. Although the host country will make money on the project, the contractor will lose. This happens
because of the initial investment made by the contractor. Although the contractor is allowed to recover those costs, the time
value of money makes the project uneconomical. Production sharing contracts, in general, are more efficient than concession
agreements because they do not contain royalty payments (payments based on gross revenue). However, for marginal
projects, it is possible for contractor to lose money while the host country makes money.
This type of marginal project discourages companies from developing fields and, hence, the loss will be to the contractor and
the host country. To avoid this problem, many production sharing contracts have clauses that change the percentage of profit
oil as a function of production rate. The higher the production rate, the more oil that is shared by the host country. In some
instances, the profit oil share is tied to the rate of return on investment. If the oil prices increase and, hence, the profit, a higher
percentage will be taken by the host country. Other variations in production sharing contracts include a domestic market
obligation. In essence, the contractor is required to provide a portion of the production at a reduced price to the host country.
This is another form of royalty payment except that it is subsidized rather than free.

Economic Evaluation in the Petroleum Industry


Chapter 3 - Economic Analysis

55

[SERVICE CONTRACTS
As we move from the concession agreement to the service contract, the involvement of the host
country increases. In essence, under a service contract, the international oil company provides the
host country with services and information to help the country develop its own resources. In return,
the company receives a fee or share of production at a reduced price. Most significant, the oil
company has no equity position in the production. The company may receive production at discount
prices, a production bonus tied to reaching a certain level of production, and the host country may
also pay the companys taxes so that the proceeds are tax free. On the other hand, the host country
retains control and ownership of the minerals.
The service contracts can be further divided into three types of agreements: (i) pure service
contract, (ii) technical assistance agreement, and (iii) risk service contract.
PURE SERVICE CONTRACT
In a pure service contract, the host country or its national oil company will contract with an
international oil company to perform a specified service for a fixed fee. These service contracts
do not provide for any right to production. To make the contracts more attractive, the host
country may include a buy back arrangement where the international oil company can obtain
crude oil instead of a fixed fee. This allows the oil company (the contractor) to receive a fixed
share of production (similar to overriding royalty) as a fee.
These contracts are common in the Middle East. In Saudi Arabia, for example, international
companies received a fixed fee per barrel of production. In Qatar, an oil company is paid back
with a fixed percentage of crude produced while providing the service.
TECHNICAL ASSISTANCE AGREEMENT
In a technical assistance agreement, the contractor provides technical assistance related to
exploration, development, production and the refining of oil. The contractors services may
include providing equipment as well as training employees to operate the facilities. In return,
the company agrees to pay for the expenses plus a fee tied to production.
Venezuela entered into such an agreement with several international oil companies, where the
oil companies agreed to operate the facilities they built in return for a fixed per barrel fee.
RISK SERVICE CONTRACT
In the risk service contract, the risk of exploration is borne by the contractor (the international
oil company). The contractor agrees to explore a specific area and evaluate its potential. If a
commercial discovery is made, the contractor is obligated to develop the reservoir. Once the
field is developed, depending on the terms of the contract, the field is operated by either the
contractor or the national oil company. The contractors investment is paid back with interest
and a fee. In addition, the contractor may receive a portion of the production at a reduced price.
The countries that employ this type of contract are Argentina and Brazil.

56

Mohan Kelkar, Ph.D., J.D.

Unlike the concession and production sharing contracts, we have not included any examples to
illustrate the applications of the service contracts. The main reason is the limited use of service
contracts compared to the other two types of contracts. Further, due to wide variations in the
terms of service contracts, it is very difficult to consider a typical service contract. Additionally,
the service contract can be analyzed as a reverse of concession agreement with some
modification, where the contractor becomes a royalty owner and the host country becomes the
operator.

An agreement is signed between an international oil company and a national oil company to develop a concession. The contract
calls for 020% royalty interest and 55% income tax rate. The oil production and cost profile follows.

Year
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20

Capitalized Costs
($ Million)
180
400
520
600

Operating Costs
($ Million)

Production
(10 6 bbls/year)

24
26
28
28
28
27
26
26
25
24
23
22
22
20
1]
12
10

80
9.0
11.0
15.0
15.0
14.0
13.0
12.2
11.5
10.4
9.9
9.3
8.2
6.0
4.5
2.6
1.3

Assume that capitalized costs can be depreciated over a 10 year period using the double declining balance method once
production begins. The oil price is expected to be $801bbl in year four, increasing at a rate of 2.5% per year.
A.
B.
C.
D.
E.

Calculate the ROR of the project using the conditions above. If the MROR is 15%, is the project economically feasible?
If the oil price is assumed to be $75/bbl at the present time, how will the economics of the project change?
If the predicted production is reduced by half each year, how will the economics of the project be affected?
Calculate the NPV of the contractor for A, B and C. Based on these calculations, calculate the NPV per barrel of oil. If the
finding cast in the United States today is $241bbl, will you select the proposed project or the one in the United States?
If the national oil company is willing to negotiate the royalty percentage, as well as the tax rate, to what percentage are
you willing to increase the royalty interest if the tax rate can be decreased by 4%?

(Hint: See the Works Cited section (Moran, 1992) for details)
Problem 3-26
Assume the production data and other information given in Problem 3-25.
A.
B.

If the host country requires that its participation interest is 30%, how will the economics change? Assume that the initial
investment is carried by the oil company.
If the capitalized costs are higher by 50%, how will the economics of the project be affected?

Economic Evaluation in the Petroleum Industry


Chapter 3 - Economic Analysis

57

C If the operating costs are higher by 50% how will the economics of the project be affected?
D. What is more critical in terms of costs capitalized costs or operating costs? Why?
E. Repeat ports B, C and Dfor a "straight-up"contract.
F. If the exploration casts for the given data are $10 million in year zero, how will the project economics change? Assume that
the exploration costs can be deducted in the first year of production as long as the taxable income is not less than zero
otherwise it is carriedforwardi Repeat the problem for both carried and straight up options
Problem 3-27
If, in year eight, the oil company is required to drill two additional wells costing $6 million, will the net revenue in that year be
affected with and without drilling the wells?
Repeat calculations for,
A.
B.

Royalty interest only.


Royalty and participation interest.

Assume the royalty interest to be 20 16 and the participation interest to be 20%. Use all the other relevant data from Problem 325. Assume that exploration casts can be deducted in the some year.
1.
2.
3.
4.
5.

For parts A and B, is your net revenue reduced by $6 million? Why?


In terms of incremental investment (such as drilling an in-fill well), are these contracts efficient or inefficient?
If the royalty interest is increased to 40%, how will the net revenue be affected with and without incremental costs?
If the participation interest is increased to 40%, how will the net revenue be affected with and without incremental casts?
Is it more beneficial to have increased royalty interest over increased participation interest? Why?

Problem 3-28
Use the production and cost data from Problem 3-25. A host country has signed a production sharing contract with an
international oil company with the following conditions.
The capitalized costs are depreciated over a seven year period using a combination of the double declining balance and the
straight-line method. The capitalized costs are to be depreciated starting in the year production begins. The host countrys share
of profit oil is 50%. The host country also receives a royalty interest on gross revenue of 10%. The tax rate is 40% on taxable
income.
If the MROR is 159 16, and the price of oil is expected to be $801bbl over the life of the project, is the project economically feasible?
Assume that $30 million is spent in IDCs in year zero, which can be deducted once production begins.
Consider the variations in the following parameters and assess their impact on the profitability of the project.
20% variation in capitalized costs.
20% variation in production rote
20% variation in operating costs.
20% variation in exploration costs.
A.
B.
C.
D.

Which input parameter has the most impact on the profitability of the project? Based on this sensitivity analysis, discuss
the progressive or regressive nature of the project.
If we assume that the royalty interest is reduced to zero and repeat port A, how will the nature of the project be affected?
If the host country wants to increase the profit oil share by 5%, how much does the tax rate need to be reduced not to
affect the profitability of the project? (Hint: See the Works Cited section (Moran, 1992) for details.)
If another oil company is willing to buy your interest at a price of $41bbl of oil in the ground, will you sell it?

Problem 3-29
Use the production data given in Problem 3-25.
In year six, if the oil company is required to spend an additional $10 million in exploration costs, how will the revenue be

58

Mohan Kelkar, Ph.D., J. D.

0
affected? Assume that there is no royalty interest, the host country takes 40% of the profit oil, and the tax rote is 55%. The
exploration costs can be deducted in the some year.
In terms of incremental costs, is this contract efficient or inefficient?

SUMMARY
In this chapter, we considered the effect of income taxes on the economic analysis of a project. The
effect can be significant depending on the tax structure. Although various nuances of the tax structures
are not considered, the basic principles were illustrated through several examples.
In this chapter, we also concentrated on the tax implications on the development of oil and gas
properties domestically and internationally. As the landscape of oil production changes and oil fields in
the United States become mature, international production becomes more relevant to the major oil
companies and large independents. International agreements can vary significantly in terms of the
control of the operation and type of compensation the oil companies receive. Hwever, there is one
* significant feature that is common to most of them - the fractional share of production received by the
host country. Unlike typical royalty contracts signed in the United States, the majority of production
goes back to the host country. As shown in the examples provided in this chapter, this type of
arrangement significantly affects the cash flow analysis of the project and may make marginal or small
oil fields difficult to develop. Understanding the implications of the type of contract a company signs is,
__
therefore, very crucial in making the project economically profitable.
WORKS CITED
Wall Street Journal. (2009, October 17). Wall Street Journal.
Allen, F. H., & Seba, a. R. (1993). Economics of Worldwide Petroleum Production. Tulsa, Oklahoma, USA:
OGCI Publishing Company.
Allinson, G. (1995). Economics of Petroleum Exploration and Production. Australia: PetroConsultants.
Bertagne, R. G. (1992). International Exploration by Independents. (R. Steinmetz, Ed.) The Business of
Petroleum Exploration, 319-330.
Blinn, K., Duval, C., LeLench, H., & Pertuzio, a. A. (1986). International Petroleum Exploration and
Exploitation Agreements: Legal, Economic and Policy Aspects.

New York: Barrows Company.

Campbell, e. a. (1987). In Analysis and Management of Petroleum Investments: Risk, Taxes and Time.
Norman, Oklahoma: CPS Publishing Company.
DeGarmo, E., Sullivan, W. G., & Bontadelli, J. A. (1993). Engineering Economy (9th Edition ed.). New York,
New York: MacMillan.
Katz, S. B. (1992). Types of International Petroleum Contracts: Their History and Development. (R.
Steinmetz, Ed.) The Business of Petroleum Exploration, 297-306.

L. G. Mosburg, J. (1989). Tax Consequences of Oil and Gas Exploration and Development under Tax
Reform. Tulsa, Oklahoma: K.S. Enterprises/ElI.

Miskell, R. F. (1984). Petroleum Company Operations and Agreements in the Developing Countries (Vol.
Resources for the Future). Washington, D.C., USA: Johns Hopkins Press.
Newman, D. G. (1991). In Engineering Economic Analysis. San Jose, California: Engineering Press.
Park, C. S. (1993). Contemporary Engineering Economics. Reading, Massachusetts: Addison-Wesley.

Economic Evaluation in the Petroleum Industry


Chapter 3 - Economic Analysis

59

ADDITIONAL CASE STUDIES.


Casa Stu(v 3-3
Among stripper gas wells, data reveals that brine accumulation is the primary reason for declining natural gas production and often
subsequent well abandonment. Just a few tenths to a few barrels per day can and does kill gas production. Conventional fluid removal
techniques using beam pumps, periodic swabbing of fluids with workover rigs, siphon strings and tubing plungers or rabbits have
both physical limitations and significant capital, operating and maintenance cost considerations. Regular, rhythmic removal of fluids as
they accumulate In the well increases gas production. Averting a brine column and a brine-wet zone in the production horizon fosters
the ease of movement of gas into the well.
A new pump, called the Gas Operated Automatic Lift (GOAL) PetroPump, has a unique "on-tool actuator-valve assembly. The tool
is designed to freely operate within the well easing, descending downhole when wellhead pressure and production drop. Upon
descending into the fluid, afforded by a through-tool passageway, a fixed column or weight of fluid accumulates atop the tool that
offsets the preset actuator pressure, and the valve automatically closes.
Flex wall cups surround the tool and actuator body and make a circular seal with the well. Additional pressure and gas accumulating in
the well below the tool build and lift the tool and fluid load to the surface. On reaching the surface, the fluids are pushed ahead of the
tool and processed off the topside of a wellhead lubricator. Follow-on gas production is produced from below the tool on a bottom
side port in the lubricator.
The tool is "smart" in both directions, In that the tool, upon ascending the wellhore to the wellhead lubricator, does not have to latch
into a wellhead catcher to await physical release by man, clock or other mechanical device. The on tool actuator valve assembly senses
tool pressure, and at such time as wellhead pressure declines to within a preset limit of sales-line pressure, the actuator opens. The
tool then again descends for another load of fluid.
The tool (Case Study Figure 3-1) has evolved significantly through a multi-year development and field-testing process. The original
tool was more than 6-ft long, weighed over 100 lbs and had more than 60 components. The current fourth-generation convertibletool design, which can accommodate 4-in, or 3-in. II) casing and/or tubing, has lust 14 components, is only 38-in, long and weighs
less than 45 tbs. Metallurgical upgrades from carbon steel to stainless steel and I lastelloy (a proprietary alloy) largely eliminated
corrosion problems, and elastomer modifications have proven effective in reducing wear. The convertible tool now being tested will
broaden the tools application environment, since tubing wells with new 4-in, and 3-in. materials will not present the irregularities of
older cased wells. BED - 0 is researching the use of non-metallic, continuously spooled casing and tubing to further reduce lift lost.

60

Mohan Kelkar, Ph.D., J.D.

(nsc Study Figure 3-1: G(1:tL

I otosop tool c 1010 tIon

(most recent pump Is on

Required wellhead modifications include a full-port ball valve to allow passage of the tool and, atop the full-port valve, a lubricator to
allow top end (above tool) takeoff of fluids, and bottom end (below tool) production of post-run gas. A top-of-lubricator catcher for
periodic tool retrieval for cup replacement and/or actuator adjustment has also been developed. Actuator operation can be changed
or reset by the removal of only one tool component: a top-end catcher rod. Cups can be removed and changed by the removal of just
two components: a lock nut and washer. Periodic tool service and adjustment can be achieved using two IS-in, adjustable wrenches.
Field testing and pumper input have led to a physical configuration comprised of standard field threads, wide flats and easily
accessible key components.
The gas/fluid ratio for the current tool is about 3 Mef/bbl per tool cycle. Pressure differential to move the tool within the well is
about 12 psi in conventional steel casing. Data demonstrate the tool is capable of lifting 0.1 barrels to as much as 40 bbl of fluid per
cycle, but normal operating range is 0.25 - 6.0 bbl per tool cycle. Cup life on the tool has proven to be greatly extended over
conventional tools and cups due to the regular prcssurelift cycling and exertion of uniform forces on the cups. Cup life on some wells
now exceeds six months.
Teoape Resources used the initial and successor tools in Well 52, a 3,200-ft Medina formation completion in New York drilled in
1986. Well 52 has 4.5-in. J-55 casing. It produces through a horizontal wellhead separator into a gas gathering system, with pressure
ranging 50 - 100 psi. Recent wellhead shut-in pressure is about 120 psi. By late 1996, the producing method had evolved from
unassisted flowing, to a 1-1/2-in, tubed well that was periodically soaped, shut-in and vented to a standard 4.0-in, casing swab that was
mcchanically/ physically dropped and operated.
An example of tool perforniaoce is shown in Case Study Figure 3-2. Annual production before tool deployment was about 1,100
Mef/ycar. Production since the tool installation has averaged 3,416 Mcf/vcar. Case Study Table 3-1
shows results for other tight
Medina wells. Production multiples in the other wells are also economically attractive. The average success rate of these wells is about
0.7; that is, 70% of the wells, where the tool is installed, have been successful.

Economic Evaluation in the Petroleum Industry


Chapter 3 - Economic Analysis

61

Wolf 52 docilne cume annual production

4
2
6

.6

q2 a T

91

iS

PIDUCtcn

Dl

rQ 0.1

POF

Care Stu dv laure 3 2 4naala s proc/ac tion from L flap e 52 we /I before and rlterdi s taiia tion
C as c., S tu cip 1 51- 1: 1 e norm a ace ian pro vone ii ts on pa r wells u s1ag the ile w p amp
Wells

(all wells are in


Queenstonc/

Medina sandstone) Depth, ft


L-52
3,200

Pre-pump
installation
flow, Mcfd
6

Post-pump installation flow, Mcfd


13-19

L-54

3,300

3-5

8-10

L-274

3,400

< 2

6-8

L-332

3,200

5-6

18-20

L-29
S-2023

2,400
2,700

< 7
0-10

13-16
28-35

Fluid Production,
bwpd
Notes
05-1.0
2-4 tool cycles!
day (rhythmic)
< 0.5
1 cycle every 2-3
days (possible
casing leak)
025-0.5
1-2 cycles/ day
(well in
adjustment)
0.5-075
2-3 cycles! day
(regular)
< 0.25
2-3 cycles! wk
0.5-0.75
3-4 cycles! day
(well was swabbed,

As a production engineer, you want like to evaluate the effectiveness of this new technology. Assume that the cost of pump is
S1 1,500. The surface equipment and the installation cost is S9,700 per pump. These costs can be depreciated over five years using the
DDB!straight -line methods. Assume that Case Study Table 3-1 represents an average response from a typical field for a similar
environment with a 70% success rate. The royalty payment is 15%, the severance tax is 8%, and the incremental operating cost for
each well is S500 per year. Assume that the price of gas is $4.50!MSCF and assume that the production in Case Study Table 3-1
represents the incremental production in the first year declining at 10% per year. The marginal tax rate is 34%. If the MROR is 15% ,
is the project feasible? What is the ROR on the project? If the price is assumed to be $3.50/MSCF, will the feasibility of the project be
affected?
Case Study 3-4

Coal bed methane (CBM) production has been receiving a lot of attention lately. Methane is primarily adsorbed to the organic matter
in coal. Coal contains large number of fissures and fractures which are filled with water. These are the primary conduits of gas. As the
reservoir is depleted, the wells initially produce significant quantities of water. As the water from the fissures is depleted, the natural
gas is slowly desorbed into the fractures and is produced. Over time, the water gas ratio decreases as less and less water is produced
and more and more gas is produced. A typical profile of gas production includes a slow increase at the beginning followed by a steady
decline in gas production.
CBM production first started in San Juan basin in New Mexico. Because of economic success of that basin, eventually operators
started exploring other basins for CR61 production. Figure Case 3-4-1 below shows the locations nfCBM production in Oklahoma.

62

Mohan Kelkar, Ph.D., J. D.

C2 se

Study Figure 3-3: CBM production placs

One of the basins which have been extensively explored is the Arkoma basin in Oklahoma As a production engineer, your job is to
understand the feasibility of drilling vertical vs. horizontal wells. Currently, you have collected data from 153 vertical wells and 53
horizontal wells. Based on a cursory analysis, Out of 153 wells, roughly 51 vertical wells produce from a poor quality coal with
distinctive different rate behavior. The other 102 wells exhibit a distinct behavior. For 53 horizontal wells, roughly 15 wells exhibit a
distinctive behavior because of low quality rcseioir. The other 38 wells exhibit distinct behavior indicating better coal quality. The
typical production profiles of vertical wells (poor and good) and horizontal wells are provided below: Note that we have only
provided the production profiles for wells for 20 years. These productions represent yearly production from a single well in MSCF. In
principle, the wells will continue to produce for a longer period of time; however, from present value analysis perspective, the
production beyond 20 years is not going to contribute significantly; therefore, we can ignore the production beyond 20 years.
Gas Production (MSCF)
Vertical Well
Poor

Horizontal Well

Good

Poor

Good

9,600

24,000

50,400

120,000

14,400

44,400

39,600

78,000

12,000

39,600

32,400

57,600

10,200

32,400

27,600

45,600

8,400

25,200

22,800

36,000

7,200

20.400

20,400

30,000

6,600

17,400

18,000

25,800

5,760

15,000

16,200

21,600

5,160

12,600

14,400

19,800

4,56()

11,400

13,200

16,800

4,32()

10,200

12,000

15,000

3,84))

9,000

11,400

13,800

3,36))

8,160

10,560

12,60()

Economic Evaluation in the Petroleum Industry


Chapter 3- Economic Analysis

63

14

3,240

7,200

96,000

11,400

15

3,000

6,600

9,120

10,200

16

2,880

6,120

8,400

9,600

17

2,580

5,320

7,920

9,000

18

2,400

5,400

7,320

8,160

19

2,280

4,800

7,200

7,800

20

2,160

4,560

6,960

7,200

Assume that the cumulative production over 20 years for each of the scenarios represents the reserves from that well. For vertical
wells, typical spacing is 80 acres (i.e., we need to drill 8 wells per 640 acre spacing). For horizontal wells, typical spacing is 160 acres;
(i.e., we need to drill 4 wells per 640 acre spacing). Do your calculations based on the development per section (640 acres). The coat of
drilling and completing a vertical well is 595,000; whereas the cost of drilling and completing a horizontal well is $400,000. These costs
can be divided as 50% IDC and 50% tangible costs. These costs are incurred in year 0. Assume that depreciation and depletion begins
in year 1. ID( s are accounted for starting in year 1. The leasehold costs include a lease bonus, calculated at $50 per acre, plus an
additional $2,000 in legal costs per section and S4,000 in G & G costs per section. The operating costs for a vertical well average
about S650 per month; whereas, the operating costs for a horizontal well average about S1,000 per month. The operator has a
working interest of iOO/s with a net revenue interest of 85%. The severance tax is 7/s. Assume an independent operator. Use the
ACRS method for depreciation using a 7 year taxable life. The marginal tax rate is 31%. Assume the gas price for the first 3 years to
he $6/N,-IS(-I-, and then, starting year 4, it will hold steady at S5/MSCF until the cud of its life. The MROR is 15%.
Calculate the payback period for good and poor, vertical and horizontal wells. Also calculate the NP\T for all four options. Based on
this information, will you drill horizontal wells or vertical wells? Why?
Case Stuc/4 3-5
Downhole Oil/Water Separator (DOWS) operates on the principle of disposing of water in another formation below the producing
formation. The produced water is separated downhole and part of it is disposed of in a formation below the producing formation.
The reduced amount of water is produced at the surface, which is eventually disposed. For wells producing significant amounts of
water, this technology can prove to be effective for the following reasons:
Since much of the produced water is not pumped to the surface, treated, and pumped back into deep formation, the cost of
handling the produced water is greatly reduced.
The production of oil can be increased by reducing the requirement of surface processing and disposal facilities.
By reducing the water/oil ratio, the back pressure on the formation is reduced; thereby, increasing the productivity of the
well.
The two main components of DOWS are an oil/water separation system and dowohole pump. Separation can be achieved using
either hydrocyclones or gravity separators. The downhole pump can be either an electric submersible pump, progressive cavity pump
or beam pump. A typical downhole installation is shown in Figure. In this configuration, there is one hydroeyclone for separating oil
and water and two pumps, one for disposal and one for lifting. The separator is designed such that under flow of the hydrocyclone
produces water clean enough for injection into disposal zone. The over flow typically contains a water/oil ratio of 50%. The reason
that high water/oil ratio exists at the surface is because of the constraint that no oil be accidentally injected in the disposal zone. Case
Study Figure 3-4 shows schematically how the process works.

64

Mohan Ke/kar, Ph.D., J.D.

Tubing to surface

Concentrate pump

Motor upper protector

Motor

Motor
shroud

Motor lower protector


Pump intake

Production
zone

Injection
zone
Case Study lCgurc3-4: DOWo operation

You are working for a small independent in Oklahoma, who has recently discovered a new oil field. This oil field produces from a
carbonate reservoir that appears to be fractured. The reservoir characteristics are not clearly understood; however, one important
factor common to all the new producing wells is the high water-oil ratio. The oil is currently produced from a zone that is
approximately 5,000 ft deep, and the produced water is disposed of in a zone that is approximately 6,700 ft deep.
A typical producing oil well has the following characteristics:
Oil production rate = 80 hbl/d
Water production rate = 3,000 bbi/d
OCR = 3,000 SCF/STB
Operating costs = 86,000 per month
Expected life of a well = 8 years with 30% decline in production
Cost of drilling a vertical well = S350,000
You read all the material available on DOWS and come
DOWS is installed on a well:

tip

with the following numbcis in terms of improvement in production if

New WOR = I
Operating costs with reduction in water handling = S4,480 per month
% increase in oil production =
Expected life of it well = 8 years with 330/s decline in production
in addition, following information is also available:
Cost of implementation of 1)1 lOWS = S250,000
Cost of drillmg a producing well deeper by 1,700 ft = S40,000
Price of oil = $25/bbl held constant
Price of gas = 83/ MSCF hckl constant
Working interest = 1 00h
Net revcnite ititcrest =
Scvcreticc tax in Oklahoma = 7Wo
Economic Evaluation in the Petroleum Industry

Chapter

- Economic Analysis

65

Marginal income tax rate = 31%


DOWS can he depreciated over 7 years using a combination of DDB and straight-line methods. The drilling costs can be deducted in
the some year as IDCs. Determine the feasibility of Dl lOWs operation by assuming MROR of 15%.
Cisc Studt .3-6
As gas and oil prices rise, the oil fields in remote locations are becoming increasingly attractive. I lere is an example of a condensate
reservoir located in North Slope, Alaska. The condensate field contains a large amount of gas along with liquid condensate. No gas
pipeline exists; therefore, gas cannot be sold and will have to be re injected. The cost of a gas pipeline from Alaska to lower 48 states
is pegged at $25 billion, a cost that is difficult to overcome by a single project. However, the condensate produced from an oil field
can be sold through the Trans-Alaska Pipeline. Here are some economic parameters to consider:
Working interest = 9%
Net Revenue Interest = 7.88%
Income tax rate - 35%
31140R = 20%
Number of wells in the field after it is developed = 8 producers and 6 injectors
The following costs are anticipated after the project begins:

Year
0
1
2
3
4
5
6

Facilities

Intagible
Development

Tangible
Drilling

Intangible
Drilling

(M $)

(M $)

(M $)

(M $)

0
0
0
400,000
400,000
220,000

10,000
20,000
70,000
50,000
40,000
10,000
200,000

0
0
13,800
0
77,280
77,280
168,360

0
0
32,200
0
180,320
180,320
392,840

The costs are provided in 1000s. The facilities costs are tangible costs to be depreciated using a 7 year DDB/straight-line
combination method. The intangible development Costs include preliminary engineering studies, geological and geophysical costs and
other leasehold costs. These costs are to be depicted using the cost depletion method.
The tangible drilling costs are depreciated over 7 years using the DDB/straight-line method.
\lreoth eed this in pa igtaph ,ib we. The
intangible drilling costs are lD(2s. 70 0/s of IDCs and are deducted in the first year of production with the remaining 30% depreciated
over five years using the straight-line method.
Production is expected to begin in year 6 and, for the first 7 years, will be 16,000 Mbbis per year at a constant rate. After 7 years,
production will decline at a rate of 2.5% per year for an additional 23 years. The severance tax is 6%. Assume, for simplicity, that
depreciation of all equipment will only begin after production starts. The operating cost in the first year is expected to be $21,000
million, increasing at a rate of 2.5% per year. The transportation cost per barrel of oil is Si. At the end of field life, the abandonment
cost is expected to be $50,000 million. The price of condensate in the first year can be assumed to he S25 per barrel escalating at 4%
per
year.
Is the project feasible under the given conditions? If not, what is the initial break-even price needed for oil? Do you think that the
price you estimated is reasonable to achieve? What do you think is the maximum initial oil price you can assume to evaluate this
project? \Xhy?
Let us assume that, in year 10, a pipeline connecting the Alaskan gas fields to the lower 48 states will be built and can carry the gas to
the lower 48 states. Let us assume that, beginning in vcar 10, the gas from the field can be sold into the pipeline. The cost of building
the futilities for processing and piping the gas to the main pipeline is S100,000 million. This -amount is spent in year 9 and will be
olepicciated as tangible costs starting in year 10, over 7 \ears using a DDB/straight-line combination method. Assume that the gas-oil
ratio will be maintained at 10,000 S(,] ,/SIB throughout the remaining life of the project. The price of the gas in year 10 is assumed to
he SI .50/3lSCli increasing at a rate of 3% per yese Note that the low gas puce results from the Let that markets are so far away and
transportation costs are very high.

66

Mohan Kelkar, Ph.D., J. D.

Assuming the baseline oil price, will selling the gas result in making the project feasible?
If our high estimates of the gas price are $2.50 increasing at a rate of Si/s per year, what will the economics look like?
If you prefer not to rely on the gas pipeline, another alternative of disposing of the gas is to use GTI. (gas to liquid) technology. This
technology allows to covert gas into liquids that can be sold like crude. Do research and find out the cost of building a (i/IL plant
by
assuming the producing gas liquid ratio is 10,000 SCF/SIB. Is it worth using (l[, plant to convert gas?
Case Srucly 3-7

Westbrook (Clearfork) is the Permian basins discovery field. It was discovered in 1920 on the Eastern Shelf in northwestern Mitchell
County. The first well pumped 10 bopd from an openholc completion in the Upper Clearfork after shooting with nitroglycerine. Main
pay in the 3,000 ft Lower Clearfork was found when this well was deepened in 1921. Three large secondary units now account for
most Clearfork production.
By 1964, 99 wells were on leases that would later be incorporated into the Southwest Westbrook Unit. The unit was formed in 1969
and operated by Union Texas. In its final form, the unit covers 3.833 acres, with calculated original oil in place of 61.6 million bbl.
Union Texas immediately drilled injectors and converted producers to injectors to initiate injection. There were 26 injectors on 160acre spacing.
Beginning in 1971, the units south end was infill drilled on a 40 acre five-spot pattern. lhis continued until 1986, when the 40-acre
five-spot pattern in the units north end was implemented in areas thought to be productive. In 1991. Meridian (Burlington) took over
as operator and drilled, on 10-acre spacing, selected areas that its studies indicated to be the most productive. The injection pattern
then became an east west line drive, due to an east-west preferential permeability trend that was noted in several areas of the unit as it
was down-spaced.
Gruy purchased the unit from Burlington in 1997 and continued to drill the 10-acre locations in what were thought to be the more
productive, less risky areas. Currently, Cimarex is operating the field.
During the Meridian and pre 2003 Gruy tenures, stimulation of the Middle Clearfork zone included small acid breakdowns, followed
by cross linked sand fracture treatments diverted with graded rock salt and some surged acid treatments. Before Gray became
operator, producers and injectors were sand fracture-treated. However, Gruy was concerned about the ability to control water
placement in the injection wells by using hydraulic fracture treatments.
Cimarex started investigating various options to improve performance and learned about BI Services LiteProp fracturing technique.
T.itcProp is a proppant used in hydraulic fracturing that has a specific gravity of 1.25 and a closure range tolerance up to 5,000 psi.
When it is pumped in a near saturated brine water with a specific gravity of 1.20, the result is a near buoyant proppant. This buoyancy
allows the propparit to be placed farther out in the induced hydraulic fracture without viscosity-enhanced fluids for proppant
transport.
These non-gelled or slick brine water fluids are essentially non-damaging compared to polymer-laden fluids that have been pumped
historically at Westbrook. The lack of viscosity also works favorably in controlling fracture height growth development, increasing the
potential to stay in zone (and out of water at Westbrook), thus creating a longer effective fracture length. It was also believed that a
proppant partial monolayer could be created in this low-closure reservoir to further enhance conductivity in the induced hydraulic
fractures. The average cost of fracturing was $140,000, and some relevant tangible costs associated with re-completion were $20,000,
which would be depreciated over a five year period using a DDB/straight-line method. If the life of the project is less than five years,
assume that you will not be able to depreciate the entire cost. All factors considered, the team believed the Clearfork formation to be
an excellent candidate. This, combined with having no other ideas for new or innovative stimulation treatments, led to the
implementation of slick water hydraulic fracture treatments using lightweight proppants.
Treatments yielded 80 to 100 bopd during flush production, and declines decreased significantly after six months so that, after a yearand-a half in production, the rate was still 20 bopd (Case Study Figure 3-4). It should he noted that most of the wells drilled or
recompleted in 2004 are in areas not supported by injection. In 2005, no drilling was scheduled, although 20 recomplctions were
performed, with results similar to those of 2004. For calculation lliu, assume that initial incremental production is 100 b/d, and
the first yearly production varies betsvccn 21,900 hbls (worst) and 25,550 bbls (best) and the decline in production per year is
anywhere between 55% (best) and 70% (worst).

Economic Evaluation in the Petroleum Industry


Chapter 3 - Economic Analysis

67

iso

o 114
l,;, .-,--44
512O
s
iF)
113

-.
--.

-.

!.-4-2
10- 29

90

i]
30

40
-

20

Z; ca c, c

es a

(0 (0 CSI (".1

C) C) C") C") C) C")

;-:: I, x3 -j
:i ,
:,

us
.- ,,
Cse Study Figure 3-4: SWWU stimulAtIon effect on well produetionAs a Cimarex engineer, you are interested in
evaluating this fracturing treatment. Assume that the operating cost per well is about SI ,500 per month, royalty interest is 20/,
severance tax is 6%, and the income tax rate is 34%. Stop production when the operating revenues equate to the operating benefits
(before taxes). Assume the oil price to be between S40/bbl and 565/bbl held constant.
-,

Based on the data of the existing wells, for both pessimistic and optimistic cases, has the project been successful? Assume the costs of
fracturing and tangible costs are incurred in year 0 and then revenue from production starts in year I. Begin depreciation and
depletion in year 1.
Looking into the future, the cost of fracturing increases to $180,000 and tangible costs increased to $40,000. Since the best wells are
already stimulated, you expect that the first years production will vary between 17,600 bbls to 20,500 bbls (pessimistic and optimistic)
with decline rates the same as in the past. The operating Cost per month has increased to about S2,500. Is the project feasible in the
future if you expect similar oil prices? I valuate both pessimistic and optimistic cases.
For calculation purposes, assume that the fracturing costs are depleted over the life of the project. Use Cost depletion only. The
reserves are to be determined based on the economic cut-off Assume MROR to be 10/.
Cisc Study 3-8

On January 26, 2010, Chesapeake Energy Corporation (NYSE: ClIK) announced the closing of its $2.25 billion Barnett Shale joint
venture transaction with Total E&P USA, Inc., a wholly-owned subsidiary of Total S.A. (NYSE: TOT, FP:FP) ("Total"), whereby
Total acquired a 25% interest in Chesapeakes upstream Barnett Shale assets. The assets in the joint venture include approximately
270,000 net acres of leasehold in the Core and Tier 1 areas of the Barnett, approximately 700 million cubic feet of natural gas
equivalent per day of current net production and approximately 3.0 trillion cubic feet of natural gas equivalent (tcfe) of proved
reserves (0.75 tcfe net to Total). Chesapeake also believes that this leasehold position will support the drilling of approximately 3,100
additional net locations with approximately 6.3 tcfe of unrisked, unproved reserves (1.6 tefe net to Total).
Total paid Chesapeake approximately $800 million in cash at closing and will pay an additional $1.45 billion over time by funding 60%
of Chesapeakes share of drilling and completion expenditures until the $1 45 billion obligation has been paid, which Chesapeake
expects to occur by year-end 2012.
In the framework of the joint venture, Chesapeake plans to continue acquiring leasehold in the Barnett and Total will acquire its 25%
share of the new acreage on promoted terms until December 31, 2015. After this date, Totals right to acquire its 25% proportionate
share of Chesapeakes leasehold will he on an unpromotcd basis and loud will also begin paying 25% of Chesapeakes support costs
related to the joint ventures corporate development activities.
Aubrey K. i\lcClendon, Chesapeakes Chief lxccntivc Officer, commented. VSc ale pleased to close our joint venture transaction
with Total and look forward to cicating substantial value for both companies in the years ahead. We are honored to partner with one
of the largest and most respected industrial enterprises in the world to further develop the Barnett Shale. This transaction allows

68

Mohan Kelkcxr, Ph.D., J.D.

Chesapeake to reduce its financial leverage and future capital expenditures and further positions us to deliver industry-leading finding
and development costs and returns on capital for years to come."
Your job is to evaluate this transaction from totals perspective. Chesapeakes wehsite provides a typical decline curve for the Core
and 11cr 1 areas in Barnett Shale. Assume that decline curve to be representative of what to expect in this area. 1he joint venture will
drill about 260 wells per scar. For convenience, assume that all the wells start at the beginning of the year. 1he cost of drilling and
completing a well is $2.6 million. Starting Jan 2010, lotal will contribute 70% (why?) of the drilling costs and Chesapeake will
contribute 30% of the drilling costs until the end of 2012 when approximately $1.45 billion of lotals contribution will be exhausted.
lotal will still receive only 25% of gross production, although it is paying 70% of the drilling costs until that time. Beyond 2012,
Chesapeake will contribute 75% of the drilling costs and Total will contribute 25%. Drilling will continue at a pace of 260 wells per
year until all of the wells are dnllcd. The operating costs of S4,000 per month per well (assume constant) will always be split 75% and
25% between Cl 1K and Total respectively. Assume the average royalty interest to be 25%. llcre is a typical production profile:
Gp
Year

S
S
S
S

S
S
I
S
I
S

0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25

(MMSCF)

480.4
260.1
196.3
162.7
141.1
125.9
114.5
105.4
98.1
92.0
89.3
83.9
78.9
74.2
69.7
65.5
61.6
57.9
54.4
51.2
48.1
45.2
42.5
39.9
37.5

Neglect depletion expenses and assume that drilling and completion costs can be subtracted in the same year in which they are
incurred. Assume the severance tax to be 6.0% and federal income tax to he 35%. MROR is assumed to be 12%.
Using this information, answer the following ucStiOfl5:
1.
2.

I
I

1
S

I
I
I
I
I
I
I

how much did Total pay for its share of current production per MSCFD? is this price reasonable based on an assumed oil price
of S80/barrel at the time of transaction? Assume 6 MSCFD is equivalent to 1 S113/D.
flow much did 1 oral pay for the reserves (in ground) per MSCI? Calculate this number based on both proved reserves and total
of proved plus probable plus Possible reserves. What do you think about this price?
The biggest uncertainty in this transaction is gas price; therefore, we need to do the economic evaluation using two gas prices,
S5/MSCF and S8/MSCl, held constant. Using these prices, calculate the NPV of a typical well when lotal is carrying
Chesapeakes interest and when there is no promote (the split is based on working interest).
By using individual well evaluations for both gas prices, determine the NP\ for lotal for the whole project. Assume that, for the
first 3 years, Total carried CI 1K and then for the next 9 years, the cost was divided according to working interests.
Using your evaluation, do you think Intal gist a grind deal for these assets?

Economic Evaluation in the Petroleum Industry


Chapter 3- Economic Analysis

rJ

w
io-s"11

In this last chapter, we cover the impact of economic uncertainties on economic evaluation. The topic of
uncertainties is extremely broad and the purpose of this chapter is to simply introduce the topic to firsttime readers. We will cover all principles related to this topic, but will not delve into great detail. Please
refer to the Works Cited section at the end of this chapter. (Mian, 2002) (Newendrop & Schuyler, 2000)
(Megill, 1984)
In the previous chapters, we incorporated economic uncertainties into some of the case studies. Most
solutions dealing with uncertainties require a better understanding of statistics; therefore, in this
chapter, we will formally introduce statistical principles and show some basic applications of statistics.
We will also discuss the two important extensions of statistical principles, the decision tree analysis, and
the application of Monte Carlo simulation.
PROBABILITY
Probability is the likelihood of a certain outcome if we repeat an experiment that can result in multiple
outcomes (a random experiment). If a random experiment is repeated many times, N, and an outcome,
A, is observed n times, the probability of event A is defined as,

p(A)

Equation 4.4

For example, if we toss a coin 1,000 times and observed an outcome of heads 500 times, the probability
of heads is 0.5 (as it should be for a fair coin).
Similarly, if we repeat the experiment of rolling a die many times, eventually, we will observe that the
probability of each of the six outcomes of rolling a die experiment is 1/6.
For controlled experiments like tossing a coin, it is easy to repeat the experiment numerous times to
determine the probability of a particular outcome. In the petroleum industry, when drilling a well, which
is a random experiment (why?), the act cannot be repeated numerous times for the sake of correctly
determining the probability. Further, we cannot conduct the experiment under controlled conditions.
Each experiment is unique because of geological variations. As a result, when we describe the
probability of a certain outcome, in many cases, it is a subjective estimate of likelihood rather than an
objective assessment of an outcome. For example, when a geologist predicts the probability of the
success of drilling an exploration well to be 0.3, it implies that there is a 30% chance that particular
location will result in a successful producer. It does not mean that, if we drill ten geologically similar
prospects, we will have three successful wells. Statistics do not distinguish between the subjective or
objective estimates of probabilities. However, the distinction is important because subjective
probabilities have associated uncertainties (i.e., the number itself is not guaranteed and is subject to
change); whereas, objective probabilities are not subject to change
(e.g., the probability of heads in
tossing a fair coin is always going to be 0.5).
LAWS OF PROBABILITY
a) For any outcome, A, the probability is not less than 0 and not greater than 1. Mathematically,

Economic Evaluation in the Petroleum Industry


Chapter 4 Economic Uncertainties

0 :!~ p(A) < 1


b)

.iwiJi71

If A i represents all of the mutually exclusive outcomes that constitute the entire sample space,
then the addition of the probabilities of all instances of A 1 should add up to one,
1

p(A) = 1

Equation 4-3

For example, when rolling a die, the probability of any of the six outcomes is 1/6. Adding the
probabilities of all the outcomes will result in a value equal to one. If the probability of drilling a
successful well is 0.3, the probability of failure has to be 0.7.
c)

If A and B are two mutually exclusive outcomes (i.e., these two outcomes cannot occur at the
same time), then,

p(AUB) =p(A)+p(B)

Equation 4-4

and,

p(A fl B) = 0

LiffDHt;7;1 Di1

where p(A U B) is the probability that either of the two outcomes will occur, and p(A fl B)
represents a probability that both A and B will occur simultaneously. Knowing that drilling a well
can result in two mutually exclusive events
a producer or a dry hole the probability that the
well can be both a producer and a dry hole is zero.
-

d)

If A and B are two independent outcomes (each outcome has no bearing on the other), then,

p(A r B) = p(A)p(B)

Equation 4-6

where p(A n B) represents the probability that A and B will occur together. For example, if we
drill two wells in a basin and assume that the drilling of these two wells are independent events,
assuming that the probability of finding a producer is 0.2, the probability that both wells will be
producers is 0.2 x 0.2 = 0.04, or the probability that both will be dry holes is 0.64. Why?
e)

Conditional probability represents the probability of an outcome given another outcome has
occurred. The notation used is p(AB). This represents the probability that outcome A will occur
given that B has already occurred. One of the most famous equations representing conditional
probability is Bayes rule. It is given by:

p(AJB)

Equation 4-7

Equation 4-7 can take many convenient forms, some of which are provided below.

p(A n B) = p(B)p(AB) =

p(A)p(BIA)

Equation

4-8

Mohcin Kelkor, Ph.D., J.D.

If we assume that A 1 represents mutually exclusive events that cover all the outcome space
= 1], then we can write:

[Z p(A 1 )

p(B) = X p(Ai

fl

B) = Z p(A)p(BA 1 )

Equation 4-9

Combining Equations 4-8 and 4-9, we can write:


p(A)p(BlA1)

Equation 4-10

p(A1IB) = X p(Aj)ptBIAj
Example 4-1

The probability for the success of an exploration well is dependent on many factors. Assume all these factors to be
independent. They include the probability of geological structure (pg), reservoir rock (pr), sealed trap (pt) and presence of
hydrocarbons (ph). For a particular area, assume that the following values are known:

pg = 0.8,pr = 0.7,pt = 0.6,ph = 0.8


Calculate the probability of success for this well. Assume that another operator drilled a well in the same basin and discovered
the presence of source rock as well as hydrocarbons. You believe that uncertainty related to the presence of hydrocarbons has
been removed. What is the new probability of success?

Solution 4-1
Since the four factors are independent, using Equation 4-6, we can calculate the probability of success (P(S)) as:
Pg X PT

Pt X

Pb = 0.8 X 0.7

0.6

0.8 = 0.269

If we assume the outcome of hydrocarbons presence is H, we can use Bayes rule:

p(SIH) =

p(SnH) 0.269
- 0.336
p(H) - 0.8

Alternately, this value can also be calculated by multiplying

pg, pr, and pt together.

Note that being successful means having all four factors satisfied; therefore, p(S 11 H) = p(S) since being successful is just a
subset of having discovered hydrocarbons. Without hydrocarbons, there is no possibility of a successful well.

Example 4-2

Based on the geological basin modeling, an oil company believes that the probability of a favorable structure for oil and gas
accumulation is 0.4. Based on the seismic data collected in a nearby region, if a favorable structure exists, the probability that
seismic data will indicate it is 0.85. If the structure does not exist, the probability that seismic data will incorrectly indicate a
structure is 0.15. Seismic data is collected on the site and it indicates the presence of a structure. What is the probability that
the structure exists?

Solution 4-2
Let us define an outcome that the structure exists as E. We can then write p(E) = 0.4. This also means that (Ec) = 0.6, where
Ec represents an outcome that the structure does not exist. Let us define the outcome that seismic data are favorable as S. We
can then state that
write:

p(SE) = 0.85 and p(S(Ec) = 0.15. We are interested in calculating p(EIS). Using Bayes rule, we can

p(S(E)p(E)
0.85 >< 0.4
(5()() + p(SIEC)p(Ec) - 0.85 x 0.4 + 0.15 x 0.6 - 0.7

Economic Evaluation in the Petroleum Industry


Chapter 4- Economic Uncertainties

If seismic data are favorable, the probability of a structure will increase to 0.79. This also means that p(ECIS) = 0.21. The
probability that the structure does not exist, even in the presence of favorable seismic data, is 0.21.
Problem 4-1
A proposed exploration well will be drilled through two independent prospects. Prospect A has a 0,2 probability of success and
Prospect B has a 0.4 probability of success. If a well is drilled, what is the probability that at least one prospect will be
successful?

71I1I
An exploration well is proposed. The well is expected to test two potential prospects. Both prospects are expected to have similar
structures. The probability of a favorable structure for both prospects is 0.6. The probability that the shallower structure is a
potential reservoir is 0.3 and the probability that the deeper structure is a potential reservoir is 0.2. As the well is being drilled
through the shallower prospect, it is realized that the structure is favorable. Based on the geological modeling, it is believed that
the probability of a favorable structure at a deeper formation is 0.95 if the structure is favorable in the shallower formation.
What is the revised probability of success at the lower prospect?
Problem 43
A well is drilled with a prior probability of success equal to 0.3. After the well is drilled, a resistivity log is run. The log indicates

the presence of hydrocarbons. Based on other wells in the field, when the well is a successful producer, the resistivity log is 80%
accurate in identifying the presence of hydrocarbons. As a compliment, 20% of the time, the log incorrectly identifies the
presence of hydrocarbons. Knowing that the log has indicated the presence of hydrocarbons, what is the likelihood that the well
will be a producer?

CUMULATIVE DISTRIBUTION AND PROBABILITY DENSITY FUNCTIONS


Before we discuss these two functions in detail, let us define a random variable. A random variable is
defined as the outcome of a random experiment. If it is discrete, it will only have a finite number of
values; if it is continuous, it will have numerous values. An example of discrete random variable is that
the outcome of drilling a well can result in either a producer or a dry hole. An example of a continuous
random variable is the distribution of porosity values in a reservoir. Porosity can take a large number of
values from minimum to maximum.
PROBABILITY DENSITY FUNCTION f(x)
The probability density function is sometimes abbreviated as pdf. This is a pdf of a random variable.
If a random variable is discrete, then we can write,
5

f(x) = 1

Mtlirm*

where the probability density function over the sample space should add up to one. For example,
when rolling a die, if we define the probability density function for each outcome as 1/6 (i.e.,
f(1) = f(2) =

= f(6)

= 1/6,) then all of the numbers should add up to one. A plot of

probability density function for rolling a die is shown in Figure 4-1.

Mohan Kelkar, Ph.D., J.D.

f(x)

1/6

Figure 4-1: pdf for rolling a die


If a random variable is continuous, then we can write,

f f(x)dx = 1

Equation 4-12

where the integration of pdf over the sample space is equal to one. Refer to Figure 4-2. In this
figure, f(d) is plotted as a function of the variable value. The only requirement that this be pdf is
that the area under the curve has to be equal to one.

0.45
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0

Value of Variable
Figure 4-2: pdf of continuous distribution

Economic Evaluation in the Petroleum Industry


Chapter 4 - Economic Uncertainties

The probability of any given outcome is related to the pdf. For example, the probability that
outcome A will occur for discrete pdf can be written as,

p[X E Al = >Af(X)

Equation 4 13
-

For example, when rolling a die, the probability that the outcome will be an even number (i.e.,
either 2, 4 or 6) will be the addition of pdf for all the even number outcomes, or:

p[xE 2,4,6]=
For a continuous variable, a similar equation can be written as,

p[a :!~ X < b] = ff(x)dx

Equation 4 14
-

where Equation 4-14 defines the probability that the random variable will be between an interval
(a, b). As shown in Figure 4-3, Equation 4-14 represents the area under the curve within the interval

(a, b).
r

iI

0.4
0.35
0.3
-

0.25
0.2
0.15
0.1
0.05
0

Value of Variable
Figure 4-3: Probability value that random variable will fall within an interval [a,b]

CUMULATIVE DISTRIBUTION FUNCTIONJ(x)


Cumulative distribution function is abbreviated as cdf and is defined as,

F(x) = p[X :5 x]

Equation 4-15

It is the probability that the value of a random variable is less than or equal to a given outcome.
Knowing how we calculate the probability, for discrete variables, we can write cdf as,

F(x)
6

f(t)

Eatio

4-16

Mohan Ke/kar, PhD., ID.

Equation 4-16 states that if we sum all the values of pdf up to and including the value x, we will
obtain cdf. For example, when rolling a die, if we want the cdf for all the values less than or equal to
3, we can calculate it as,
1111

F(3)=f(1)+f(2)-i-f(3)=++=-

A plot of cdf for rolling a die is shown in Figure 4-4. As is evident in the figure, the probability that
the outcome is less than any of the six outcomes can be calculated using this figure. For example,
the probability that the outcome will be less than or equal to 4 is 4/6.
A similar equation can also be written for a continuous random variable. Mathematically,

F(x) = p[X x]

= ff(t)dt

Graphically, refer to Figure 4-2. Using the pdf shown in Figure 4-2, we can calculate the cdf as shown
in Figure 4-5. For any given value, the area under the curve up to that point is equal to F(x). The
entire plot for F(x) can be constructed this way. For a discrete variable, cdf appears as steps,
whereas, for a continuous random variable cdf increases gradually (and continuously) until it
reaches a value of one.

0.83
0.67
0.50
LL

0.33
0.17
0.00
0

Value of Variable
Figure 4-4: cdf for rolling a die

Economic Evaluation in the Petroleum Industry


Chapter 4 - Economic Uncertainties

1
0.9
0.8
0.7
0.6
U

0.4
0.3
0.2
0.1
0
0

Value of Variable
Figure 4-5: cdf for continuous variable
We can use cdf to determine the probability that the value of a random variable is less than a
certain threshold. The two important characteristics worth remembering about cdl are that it is a
non-decreasing function and its limiting values are always zero and one.
EXPECTED VALUE
Expected value is defined as the average outcome of a random experiment if the experiment is
conducted numerous times. Expected value has no meaning if we conduct the experiment a limited
number of times. The following example illustrates the concept of expected value more clearly.
Example 43
In a casino, the wheel of fortune contains 80 slots. Each time you bet you have to place $1. Of the 80 slots, if you hit one of
seven designated slots, you will win $10. If you hit any of the other 73 slots, you will lose your $1. What is the expected value of
this experiment?

Solution 43
Knowing the total number of slots and the number of slots that will allow you to win, the probability of winning is (7/80) and
the probability of losing is (73/80). The expected value is calculated as,
f7)

(73)
($10) + - (-1) = $00375
80
80

EV = 1

In the equation above, we multiplied the probability by the associated amount. The expected value for this experiment is $0375. Obviously, we know that, for a given bet, we will either win $10 or lose $1; therefore, we will never lose $00375. This
number is, however, telling you that if you play the game many times, on average, you will lose $0375 per game. That is, if you
play the game 1,000 times, you will lose 1,000(0.0375) z $37 over 1,000 games.

Mohan Kelkar, Ph.D., J.D.

As illustrated, the expected value only achieves meaning if an experiment is conducted numerous times.
Let us consider another example. If we roll a die, what is the expected value of the outcome? We know
that the probability of any of the six outcomes is 1/6. We can calculate the expected value as,

EV

3.5

Obviously, we know that none of the experiments will result in an outcome of 3.5. What this number
indicates is that if we roll the die 1,000 times, and calculate the average of all our outcomes, it will be
close to 3.5.
Mathematically, the expected value is defined as:

5 u(x)f(x)

E[u(X)}

Equation 4-13

for a discrete variable, and:

E[u(X)]

= fu(x)f(x)dx

where u(x) is any function of a random variable X.


For our purposes, we are most interested in two expected values of a random variable; mean and
variance. The mean for a discrete variable is defined as,

E[X] = xf(x) =
A similar equation can be written for a continuous random variable. A variance is defined as,
E[(X - ii)2]

- Lt)2f(x) =

Traditionally, ji denotes the population mean and a 2 denotes the population variance. In the two
equations above, f(x) represents the probability density function. For discrete variables, this function
represents the probability of a certain discrete outcome. We can, therefore, simplify the two equations
above as:
[1 =

where p1 IS the individual probability value for an outcome x. The variance is calculated as:
a2 =

1=1

Pt (x

Equation 4-23

where i is the mean given in Equation 4-22 and Pt IS the probability of a discrete outcome x.
In economic calculations, instead of using mean, we use expected monetary value (EMV). The definition
is the same as shown in Equation 4-22, except that we use our outcome as money. The following
example illustrates the concept.

Economic Evaluation in the Petroleum Industry


Chapter 4 - Economic Uncertainties

Example 4-4
Based on the exploratory analysis of an oil field, the following probability distribution for possible outcomes is expected.
Calculate the expected monetary value of this venture.
Probability, p-

Barrels of Oil(bbls)

0.4
0.3
0.2
0.1

0
100,000
300,000
500,000

NPV ($)
-400,000
200,000
600,000
900,000

Solution 4-4
As evident from the table above, there is a 40% probability that the well will be dry and we will lose $400,000, the cost of
drilling. On the other hand, there is a 10% probability that the well will make $900,000. Using Equation 4-22,

EMV = p1(NPV)

where n is the number of possible outcomes, (NPV)1 is the net present value of the outcome i, and pi is the probability of the
outcome i,
= 0.4(-400,000) + 0.3 (200,000) + 0.2(600,000) + 0.1(900,000)
= $110,000
The expected monetary value (EMV) of this venture is $110,000. If we participate in a similar, large number of ventures, on
average, we will make $110,000 per venture. Unfortunately, no two ventures are exactly alike. Nevertheless, the EMV concept
is still attractive from the decision-making perspective. In a more general sense, assuming that our probability distribution
represents the true nature of our outcomes, we can say that, if we select the projects that have positive EMVs, on average, we
will be profitable if we participate in a relatively large number of similar adventures.

EMV can be a very useful tool in making economic decisions. As discussed in the Probability section, in
the petroleum industry, the probability determination is often made using subjective evaluation. As a
result, there is always some uncertainty associated with the estimation of probability itself. EMV can be
used to assess the impact of uncertainty with respect to probability. The following examples illustrate
this application.
Example 4-5
It is expected that drilling a well will cost $100,000. Based on the analysis of wells nearby in similar areas, there is a 50%
probability that the well will be successful. If successful, the annual revenues are expected to be $40,000 over the next seven
years with a salvage value of $10,000. Calculate the EMV of this venture. What will be the probability of success for the venture
to break even? Assume the MROR = 15%.
Solution 4-5
Based on the values given, the probability of success is:
Ps = 0.5
The probability of failure (dry hole) = 1 p = 0.5.
We can calculate the EMV as:

10

Mohan Kelkar, Ph.D., ID.

EMV

p1 (NPV)

where n represents the number of outcomes. In this case, we have only two outcomes. If the well is successful:
(1+.15)-1

NPV = 40,000 .15(1 +.15)7

+.15) - 100,000
1 + ( 110,000

= $70,176
If the well is failure:

NPV = $100,000 = cost

of drilling

Using the EMV equation,

EMV = p(NPV) 1
= 0.5(70,179) + 0.5(-100,000)
-$14,912
-

Knowing that there is always some uncertainty with respect to probability value, we can extend this analysis by plotting EMV as
a function of the probability. Figure 4-6 shows this plot where EMV is calculated for probability values between 0 and 1. As
expected, [MV is -100,000 for probability equal to zero and EMV is 70,176 for probability equal to one. For probability of 0.5,
EMV is negative. However, probability greater than 0.58, [MV becomes positive. In other words, if we know that the probability
of success is at least 0.58, we can say that the project will be successful. We do not need to know the exact value of the
probability of success; we only need to know the minimum value of probability for success and be confident that that value can
be achieved.

80000

....

LU

120000

Probability
Figure 4-6: EMV versus probability
Farming out is another application where this type of graphical representation is useful in investigating the feasibility of a
project. Farming out is a procedure whereby a company that owns the working interest in a lease gives away the working
interest in return for override royalty or some other interest. A company owning a leasehold interest may not have enough
capital to drill a well, or it may have interest in other areas where it is more confident about success. Rather than lose the lease,
it may opt to farm out the interest to another company. In return, it will receive an override royalty or a "back in" interest.
Back in interest represents a working interest after it pays a penalty for not participating in the initial drilling of the well

Economic Evaluation in the Petroleum Industry


Chapter 4- Economic Uncertainties

11

0
I

a
a

Example 4-6
A company owns 100% working interest in a lease. If a development well is drilled on the lease, based on the geological
knowledge, there is more than a 65% chance that a successful gas well will be drilled. The cost of drilling is expected to be
$1,200,000. If successful, an initial income of $700,000 is expected, which will decline at a rate of 20% per year for the next 20
years. The operating costs are assumed to remain constant at $50,000 per year. Assume the salvage value to be negligible. The
company is also considering a farm out option where, after assigning 100% working interest, the company can acquire 1/16 of
the override royalty interest. Which option should be selected? Under what circumstances will the other option be the better
option? Assume the MROR = 10%.
Solution 4-6
The NPV, if the well is successful, can be calculated as:
700,000

0.8 20

NPV = (0.1+0.2) [ -

1.120

- 50,000 0.1 >

- I
1.120 -

1,200,000 = $703,656

If the operator opts to override royalty interest, the NPV will be:

700,000 x()
NPV = (

OT +O.2)
0.2)

0.8 20

1 - --- j-

= $ 145,583

Although the NPV using an override option is smaller, there is an advantage because there is no cost for failure since the
operator does not have to participate in the drilling. So the EMV for maintaining the working interest can be written as:

EMV = p(703,656) + (1 - p)(-1,200,000)


The EMV for only override royalty interest can be written as:

EMV = p(145,583)
The two equations are plotted in Figure 4-7. As shown, for probability of success greater than 0.68, drilling a well always results
in better EMV than securing an override royalty interest. If the operator believes that there is at least a 65% chance of success,
it is better to drill the well rather than secure an override royalty interest.

1100000

600000

1/16 Ri
100000 ....................
Uj

z::::i::: ....:1

100..........................................
....................

-1400000 ______ -------- -------- 0

0.2

0.4

0.6

______
0.8

Probability
Figure 4-7: The impact

of probability on drilling well vs. override royalty

We can add a little more complexity to this analysis by considering a "back in" option. Unlike the farm
out option, where working interest is traded in for an override royalty interest, the "back in" option
12

Mohan Kelkar, Ph.D., ID.

S
S

a,
S
S
0

allows trading in interest with the option of backing in with the same or smaller working interest after
paying a penalty for not taking any risk. For example, a company with 50% working interest may assign
the working interest to another company with the option of gaining back the 50% working interest after
the other company recovers the cost of drilling plus the penalty cost. Typically, the penalty cost is a
percentage of the drilling cost. If the penalty is 100%, the other company will be allowed to recover
twice the cost of drilling as a penalty before the first company can back in with a working interest. The
following example illustrates this option.

Company A owns 50% working interest in a new prospect; Company B owns the other 50%. Company B wants to drill a well in
the prospect. It is expected that the cost of drilling the well will be $2 million. The revenue, after subtracting the royalty
interest, is expected to be $1,200,000 in the first year, declining at a rate of 8% per year for ten years. The operating costs are
$60,000 per year, held constant. Company A is considering the following options:
Participate in the well with 50% working interest.
Do not participate in the drilling with the option of backing in with 50% working interest after 100% penalty.
Farm out the interest with 3/16 royalty interest.
If p is the probability of success, develop equations for EMV for all three options and calculate the probability range for which
each of the options will be successful. Assume the MROR to be 10% per year.

Option (1)
Since company A owns 50% working interest, it will have to pay $1 million for drilling the well. In return, we can calculate the
NPV as:
600,000 1

0.92101

F 1.110 - 11

NPV = (0.1 + 0.08) [i - 1110 j - 1,000,000 - 30,000 [1.110 x

o.4 = $

1,590,744

The EMV can be written as:

EMV = Ps

1,590,744 + (1 -

jj 5 ) X

1,000,000

Option (2)
Company A wants to back in with 50% working interest after paying a 100% penalty. That is, Company A will have to pay
$2,000,000 in drilling costs (instead of $1,000,000) before it can "back in" with 50% working interest. Company B will have to
recover $2,000,000 from the net revenue of Company A before Company A can "back in." That is, for the first year, Company
As revenue ($600,000 - $30,000 "$570,000) will go to Company B. Based on an 8% decline each year, for the first four years,
Company A will not recover any money. NPV under this option can be written as:
[1.1 6 11
0.92 1 1
----30,000
j = $983,528
NPV = (0.1+0.08) [ - --jj
[ 1.110
429,836 1

EMV can be written as

EMV = Ps

983,528

Option (3)
In this case, Company A will get 3/16 royalty interest if the well is successful. NPV can be written as:

Economic Evaluation in the Petroleum Industry


Chapter 4 - Economic Uncertainties

13

600,000 x 3/16

0.92 10

NPV = (0.1+0.08) 1 - 1:110 = $520,328


EMV can be written as:
EMV = Ps ( 520,328
The three options are graphically presented in Figure 4-8. Examining Figure 4-8, Option 2 is always better than Option 3 for any
probability value. In both cases, there is no cost for failure but the benefit increases more rapidly under Option 2 than Option 3.
Comparing Option 1 with Option 2, if the probability of success can be assumed to be greater than 0.6, Option 1 is always going
to be better than Option 2. On the other hand, if we are confident that the probability of success is less than 0.6, it is better to
choose Option 2 rather than Option 1.
-Option I - - Option II
2100000

...

....................

-Option III

..... ............................................

TI1l

LU

-1400000 -

Probability
Figure 4-8: Comparison

of WI versus "back in" us. override royalty

From this analysis, it is clear that if prolific production is expected from the well, the option of paying the penalty is a better
option. On the other hand, if the well is expected to be marginal, securing override royalty is a better choice. For example,
instead of $1,200,000 revenue in the first year, if we assume that the revenue is $800,000 in the first year, it will take about
seven years to recover the drilling penalty before Company A can "back in". The graph will be similar to Figure 4-9. Under this
scenario, Option 3 is always better than Option 2. That is, it is better to accept the override royalty than pay a drilling cost
penalty. Further, the probability of success has to be greater than 80% before Option I becomes better than Option 3. As the
well becomes more marginal, the option of accepting an override royalty looks increasingly better.
-Option I - - Option II - Option III

1100000
600000

......,

..

Uj

100
_
Probability

Figure 49: Impact of less revenue on decision making

14

Mohan Kelkar, Ph.D., J.D.

Another interesting application of probability analysis is to estimate the expected monetary value for a
multi-zone prospect (Rose, 1992). Recall that Equation 4-6 states that the probability of success can be
calculated as a product of four factors: reservoir rock, favorable structure, presence of hydrocarbons
(source rock), and the presence of a trap.
Pi - Pr X Pst X Ph X Pt
If we are considering two prospects, one underneath the other, some of the probabilities on the right
side will be common to both the prospects. For example, if both zones have the same source and similar
structures, Ph and Pst may be identical for both; whereas, the probabilities Pr and Pt are different. Also,
remember that when investigating two zones, four possibilities exist: both are successful, both are
unsuccessful, or one of them is successful. We need to estimate the probabilities of all four possibilities
before we can estimate the expected value.
Example 48
A company is investigating the potential of a two zone prospect: zones x and Y. Both are expected to have the same source
rock with Ph equal to 0.85. The probability of structure is 0.60 for both the zones. For zone x, p1 = 0.7 and Pt = 0.8 ; for zone
y, Pr = 0.4 and Pt = 0.7. Drilling and completing a well in multiple zones will cost $1 million. If production from zone x is a
success, the NPV will be $4 million. If production from zone y is a success, the NPV will be $10 million. Calculate the EMV for
this project.
Solution 48
To calculate the probabilities of all four possibilities, we need to separate dependent and independent factors. Dependent
factors are Ph and Pst These factors have to co-exist for both at the same time.
For both zones x and y, the probability of dependent factors:
Pde = Ph X Pst

= 0.85 x 0.6 = 0.51


For zone x, the probability of independent factors, if successful:
Pm = Pr X Pt
= 0.7 x 0.8 = 0.56
For zone y:
Pin = Pr X Pt
= 0.4 x 0.7 = 0.28
The probability of independent factors represents the probability of success.
Using these numbers, we can calculate the probability that both x and y are successful,
= (Pin)x(Pin)yPde = 0.56 X

0.28 X 0.51 = 0.08

the probability that x is successful and is unsuccessful,


= (Pin)x( 1 - Pin) yPde =

0.56(1 - .28)(. 51) = 0.2056

and the probability that x is unsuccessful and is successful,

Economic Evaluation in the Petroleum Industry


Chapter 4 - Economic Uncertainties

15

= (1 - Pin)x(Pin)yPde = (1 -.S6) 28(. 51) = 0.0628


Knowing that probabilities of all four possibilities should equal one, we can calculate the probability that both x and y are
unsuccessful:
= 1 - 0.08 - 0.2056 - 0.0628 = 0.6516
Using the equation:

EMV =

pL(NPV)I

= 0.08(14) + 0.2056(4) + 0.0628(10) + 0.6516(-1)


= $1.92 million
Since the expected monetary value is positive, the project is feasible.
Problem 4-4
A new well is going to cost $2,000,000 to drill. There is a 50% probability that the well will be a dry hole, a 30% probability that
the well will produce 40 bbls/day, a 15% probability that the well will produce 70 bbls/day and oS% probability that the well will
produce 150 bbls/day. If production is expected to decline at a rote of 12% per year over the next seven years, what is the EMV
of this property? Assume that the MROR is 20%. Based on the EMV, how much lease bonus are you willing to pay? The price of
oil is expected to be $901bbl and the operating costs are $101bbl. The salvage value is negligible.
Problem 4-5
A drilling program involves drilling two wells at two potential targets. Based on the geological analysis, the probability
of
success is 0.2 at location A and 0.4 at location B. The cost of drilling wells at either location is $1,000,000. If successful, a
producer will result in a NPV of $8,000,000 at location A and $5,000,000 at location B. What is the EMV of this venture? Assume
that the drilling at these two locations are independent events.

Problem 4-6
An oil company is considering two alternatives for exploring a new area. Alternative A requires drilling a vertical well at a cost of
$1,000,000 and obtaining production of 30 bbls/day with a probability of 0.6. There is a 40% chance that the well is a dry hole.
Alternative B requires drilling a horizontal well at a cost of $3 million and obtaining production of 150 bbls/doy with a
probability of 0.4, obtaining a production of 450 bbls/day with a probability of 0.2, or hitting a dry hole with a probability of 0.4.
Production is expected to decline at a rote of 11% /year. If production is expected to last for a six years, the oil price is $801bbl
with an operating cost of $100,000 for a vertical well and $300,000 for a horizontal well, select the correct alternative. Assume
that the MROR is 15% and the salvage value is negligible.
Problem 4-7
An oil company is considering a new enhanced oil recovery method for increasing production from existing reservoirs. The
research effort is going to cost $1 million per year over the next four years. The probability that the process will be successful in
the laboratory is 0.4. If, after four years, it proves to be successful, further testing will be needed in the field. This testing will cost
$15 million in the fifth year. The probability of success in the field, once successful in the lob, is 0.7. If successful, the project will
result in on additional $25 million, after tax, income over the next ten years. From the FMV perspective, is the research effort
worth investing? Assume the MROR to be 15%.
Problem 4-8
An independent producer has 100% working interest in a lease. Due to deep drilling, the cost of drilling a well is expected to be
$3,000,000. If successful, production will result in a NPV of $12 million. Another option for the producer is to form out the
working interest and retain 118 royalty interest. Plot the FMV for both options as a function of the probability of success. At
what value of probability will drilling the well by the producer be more profitable?

16

Mohan Kelkor, Ph.D., J.D.

allowt
An oil company has a 40% working interest in a lease. There is a 40% probability that drilling a well will result in a successful
producer with an oil production of 100 bbls/day, declining at a rote of 15% per year over the next six years. There is a 60%
probability that the well will be a dry hole. The price of oil can be assumed to be $801bbl with an operating cost of $121bbl. The
cost of drilling the well is going to be $1,180,000. The company is also considering farming out the working interest and
receiving, in return, 1116 royalty interest. Which option should be selected? At what probability value will the other option be
more suitable? Assume the salvage value to be zero and the MROR to be 15%.
Problem 4-10
Oil Company A has on overriding royalty interest of 3116 in a potential prospect. Oil Company B wishes to trade its 60% working
interest for the overriding royalty. If the cast of drilling is $700,000 and the NPV of a successful well is $5,000,000, for what
range of values of the probability of success should Oil Company A trade its interest to Oil Company B?
Problem 4-11
An oil company, which currently owns 100% working interest in a potential prospect, has two possible options of trading in its
working interest. Under option one, it can trade 100% of its working interest for 3116 royalty interest. Under option two, if the
well is successful, the company can back in the well with 80% working interest after paying a 150% penalty. If the cost of drilling
is $1,600,000 and the expected NPV of a successful project is $5.5 million, state the probability of success ranges for which either
of the options (including retaining the 100% working interest) will be the most profitable.
Problem 4-12
A company owns 40% working interest in a potential oil prospect. The cast of drilling a horizontal well is expected to be
$6,000,000. If a well is successful, it is expected to produce 30,000 bbls of oil in the first year, declining at a rate of 15% per year.
The price of oil is $851bbl and the operating casts are $300,000 fixed cost plus $81bbl lifting cost. Assuming five years
of
production and negligible salvage value, if the company can trade in its working interest with the option of backing in at 30%
working interest with 150% penalty, which option should the company choose if the probability of success of a horizontal well is
0.4?At what range of probability of success values will the other option be vioble?Assume the MROR to be 10%.
Problem 4-13
A two zone prospect is currently being investigated by an oil company. The probability of structure is 0.5 for both zones, L and
M. The other probabilities are given below.
Probability

Pr
Ph
Pt
Pc

0.7
0.9
0.8
0.9

0.4
0.7
09
0.6

Pc represents the probability of completion success. If drilling the well costs $2 million, a successful completion in L will result in
a NPV of $3.5 million and a successful completion in M will result in a NPV of $12 million. Calculate the EMV of the prospect. Is
the project feasible?

DISTRIBUTION FUNCTIONS (Mian, 2002) (Newendrop & Schuyler, 2000)


A distribution function is a way by which probability density function can be defined with a minimum
number of parameters. The functions are defined so that, once we define some key parameters, the
entire probability function is defined. Most of these functions are applicable for a continuous random
variable. One important function, which is applicable for discrete random variable, is a binomial
distribution function. We will discuss it first.
Economic Evaluation in the Petroleum Industry
Chapter 4- Economic Uncertainties

17

B INOMIA L DISTRIBUTION FUNCTION


As indicated, this function describes a discrete random variable. The function has several
characteristics.
The function can have only two outcomes, typically denoted as success (S) or failure

(F)

The two outcomes are mutually exclusive.


The probability of success is p in every trial.
Subsequent experiments are independent of each other.
A simple example, which satisfies these criteria, is a coin flipping experiment. A coin flip has only
two possible outcomes, heads or tails. For a given experiment, only one of the two outcomes can be
observed (mutually exclusive), the probability that we will observe heads or tails is always 0.5, and
what happened in the previous toss has no reflection on the outcome of the next toss (subsequent
experiments are independent).
Example 4-9
Calculate the probability that if we flip three coins simultaneously, we will observe the outcome of heads on all the three coins.
Solution 4-9
Since the three coin flips are independent of each other, extending Equation 4-6 for three independent events, p(A
p(A)p(B)p(C). Knowing that the probability of observing heads is 0.5,

n B n C) =

p(A fl B 11 C) = 0.5 x 0.5 x 0.5 = 0.125


The probability that we observe three heads simultaneously is 0.125.

Example 4-10
A company is planning to drill three wells in a new area. Based on past experience, the probability of finding a producer is 0.2.
Calculate the probability that 1) all the wells are producers; 2) two wells are producers and one is a dry hole; 3) one well is a
producer and the other-two holes are dry; and, 4) all three wells are dry holes.
Solution 4-10
We know that drilling three wells are three independent events, we also know that the probability of success is 0.2 and the
probability of failure is 0.8.
Let us write all the possible combinations in which the four events listed above can occur and calculate the probabilities. Assign
the letter P for a producer and the letter D for a dry hole.
1)

All three producers


p(PPP) = 0.2 x 0.2 x 0.2 = 0.008

2)

Two producers and one dry hole


p(PPD) = 0.2 x 0.2 x 0.8 = 0.032
p(PDP) = 0.2 x 0.8 x 0.2 = 0.032
p(DPP) = 0.8 x 0.2 x 0.2 = 0.032

0.096
18

Mohan Kelkar, Ph.D., J.D.

3)

One producer and two dry holes

p(DDP) = 0.8 x 0.8 x 0.2 = 0.128


p(DPD) = 0.8 x 0.2 x 0.8 = 0.128
p(PDD) = 0.2 x 0.8 x 0.8 = 0.128
0.384
4)

Three dry holes

p(DDD) = 0.8 x 0.8 x 0.8 = 0.512


In parts (2) and (3), since the order in which the given event occurs is not important, we have added the probabilities of
individual combinations to calculate the probability of that event. If we add the probabilities of all four events,

= 0.008 + 0.096 + 0.384 + 0.512 = 1.0


will add up to one indicating that these four events cover the entire samples

Although we can solve every problem exhibiting binomial distribution this way, for a large number
of wells this can become cumbersome. Fortunately, we can write a simple formula to calculate the
probability of any combination,
p(S =x) = cpx(1_p)n_x

r..thii.ZJ

where x is the number of successes, n is the number of trials (experiments) and c


combinations in which x successes can occur and is defined as,

is the number of

n
- x!(nx)!

Example 4-11
In the initial drilling program, a company wants to drill six exploratory wells. Based on the analysis of preliminary data, chances
of finding a producer are 0.3. calculate the probabilities of all the possible combinations in which these trials will result.

Solution 4-11
n = 6 = the total number of trials and p = 0.3. If we define a producer by a letter P and a dry hole by a letter D, we can calculate
the probabilities of all the possible events using Equation 4-24,
1)

p(6P) = C(0.3) 6 (0.7) = 7.29 x iO


6

1 (note that 0! is one)


=-j=
6!

2)

p(5P, 1D) = C(0.3) 5 (0.7) 1 = 0.01021


3)

p(4P,2D) = C(0.3) 4 (0.7) 2 = 0.05954


4)
p(3P, 3D) = C.(0.3) 3 (0.7) 3 = 0.1852

Economic Evaluation in the Petroleum Industry


Chapter 4 - Economic Uncertainties

19

p(2P,4D) = C(0.3) 2 (0.7) 4 = 0.3241


6)

p(1P,5D) = C , (03)(0.7) = 0.3025


7)

P(6D) = C6 (0.3) 1 (0.7) 6 = 0.1176


The probabilities of all seven combinations add up to 1.0.

A related issue to binomial distribution is what is commonly referred to as gamblers ruin. Gamblers
ruin is a normal run of bad luck; a dry spell. You keep on betting and you keep on losing over a long
period. If you dont stop, you may lose everything. We can easily equate the gamblers ruin to
drilling wells in exploratory areas. With a normal run of bad luck, you may exhaust your resources
and hit all dry wells. To estimate the chances of exhausting all the resources, we can use the
binominal distribution function.
Assuming that drilling of subsequent wells is an independent event, to avoid gamblers ruin we need
to hit at least one producer. That is, we need to find probabilities of all events where the number of
producers is greater than or equal to one. Knowing that the probabilities of all the combinations will
add up to one, we can calculate the probability of at least one success by:
p(at least 1P) 1 - p(all dry holes)

= 1 - C(p)(1 - p

Equation 4-26

If we subtract the probability of all the holes being dry, we can calculate the joint probability that at
least one of the wells will be a producer.
Example 4-12
A company has an exploration budget of $500,000. Each wildcat well is expected to cost $100,000. If the probability of success
is 0.1, what is the probability of hitting a producer using the exploration budget?

Solution 4-12
The number of wells that can be drilled:
$500,000
$100,000
Therefore, n = 5. Using Equation 4-26,

p(at least 1P) = 1 = 0.4095


There is a 40.95% chance that at least one of the wells will be a producer. Considering that the company is exhausting its entire
budget, it is not a very good chance.

One alternative to reduce the risk of gamblers ruin is to participate in more wells. Instead of drilling the
wells on your own, join with other oil companies so that the company can participate in more
exploratory wells. This has been a common practice in the oil industry especially in frontier areas. Let us
consider the above example and assume that the company has decided to jointly explore the wildcat

20

Mohan Kelkar, Ph.D., J.D.

area by reducing its interest to 50%. Therefore, instead of drilling only five wells, the joint operation can
drill 10 wells in the same area. We can calculate the probability of at least one success by,
p(at least 1P) = 1 - CO(0.1)0(0.9)b0
= 0.6513
By reducing the interest and participating in more wells, the probability of success has improved by 25%.
A company can further reduce risk by reducing the interest in individual wells and participating in more
wells.
Example 4-13
A company is anticipating drilling a well in a wildcat area. The cost of drilling is expected to be $1,000,000. If successful, the well
is expected to generate $10 million in net present revenues. The probability of success is calculated to be 0.2. The two options
considered are:
1.
2.

Drill a well by owning 100% interest.


Drill two wells jointly owning 50% interest.

Solution 4-13
1)

Under option one, the probability of success is 0.2.

EMV = >Pj(NPV)j
For the possible alternatives,

EMV = 0.2($10,000,000) + 0.8($1,000,000)


= $1,200,000
2)

Under option two, three possibilities exist:

p(2P) = 0.2 x 0.2 = 0.04


p(1P, 1D) = (0.2 x 0.8)2 = 0.32
p(2D) = 0.8 x 0.8 = 0.64
The probability of at-least one success is 0.32 + .04 = 0.36, which has increased substantially from 0.2. It can easily be shown
that the expected value does not change by participating in two wells; however, the probability of at least one success
increases substantially.

In using binomial distribution, we made an assumption that each event is independent; that is, what
happens in the previous event has no bearing on the next. In a basin where exploration is carried
out, we have a limited number of prospects. If we assume a certain success probability, what has
happened in the past can influence what will happen next. This is because only a certain number of
prospects are productive. If we discovered a productive prospect, we will need to eliminate the
number of productive prospects by one and recalculate the probability of success for the remaining
prospects. A separate distribution function exists to describe these characteristics called
hypergeometric distribution. In practice, since it is very difficult to determine the total number of
prospects as well as number of productive prospects, the hypergeometric function is rarely used.
Problem 4-14
If you flip three coins, calculate the probability that we will observe two heads and one tails. Will the result be different if we

Economic Evaluation in the Petroleum Industry


Chapter 4- Economic Uncertainties

21

want to calculate the probability that we observe one heads and two tails?
Problem 4-15
An oil company wishes to drill five wells in on exploratory drilling program. If the probability
drilling of wells is an independent event, calculate the probabilities of all possible events.

of finding a producer is 0.2 and the

Problem 4-16
A company wishes to drill four development wells. The probability of success is 0.4. Based on the analysis of other wells in the
area, a successful well will result in a $5 million NPV. The cost of drilling an individual well is $2,000,000. Calculate the EMV of
this venture. Assume the events to be independent.
Problem 4-17
An independent oil producer anticipates that, using the existing exploration budget, he can drill five wells on his own. The
probability of success in the area is 0.15. What is the probability that at least one well will be successful? If he wants to increase
the probability of success to 0.9, in how many wells does he need to participate?
Problem 4-18
Based an geological analysis of nearby fields, one in ten drilled we/Is will be a successful producer. How many we/Is should an oil
company participate in to increase the probability of success to 0.8? If the cost of drilling on individual well is $1 million and the
exploratory budget of an oil company is $4 million, what is the working interest owned by the oil company in an individual well?

If a successful well will result in a NPV of $15 million, what is the EMV of this venture?
UNIFORM DISTRIBUTION
Uniform distribution is one of the simplest distributions for a continuous random variable. The pdf
for uniform distribution function is shown in Figure 4-10 along with its cdf.

f(x)

F(x)

a
x

Figure 4-10: Uniform distribution function


As shown, the uniform distribution function assumes that there is equal probability that a random
variable is selected from the interval (a, b). The only two parameters that needed are the minimum
and the maximum values. Knowing that the area under the pdf curve should be one, we can write:
f(x)=O

x<a
1

22

axb

Mohan Kelkar, Ph.D., J.D.

f(x)=O

x>b

MIUMMIMM

Knowing that

F(x) = f f (x)dx

we can write:

F(x) =

Equation 4-28

An advantage of using uniform distribution is the minimal requirement of data. For variables that
are not very well sampled, if the minimum and maximum are known, a uniform distribution may be
assumed.

TRIANGULAR DISTRIBUTION
Triangular distribution is arguably the most popular distribution function used in economic analysis.
This distribution requires three pieces of information of a random variable: the minimum, the
maximum, and the most likely value. The pdf and cdf of the triangular distribution are shown in
Figure 4-11.

>(
U.

-II

b
x

Figure 4-11: Triangular distribution


In this figure, (a) represents the minimum value, (c) represents the most likely value and (b)
represents the maximum value. Knowing that the area (a) under the curve for pdf function should
be one, we can write:
f(x)=O

x<a

2(xa)

f( X ) = (b

a)( ca)

2(bx)
f(X)=(ba)(b_c)

cx~b

Economic Evaluation in the Petroleum Industry


Chapter 4 Economic Uncertainties
-

23

x>b

AX) = 0

Equation 4-29

Knowing the relationship between cdf and pdf, we can write,


(x

F(x) = 1

ax~c
(b-x)2

(b-a)(b-c)

c :!~ x b

Equation 4-30

Example 4-14
If payzone thickness for a reservoir can be represented by a triangular distribution where the minimum is thirty feet, the most
likely value is fifty feet and the maximum is ninety feet, calculate the probability that the thickness is less than sixty feet for this
distribution.

Solution 4-14
In this example, a =3Oft.,b=90ft., and c=50ft.

4 30 because c < 60 < b. Recall that F(x) = p[X < x].

To calculate the p (thickness :5 60 feet), we have to use Equation


Equation 4 - 30,

(b X)2

p[thickness :560] = 1

(Li

= 1
-

(90

a)(b
c)
(90 - 60) 2

30)(90

50)

= 0.625

The popularity of triangular distribution is a result of the triangular distributions simplicity as well as
flexibility. It can be constructed with relatively limited information. By adjusting the most likely value,
the triangular distribution can approximate the normal and log-normal distributions, which will be
discussed later.
NORMAL DISTRIBUTION

Normal distribution is the most commonly used distribution in conventional statistics. It is also
called a Gaussian distribution. The pdf and cdf for normal distribution are shown in Figure 4 - 12. As
shown, the distribution is bell shaped and is symmetric with respect to the maximum pdf value.

f(x)

F(x)

Figure 4-12: Normal distribution

24

Mohan Kelkar, Ph.D., J D.


.

The pdf for normal distribution is defined as,


1

e_(x_

2 /2Z - -: < x <

Knowing the relationship between pdf and cdf, we can write an equation for cdl. Before we define
cdf, we can simplify Equation 4-31 further. It can be shown that the mean of the normal distribution
function is it and the variance is cr 2 . If we define a standardized variable:
Table 4-1: z values for normal distribution (MegilI, 1984) (Davis, 1986)

Standard Deviations
from the Mean
-3.0
-3.0
-2.9
-2.8
-2.7
-2.6
-2.5
-2.4
-2.3
-2.2
-2.1
-2.0
-1.9
-1.8
-1.7
-1.6
-1.5
-1.4
-1.3
-1.2
-1.1
-1.0
-0.9
-0.8
-0.7
-0.6
-0.5
-0.4
-0.3
-0.2
-0.1
-0.0

Cumulative
Probability
0.0014
0.0014
0.0019
0.0026
0.0035
0.0047
0.0062
0.0082
0.0107
0.0139
0.0179
0.0228
0.0287
0.0359
0.0446
0.0548
0.0668
0.0808
0.0968
0.1151
0.1357
0.1587
0.1841
0.2119
0.2420
0.2743
0.3085
0.3346
0.3821
0.4207
0.5602
0.5000

Standard Deviations
from the Mean
+0.0
+0.0
+0.1
+0.2
+03
+0.4
+0.5
+0.6
+0.7
+0.8
+0.9
+1.0
+1.1
+1.2
+1.3
+1.4
+1.5
+1.6
+1.7
+1.8
+1.9
+2.0
+2.1
+2.2
+23
+2.4
+2.5
+2.6
+2.7
+2.8
+2.9
+3.0

Cumulative
Probability
0.5000
0.5000
0.5398
0.5793
0.6179
0.6554
0.6915
0.7257
0.7580
0.7881
0.8159
0.8413
0.8643
0.8849
0.9032
0.9192
0.9332
0.9452
0.9554
0.9641
0.9713
0.9773
0.9821
0.9861
0.9893
0.9918
0.9938
0.9953
0.9965
0.9974
0.9981
0.9987

We can write Equation 4-31 as,


Economic Evaluation in the Petroleum Industry
Chapter 4 - Economic Uncertainties

25

AZ)

= =e_z2/2 - 00 <z <cx)

Integrating, cdf can be written as,

F(z)

=-f

e_t2,72dt

I!Ii1t;17wr4

The right side of the equation is called an error function. For all practical purposes,

F(-3) 0

WIZZIRM

F(3) 1

The right side of Equation 4-34 has to be integrated numerically. Standard tables (see Table 4-1) are
available to calculate F(z) for a given value of z.
The two parameters that describe the normal distribution completely are the mean (ii) and the
variance (a 2 ). Once these two values are known, we know the normal distribution function.
Example 4-15
Based on the analysis of the sample porosity data, it was concluded that porosity was normally distributed. If p = 0.2 and
a 2 = 0.0004, calculate the probability that porosity values will be 1) less than 0.18; 2) between 0.18 and 0.22; and 3) between
0.2 and 0.24.
Solution 4-I5
To solve this problem, we need to standardize all the values. Using Equation 4-32 and knowing that p = 0.2 and a = 0.02,
xl2

z=

1)

When

x1 = 0.18,z1 =

0.18 - 0.2
.02

=1

we know that

p[Z <zi ] = F(z1 )


Looking at Table 4-1, F(-1) = 0.1587. Therefore, p{porosity < 0.18] = 0.1587.
2)

When

x2 = 0.22,z2 =

0.22 - 0.2
0.2

= 1,F(z2 ) = 0.8413

we know that

p1z1

<Z <z2 1 = F(z2 ) - F(z 1 )


= 0.8413 - 0.1584 = 0.6826

Therefore, [0.18 < porosity < 0.22 = 0.6826.


3)

26

When

Mohan Kelkar, Ph.D., J. D.

0.2 - 0.2

X3 = 0.2,z3 =02 = 0,F(z3 = 0.5)


0.24 - 0.2
= 0.24,z4 =02
= 2,F(z4 = 0.9773)

p[z3 <Z < z] = F(z4

F(z3 ) = 0.9773 - 0.5 = 0.4773

Therefore, p[0.2 <porosity < 0.24]= 0.4773.


As shown, once the mean and the variance are known, the probability value for any interval can be calculated.

Normal distribution can be approximated by a triangular distribution if the difference between the
most likely and the minimum is equal to the difference between the maximum and the most likely
values.
LOG NORMAL DISTRIBUTION
A log normal distribution is closely related to the normal distribution. If a log of random variable is
normally distributed, then the variable is assumed to be log normally distributed. This relationship is
shown in Figure 4-13. In this figure, the random variable is log-normally distributed because log x is
a normally distributed variable.

f(x)

f(Iog x)

/
I
log
Figure 4-13: Transformation of log-normal to normal distribution
Several variables exhibit log-normal behavior. These include permeability values in the reservoirs,
the size of sand grains in the sediment, the size of oil and gas fields resulting from past discoveries,
EUR distributions in a shale gas reservoir, and economic variables such as well costs and completion
times. We can use log probability plot to verify the behavior of a variable to see if indeed the
variable is log normally distributed. If we observe a straight line, it is an indication of log normal
behavior. Figure 4-14 shows a permeability distribution indicating a log-normal behavior in a
probability plot.

Economic Evaluotion in the Petroleum Industry


Chapter 4- Economic Uncertainties

27

9
>

9
9

I
:5
E

4
3
9

C)

001 -

0.010

o 100

too

100

100

1000.

PerrnebOty. md

Similar to the normal distribution, the log-normal distribution can be described using the
parameters mean and variance. The probability density function for a log normal variable can be
written as,
f(x) =

1
xf3f

exp

[Inxa]

213 2

where x is log normally distributed, ci is the arithmetic mean of natural logarithm of x values and /32
is the variance of natural logarithm of x values.
In addition to knowing the probability density function, we can also define some additional useful
relationships for a log normal distribution. For example, if i and a 2 are the arithmetic mean and
variance of the variable x, we can relateji and cr 2 to ci and p 2 by:
p 2 = In (i +

Equation 4-37

and

a=

28

Mohan Kelkar, Ph.D., ID.

Example 4-16
A survey of oil and gas reservoirs in a given basin indicates that the arithmetic mean of all the reserves is 200,000 bb!s and
the standard deviation is 400,000. If the distribution of the reserves is log-normal, calculate the probability that the
prospect will produce less than 400,000 bbls. Also calculate the value of reserves so that 10% of the reserves are less than
that value.

Solution 4-16
In most instances, the mean and variance are easy to calculate based on the sample data. If the distribution is log-normal,
however, then we need to convert the arithmetic mean and variance to the mean and variance of log of the values.
Using Equation 4-37,

= ln(1 +_-)
= In

(400,000) 2

Fi + ( 200,000)2j

= 1.609
Using Equation 4-38,
j2
a=
ln(200,000) - 1.609
----= 11.4
Since distribution of the log of the variable is normal, we can use Table 4-1 to estimate the probability that reserves are
less than 400,000 bbls,
ln(400,000) = 12.90
To define a standardized variable,
- In(x) - a - 12.9-11.4
Z-

= 1.1825
F(1.1825) = 0.88 from Table 4-1.
Therefore, there is an 88% probability that a future successful prospect will produce less than 400,000 bbls. The
corresponding to the 10th percentile is 1.28 (Table 4-1). By manipulating Equation 4-32,

z value

X10 = ea-1.28fl = ehl 4 _l 28 X 1268


= 17,613 bbls

Problem 4-19
If the area of the reservoir is assumed to be uniformly distributed, with the minimum area equal to 60 acres and the maximum
area to be 200 acres, what is the most likely value of the reservoir area? What is the probability that the area will be less than
160 acres?

Economic Evaluation in the Petroleum Industry


Chapter 4- Economic Uncertainties

29

Problem 4-20
A reservoir recovery factor is assumed to be triangularly distributed with a minimum of 0.15, a most likely value of 0.23 and a
of
maximum of 04 What is the probability that the value of the recovery factor is between 0.2 and 0.3? What is the value
recovery at which you are 90/b sure that the recovery factor will be less than that value?
Problem 4-21
The saturation in the reservoir is assumed to be normally distributed. If the mean saturation is 0.3 and the standard deviation is
0.05, calculate the probability that the saturation lies between 0.27 and 0.33.
Problem 4-22
lithe formation porosity is normally distributed with a mean of 0.15 and a variance of 0.0016, and the reservoir quality rock is
assumed to have a porosity of at least 0.10, calculate the probability that the porosity in this reservoir is less than 0.10. Does this
value represent the fraction of the reservoir that is unproductive?

Based on the survey of various economic analysts, the oil price forecast for the next year is normally distributed with a mean of
$951bbl and a standard deviation of $101bbl. If this analysis is assumed to be true, what is the probability that oil prices will be
lower than $701bbl? What is the probability that the price of oil will be greater than $1101bbl?
Problem 4-24
Permeability of a reservoir is assumed to be log-normally distributed. If a sample of well bore data indicates a mean of 30 md
and a standard deviation of 50 md, what is the probability that the permeability of a given sample is less than I md? What is the
probability that the permeability is greater than 100 md?
Problem 4-25
The following data represents average porosities in Canadian fields. Verify whether or not the data represent log normal
distribution (Capen, 1992). Use a log probability plot.
0.03
0.07
0.1
0.19

0.04
0.07
0.1
0.19

0.05
0.07
0.12
0.19

0.05
0.07
0.13
0.19

0.06
0.07
0.14
0.19

0.06
0.09
0.14
0.2

0.06
0.09
0.15
0.22

0.06
0.1
0.15
0.27

0.1
0.15

0.18

0.18

DECISION TREE ANALYSIS


Decision tree analysis is a Logical extension of probability analysis. In the Expected Value section, we
discussed how to make an economic decision based on EMV analysis. That is, for a given decision, if we
find that the EMV is positive, we consider that decision to be feasible. It does not mean that we are
always going to be successful in making the decision. It just means that if we make similar decisions for a
large number of problems, on average, we will be successful. Decision tree analysis allows us to extend
EMV analysis when we are examining more complex problems that require more than one decision and
may depend on earlier decisions. Decision analysis provides us with a structure so that understanding
the subsequent decisions that are dependent on earlier decisions can help us make an optimal decision.
Similar to [MV analysis, we can conduct sensitivity analysis to understand the impact of uncertainty with
respect to probability on decision tree analysis.

30

Mohan Kelkar, Ph.D., J.D.

In a typical decision tree plot, we always denote decision by a square node; whereas, the probability (or
chance) node is described by a circle. A payoff node provides the value of payoff for a particular
decision. This is the final value at the end of the tree and it is defined for every branch of the tree. The
best way to illustrate the decision tree analysis is through a simple example.
Example 4-17
An operator is thinking about drilling a well at a cost of $2 million. The probability of a dry hole is 0.6 and, if successful, there is
a 0.3 probability that the P Vb ene jts will be $4 million, 0.4 probability that the PVb,,,,Fu will be $8 million and 0.3 probability that
the PVbenefits will be $13 million. Should the operator drill the well? Row will the decision affected by the probability of success?

Solution 4-17
We can draw the decision tree diagram as:
NPV

P = 0.12
$2m

p = 0.16
$6 m

Drill

p = 0.12
$11 m

111111
No Drill
$Om

Figure 4-15: Decision tree for Example 4-16

The square represents the decision whether to drill the well or not. The circle represents the probability or trial node. The
probability associated with each of the successful options is calculated by multiplying the probability of success (0.4) with
likelihood of each of the successful outcomes. If the probability of "benefits is 4 million (03), then 0.3 x 0.4 gives us the
probability 0.12 that the NPV of that branch will be $4 -$2 = $2 million. This requires subtracting the cost of drilling the well.
We can do the calculation at the probability node to determine the EMV if the well is successful.
EMV - 0.12

2 + 0.16 x 6 + 0.12 x 11 + 0.6 x 2 = $1.32 m

Therefore, at the decision node, the EMV is calculated as:


EMV = 2.52 - 1.2 = $1.32 m
Since the EMV is positive, the decision should be to drill the well. The final decision tree is shown in Figure 4-16.

Economic Evaluation in the Petroleum Industry


Chapter 4- Economic Uncertainties

31

N PV

P = 0.12
- --------.- $2m

p=0.16
$6m

EMV Drill

p = 0.12
$llm

=$1.32m7

EMV=$1.32m

=06

EMV$Om

No Drill
$-2m

re 4-16: Finel answer from decision tree in Example 4-16


As with the [MV analysis, we can examine the sensitivity of the [MV at the decision node for different
probability of success values. This is shown in Figure 4-17.

8
6
4

>
LU

0
-2
-4
0

0.2

0.4

0.6

0.8

Probability of Success
Figure 4-17: Sensitivity of EMV to probability of success in Example 4-16
As Figure 4-17 shows, unless the probability of success is less than 0.23, the [MV will be positive. This
means that, as long as the operator believes that the probability of success is at least 0.23, this project is
feasible.
Example 4-18
A company is considering buying a new prospect. The lease hold bonus is expected to be $100,000. Based on the current
analysis, there is a 20% chance that a successful well can be drilled resulting in a present worth of $1.2 million. Once bought,
another alternative is to conduct a 3-0 seismic to increase the chance of recovery. Based on the survey of nearby areas, there is
a 0.7 probability that seismic survey will give a favorable result. If favorable, the probability of a successful well will increase to
0.8. If seismic survey is unfavorable, the probability of success will decrease to 0.05. The cost of conducting the seismic survey is
estimated to be $300,000. The cost of drilling is estimated to be $100,000. Using decision tree analysis, what actions should the
company take?

32

Mohan Kelkar, Ph.D., J.D.

Solution 4-13
This problem requires decision making at several occasions. The three major decisions are 1) whether to buy a lease, 2)
whether to conduct a seismic survey, and 3) whether to drill a well. Figure 4-18 shows the decision tree for this problem.
Drill
Ps

No Drill

Favorable
Ps0 7

Drill

p 5 = 0 05
2

Seismic
Unfavorable

No Drill

pS=O. 3

No
Drill

Seismic

Buy
Lease

Ps 2

No Drill

Dont Buy
Lease

Figure 4-18: Decision tree for Example 4-17


In this decision tree, there are five decision nodes indicating the point at which a decision is needed. Treat the decision at each
decision node to be an isolated one where, depending upon the EMV for each cAernative, we can select the alternative that has
the highest EMV.
Consider node 1 where, after a favorable seismic survey, we need to decide whether to drill or not. Using

Equation 4-22,

EMV = p(NPV) 5 - NPV) f ] + (NPV)J.


(

If we drill the well,

(NPV) = 1.2 x 10 6 - 100,000 - 100,000 - 300,000


= $700,000
In the calculation above, 1.2 x 106 represents the present worth if the well is successful, $100,000 represents the cost of
drilling, the second $100,000 represents the cost of leasing and $300,000 represents the cost of the seismic survey.

(NPV) 1 = 100,000 100,000-300,000


=

$500,000

Therefore,

Economic Evaluation in the Petroleum Industry


Chapter 4 - Economic Uncertainties

33

EMV = 0.8[700,000 - (-500,000)1 + (-500,000)


= $460,000
If we do not drill the well,

EMV = $400,000
where -$400,000 represents the costs of leasing and of conducting seismic survey.
Comparing the two expected values, we should drill the well if the seismic survey is favorable.
The (EMV) corresponding to the selected decision is carried forward for further analysis.
At decision node 2, we can carry out a similar analysis. This node represents the decision of drilling a well if the seismic survey is
unsuccessful.
If we drill the well,

EMV = 0.5700,000 + 500,0001 - 500,000


-$440,000
-

If we do not drill the well,

EMV = $400,000
where - $400,0 0 0 represents the costs of leasing and of conducting a seismic survey.
Since the EMV drilling option will result in a bigger loss, we should opt to not drill the well.
At decision node 3, where we have to consider drilling a well without conducting a seismic survey,

(NPV) S = 1.2 X 106 - 100,000 100,000


= $1,000,000
1.2 x 106 represents the present worth if the well is successful, the two $100,000 values represent the cost of leasing and the
cost of drilling respectively. There is no cost of seismic for this option. Using Equation 4-22, if we decide to drill a well,

EMV = 0.2[1,000,000 - (-200,000)] - 200,000


= $40,000
If the option of not drilling the well is chosen,

EMV = $100,000
where - $100, 0 00 represents the cost of leasing the land.
Comparing the two options, we need to select the option of drilling the well.
After we have made the decisions at the three nodes, we can redraw our decision tree as shown in Figure 4-19.
We have a probability node after deciding to conduct a seismic survey. We can calculate the [MV at the probability node by:

EM

Equation 4-39

where pi represents the probability of the event i, and (EMV) 1 represents the expected monetary value of the event i.

Mohan Kelkar, Ph.D., J.D.

EMV = 460,000
Favorable
Ps .7

Seismic
Unfavorable
EMV =-400,000
4
No
Seismic

Buy
Lease

5
Dont Buy
Lease

EMV = 40,000

EMV=0
Figure 4-19: Partial decision tree for Example 4-17
Using Equation 4-22, the EMV at the probability node "a" is,

EMV = 0.7 x 460,000 + 0.3 x (-400,000)


= $202,000
Consider decision node 4. The EMV, if we conduct a seismic survey, is $202,000. If we do not conduct a seismic survey, it is
$40,000; therefore, we should select the option to conduct the seismic survey. The decision tree now can be drawn as:

Economic Evaluation in the Petroleum Industry


Chapter 4- Economic Uncertainties

35

EMV = $202,000
Buy
Lease

Dont Buy
Lease

\EMv=$0

Figure 4-20: Partial decision tree for Example 4-17


Lo o k ing at the decision tree for Figure 4-21, the option to select is to purchase the lease.

Example 4-19
A company is considering a waterflooding project in a depleted solution-gas drive reservoir. The current estimates of decline
curve analysis indicate that, if produced under existing conditions, the present worth of the reserves is $20 million. One option
under consideration is to use the existing wells and convert half of the welts to the injection wells. It is estimated that this
conversion will cost $1 million and, due to additional reserves, with a 40% probability, will result in a present worth of $32
million and, with a 60% probability, will result in a present worth of $26 million. Another option is to drill injector wells and then
initiate a water flood. Drilling an additional 10 injectors and converting the current operation to watertlood will cost $5 million.
It is estimated that, due to additional reserves, with a 60% probability, it will result in a present worth of $35 million and, with a
40% probability, it will result in a present worth of $28 million. Based on the EMV analysis, which option should be selected?
Solution 4-19

The decision tree can be drawn as follows,

36

Mohan Kelkar, Ph.D., J.D.

Based on the decision tree, we need to make two decisions: 1) whether to conduct waterflood or not, and 2) if we decide to
conduct, whether to drill additional wells for waterflooding. We have two probability nodes in the decision tree. The first step
will be to calculate the EMV at each probability node.
At probability node ct, for p = 0.6,

EMV = $35m - $5m = $30m


where $35m is the present worth and $5m is the cost of drilling additional wells.
For p = 0.4,

EMV = $28m - $5m = $23m


Using Equation 4-22,

EMV = p, (EMV) 1
= 0.6(30) + 0.4(23)
= $27.Om
At probability node b, for p = 0.4,

EMV = $32m - $lm = $31m


For p = 0.6,

EMV = $26m - $lm = $25m


Using Equation 4-22,

EMV = 0.4 x 31 + 0.6 x 25 = $27.4m


At decision node 1, the option to drill wells results in an EMV of $27.2m versus $27.4m for the option not to drill wells;
therefore, the option not to drill wells should be selected.
At decision node 2, the option for watertlooding will result in an EMV of $27.4m versus $20m with no waterflooding; therefore,
we should select the decision to initiate a waterflood.

In Example 4-18, we saw an application of decision tree analysis for understanding value of information;
-to determine if it is worth conducting seismic survey or not. In many instances evaluating the value of
information requires the application of Bayess rule. We will illustrate this application in the following
example.
Example 4-20

P
P
P

An oil company has acquired a new concession in offshore Gulf of Mexico. Based on an analog study and an old 3-D seismic
shoot done 10 years ago, the probability of finding successful hydrocarbons is determined to be 0.2. The cost of drilling a well is
estimated to be $50 million. If the first well is successful, there is a 0.2 probability that the present value of benefits (after
subsequent costs of drilling are accounted) will be $200 million, a 0.5 probability that the present value of benefits will be $400
million, and a 0.3 probability that the present value of benefits will be $800 million. There is a proposal by an exploration group
that an additional 3-D seismic survey be performed at a cost of $10 million. Based on other exploration plays, when a 3-D
seismic survey was performed, the survey was accurate in predicting the successful location of hydrocarbons 80% of the time;
whereas, successful seismic surveys have incorrectly predicted the correct location for drilling a well 20% of the time. The
probability of the present value of benefits does not change with seismic data. Should the seismic data be collected? We will
assume that, if seismic data indicates an unfavorable result, we will not drill the well.

Economic Evaluation in the Petroleum Industry


Chapter 4 - Economic Uncertainties

37

Solution 4-20
The decision tree for this example can be drawn as shown in Figure 4-22. The probability values shown in the decision tree
require some explanation. As shown in Figure 4-22, there are three decision nodes. Let us assume that event S represents
successful drilling (finding hydrocarbons) and that the event of successful seismic data is D. We already know that p(S) = 0.2).
We also know that p(DIS) = 0.8 and p(DISC) = 0.2, where SC represents a failure event, which is complimentary to success.
Using these values, we need to calculate p(SID). This represents the probability of success if seismic data are successful. We
also need to calculate p(SC D), which represents the probability of failure if seismic data are successful. This requires the use of
the Bayes rule. Using Equation 4-10, we can calculate
p(DIS)xp(S)
SD) p(DIS)xp(S)+p(DS c )xp(S c
p(SD) =
Using a similar equation, we can calculate p(5C

0.8 x 0.2
0.5
0.8 x 0.2 + 0.2 x 0.8 =

ID) = 0.5.
P = 0.1

$ 140 m

p = 0.25
..- --... ..................................................$ 340 m
Drill (p, = 0.5)
/

p=O.15
740 m

\..

Seismic
-

I I

p=0.5

-$ 60 m

No Drill
---.

-$ 10 m

No Drill

____

..--- ................-------

$Om

No Seismic
p = 0.04

$150 m

Drill (p,=0.2)

$350m
N

p=0.06

P =0.8

$ 750 m

-$50 m

Figure 4-22: Decision tree for Example 4-19

The probabilities of three successful possibilities are calculated by multiplying the probability of particular outcome with the
probability of success. For example, if the probability of PVb ene fl ts is 0.2, then multiplying 0.2 by 0.2, we obtain the value of 0.04.
In reality, after collecting seismic data, we should have a probability (chance) node indicating the probability of favorable
seismic versus the probability of unfavorable seismic. If the seismic is unfavorable (we can define the event as DC), we will need
to calculate p(SIDC) and p(SdIDT). There will be another decision node associated with unfavorable seismic data
corresponding with the decision to drill or not to drill well; however, in this example, we made asimplifying assumption that we

38

Mohan Kelkar, Ph.D., ID.

will not drill a well if the seismic data are unfavorable. Therefore, that decision is already known and has been eliminated from
decision tree analysis.
The NPV for each of the options is calculated by subtracting the cost of drilling of a well from the present value of benefits. The
reason for slightly different results when seismic data are collected is due to the additional $10 million cost of conducting
seismic data. We can calculate the EMV at the first chance node (after seismic data are collected) as:
EMV = 0.1 x 140 + 0.25 x 340 + 0.15 x 740 + 0.5 x 60 = $180m
We can compare this EMV with EMV of not drilling the well after collecting seismic data, which is -$10 m. Since 180 is greater
than -10, we will choose the option to drill the well.
If we calculate the EMV at the probability node without seismic, we can calculate it as:
EMV = 0.04 x 150 + 0.1 x 350 + 0.06 x 750 + 0.8 x 50 = $46m
Comparing this value with the EMV of the not drilling option (zero), even without seismic data, we should choose the option to
drill the well.
Comparing the two options, $180 m is greater than $46 m; therefore, we should choose the option of collecting seismic data.

Problem 4-26
An oil company is considering leasing a highly faulted prospect for potential gas reserves. The cost of leasing is estimated to be
$7501acre. The company has the option of leasing 640 acres and drilling a well by itself or leasing 160 acres and unitizing the
leased area with other companies to receive 25% working interest in 640 acre unit. If the 640 acre land is leased, the company
has the option to conduct a 3-D seismic survey at a cost of $1.5 million. If the seismic survey is successful (the probability of the
seismic survey being successful is 0.6), the probability of a successful well will increase from 0.2 (before seismic) to 0.6. If the
seismic survey is unfavorable, the probability of a successful well will reduce to 0.03. If the company only leases the 160 acres, it
will have to participate in the seismic survey by sharing 25% of the seismic survey cost. The cost of drilling a well is $3 million. If
successful, the well will produce at a rote of 2 MMSCF/D during the first year declining at a rote of 10% per year. If the life of the
gas well is seven years and the average price of gas received is $2. 70/MSCF, which option should the company choose? Assume
that the operating costs for the lease are $200,000 per year, the MROR is 12%, and the salvage value is negligible. Use the
decision tree analysis.
Problem 4-27
An oil company is considering drilling an infill well to reach reserves otherwise not contacted by existing wells. The company has
several options. Under option 1, the company can drill a vertical well without collecting any additional data. The chances of
hitting a successful target are 0.4. If successful, it is expected that, after drilling the well at a cost of $800,000, tin well will
produce 7,000 bbls/yeor with an operating cost of $101bbl over the next six years. Under option 2, the company can collect
additional geological, well testing, and cross-well seismic data at a cast of $1,000,000. The chances that the additional data
collection will indicate favorable results are 0.7. Based on other available data, the additional data is accurate 70% of the time if
the results are favorable. If unfavorable, the additional data is accurate in indicating unfavorable drilling prospect 80% of the
time. With option 3, the company can choose to drill a horizontal well after collecting additional data and receiving favorable
results. Drilling a horizontal well will cost $3,000,000. The chance of hitting a successful target is 0.6. If successful, the well will
produce 15,000 bbls/year for the next five years with an operating cost of $121bbl. If the price of oil is $801bbl the MROR is
18%, and the salvage value is negligible, which option should the company choose? Use the decision tree analysis.
Problem 4-28
An oil company, which owns a 100% working interest, is considering drilling a potential prospect. The drilling casts are expected
to be $2,000,000. The well has a 60% probability of being a thy hole, 030% probability of producing 10,000 bbls in the first year,
and a 10% probability of producing 20,000 bbls in the first year. Based on nearby wells, the well will decline at a rate of 18% per
year. Economic analysis indicates that there is a 60% probability that the oil price will remain at $801bbl over the production
period and a 40% probability that the oil price will remain at $1001bbl. Assume the operating costs will remain steady at
50,000 per year. Assume the income tax rate to be 28% and negligible royalty interest. With option 4, the company will receive
3116 overriding royalty interest in the some well. If the life of the well is assumed to be six years, which option should the

Economic Evaluation in the Petroleum Industry


Chapter 4 - Economic Uncertainties

39

company choose? The MROR is 15%. Use the decision tree analysis.

. . . : . .....

Oil Company A owns a lease on a 40 acre wild cot area. Based on geological and geophysical analysis, the company has a 20%
chance of drilling a successful gas well. The drilling of a well will cast $500,000 and will result in $4 million PVb, fl itS . Company B,
owning the adjoining land, is proposing to drill a well on their land. Both lands indicate similar geological and geophysical
features. Company B offers two options to Company A:
1)

Company A can receive the welibore data from the drilled well at a cost of $60,000. If the results of the welibore data are
favorable (a 50% chance), company As chances on its own lease will improve to 0.5. If unfavorable, the chances of a
successful well will be reduced to 0.05.

2)

Company A can participate in the well Company B is drilling at a 50% working interest with some override to Company B.
The chances of a successful well on company Bs lease are 20% with the cost of drilling being $600,000 and if successful,
resulting in a PV to Company A of $1.8 million. If the well is successful, the chances of Company A drilling a successful well
on its own lease will improve to 50%. If unsuccessful, then Company As chances will reduce to 5%.

Which option should Company A choose? Use the decision tree analysis.

MONTE-CARLO SIMULATION (Megi!!, 1984), (Bratvold & Begg, 2010)


Monte-Carlo simulation is an extension of the probability analysis. It is the method by which a
probability distribution of an output variable can be determined if the probability distributions of input
variables are known. Schematically, Figure 4-23 represents the concept of Monte-Carlo simulation. On
the left side, all the input variables are shown. We assume that the distribution functions of all the input
variables are known. We also know the relationship between the output variable and the input variable,
y=f(x 1 ,x2 ...,x)

ytadl7DJ

where y is the output variable and x 1 ,",x are input variables. As a simplistic case of Monte-Carlo
simulation, if we assume that only one value of all the input variables is known, then we will obtain only
one output of value of y. Unfortunately, due to uncertainties with respect to input variables, we need to
estimate the uncertainty with respect to output variables. Monte-Carlo simulation allows us to generate
the probability distribution function of an output variable knowing the distribution of the input variables
and the relationship between the output variables and the input variables.
In principle, if we know the distribution of input variables, it is possible to generate the distribution of
output variables under some limiting circumstances. This can be obtained analytically. If we assume that
all the input variables have Gaussian distribution and we know the mean and variance of those
distributions and, if we further assume that those input variables are independent of each other, it is
possible to determine the distribution of the output variables (including mean and variance) under
certain conditions. In practice though, the relationship between the input variables and output variables
can be complex and non-linear. Additionally, it is possible for input variables to be dependent on each
other. That dependency needs to be accounted for in our analysis. Monte-Carlo simulation can allow for
such complex relationships.

40

Mohan Kelkor, Ph.D., J.D.

INPUT

RELATIONSHIP

OUTPUT

Figure 4-23., Concept of Monte-Carlo simulation


The Monte-Carlo simulation method requires numerous computations; therefore, it can be used only
with the help of computers. A logical flow diagram of the Monte-Carlo simulation is represented in
Figure 4-24. Each of the steps in the flow diagram is explained in more detail below.
Step 1 requires input of all relevant data. This includes the distribution functions of all input variables.
These functions include uniform, triangular, normal, log normal or any other type of function. These
functions are specified by inputting the appropriate parameters for each distribution function. For
example, for a uniform distribution function, we need to input the minimum and maximum or, for
normal distribution function, we need to specify the mean and variance. We also need to specify the
functional relationship between input and output variables. The input should also include the number of
passes the computer has to loop through before the program is terminated. This number should be
sufficiently large in order to obtain a representative distribution of the output variables. With the recent
speed of computers, it is very easy to generate the output variables by using a large number of passes
unless the problem is extremely complex. Ten-thousand passes is not uncommon in Monte Carlo
simulation.

Economic Evaluation in the Petroleum Industry


Chapter 4- Economic Uncertainties

41

Read In Data

y=f(x1,x,. X 11

Number of Passes, N

Select Values for Input V

ariables

x ni

xli

Determine

for Pa,i

y i=f (x1i,x,

xj)

No

SucientPas:s?

yes

Distiibution of y

STOP

Figure 4-24: Flaw diagram of Monte-Carlo simulation


Step 2 of the Monte-Carlo simulation requires selecting values for input variables for a given pass. This
can be accomplished using a uniform random number generator and converting the probability density
function into a cumulative distribution function. A uniform random number generator generates
random numbers between 0 and 1 with equal probability. That is, any number between the interval 0
and 1 can be selected with an equal chance. Knowing that the cumulative distribution function also
42

Mohan Kelkar, Ph.D., J. D.

varies between 0 and 1, the value of a random number is assigned to the cumulative distribution
function and the corresponding value of the variable is selected.
Let us illustrate this procedure through a simple example. Assume that we have defined a variable by a
uniform distribution between an interval [a, b]. The cumulative distribution function for this interval can
be defined as:

F(x)

= x-a

Equation 4-41

b-a

This cumulative distribution function is shown in Figure 4-25.

_:____

As evident in Equation 4-27, it is a linear relationship. A random number is selected within a uniform
random number generator; any number between [0, 1] interval. We assign this random number RN to
the cumulative distribution function. Substituting RN for cumulative distribution function F(x) in
Equation 4-27, results in,

RN =

Equation 4-42

Rearranging Equation 4-40, we can write,

x i = a + RN(b - a)

Equation 4-43

We assign the value xi to this particular variable.


Although the equations illustrated above show how to select a value from a uniform distribution
function, a similar technique can be applied to any other distribution function. Once we identify a
relationship between F(x) and x for any distribution function, selecting a value for the variable is easy.
From the discussion on distribution functions, we know that such a relationship exists for every
distribution function including the discrete distribution functions.
Note that the value of x1 in Equation 4-41 will change depending upon the value of a random number.
We repeat a similar procedure for every input variable. For selecting a variable, every time, a new
random number is drawn within the interval [0, 11.

Economic Evaluation in the Petroleum Industry


Chapter 4 Economic Uncertainties

43

Once the values for all the input variables are selected, in Step 3, we can use the relationship between
the output and input variables. This will result in one value of the output variable y. This completes the
calculation for one pass.
Step 4 in the Monte-Carlo simulation is to check to see if the number of passes for which the
calculations are done exceeds the maximum number of passes. If not, the procedure in steps 2 and 3
(selecting the values of the input variables using uniform random number generator and calculating the
value of y using the relationship between the output and the input variables) is repeated.
Depending upon the number of passes, we will generate an equal number of output values. Since, in
each pass, different values of the random numbers are selected, we will have different values of the
output variable. Therefore, if we have gone through 1,000 passes, we will have 1,000 values of the
output variable. Using these 1,000 values, we can construct a frequency distribution function of the
output variable. This function should be able to quantify uncertainties with respect to the prediction of
the output variable.
As explained above, Monte-Carlo simulation is a procedure that describes and quantifies uncertainties
through a distribution function of an output variable. Instead of a conventional procedure, which may
allow an estimation of output variables based on the most likely estimates of the input variables,
Monte-Carlo simulation describes the alternative values the output variables can take and the relative
frequency with which it can take those values.
In making economic decisions, understanding of uncertainties with respect to output variables is
immensely important. By using the range of estimates as a basis, we can quantitatively evaluate the
risks involved in a project. This type of evaluation is much more realistic than simply assigning a single
value to the output variable.
A note of caution is warranted about the use of the Monte-Carlo simulation. The technique is as good as
the knowledge about the distribution of the input variables. If the distribution of the input variables is
not adequate, the distribution of the output variables will not reflect the extent of uncertainties.
Hopefully, even in the presence of sparse information, we will at least be able to describe the input
variables by quantifying the minimum and the maximum. If such information is not available, we will not
be able to use the Monte-Carlo simulation to correctly describe the uncertainties of the output
variables.
The Monte-Carlo simulation may be extended to a situation where two input variables are related to
each other. If we know the type of relationship available between the two variables, we can incorporate
such a relationship very easily. We can use a correlation coefficient to define the relationship and,
hence, sample the value of a second input variable knowing the value of the first input variable. If the
relationship is not linear, we can use conditional distribution functions to sample the value of a second
variable knowing the value of the first variable.
Example 4-21
We are interested in estimating potential reserves under a new prospect. Based on the geological and petrophysical analysis of
nearby wells, it is estimated that following the distribution of variables should be observed.

44

Mohan Kelkar, Ph.D., J.D.

OW
OW
ON

Most
Distribution

Variable

Triangular
Triangular
Triangular
Uniform
Uniform

Area (acres)
Thickness (feet)
Porosity (fraction)
Water saturation (fraction)
Recovery Factor (fraction)
Formation Volume Factor (bbl/STB)

Single

Minimum

Likely

Maximum

20
20
0.2
0.3
0.2
-

40
30
0.25
1.2

120
50
0.3
0.35
0.3
-

The equation for calculating the reserves is given by,

N=

7758Ah(l - S)
B01

RF

where,
A = area in acres
h = payzone thickness in feet

0 = porosity in fraction
S,,1 = water saturation in fraction
RF = recovery factor in fraction
B0 , = formation volume factor in bbl/STB
N = recoverable oil in STB
Estimate the distribution function for the oil that can be recovered.
Solution 4-21
Following the procedure discussed in the previous paragraphs, we input the distribution functions of all the variables, the
functional relationship between the output variables and the input variables and the number of passes in the Monte-Carlo
simulation program.
Using a Monte-Carlo simulation program with 2,000 passes, we have created the distribution of the amount of oil that can be
recovered in Figure 4-26. As shown in the histogram plot, this distribution appears close to log-normal distribution. As
previously discussed, this is a result of a central limits theorem that states that the product of a large number of independent,
random numbers tends to be log-normally distributed. Considering that recoverable oil is a product of several independent
random variables, it should be log-normally distributed.
In practice, when you evaluate the distribution of oil reserves in a given basin, you will notice a similar trend - a log-normal
distribution. This can be attributed to the fact that the reserves recovered are a product of various independent variables.
Knowing the distribution of the recoverable reserves, we can calculate the expected value of the reserves. If we identify a class
mark for each class, then
EV

=Y p 1 Np 1

where P1 is the probability of class i, and Np1 is the class mark. Defining the class mark as the center of each class, the expected
value in this case is 4.24 x 10 s STB. This value represents the average amount of oil that can be recovered if several, similar
reservoirs are explored. This number can be used as a single outcome for further economic analysis if such analysis is needed.

Economic Evaluation in the Petroleum Industry


Chapter 4- Economic Uncertainties

45

0.16
0.14
0.12
0,1

Prnt,abiffty 008
0.06

0.04

0.02
0
1.06 lUS 2.46 345 4.24 5.03 5.83 8.62 7.4* 8.2 S.0 LB 10.6 11.4 12.2 13 13.1 14.5

Od Reserves. SIB x 10 -5
Figure 4-26: Distribution

of recoverable oil

Example 4-21 illustrates the utility of the Monte-Carlo simulation for generating the distribution of
recoverable reserves. The method, however, can be extended to other estimations where uncertainties
with respect to input variables are known. For example, by coupling the economic evaluation and its
related uncertainties, we can generate NPV distribution for different scenarios. The distribution of NPV
values presents us with the economic uncertainties distribution. By studying this figure, we can make a
decision as to the feasibility of the project.
To summarize, the Monte-Carlo simulation is a very powerful technique for assessing and quantifying
the uncertainties of important variables. Knowing the uncertainties with respect to input parameters,
the Monte-Carlo simulation can generate the distribution of output variables. Unlike the other
techniques we studied in this chapter, the Monte-Carlo simulation gives a range of output values. This
range of values should allow us to objectively evaluate the feasibility of a given project in light of
uncertainties. Such evaluation is much more realistic than the evaluations that are based on single-value
analysis.
Problem 4-30
Estimate the reserves distribution for a reservoir with the following property distribution:
Minimum

Most Likely

Maximum

Porosity (%)

13

20

26

Area (acres)

1,500

3,000

Payzone (feet)

50

100

130

Water Saturation (%)

15

25

Formation Volume Factor (bbl/STB)

1.1

13

Recovery Factor

.3

.4

.45

Variable

Generate the distribution of reserves using the Monte-Carlo simulation method. Make two runs using 100 passes and 2,000
passes. Do you observe any difference? Which one is more representative of uncertainties? Calculate the expected value of

46

Mahan Kelkcir, Ph.D., J.D.

reserves. If the cost of drilling in this reserve is $250,000 and the PV/bbl in this reservoir is $10 (including operating Costs),
should we invest the money in this project?
Problem 431
Estimate the reserves distribution for a reservoir with the following properties distribution
Minimum

Most Likely

Maximum

Porosity (%)

20

30

36

Area (acres)

100

640

750

Payzone (feet)

30

70

Water Saturation (%)

15

18

25

1.25

.25

.4

Variable

Formation Volume Factor (bbls/STB)


Recovery Factor

Calculate the distribution of the possible reserves using the Monte-Carlo simulation method. Calculate the expected value
reserves. How does it compare with the short-cut method?

of the

9711471=111114M
The following data are given for a particular reservoir:
1. Porosity: Histogram Type Distribution

2.

3.

4.

Range

Probability

.14-16

.1

.16-.18

.15

,18-.20

.30

.2-.22

.20

.22-24

.15

.24-26

.07

.20-28

.03

Area: Uniform Distribution


Minimum

80 acres

Maximum

160 acres

Thickness: Triangular Distribution


Minimum

60 feet

Most Probable

90 feet

Maximum

50 feet

Saturation: Histogram Distribution

Economic Evaluation in the Petroleum Industry


Chapter 4 - Economic Uncertainties

47

5.

Range

Probability

.14-.18

.1

.18-.2

.2

.2-.24

.30

.24-27

.2

.27-30

.12

.30-.35

.08

Formation Volume Factor: Triangular


Minimum
Most Probable
Maximum

6.

Recovery Factor: Uniform


Minimum

.20

Maximum

.50

Calculate and predict the producible oil distribution after making 1,000 passes. Estimate the expected value of the producible
reserves. If the NPV per bbl of oil is $8, and the cost of drilling is $200,000, what is the maximum lease hold costs you are willing
to pay?

WORKS CITED

Bratvold, R. B., & Begg. S. H. (2010). Making Good Decisions. In R. B. Begg. Richardson, TX:
SPE Publications.
Capen, E. (1992). Dealing with Uncertainties. (R. Steinmetz,
Exploration, 29-62.

The Business of Petroleum

Davis, J. (1986). Statistics and Data Analysis Geology. New York: John Wiley and Sons.
Megill, R. E. (1984). In An Introduction to Risk Analysis (pp. Chapters Eight, Nineteen and
Fourteen). Tulsa, OK: PennWell Publishing Company.
Mian, M. A. (2002). Project Economics and Decision Analysis; Volume II: Probabilistic Models,
Tulsa: PennWell Publications.
Newendrop, P., & Schuyler, J. (2000). Decision Analysis for Petroleum Exploration. Aurora,
CO: Planning Press.
Rose, P. R. (1992). Chance of Success and Its Use in Petroleum Exploration. (R. Steinmetz, Ed.)
The Business of Petroleum Exploration, 7 1-86.

48

Mohan Kelkar, Ph.D., ID.