PRMIA Calgary ROWorkshop PDF

An Overview of Using Dynamic
Discounted Cash Flow and Real Options

to Value and Manage Petroleum Projects
Michael Samis, Ph.D., P.Eng.

AMEC Americas Limited
David Laughton, Ph.D.
David Laughton Consulting
Disclaimer
This presentation was prepared for a valuation workshop presented to the Calgary Chapter of the Professional
Risk Managers International Association by AMEC Americas Limited (AMEC) and David Laughton Consulting
Limited. The quality of information, conclusions and estimates contained herein is consistent with the level of
effort involved in the services provided by AMEC and David Laughton Consulting Limited based on: i)
information available at the time of preparation, ii) data supplied by outside sources, and iii) the assumptions,
conditions and qualifications set forth in this presentation.
This presentation is intended only for educational purposes as an overview of market based valuation methods
such as real options. The case studies presented in this workshop were constructed for illustrative purposes
based on inputs and models that were chosen to support these purposes, rather than their detailed resemblance
to actual economic environments or particular asset structures current or past. Any such resemblance is purely
coincidental. These case studies are expressly not a professional opinion on the economic viability or value of
any natural resource project discussed in this presentation.
Any other use of, or reliance on, this presentation by a third party is at that partys sole risk.
2007 michael.samis@amec.com
gdavis@mines.edu
laughton.david@davidlaughtonconsulting.ca
Presentation agenda
Valuation in the petroleum industry
Valuation influences: Uncertainty, structure and value estimation
A simple demonstration of DCF and RO value mechanics
Modelling output and input prices
Case study #1: Long-term cash flows at a SAGD project
Case study #2: Equity and government cash flows at a coal bed
methane project
Case study #3: Valuing a dual-fuel boiler at a SAGD project
Final comments
gdavis@mines.edu

methane project
Final comments
Economic assessment
Financial market and real asset disconnect
An economically viable project generates after-tax operating
profits sufficient to pay capital and financing costs and provide a
return compensating for the projects unique uncertainty profile.
Each project has its own uncertainty and risk characteristics that
should be recognized in an economic analysis.
There are many methods of assessing economic viability

including net present value, internal rate of return, payback
period, present value index, breakeven analysis etc.
Net present value (NPV) is the most robust method of
determining economic viability.
NPV is the value added to an organization by investing in the project
and represents the value of the project on an open market.
gdavis@mines.edu
Evolution of valuation
Financial market and real asset disconnect
Valuation methods for financial assets have experienced
monumental changes since the early 1970s
Introduction of derivative valuation methods, and new products
and markets (e.g. credit derivatives)
Valuation of real assets in the natural resource industries has not
experienced the same degree of change
Important advances have been made on the technical side but
valuation has only experienced incremental changes
gdavis@mines.edu
Financial markets and assets
Valuing uncertainty (risk adjustment)
Modeling uncertainty
and flexibility
At net cash-flow (DCF)
Dynamic
quantitative
At source (real options)
1990
Traded derivatives
of many types
Static
quantitative
1970
Qualitative Old style DCF
analysis
David Laughton (2004). Determining petroleum and mineral asset values. Where we have been, where we might go, CIM AGM, Edmonton.
gdavis@mines.edu
Natural resource industries
Modeling uncertainty
and flexibility
Valuing uncertainty (risk adjustment)

At net cash-flow (DCF)
Dynamic
quantitative
Static
quantitative
Qualitative
At source (real options)
Integrated DCF
Monte Carlo and
Simple DCF decision trees
decision trees
DCF
simulation
Monte Carlo with

true distributions
DCF simple
scenarios
Simple
scenarios
DCF
1-point
forecasts
Static cash flows

with true prices
David Laughton (2004). Determining petroleum and mineral asset values. Where we have been, where we might go, CIM AGM, Edmonton.
gdavis@mines.edu
Why question status quo valuation?

Six reasons
The low equity returns in the natural resource industries in the
1990s may in part be linked to poor investment and asset
management decisions
Return on equity improves when we become more productive
allocating and managing capital.
Current valuation methods often rely on professional intuition
(e.g. special project discount rates) or inconsistent reasoning to
assess risk and calculate value
We need a reasoned valuation approach to test intuitive
conclusions and highlight inconsistencies.
gdavis@mines.edu

Six reasons
Conventional DCF valuation methods need to be supplemented
with add-ons such as strategic value or value multiples or are
simply not used in certain valuation problems because they just
dont produce reasonable numbers
Earn-in options, exploration, royalties, certain capital
expansions, loss-making operations, staged investments, gold
mines, world class assets, leases, market capitalizations.
Renewed emphasis on professionally validated valuation models
and project assessments
Valuation codes (CIMVal) and financial market regulations
(NI43-101) will ultimately require valuation models that explicitly
recognize the influences of project uncertainty and structure on
project value.
gdavis@mines.edu
10

Six reasons
Two significant biases using current methods:
Against long-term production
Against investing in future cost reduction
Current methods do not support as well as possible high quality

discussions about:
Sources of value
The creation and management of future flexibility
gdavis@mines.edu
11

methane project
Final comments
Three value influences

Uncertainty, structure, and estimation
Project Uncertainty, Project Structure, and Value Estimation
Management flexibility
(expansion / closure)
Cash flow structure

(unit margin, non-linear CF, timing)
Characteristics
(distribution / resolution)
Project
uncertainty
Source or type
(economic / physical / other)
Project
structure
Stakeholders
(equity / debt / government)
Elements of
a valuation model
Valuing uncertainty
(aggregate: DCF / source: RO)
Value
estimation
Modeling uncertainty/flexibility
(scenarios / Monte Carlo / DT)
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13
Project uncertainty
Uncertainty resolution and updating
Commodity prices exhibit reversion to a long-term equilibrium
due to market forces - uncertainty growth slows with term.
120
120
120
WTIprice
price($/bbl)
($/bbl)
WTI
WTI
price
($/bbl)
100
100
100
80
80
80
60
60
60
40
40
40
Long-term expected price = US$50/bbl

Long-termexpected
expected price
price == US$50/bbl
US$50/bbl
Long-term
20
20
20
0
00
0
00
1
11
2
22
3
33
4
44
5
6
55
66
Project time (year)
Project time
time (year)
(year)
Project
7
77
8
88
9
99
10
10
10
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14
Project uncertainty
Uncertainty resolution and updating
Non-reverting processes are used for investment assets like
stocks and gold - uncertainty continues growing in the long-term.
1200
1100
Mineral price ($/unit)
1000
900
800
700
600
500
400
300
200
0
4
5
6
Project time (year)
10
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15
Project structure
Unit costs and operating leverage
Unit operating costs vary between petroleum projects which
produces different magnitudes of net cash flow uncertainty
Investors are risk averse and care about uncertainty.
Upside Pure WTI Play
Low-cost Oil Field
High-cost Oil Field
Outcome
Units=4; UC=$30/bbl
Units=8; UC=$45/bbl
Units=2
SWTI, U = $70
CFU = 2*$70
CFU = 4*($70$30)
CFU = 8*($70$45)
= $140
= $160
= $200
SWTI, Now=$60
Expected
E[CF] = 4*($60$30)
E[CF] = 8*($60$45)
E[CF]= 2*$60
outcome
= $120
= $120
$120
CFD = 2*$50
Downside
= $100
Outcome
SWTI, D = $50 SCu( ) = 17%
CFD
= 4*($50$30)
= $80
CF( ) = 33%
CFD = 8*($50$45)
= $40
CF( ) = 66%
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16
Project structure
Flexibility allows management to choose the operating policy
that maximizes value as uncertainty is resolved.
Project
Value
The dashed lines

indicate the prices
at which an action
is sub-optimal.
Develop satellite
field
Operate main
field
Shut-in field
Current mineral price

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17
Project structure
Flexibility allows management to limit downside losses and
magnify upside cash flows over the projects lifetime.
Net cash flow distribution for
project with no flexibility
Small cumulative
net cash flow
Expected net CF
with no flexibility
Net cash flow distribution for project with

upside and downside policy
alternatives.
Expected net CF
with flexibility
Large cumulative
net cash flow
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18
Project structure
Decision phase diagrams
Decision points determined by comparing

value resulting from different production
alternatives
Scatter plots show different optimal
choices (e.g. abandon vs. operate) for a
copper mine with some local costs given
different copper price / exchange rate
pairs at a particular time.
Use pattern of decision "phases" to
determine value and risk effects of
flexibility.
1.05
1.00
0.95
0.90
0.85
0.80
0.75
Green dot: Continue mining

Red dot: Early closure
0.70
1.10
Foreign exchange rate (Host/US$)
Monte Carlo simulation can be

combined with decision trees to analyze
the value and risk-mitigation effects of
flexibility.
Foreign exchange rate (Host/US$)
1.10
1.05
1.00
0.95
0.90
0.85
0.80
0.75
Blue dot: High capacity mining

Green dot: Low capacity mining
Red dot: Early closure
0.70
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19
Value estimation
DCF and RO are methods of calculating NPV
DCF: traditional discounted cash flow analysis.
RO: Real options, named in the 1980s when financial option
pricing techniques were applied to the valuation of real assets
(factories, mines, forests, oil fields).
The main emphasis of real options was modeling uncertainty and
valuing management flexibility, though here we are interested in its
implications for valuation with or without flexibility.
Both DCF and RO calculate Net Present Value.

Valuation analysts often speak of RO project value as being
something different to NPV it is not.
gdavis@mines.edu
20
Value estimation
Differentiating between DCF and RO
DCF
(risk adjust net cash flow)
Real options
(risk adjust at source)
Uncertainty
Risk adjustment
Project structure
Project net cash-flow
Risk-adjusted
discount rate
Time adjustment
Project value
gdavis@mines.edu
21
Value estimation
DCF uses an aggregate risk/time adjustment
Conventional static DCF applies an aggregate average risk and
time adjustment to net cash flows and ignores flexibility
.
S= oil price (only source
of uncertainty in this
example)
Aggregate risk and time
adjustment applied to the
net cash flow stream (i.e.
discounting with RADR
or WACC discount rate).
E S Oil Amount =Revenue

OpCost
Operating profit
CAPEX
Net cash flow
Time and risk adj.
Present Value net cash flow
Base alternative
gdavis@mines.edu
22
Value estimation
RO separates risk and time adjustments
Real options applies a risk adjustment to the source of
uncertainty and a time adjustment to net cash flow.
Risk adjustment applied
to expected oil price (i.e.
pure oil risk
discounting).
Time adjustment
applied here (i.e.
discounting at the
risk-free rate).
E S Risk adj.=
E RA S
Oil Amount
Risk adjusted revenue
OpCost
Risk adj. operating profit
CAPEX
Risk adjusted net cash flow
Time adj.
Present Value net cash flow
Base alternative
gdavis@mines.edu
23
Value estimation
Choosing between single-rate DCF and RO
The choice between single-rate DCF and RO valuation methods
is a matter of selecting the method that is best able to recognize
the unique risk characteristics of a particular project.
They both recognize uncertainty variation but differ on how to
calculate the compensation an investor requires for exposure to
project uncertainty (i.e. a risk-adjustment).
RO recognizes the dynamic risk variation within the project

environment while single-rate DCF does not.
RO applies an adjustment at source based on pure risk
characteristics and filters this through to the net cash flow stream.
DCF uses an aggregate risk adjustment representing the
interaction of all uncertainties and flexibilities. This is difficult to do.
gdavis@mines.edu
24
Consider the following

You are in an E&P organisation that has been operating
primarily in the Canadian western sedimentary basin, and are
part of a team looking at prospects off the west coast of Africa.
As part of the analysis, your colleagues suggest that, without
further study, you should approximate the well productivity in
any of these prospects to be the average (weighted by
production) of all the wells in which your corporation has an
interest.
Would you agree with this course of action?
gdavis@mines.edu
25

methane project
Final comments
A simple 1-period production asset

Asset cash-flow model
1 year from now
net cash-flow = output * output price - cost
High cost
Low cost
Asset information
Output
Cost
100
160
120
27
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27
A simple 1-period production asset

Corporate information
Output price forecast
2.00
Discount rate
0.20
Discount factor
0.833 = 1/(1+0.20)
28
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28
DCF analysis
High cost
Low cost
Forecast cash-flows
Revenue
Cost
Net
DCF value
200 =100*2.00
160
40 =200 -160
33.3=40*0.833
120
80 =200-120
66.7 =80*0.833
29
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29
Now add capital

now
net cash-flow = - capital cost
High cost
Low cost
15
50
18.3 = 33.3-15
16.7 = 66.7-50
Asset information
Capital cost
DCF value
30
gdavis@mines.edu
30
Valuing components of a linear cash-flow

If cash-flow is linear in underlying uncertain variables, e.g.
Cash-flow = A * output price + B
Value of the claim to the cash-flow can be determined by using
value additivity
Value = A * value of claim to output price
+ B * value of claim to a unit of risk-free cash-flow
31
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31
Forward pricing
Value =
A * value of claim to output price

+ B * value of claim to a unit of risk-free cash-flow
A * output forward price * time discount factor
+ B * time discount factor
= (A * output forward price + B) * time discount factor

Recall
Cash-flow = A * output price + B
32
gdavis@mines.edu
32
MBV valuation of the production asset

Market information
Forward output price
1.80
Cash bond price

(time discount factor)
Output bond value
0.95
1.71 =1.80 * 0.95
How can we value a claim to the cash-flow

output * output price - cost ?
33
gdavis@mines.edu
33
MBV valuation
High cost
Low cost
Market information
Output bond value
1.71 =1.80 * 0.95
Valuation
Revenue
Cost
Net
171 =100 * 1.71

152 =160*0.95
19 =171-152
114 =120*0.95
57 =171-114
34
gdavis@mines.edu
34
MBV discounting
High cost
Low cost
Forecast cash-flows
Revenue
200
Cost
160
Net
40 =200-160
120
80 =200-120
MBV value : Discount factor (value / forecast cash-flow)

Revenue
Cost
Net
171 : 0.855
152 : 0.95
19 : 0.475
114 : 0.95
57 : 0.7125
35
gdavis@mines.edu
35
MBV discounting (cont'd)

High cost
Low cost
Risk discount factor (discount factor / time discount factor)

Revenue
0.90
Cost
1.00
1.00
Net
0.50
0.75
Risk discount (1- risk discount factor)

revenue
0.10
Cost
0.00
0.00
Net
0.50
0.25
36
gdavis@mines.edu
36
Uncertainty and risk discounting

High cost
Low cost
Output price realisations
Price uncertainty
2.00 0.50
0.25 =0.50/2.00
What is the uncertainty in the net cash-flow?

How does the risk discount relate to the uncertainty?
37
gdavis@mines.edu
37

High cost
Low cost
Output price realisations
Price uncertainty
2.00 0.50
0.25 =0.50/2.00
Uncertainty (absolute : proportional)

Revenue
Net cash-flow
200 50 : 0.25
40 50 : 1.25
80 50 : 0.625
38
gdavis@mines.edu
38

High cost
Low cost
Risk discount and proportional uncertainty

Revenue
Net cash-flow
0.10 = 0.4*0.25
0.50=0.4*1.25
0.25=0.4*0.625
Price of output price risk = 0.4
39
gdavis@mines.edu
39
Forward price and price of risk

Forward price
= Expectation *
risk discount factor
= Expectation *
(1 - risk discount)
= Expectation *
(1 - price of risk * amount of uncertainty)
40
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Prices of risk
For the same level of uncertainty, the greater the price of risk,
the greater the risk discount
Price of risk measures how averse the marginal investor is to
bearing this particular type of uncertainty
Price of risk = 0 means no risk discounting
Typical of local, nonsystematic, diversifiable uncertainty
Price of risk negative means risk mark-up
Marginal investor want to bear this uncertainty

Usually hedges other uncertainties
41
gdavis@mines.edu
41
CAPM and prices of risk

CAPM is actually a model of prices of risk
Price of risk
= economy price of risk * correlation with economy
Annual economy price of risk is roughly 0.5
Annual prices of risk typically between -0.5 and 0.5
Empirical determination of price of risk equivalent to determination
of an equity beta risk premium in a WACC calculation
42
gdavis@mines.edu
42
Back to the example, add capital

now
net cash-flow = - capital cost
High cost
Low cost
Asset information
Capital cost
15
50
DCF value
18.3 = 33.3-15
16.7 = 66.7-50
MBV value
4.0 =19-15
7.0 = 57-50
43
gdavis@mines.edu
43
Insights
Different assets, different uncertainties, different risk discounting
Greater discountable uncertainty => greater risk discount
Effect of uncertainty on value governed by "prices of risk"
Risk discount = price of risk * amount of uncertainty
We can think systematically about prices of risk
Equivalent to WACC determination
Risk discounting still determined centrally
MBV, if anything, increases consistency and central control
44
gdavis@mines.edu
44

methane project
Final comments
Forward contracts
Gold forward curves
Gold Futures Contracts as of 1st Trading Day of Each Month, 2004
550.0
525.0
500.0
475.0
450.0
425.0
400.0
375.0
r-0
4
Ju
l-0
4
O
ct
-0
4
Ja
n05
Ap
r-0
5
Ju
l-0
5
O
ct
-0
5
Ja
n06
Ap
r-0
6
Ju
l-0
6
O
ct
-0
6
Ja
n07
Ap
r-0
7
Ju
l-0
7
O
ct
-0
7
Ja
n08
Ap
r-0
8
Ju
l-0
8
O
ct
-0
8
Ja
n09
Ap
r-0
9
Ju
l-0
9
O
ct
-0
9
Ap
Ja
n-
04
350.0
Delivery Date
gdavis@mines.edu
46
Forward contracts
Copper forward curves showing reversion
150.0
140.0
130.0
120.0
110.0
100.0
90.0
80.0
70.0
03
0
03 1
0
03 3
0
03 5
0
03 7
09
03
1
04 1
0
04 1
0
04 3
0
04 5
0
04 7
09
04
1
05 1
0
05 1
0
05 3
0
05 5
0
05 7
09
05
1
06 1
01
60.0
Forward Contract Expiry Date
gdavis@mines.edu
47
03/26/1998
04/26/1998
05/26/1998
gdavis@mines.edu
Forward Contract Expiry Date
06/26/1998
07/26/1998
08/26/1998
09/26/1998
10/26/1998
11/26/1998
12/26/1998
01/26/1999
02/26/1999
03/26/1999
04/26/1999
05/26/1999
06/26/1999
07/26/1999
08/26/1999
09/26/1999
10/26/1999
$4.00
02/26/1998
$3.50
01/26/1998
$3.00
12/26/1997
$2.50
11/26/1997
$2.00
10/26/1997
$1.50
$1.00
09/26/1997
Forward contracts
Natural gas forward curves
Gas Price, $/MCF
48
Oil prices
1970-2005 (real US$/bbl)
100
90
80
2006 US$/b
70
60
50
40
30
20
10
1970
1980
1990
2000
49
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49
Oil prices
Four periods of rising oil prices
1973-74
1979-81
1991
1998-now
Supply-side vs demand-side shocks

Permanent vs temporary changes
Long-term vs short-term uncertainty
Financial market information

Implications for price models
Most sustained
Reversed
Short-lived
???
50
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50
Oil prices
Financial market Information
Before the late 1980s

Equity prices
Predicted much lower prices than
the US$100/bbl by 1990 touted by analysts in 1980
Since then
Forward and futures markets
51
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51
Oil prices
Oil forward prices 1989-1991
O il F u t u r e s P r ic e s v s T im e
40
35
Oil Price, $/Bbl
30
25
20
15
10
0
1 9 8 8 .0 0
1 9 8 9 .0 0
1 9 9 0 .0 0
1 9 9 1 .0 0
1 9 9 2 .0 0
1 9 9 3 .0 0
1 9 9 4 .0 0
1 9 9 5 .0 0
1 9 9 6 .0 0
T im e
19890117
19890203
19890217
19890303
19890403
19890417
19890503
19890517
19890717
19890803
19890817
19891003
19891017
19891103
19891117
19900103
19900117
19900403
19900417
19900503
19900517
19900703
19900717
19900803
19900817
19900917
19901003
19901017
19901203
19901217
19910103
19910117
19910403
19910417
19910503
19910517
19910603
19910617
19910703
19910717
19910903
19910917
19911003
19911017
19911203
19911217
52
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Oil prices
Oil forward prices 2002-2005
O il F u tu r e s P r ic e s v s T im e
60
Oil Price, $/Bbl
50
40
30
20
10
0
2000
20020103
20020717
20030303
20030917
20040303
20040917
2002
20020117
20020903
20030317
20031003
20040317
20041103
2004
20020403
20021003
20030403
20031017
20040503
20041117
2006
20020417
20021017
20030417
20031103
20040517
20041203
2008
20020503
20021203
20030603
20031117
20040603
20041217
2010
20020517
20021217
20030617
20031203
20040617
20050103
2012
20020603
20030103
20030703
20031217
20040803
2014
20020617
20030117
20030717
20040203
20040817
20020703
20030203
20030903
20040217
20040903
53
gdavis@mines.edu
53
Oil prices
Models
Price = long term factor * short term factor
Long term factor was fairly stable 1983-2002

Band of US$14-US$26 per bbl
Now long-term factor increased and more uncertain

-> Long-term flexibility more valuable
54
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Oil prices
NYMEX oil forward prices on 27 May 2007
120
110
100
90
80
70
60
50
40
30
20
10
0
0
10
Time horizon (years)

Expected price
Forward price
90% lower boundary
Median price
90% upper boundary
Nymex price deflated
55
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55
Input prices
Deepwater rig day rate index vs WTI oil
Deepwater Rig Day Rate Index vs WTI Oil $/Bbl
$70.00
500
Rig index from ODS-PETRODATA
DW Rig Rate Index
$60.00
Oil $/Bbl
$50.00
350
1994 = 100
DWDay Rate Index
400
300
$40.00
250
$30.00
200
150
$20.00
100
WTI $/Bbl Avg for Month
450
$10.00
50
0
$0.00
Jul-01
Jan-02
Jul-02
Jan-03
Jul-03
Jan-04
Jul-04
Jan-05
Jul-05
56
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56
Input prices
Cost index modelling
Rent effects
Cost index
= 1 + a (Price - Current Price) / Current Price
Quasi-rent effects
Cost index
= 1 + b (price change-expected price change)
57
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57
Input prices
A rough cut at the Alberta SAGD cost index
58
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58

methane project
Final comments
Case study #1:

Alberta oil sands with no flexibility
Steam-assisted gravity drainage (SAGD) project
Steam forced
underground
Bitumen
pumped
to surface
Overburden 150m
1. Steam exits injector well
and forms a steam chamber
in the upper formation.
Upper steam injector well
2. Bitumen and condensed

water flow by gravity to
lower producer well for
pumping to surface
Lower producer well

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60
Case study #1:

Project background
Project background:
2 billion barrels of recoverable reserves at a maximum production rate of
190 thousand b/d (70.6 million b/y).
Production increased in phases for a mine life of 35 years.
50% of operating costs are from natural gas.
Two design options:

No on-site upgrader (third party refinery).
Development and sustaining CAPEX: CAD$7.6b; US$24/bbl refining
penalty; Net CF: CAD$410m/yr.
Build on-site upgrader / refinery CAPEX.
Development and sustaining CAPEX: CAD$15.6b; No refining
penalty; Net CF: CAD$775m/yr.
A non-linear royalty and CIT tax regime.

gdavis@mines.edu
61
Case study #1:

Sources of uncertainty
WTI / synthetic crude oil price
Moderate levels of uncertainty (25%) with strong reversion to a
long-term equilibrium price of US$50.00/bbl.
Natural gas price

High levels of uncertainty (50%) with strong reversion to a longterm equilibrium price of CAD$6.00 mmbtu.
Light-heavy differential (heavy oil refining penalty)

High levels of uncertainty (50%) with strong reversion to a longterm equilibrium price of US$24.00/bbl.
Low level of systematic uncertainty.
Correlations between uncertainties:

WTI - NatGas: 0.7; WTI - LHDiff: 0.7; NatGas - LHDiff: 0.5
gdavis@mines.edu
62
Case study #1:

WTI / Synthetic crude oil price
90
80
WTI price (US$/bbl)
70
60
50
40
30
20
10
0
0
10
12
14
16
18
20
22
24
26
28
30
32
34
36
38
Project time (years)

Expected WTI price
Upper confidence bdy
Risk-adjusted WTI price

Lower confidence bdy
gdavis@mines.edu
63
Case study #1:

Natural gas price
Natural gas price (CAD$/mmcf)
12
10
8
6
4
2
0
0
10
12
14
16
18
20
22
24
26
28
30
32
34
36
38

Expected NatGas price
Forward NatGas price

gdavis@mines.edu
64
Case study #1:

Light-heavy differential (refining penalty)
Light-heavy differential (US$/bbl)
45
40
35
30
25
20
15
10
5
0
0
10
12
14
16
18
20
22
24
26
28
30
32
34
36
38

Expected light-heavy differential
Risk-adjusted light-heavy differential

gdavis@mines.edu
65
Case study #1:

Monte Carlo DCF and RO valuation results
Cumulative net cash flow
SAGD:
CAD$ 7201m
SAGD+Upgrader: CAD$ 12309m
Discounted cash flow and

real options make conflicting
Time-adj. cumulative net cash flow
SAGD:
CAD$ 3450m
design recommendations.
Discounted cash flow

DCF net present value
SAGD:
CAD$ 277m
SAGD+Upgrader: CAD$ -697m
Real options
RO net present value
SAGD:
CAD$ 1104m
DCF risk-adj. value reduction

SAGD:
CAD$3173m
SAGD+Upgrader: CAD$5789m
RO risk-adj. value reduction

SAGD:
CAD$ 2346m
gdavis@mines.edu
66
Case study #1:

Project total unit operating costs
Effective unit operating costs (CAD$/bbl)
80
70
60
50
40
30
Development
horizon
20
10
0
0
10
15
20
25
30
35
40
Project time
SAGD
SAGD + Upgrader
Expected WTI (CDN$)

gdavis@mines.edu
67
Case Study #1
CF deviations, NCFDFs, and NCFRDFs
Cash flow deviations indicate average cash flow variability.
CF Deviationt, i =
Standard deviation (Stakeholder CFt)
Expected
CFt
Net cash flow risk discount factors (NCFRDFs) indicate the size
of the risk adjustment applied to a cash flow.
Present value of cash flow t
NCFDF t =
Expected cash flow t
Present value of cash flow t
NCFRDFt =
Expected cash flow t Time discount factort
NCFDFs and NCFRDFs profile should change with variations in
cash flow uncertainty since both adjustments applied to the project
cash flows reflect investor sensitivity to uncertainty.
gdavis@mines.edu
68
Case study #1:

Equity coefficient of variation
120%
Development
horizon
Coefficient of variation (%)
100%
80%
60%
40%
20%
0%
0
10
15
20
25
30
35
40
Project time
SAGD
SAGD + Upgrader
gdavis@mines.edu
69
Case study #1:

Expected CF and CF boundaries
3000
Development
horizon
Net cash flow (CAD$ million)
2500
2000
1500
1000
500
0
0
10
-500
15
20
25
30
35
40
Project time (year)

SAGD E[CF]
SAGD+Upgrader E[CF]
SAGD 90% CB
SAGD+Upgrader 90% CB
SAGD 10% CB
SAGD+Upgrader 10% CB
gdavis@mines.edu
70
Case study #1:

Net CF time and risk discount factors
Net cash flow discount factor
1.2
1.0
0.8
0.6
0.4
Developmen
t
horizon
0.2
0.0
0
10
15
20
25
30
35
40
Project time
DCF (SAGD & SAGD+Upgrader)
RO SAGD
RO SAGD + Upgrader
gdavis@mines.edu
71
Case study #1:

Net CF risk discount factors
Net cash flow risk discount factor
1.2
1.0
0.8
0.6
Note that the horizontal structure of the RO

NCF-RDF is consistent with reversion in oil
and natural gas prices.
0.4
Developmen
t
horizon
0.2
0.0
0
10
15
20
25
30
35
40
Project time
DCF (SAGD & SAGD+Upgrader)
RO SAGD
RO SAGD + Upgrader
gdavis@mines.edu
72
Case study #1
SAGD project conclusions
Interaction of project design and uncertainty has important value
effects especially in the long-term.
Conventional DCF assumes project uncertainty grows at a fixed
rate; RO recognizes project uncertainty is non-linear.
Project cash flow risk is dependent upon design (sometimes in
surprising ways). RO respects this while a constant DCF discount
rate does not.
Real option analysis helps focus valuation analysts on explicit

recognition of project characteristics.
Avoids hiding features in DCF discount rates and circular debates
about discount rates (10% or 12%).
Facilitates a detailed discussion about the interaction between the
economic environment and the project.
gdavis@mines.edu
73
Case study #1
SAGD project conclusions
A key parameter in this analysis may be the correlation of the
LHDiff with the economy, which determines the amount of risk
discounting in its forward prices
Assumed low here: based on presumption that it is determined
by Venezuelan politics
What if Venezuelan political risk is correlated with the economy
or if differential is strongly influenced by supply-demand balance
of different types of refining capacity which is in turn driven by
the economy?
MBV highlights the importance of asking these sorts of
questions and doing sensitivity analysis around them
gdavis@mines.edu
74

methane project
Final comments
Case Study #2
Coalbed methane project
Development CPX of CAD$190m.
7.0
6.0
5.0
4.0
3.0
2.0
1.0
0.0
0
10
15
Project time (year)
20
25
30
Methane production
Real CAD$/ mcf
Stable long-term unit costs and

profit margins.
Average real unit production cost
is CAD$3.64/mmcf (includes tax
and royalties).
Average profit margin is 43%
10.00
100%
8.00
80%
6.00
60%
4.00
40%
2.00
20%
0.00
Profit margin (%)
Strong initial production rates

declining over the next 30 yrs.
8.0
Methane production (million mcf)
An undeveloped coalbed methane

project containing 104 million
mmcf of methane.
9.0
0%
0
10
15
20
Project time (year)
Expected unit revenue

Expected unit operating profit
25
30
Expected unit operating cost

Expected profit margin
gdavis@mines.edu
76
Case study #2
Natural gas price model
Reverting natural gas price model with a real long-term expected
price of CAD$6.43/mmcf. High levels of volatility with riskadjustment because of correlation to financial market activity.
Natural gasprice (CAD$/mmcf)
12
10
8
6
4
2
0
0
10
15
20
25
30

Expected NatGas price
Risk-adjusted NatGas price

gdavis@mines.edu
77
Case study #2
Project tax regime
A royalty payment dependent on whether pre-production capital
has been repaid. Royalty base may be adjusted for field
operating costs.
1% royalty rate during capital repayment period.
25% royalty rate after capital repayment period.
Corporate income tax rate of 35% on taxable income.

Tax losses may be carried forward 7 years.
Declining balance depreciation with accelerated schedules for preproduction capital (Class 41a).
gdavis@mines.edu
78
Case study #2
Expected after-tax equity cash flows
Expected equity net cash flow (not adjusted for time and risk) over the
life of the project is $477 million.
Probability of a negative lifetime net cash flow balance is small using
the current price model.
Lower 10% confidence boundary is $398 million.
Real cash flow (CAD$ million)
100
80
60
40
20
0
0
10
15
20
25
30
Project time (year)

Expected equity after-tax cash flow
10% confidence bdy
90% confidence bdy
gdavis@mines.edu
79
Case study #2
Expected royalty cash flows
Expected royalty cash flows (not adjusted for time and risk) over the
life of the project are $136 million.
There is no possibility of a negative lifetime cash flow balance and the
lower 10% confidence boundary is $97 million.
Narrow histogram when there is no management flexibility.
Real cash flow (CAD$ million)
20
15
10
0
0
10
15
20
25
30
Project time (year)

Expected royalty cash flow
10% confidence bdy
90% confidence bdy
gdavis@mines.edu
80
Case study #2
Expected corporate income tax cash flows
Expected corporate income tax cash flows (not adjusted for time and
risk) over the life of the project are $142 million.
There is no possibility of a negative lifetime cash flow balance; the
lower 10% CB is $99 million and the upper 90% CB is $189 million.
Real cash flow ($ million)
20
15
10
0
0
10
15
20
25
30
Project time (year)

Expected CIT cash flow
10% confidence bdy
90% confidence bdy
gdavis@mines.edu
81
Case study #2
Cash flow uncertainty comparison
300%
Coefficient of variation
250%
200%
150%
100%
50%
0%
0
5
Equity
10
15
Project time (year)
Royalty
20
25
30
Corporate income tax

gdavis@mines.edu
82
Case study #2
DCF/RO NOFLEX results
Stakeholder
NPV (CAD$ million)
Equity
Royalty
DCF
73.2
44.5
RO
154.0
75.6
Corporate income tax
45.1
76.9
DCF NPV is calculated with a 12% risk adjusted discount rate.

RO NPV is calculated with a 5% risk-free rate and a riskadjusted price curve.
Equity IRR is 24.3%. Implied RO cost of capital is 6.6% which
is the DCF discount rate that equates DCF NPV to RO NPV.
Excess RO return is 17.7%.
gdavis@mines.edu
83
Case Study #2
Equity CF deviation, NCFDF and NCFRDF
1.0
80%
0.8
80%
0.8
60%
0.6
60%
0.6
40%
0.4
40%
0.4
20%
0.2
20%
0.2
0%
0.0
0
5
Equity CF CoV
10
15
20
Project time (year)
DCF NCFDF
25
RO NCFDF
30
Cash flow CoV (%)
100%
1.0
Cash flow CoV (%)
100%
0%
Net cash flow RISK discount factor
Cash flow uncertainty stabilizes in the long term due to price

reversion and constant real unit operating costs.
RO risk adjustments track cash flow variability.
DCF NPV lower than RO because NCFDFs are on average smaller
(i.e. a larger risk adjustment than RO).
0.0
0
5
Equity CF CoV
10
15
20
Project time (year)
DCF NCFRDF
25
30
RO NCFRDF
gdavis@mines.edu
84
Case Study #2
Royalty CF deviation, NCFDF and NCFRDF
1.0
80%
0.8
80%
0.8
60%
0.6
60%
0.6
40%
0.4
40%
0.4
20%
0.2
20%
0.2
0%
0.0
0
5
Royalty CF CoV
10
15
20
Project time (year)
DCF NCFDF
25
RO NCFDF
30
Cash flow CoV (%)
100%
1.0
Cash flow CoV (%)
100%
0%
Royalty CF uncertainty is initially very high because of uncertainty in

capital repayment period and stabilizes once this period is finished.
Real option risk adjustments are initially high compared to later years
because of high initial royalty uncertainty.
0.0
0
5
Royalty CF CoV
10
15
20
Project time (year)
DCF NCFRDF
25
30
RO NCFRDF
gdavis@mines.edu
85
Case Study #2
CIT CF deviation, NCFDF and NCFRDF
1.0
80%
0.8
80%
0.8
60%
0.6
60%
0.6
40%
0.4
40%
0.4
20%
0.2
20%
0.2
0%
0.0
0
10
15
20
Project time (year)
Corporate income tax CF CoV
DCF NCFDF
25
30
RO NCFDF
Cash flow CoV (%)
100%
1.0
Cash flow CoV (%)
100%
0%
High volatility of CIT in early years due to uncertainty in the time

necessary to depreciate development capital.
RO risk adjustments recognize changes in CIT uncertainty.
0.0
0
10
Corporate income tax CF CoV
15
20
Project time (year)
DCF NCFRDF
25
30
RO NCFRDF
gdavis@mines.edu
86
Case Study #2
Final comments
Highlighted that the level of cash flow uncertainty can vary
greatly between project stakeholders and during the project.
RO was able to explicitly recognize this variation in its risk
adjustment whereas constant discount rate DCF does not.
This analysis can be extended to analyze the impact of

financing terms or tax policy on project development.
Flexible models can estimate the increased probability that some
areas of a petroleum project are not developed because of onerous
terms.
gdavis@mines.edu
87

methane project
Final comments
Case study #3:

Dual-fuel boiler SAGD with fuel switching
Similar SAGD project to that in Case Study #1:
2 billion barrels of recoverable reserves at a maximum production rate of
190 thousand bbl/d (70.6 million bbl/y).
Production increased in phases for a field life of 38 years.
Transport cost: $3.00/bbl
Two design options:

gas-fired boiler
CAPEX ($b)
Nat. gas(mcf/bbl)
Bitumen (bbl/bbl)
Other OPEX ($/bbl)
8.2
1.1
5.50
dual-fuel boiler
gas-fired
bitumen-fired
9.2
1.1
0.033
0.179
6.00
8.00
Annual decision with no switch cost
gdavis@mines.edu
89
Case study #3:

Production profile
gdavis@mines.edu
90
Case study #3:

CAPEX profile
"
"
gdavis@mines.edu
91
Case study #3:

Sources of uncertainty
Moderate levels of uncertainty (25%) with strong reversion to a
long-term equilibrium price of $55.54/bbl; current $75.00/bbl
Natural gas price

High levels of uncertainty (50%) with strong reversion to a longterm equilibrium price of $7.00/mcf; current $7.50/mcf
WTI-bitumen differential
High levels of uncertainty (50%) with strong reversion to a longterm equilibrium price of $26.66/bbl; ; current $39.00/bbl
Correlations between uncertainties:

WTI - NatGas: 0.7; WTI - LHDiff: 0.7; NatGas - LHDiff: 0.5
gdavis@mines.edu
92
Case study #3:

WTI model
%&'
(# )
'
'
'
gdavis@mines.edu
93
Case study #3:

WTI-bitumen differential model
%&'
(# )
'
'
'
gdavis@mines.edu
94
Case study #3:

Natural gas price model
%&'
(# )
'
'
'
gdavis@mines.edu
95
Case study #3:

Taxes
Royalty
Pre-payout : 1% of plant gate revenue
Post-payout: max (pre_payout royalty, 25% of cash-flow)
Losses carried forward at long Canada bond rate
CIT
28.5% rate
30% declining balance on lagged sustaining capital
25% declining balance on half-year lagged development capital
41a: 100% declining balance up to accounting income limit
Large other income so losses claimed immediately
gdavis@mines.edu
96
Case study #3:

Effects of uncertainty
Uncertainty relevant only because of "non-linear cash-flows"
Taxes
Flexibility
Analysis without uncertainty

Analysis with varying level of correlation
between bitumen and natural gas prices
Stong, weak, none
Lower correlation, more uncertainty in net
Value without flexibility down with uncertainty in net

Value of flexibility up with uncertainty in the effects of the choice
gdavis@mines.edu
97
Case study #3:

Computation: DCF
value of asset
= max over policies p
(sum over realisations r
(probabilityr
* sum over times t
(asset net cashflow t (p,r)
* corporate risk discount factor t
* time discount factor t)))
gdavis@mines.edu
98
Case study #3:

Computation: RO
Value of asset
= max over policies p
(sum over realisations r
(probabilityr
* sum over times t
(asset net cashflow t (p,r)
* realisation risk adjustment r,t
* time discount factor t)))
Same except uniform risk-discounting
becomes realisation-dependent risk adjustment
gdavis@mines.edu
99
Case study #3:

Policy search
Depends on state variables:
Prices
Tax balances
Current operating state (if costs to switching)
Generally done within valuation

Here an approximation pre-specifies policy that maximises
current operating cash-flow
Pretax capital costs independent of operating mode
Not quite optimal because of operating effects on royalty payout
and 41a claim
Underestimates value of flexibility
gdavis@mines.edu
100
Case study #3:

Policy
* +
-./ #) #
gdavis@mines.edu
101
Case study #3:

Values
DCF
gas
dual gas
dual bit
dual choice
RO
gas
dual gas
dual bit
dual choice
no uncert. strong corr. weak corr. no corr.

884
409
630
630
543
13
211
383
536
6
211
426
529
-2
211
462
3473
2693
3249
3249
2991
2135
2710
3217
2969
2112
2710
3328
2944
2086
2709
3422
gdavis@mines.edu
102
Case study #3:

No 41a
DCF
gas
dual gas
dual bit
dual choice
RO
gas
dual gas
dual bit
dual choice
no unc
strong corr
weak corr
no corr
812
359
571
571
471
-50
148
314
464
-59
148
355
456
-69
148
390
3431
2661
3214
3214
2943
2092
2667
3171
2920
2067
2667
3280
2896
2040
2667
3373
gdavis@mines.edu
103

methane project
Final comments
Final comments
Asset valuation methods in the natural resource industries have
not incorporated advances in the financial markets
There is some agreement on improving the analysis of effects of
dynamic uncertainty with Monte Carlo simulation and decisiontrees
There is not yet an agreement in the industry on whether
aggregate risk adjustments (DCF) or source risk adjustments
(RO) are better
Demonstrated that RO recognizes variations in net cash flow
uncertainty across assets while the conventional DCF approach
does not
This has important implications for qualified person reports, and
the internal analysis of assets with with atypical uncertainties.
gdavis@mines.edu
105
Final comments
The ability to manage risk with operating strategies (flexibility)
adds value
This is true for both DCF and MBV
Tools are being developed to anlyses complex situations with
many incertainties and decisions throughout the asset life cycle
Work needed on
Refining output price models
Modelling of input price and technical/geological uncertainty
Decision models
Methods of presenting multi-dimensional results
Creation of commercial-grade software
gdavis@mines.edu
106

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An Overview of Using Dynamic

Discounted Cash Flow and Real Options

Michael Samis, Ph.D., P.Eng.

Valuation in the petroleum industry

There are many methods of assessing economic viability

At net cash-flow (DCF)

At source (real options)

Valuing uncertainty (risk adjustment)

At source (real options)

Monte Carlo with

Static cash flows

Why question status quo valuation?

Why question status quo valuation?

Why question status quo valuation?

Current methods do not support as well as possible high quality

Valuation in the petroleum industry

Three value influences

Cash flow structure

Long-term expected price = US$50/bbl

Mineral price ($/unit)

The dashed lines

Current mineral price

Net cash flow distribution for project with

Decision points determined by comparing

Green dot: Continue mining

Monte Carlo simulation can be

Foreign exchange rate (Host/US$)

Blue dot: High capacity mining

Both DCF and RO calculate Net Present Value.

E S Oil Amount =Revenue

RO recognizes the dynamic risk variation within the project

Consider the following

Valuation in the petroleum industry

A simple 1-period production asset

A simple 1-period production asset

Now add capital

Valuing components of a linear cash-flow

A * value of claim to output price

= (A * output forward price + B) * time discount factor

MBV valuation of the production asset

Cash bond price

How can we value a claim to the cash-flow

1.71 =1.80 * 0.95

171 =100 * 1.71

MBV value : Discount factor (value / forecast cash-flow)

MBV discounting (cont'd)

Risk discount factor (discount factor / time discount factor)

Risk discount (1- risk discount factor)

Uncertainty and risk discounting

What is the uncertainty in the net cash-flow?

Uncertainty and risk discounting

Uncertainty (absolute : proportional)

Uncertainty and risk discounting

Risk discount and proportional uncertainty

Price of output price risk = 0.4

Forward price and price of risk

Typical of local, nonsystematic, diversifiable uncertainty

Price of risk negative means risk mark-up

Marginal investor want to bear this uncertainty

CAPM and prices of risk

Back to the example, add capital

Valuation in the petroleum industry