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Economic Indicators
A number of economic indicators were
derived from the annual net cashflow;
the most useful being the economic life of
the project, determined when the annual
net cashflow becomes permanently
negative.

The cumulative net cashflow was used to

derive ultimate cash surplus - the final value
of the cumulative net cashflow;
maximum exposure the maximum value
of the cash deficit;
payback time - the time until cumulative net
cashflow becomes positive.
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The shortcoming of the maximum

exposure and payout time is that they say
nothing about what happens after the net
cashflow becomes positive (i.e. when the
investment is recouped).
Neither do they give information about the
return on the investment in terms of a ratio,
which is useful in comparing projects.

We have discussed the derivation and

importance of NPV, often considered as the
most important indicator in the upstream
business.
It is appealing in its simplicity but is one-
dimensional in that it does not test
efficiency of investing a constrained amount
of capital.
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A common ratio which indicates the

efficiency with which the project creates
profit is the Profit to Investment Ratio

PIR = Cumulative net cashflow

Total capital expenditure

This may be more useful if the net cashflow

items are discounted, for example

PIR = 10% NPV

10% PV CAPEX

where 10% is the assumed cost of capital.

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This indicator is particularly useful where

investment capital is a main constraint.
It is a measure of capital efficiency,
sometimes referred to as NPV/NPC (net
present cost), or the PV ratio.

UTC
Per barrel costs (costs per barrel of
development and production), also referred
to as unit costs, unit technical costs or
development and lifting costs, are useful
when production throughput or export
production levels are the constraint on a
project, or when making technical
comparisons between projects in the same
geographical area.
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Per Barrel Cost = CAPEX + OPEX ($/bbl)

Production

It is often more useful to use the

discounted values, to allow for the time
effect of money.
Hence

Per bbl PV cost = PV CAPEX + PV OPEX ($/bbl)

PV Production
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Within the same geographical area (e.g.

water depth, weather conditions, distance
to shore, reservoir setting) this is a useful
tool for comparing projects to check that
the appropriate development concept is
being applied.
If the indicators vary significantly then the
reasons should be sought.

Unit costs vary dramatically by region - in

the order of $10-20/bbl in the North Sea,
deep water GoM, Russia, North Slope of
Alaska, but just $2-5/bbl in the Middle East.
This is a reflection of the location, climate
and reservoir productivity.
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In the case of a country whose output is

constrained, perhaps by a pipeline capacity
but more commonly by an OPEC
production quota, it makes sense to
minimise per barrel PV cost to produce the
quota level as cheaply as possible.
While this can lead to some inefficiency in
development planning, the initial
attractiveness of this simple approach is
appealing.

In conclusion, Table 14.7 compares the

aspects of the project highlighted by the
economic indicators discussed so far.
It demonstrates that no single indicator can
paint a complete picture of the
attractiveness of the project, and therefore
a combination of these indicators is
normally used to make an investment
decision.
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Which indicator is of prime importance

depends on the situation of the investor.
With no limitations, NPV would probably
be the primary indicator. In a capital
constrained environment the PIR would be
very important, and if cashflow was a
critical issue then payback or IRR would be
looked at keenly.

Table 14.7 Profitability indicators

Indicator Unit Value Efficiency Risk Timing
Economic life Year X X
Maximum exposure $ X X X
Payback time Year X
Cumulative net cashflow $ X X X
PIR (NPV/NPC) % X X
Unit technical cost (UTC) $/bbbl X X
NPV $ X X X
IRR % X X
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14.5. Project Screening and Rating

14.5. Project Screening and Rating

Project screening involves checking that the
predicted economic performance of a
project passes a prescribed threshold or
hurdle.
It is used to quickly sift out interesting
projects from non-starters
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Investors commonly use IRR as a screening

criterion by testing the project IRR against a
minimum hurdle rate, for example, 20% IRR
at $30/bbl.
Providing that the project IRR exceeds the
hurdle rate, then the project is considered
further, otherwise it is rejected in its
current form.

Figure 4.12 Project ranking using the PV profile.

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With unlimited resources, the investor

would take on all projects which meet the
screening criteria.
Project ranking is necessary to optimise the
business when the investors resources are
limited and there are two or more projects
(which both pass the screening criterion) to
choose between.

The PV Profile can be used to select the

more attractive proposal at the appropriate
discount rate if the primary indicator is
NPV
Figure 14.12 illustrates that the outcome of
the decision may change as the discount
rate changes.
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At discount rates less than 18%, Proposal 1

is more favourable in terms of NPV,
whereas at discount rates above 18%,
Proposal 2 is more attractive.
NPV is being used here as a ranking tool for
the projects.
At a typical cost of capital of say, 10%,,
Proposal 1 generates the higher NPV,
despite having the lower IRR.

The typical procedure would be to screen

the projects on offer against the hurdle IRR,
say 20%.
In the above example, both projects pass
the rest.
The next step is to rank the projects on the
basis of NPV at the cost of capital.
This would then rank Project 1 higher.
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Choosing between projects on the basis of

IRR alone risks rejecting higher value
projects with a more modest, yet still
acceptable rate of return.
Again, the comparison of project indicators
(Table 14,7) must be kept in mind one
needs to be aware of what criteria are
important to the company at the time.
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14.6. Sensitivity Analysis

The technical, fiscal and economic data
gathered to construct a project cashflow
carry uncertainty.
An economic base case is constructed
using, for example, the most likely values of
production profile and the 50/50 cost
estimates, along with the 'best estimate' of
future oil prices and the anticipated
production agreement and fiscal system.

In order to test the economic performance

of the project to variations in the base case
input data, a sensitivity analysis is
performed.
This indicates how robust the project is to
variations in one or more parameters, and
also highlights which of the inputs the
project economics is more sensitive to.
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These inputs can then be addressed more

specifically.
For example, if the project economics is
highly sensitive to a delay in first
production, then the scheduling should be
more critically reviewed.

Changing just one of the individual input

parameters at a time gives a clearer
indication of the impact of each parameter
on NPV (the typical indicators under
investigation), although in practice there will
probably be a combination of changes.
The combined effect of varying individual
parameters is usually closely estimated by
adding the individual effects on project NPV.
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Typical parameters which may be varied in

the sensitivity analysis are
Technical parameters
CAPEX
OPEX (fixed and/or variable)
reserves and production forecast
delay in first production.

Economic parameters
timing of fiscal allowances (e.g. ring fencing)
discount rate
oil price
inflation (general and specific items).
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If the fiscal system is negotiable, then

sensitivities of the project to these inputs
would be appropriate in preparation for
discussions with the host government.
When the sensitivities are performed the
economic indicator which is commonly
presented is NPV at the discount rate
which represents the cost of capital say
10%, this being considered as the true value
of the project.

The results of the sensitivity analysis may be

represented in tabular form, but useful
graphical representation is a plot of the
change in NPV(10) against percentage
change in the parameter being varied, as
shown in Figure 14.13 sometimes called a
spider diagram.
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The plot immediately shows which of the

parameters the 10% NPV is most sensitive
to - the one with the steepest slope.
Consequently the variables can be ranked in
order of their relative impact.

Figure 14.13 Sensitivity diagram for

l0% NPV
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It is useful to truncate the lines at the

extreme values which are considered likely
to occur, for example oil price may be
considered to vary between -40% and
+20%, of the base case consumption.
This presentation adds further value to the
plot.