PETROLEUM

ECONOMICS
Sunday Isehunwa (Ph. D)
SPECIAL FEATURES OF
MINERAL ECONOMICS
Minerals are found only in certain favoured
places. There is no question of locating a mine
anywhere else except where it is found in
commercial quantities.
The minerals are exhaustible
The minerals are found in places where they may
not be needed and used.
SPECIAL FEATURES OF
MINERAL ECONOMICS
There is always a very large excess capacity
built into the system. Therefore the normal
laws of supply and demand, marginal costs,
etc are not often readily applicable in the
case of minerals.
Very long term forecasts have to be made
SPECIAL FEATURES OF
MINERAL ECONOMICS
Mineral economics is bound up with politics very
intimately.
Mineral industries are extremely well organized in
the hands of a small number of integrated firms
who have considerable power in regulating
supply, demand and prices. Thus normal
economic mechanisms are simply not operative
under these conditions in their classical forms.
ECONOMIC CHALLENGES
Petroleum getting more difficult to find
Smaller fields
Aging facilities and staff
Harsher terrains of discovery
Environmental challenge
Unstable prices
Community issues (in developing countries)
Technology and higher business costs
Depleting reserves
ECONOMIC CHALLENGES
Companies have tried to meet these
challenges through:
Cost reduction measures
Staff rationalization
Vertical integration
Strategic business units
Portfolio diversification
Other measures
OIL AND GAS PRICES
There are 5 factors that determine the price of
crude oil:
Market (Supply and Demand)
Reliability (Production rate)
Location (Transportation)
Quality (Refining cost and Yield)
Availability (Reserves)
Oil Pricing Model
Oil Price /bbl
= Base Price/bbl + A (API) - B (% S)
Base price = current price for 0 API oil
A= Scale factor for API gravity
B = Markdown Factor for presence of sulphur
Marker Crudes
A marker crude is an oil from a specified
field or region which is traded in spot
markets and considered a standard
Characteristics of Marker Crudes
Perceived to represent fair value
Traded in liquid and transparent markets
Wide range of buyers and sellers
Supply is freely tradable
Adequate reserves
Production is strategically situated
Politically acceptable to producers and end users
Spot price is widely reported
Reasonably immune to manipulation
CRUDE OIL MARKETS
There are 2 basic types of markets in crude oil:
The Wet or cash Market, and
Futures market where trades are made through a
formal commodities exchange for some specified
future delivery date.
CRUDE OIL MARKETS
The bulk of the worlds crude oil traded
internationally never reaches an open market in
the literal sense.
They are handled within the integrated operations
of the majors and in direct deals or contarct
arrangements between producers and consuming
governments as well as other players.
THE SPOT MARKET
Little happens in the industry without the Spot
Market, particularly the Rotterdam spot market.
The spot Market refers to one-off or spot sales of
crude oil in tanker loads. This is usually crude oil
that is surplus to the requirements of direct
purchasers. Companies that are short of crude also
resort to the spot market to make up the balance.
THE SPOT MARKET
However, price movements in the spot market do
not necessarily reflect real market conditions as
can fluctuate widely and involve relatively small
amounts of crude oil on a global scale.
During surplus, spot prices tend to fall below
official prices, while they can rise steeply during
peiods of shortages.
THE SPOT MARKET
Major Players
The major international oil companies
Traders
Brokers
Independent oil companies
NET BACK PRICING
In a netback transaction, crude oil is sold on
the basis of the price that the buyers expect
to receive for his final products, rather than
the price set by the producer at the time of
sale.
COMPONENTS OF NETBACK
DEALS
Refinery Yields
Products Prices
Timing
Transportation
Other fees and Profit Margin
MAJOR INTERNATIONAL
PETROLEUM COMMODITY
MARKETS
NYMEX (New York Mercantile Exchange)
IPE (International Petroleum Exchange
London)
SIMEX (Singapore Mercantile Exchange)
PETROLEUM PROJECT
ECONOMICS
In any decision making process, one must
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
occur over a period of time.
TASKS IN PETROLEUM PROJECT
ECONOMIC ANALYSIS
Setting an economic objective based on
corporate economic criteria
Formulate scenario for the projects
Collecting all relevant Technical and
economic data
Making Economic calculations
Making Risk Analysis
Selection of optimum development plan
COST ESTIMATING AND
ECONOMIC EVALUATION
Predicting future operating costs
Economic limits of producing wells (or plants in
downstream projects)
Field life (or project life)
Failure Analysis
Price-effect cost escalation
Risks
Funding
TIME VALUE OF MONEY
Theory of Equivalence
When cash flows can be traded for one another in
a financial world, those cash flows are considered
equivalent to each other.
Economic equivalence depends upon
Interest rate
Time
PROJECT ECONOMICS
When conducting a cost benefit analysis of
any project, if the benefits are received in
the future, we cannot directly compare the
front cost to the future benefits unless we:
Convert the future benefit to equivalent
present benefit, or
Convert the present cost to equivalent future
cost
ECONOMIC INDICATORS
They reduce net cash flow projection to single
numbers
Measures the relative economic attractiveness of
the cash flow
Tells us whether one investment gives a greater
economic benefit than other investments
COMMON ECONOMIC
INDICATORS
Net present value (NPV)
Internal rate of return (IRR)
Pay back time (PB)
Discounted profit to investment ratio
(DPIR)
Unit technical cost (UTC)
ECONOMIC INDICATORS
NPV
Consistently the most reliable and most frequently
used in practice
Takes into account timing of future cash flow
Tells us how much an investment is better or
worse than putting money into the bank or some
alternative investment
Makes large projects more attractive than smaller
ones, no indication of investment efficiency.
Highly dependent on discount rate
ECONOMIC INDICATORS
IRR
It is the after tax return equivalent to putting an
investment in an interest bearing account.
Frequently used as an initial screening device
Tends to favour high initial earnings projects over
long-lived projects
Can produce multiple values, and ambiguous.
Could be difficult to calculate (trial and error)
ECONOMIC INDICATORS
PAYBACK (PB)
Indicates length of investment exposure,
or break-down point of a project.
Easy to calculate and understand
It ignores the timing or variations of cash
flow before payback
Useful as an initial indicator of the merits of
a project
ECONOMIC INDICATORS
DPIR
defined as the net cash flow of the project
per dollar of capital investment
used as quick first look investment
criteria
excellent for ranking projects
highly dependent on discount rate
measures investment efficiency
ECONOMIC INDICATORS
CASH FLOW ANALYSIS
Cash flow is defined as cash received and
the cash expanded over a defined period
of time.
Forecasts of cash flow are the foundation
of almost all economic analysis carried out
for investment decision-making.
BASIC PRINCIPLES OF CASH
FLOW ANALYSIS
Basic principles of cash flow analysis that are vital to
the correct analysis of investment alternatives include:
Difference between cash flow and profit
Treatment of depreciation
Way in which inflation can be incorporated
Concepts of nominal and real cash flow
Treatment of loans
Interest on loans
Loan repayments
BASIC DEFINITIONS
Capital Costs
One-time costs usually incurred at the beginning of a
project. They are usually large expenditures incurred
several years before any revenue is obtained.
Examples
Tankers
Pipelines Construction
Process facilities
Camps and Accommodations
Storage vessels
BASIC DEFINITIONS
Operating Costs
Occurs regularly and are necessary to maintain
operations.
Usually expended in terms of expenditure per year or per
unit production.
Examples
Field labour cost
Maintenance cost
Office overhead
It can be fixed periodic/annual amount or can be variable and
determined as a function of production rate.
Petroleum Fiscal Terms
Government Take
In many projects worldwide, government take is
over 50% of net pre-tax cash flow. It includes:
Royalties
Profit Sharing
Taxes
JV S vs PSC
CASH FLOW ANALYSIS
Net Cash Flow
Net cash flow = cash received capital
expenditure operating expenditure
royalties, taxes, profit sharing.
PROFIT
Accounting concept used in reporting company
accounts or in assessing tax liability.
Does not refer to total money flow but usually
incorporates depreciation of capital costs.
Profit = cash received depreciated capex
opex royalties, taxes, profit sharing, etc
CASH FLOW VS PROFIT
I
1 2 3 4 5
Income ($mm)
- CAPEX ($mm)
- OPEX ($mm)
0
100
0
40

10
40

10
40

10
40

10
= Net Cash flow ($mm) -100 30 30 30 30



Description Year 1 Year 2 Year 3 Year 4 Year 5
Income ($mm)
- Depreciated CAPEX ($mm)
- OPEX ($mm)
0
0
0
40
25
10
40
25
10
40
25
10
40
25
10
Profit 0 5 5 5 5

CASH FLOW VS PROFIT
Conclusion
Net cash flow gives the forecasted actual money
spent and received. It correctly represents the size
and timing of cash flow.
Profit is an Artificial Construction
It is inappropriate for making investment decisions
because it does not represent actual money flow.
Used for annual reporting to stockbrokers and
assessing tax liability.
EXAMPLE ECONOMIC
CALCULATION
Capital Investment = $110,000
Net Operating Income:
Year Income
1 $40,000
2 $40,000
3 $40,000
4 $40,000
5 $40,000
6 $30,000
7 $20,000
8 $10,000
9 $4,000
EXAMPLE ECONOMIC
CALCULATION
Net Cash Recovery = Ix - P
= $264,000 - $110,000
= $154,000
EXAMPLE ECONOMIC
CALCULATION
Payback Time = P/ Ix/N
= 110,000/ 264,000/9
= 3.75 Years
EXAMPLE ECONOMIC
CALCULATION
Discounted Profit = NPV(I) NPV(P)
Assuming i=9%
1
ST
5 Yrs: $200,000(Fc, 9%, 5 yrs)
=$162,400
6
th
Yr : $30,000* Fc (1 yr)* Fsp (5 yrs)
= $30000* 0.958*0.6
= $18,281
EXAMPLE ECONOMIC
CALCULATION
7
th
Yr : $20000* 0.958*0.596
= $11,419.36
8
th
Yr : $10000* 0.958*0.547
= $5240.26
9
th
Yr : $4000* 0.958*0.502
= $1923.37
EXAMPLE ECONOMIC
CALCULATION
NPV (I) = $199,664.29 (@9 %)
Discounted Profit = $199664.29-110000
= 89,664.29 (@ 9%)
NPV(I) @ 25% = 136,595.4 Profit =$26595.4
NPV(I) @40% = 104833.2 Profit = -$5166.77
IRR = 37%
ECONOMIC EVALUATION
PROJECT RISK MANAGEMENT
Why is Project Risk Management Important?
Dilemma of a project manager:
Project costs are uncertain
Schedules are uncertain
Scope of work is often uncertain
External factors are uncertain
But the project manager must never be uncertain.
RISK AND UNCERTAINTY
Derivation of cash flow and the measurement of
economic worth are based on the assumption that
investments are risk-free.
Assessment of risk and uncertainty is important to
decision making
Analysis allows one to select the appropriate
discount rates which account for risk and
uncertainty.
DEFINITION OF RISK
Risk
The probability that a certain undesirable outcome will occur
Uncertainty
The range of values within which the actual value is
expected to fall
Contingency
Provision for variations to the basis of a plan or cost
estimate which are likely to occur and which cannot be
specifically identified at the time the plan or estimate was
prepared.
It provides an equal chance of over run or under run.
ELEMENTS OF PROJECT RISK
MANAGEMENT
Risk Identification
Risk Quantification
Risk Response Development
Risk Response Control
PROJECT RISK MANAGEMENT
How is Project Risk Management undertaken?
Identifying risks and uncertainties
Calculating the cost of contingency
Calculating the schedule contingency
Calculating the estimate accuracy
Calculating the sensitivity of cost, schedule, or profitability
to specific risk factors
Identifying the elements of risk that contribute most to
current inconsistency
Defining a program to reduce and manage risk