Petroleum Department Third Stage Petroleum Economics Depreciation and Depletion in Oil Projects Economic analysis of the expenditures and revenues for oil operations requires Tecognition of two important facts: 1) Physical assets decrease in value with time, ie., they depreciate 2) Oil resources, like other natural resources, cannot be renewed over the years and they are continuously depleted Depreciation: is a system which aims to distribute the cost or other basic value of tangible capital assets (less salvage if any), over the estimated useful life of the unit. It is considered a process of allocation of valuation. Depreciation itself as a process is simply defined, on the other hand, as the unavoidable loss in value of a plant, equipment and materials. The primary purpose of depreciation is to provide for recovery of capital that has been invested in the "physical" oil property. Depreciation is a cost of production; therefore, whenever this production causes the property to decline in value, depreciation must be calculated. Investment of depreciable capital is used for one of two purposes in the oil fields: 1. As working capital for everyday operating expenses such as wages, materials and supplies, 2. To buy oil drilling machinery, rigs, etc., used in development and production of oil wells. Investment used for oil drilling machinery, well casings, etc. that is, fixed capital cannot be converted directly to original capital invested in oil equipment and machinery, because these physical properties decrease in value as time progresses. They decrease in value because they depreciate, wear out or become obsolete. Recovery of this investment of fixed capital, with interest for the risks involved in making the investment, must be assured to the investor. The concept of capital recovery thus becomes very important. When limited natural resources, such as crude oil and natural gas, are consumed, the term "depletion" is used to indicate the decrease in value which has occurred. As some of the oil is pumped up and sold, the reserve of oil shrinks and the value of the oil property normally diminish. Unless some provision such as depletion charges is made to recover the invested capital as the crude oil is pumped and sold, the net result will be loss Lecture3 8/12/2016Petroleum Department Third Stage Petroleum Economics of capital. This is prevented by charging each barrel, or ton, of crude with the depletion it has caused. Depletion costs are made to account or compensate for the loss in value of the mineral or oil property, because of the exhaustion of the natural resources. Also it is defined as the capacity loss due to materials consumed or produced. There some basic diffusion related of depletion and depreciation process such as: > Salvage value/junk (scrap) value: The value of the asset by the end of its useful life service. The term "salvage" would imply that the asset can be of use, and is worth more than merely its scrap or junk value. The latter definition is applicable to cases where assets are dismantled and have to be sold as junk. Book value: The value of an asset or equipment as it appears in the official accounting record of an oil organization. It is equal to the original cost minus all depreciation costs made to date. Market value: The value obtained by selling an asset in the market. In some conditions, if equipment is properly maintained, its market value could be higher than the book value. Replacement value: As the name implies, it is the cost required to replace an existing asset, when needed, with one that will function in a satisfactory manner. Methods for Determining Depreciation There are three main methods for grouping DD&A: 1. Straight Line 2. Declining Balance 3. Unit of Production Depletion 1) Straight-Line Depreciation (S.L.D.) In this method the cost of an asset is distributed uniformly over its expected useful life. If | is the depreciable capital, n is the expected service life, then the annual depreciation charge is |/ n: If salvage value is estimated, then the annual depreciation is as show in eq. below: D= Lecture3 8/12/2016Petroleum Department Third Stage Petroleum Economics Mathematically, it is assumed that the value of the asset decreases linearly with time. Now, if the following variables are defined: D = annual depreciation rate, $/year n= service life, years If salvage value(S) is not taken, than S = 0 and the depreciation charge is; p=t a The straight-line method is widely used by engineers and economists working in the oil industry because of its simplicity. For example, a tank battery has an initial cost of $100000, and will have a useful life of 10 years. The basic straight line equation is Annual Depr. Amt. = Initial Cost / Useful Life = $100000 / 10 = $10000 / year for 10 years 2) Declining Balance Depreciation (D.B.D) The declining balance method is also called the fixed percentage method. Each year the capital allowance is a fixed percentage of the unrecovered value of the asset at the end of the year. At the end of the project life a residual unrecovered asset value will remain. This is usually accepted in full as a capital allowance in the final year of the project. Hence the total asset value is fully recovered over the life of the field, but at a slower rate than in the straight line method, see typical example in table below: Lecture3 8/12/2016Petroleum Department Third Stage Petroleum Economics Year CAPEX Declining Balance Capital Allowance (@ 20% pa. Unrecovered Assets ac Year End Capital Allowance 1 100 100 20 2 400 480 9 3 584 7 367 93 374 73 Yearly Depr. = Depr. Balance * (Yearly Rate * 2) For example, assume the same 100 MS investment and the 10 year life of the straight-line method, but now accelerate the depreciation using the 20% factor. The recovery schedule would be: Year One 400+0:20 $20.00 Year Two (100-20) + 0.20 20-0.20 $16.00 Year Three (20-46) +0.20 64-0.20 $13.00 Year Four (64-1300) 6020 51,000.20 $1020 Year Five (1-10.20) +0.20, 40,800.20 se16 ‘year six (aus9.10) zy 2090.20 30.53 Year Seven (3264-652) +0.20 25.110.20, 35.22 Year Eight (20:11-6.22) +0.20 20,830.20 sais Year Nine (2089-4 1€) +0.20 16.71+0.20 $334 Year Ten (18.71-2.34) +0.20 4337-020 5267 The remaining unrecovered balance is either handled as salvage or written off in the next year. Peep takes the balance in the next year. If the economic life of the property is less than the years of recovery, then all unrecovered balances are written off in the last year of the property. 3) Unit of Production Method This is a method for calculating the depreciation of certain properties usually used in the manufacture of tools, equipment, and objects. The depreciation is determined by Lecture3 8/12/2016Petroleum Department Third Stage Petroleum Economics estimating the number of units that can be produced by a property before it is worn out. For example, if it is estimated that a machine will produce 10000 units before its useful life ends and that 1000 units are produced each year, the percentage to calculate depreciation is 10%of the machine cost less salvage value, if permitted. This percentage is applied to the cost of the asset as yearly depreciation. Break-Even Analysis The purpose of break even analysis is to determine the number of units of a product to produce that will equate total revenue with total cost. At this point, referred to as the break-even point, profit is zero. As such, the break-even point is a point of reference in determining the number of units needed to ensure a specific profit. Many decision problems of oil Industry involve a determination of the minimum volume or quantity of a production for oil or gas that must be produced or provided in order for revenues to cover the cost of the production or development for any FDPs. At the point where revenues equal all operation and production costs, the firm will just break even on the product such as oil production or service. At volumes beyond the break-even points, the firm will realize a profit. This area of decision making is often referred to as cost-volume-profit analysis or break-even analysis. The break-even point as such gives the decision maker a point of reference in determining how many units will be needed to ensure a profit. Break-even analysis is concerned with answering three important and basic economic questions: 1. What is the minimum level of activity that can be operated at? 2. What is the level of production that will cover the cost? 3. At what level of production will maximum profit be achieved? There are three main components of break-even analysis: volume, cost and profit. Each of these three components is a function of several other components. These components will be analyzed as follows: 1- Volume Volume is the level of production and can be expressed as the number of units produced and sold, It can also be expressed in monetary terms or as a percentage of total capacity available. Lecture3 8/12/2016