Petroleum Economics

INTEGRATED GRADUATE
DEVELOPMENT PROGRAM
CLASS 2011
PETROLEUM ECONOMICS
David Wood
IN-HOUSE COURSE
prepared for
OMV EXPLORATION & PRODUCTION GMBH

Vienna, Austria
HOT Engineering GmbH

Parkstrasse 6
A-8700 Leoben, Austria
Tel: +43 3842 430530
Fax: +43 3842 430531
E-Mail: training@hoteng.com
www.hoteng.com
Copyright © 2012 by HOT Engineering GmbH
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Overview of Course Objectives & Materials
The Need for Petroleum Economics
Project Cash Flow & Income Components
Project Cash Flow & Income Components (Exercise #1)
Petroleum Reserves Categories & Valuation
Discounting & Time-Value Considerations (Exercise #2)
Rates of Return
Payout Time or Payback Periode
Profit to Investment Ratios
Risk and Opportunity Analysis
Capital Budgeting Techniques & Yardsticks (Exercise #3)
Which Oil & Gas Prices Should be Used to Value Assets?
Valuing Incremental Investments
Inflation, Buying Power, Money of the Day & Real Values
Inflation Indices
Estimating Values & Costs and Budget Cost Control (Exercise #4)
Introduction to Upstream Fiscal Terms & Contract Types
Production Sharing & Cost Recovery (Exercise #5)
Funding Criteria: The Cost of Capital & Oil & Gas Finance
Hurdle Rates and Selection of Discount Rates
Probabilistic Methodology & Techniques for Economics & Risk Analysis
Decision Analysis, Decision Trees & Flexibility
Monte Carlo Simulation Demonstration (Exercise #6)

Petroleum Economics
Overview of Course Objectives & Materials
David A. Wood
Course Structure & Approach
 The course is structured into a sequence of

PowerPoint presentations and exercises.
 Your participation is welcome.
 My preference is for an informal approach to

encourage an exchange of ideas and
experience.
The course aims to be a stimulating & enjoyable experience for all!!
© by David A. Wood 2
Course Director: David A. Wood
www.dwasolutions.com
 Some 30 years of energy industry experience dw@dwasolutions.com
 Widespread international operations & project exposure
Twitter: @DWAEnergy
Facebook: DWA Energy Limited
 Governments, majors, independents, services & consultants LinkedIn: David A. Wood
 Technical, commercial, training and senior corporate expertise

 Risk, economics, portfolio and fiscal modelling & research
 Advises governments and companies on approaches to fiscal design
 Broad focus: upstream, midstream and downstream
 Technical evaluation, numerical modelling and due diligence
 Mergers, acquisitions and divestments (management & negotiation)
 Project finance, hedging and trading
 Oil, gas (LNG, GTL and storage), power and renewables
 Strategy, geopolitics and contract negotiations
 PhD - Imperial College London (1977) – geology / deepwater drilling
 Diploma Company Direction – Loughborough / IOD (1996)
 Independent consultant since 1998; widely published; expert witness
Petroleum Economics
2-day Module – Daily Themes
Outline structure of course - each day has a distinct theme.
The aim is to provide delegates with a

comprehensive introduction and
balanced view of petroleum economics.
 Day 1 – Basic Analysis & Valuation Techniques
 Day 2 – Constructing Economic Evaluation Models
DAY 1 – Basic Analysis & Valuation Techniques
Morning Session 4.1
 Overview of Course Objectives & Materials
 The Need for Petroleum Economics
 Project Cash Flow & Income Components
Morning Break
Morning Session 4.2

 Distinguishing Cash Flow & Other Measures of Profitability (Exercise#1)
 Petroleum Reserves Categories & Valuation
 Discounting & Time-Value Considerations (Exercise#2)
Lunch Break
DAY 1 – Basic Analysis & Valuation Techniques

Afternoon Session 4.3
 Rates of Return
 Payout Time
 Profit to Investment Ratios
 Risk and Opportunity Analysis
Afternoon Break

 Capital Budgeting Techniques & Yardsticks (Exercise#3)
 Which Oil & Gas Prices Should be Used to Value Assets?
End of Day 1
DAY 2 – Constructing Economic Evaluation Models
Morning Session 4.5

 Valuing Incremental Investments
 Inflation, Buying Power, Money of the Day & Real Values
 Inflation Indices
 Estimating Values & Costs and Budget Cost Control (Exercise #4)
 Introduction to Upstream Fiscal Terms & Contract Types
Morning Break
Morning Session 4.6
 Production Sharing & Cost Recovery (Exercise #5)
 Funding Criteria: The Cost of Capital & Oil & Gas Finance
 Hurdle Rates and Selection of Discount Rates
 Probabilistic Methodology & Techniques For Economics & Risk Analysis
Lunch Break
DAY 2 – Constructing Economic Evaluation Models

 Decision Analysis, Decision Trees & Flexibility
 Monte Carlo Simulation Demonstration (Exercise #6)
 Assessment Test
Afternoon Break

 OMV Session on in-house “Easy Evaluation” Pre-tax Cash Flow Tool
End of Module
Ask if You Need Clarification
There is a lot of material to get

through, but time will be made for
discussion.
Don’t be shy!
Petroleum Economics
The Need for Petroleum Economics
David A. Wood
Key Metrics Show Distinctive &

Dislocated Trends For E&P Assets
Key performance
indicators (KPIs) give
different impressions
at different stages of
an oil and / or gas
assets life cycle.
Economic and risk

analysis provides a
means of clarifying
and quantifying the
importance and
relevance of these
trends.
E&P Investment Appraisal & Decisions
Upstream projects are characterised by:
 Large initial capital investment
 High rate of capital investment

throughout asset life
 Long payback period
 High risk and uncertainty
 Complexity
 Multiple stages with deferrable decision

points
 Incremental information flows and

decision points
 Dependency upon volatile product prices

and demand
Cost – Time Cycle for Exploration

Through to Field Production
Constraints on Upstream
Oil & Gas Companies
Major upstream companies are characterised by:
 Large portfolios of E&P projects available for investment at any one time.
 Finite technical resources & skills to evaluate & manage each project.
 Finite time in which to perform commitment work programmes
 Finite financial resources and frequent budget constraints making them not
indifferent to the level of risked capital required to optimise the portfolio.
Which Development Option

Makes Most Economic Sense?
The type of field facilities, number of wells,

timing of drilling, owning or leasing facilities
are all decisions that require economic and
risk analysis as well as engineering design.
Oil Industry of Last 30 Years has
been Characterised by Volatility
Volatility caused by booms and recessions driven by the supply-demand balance and oil prices.
For how long will such cycles be repeated?
Access to quality
international upstream
permits to explore and
develop is a major
challenge for IOCs,
together with finding
and retaining skilled
staff.
Oil supply & demand main drivers for volatility in recent decades
Boundary Scenarios Can Frame

Economic Sensitivity Analysis
Framing the future in terms of options helps to identify and quantify key issues and potential
risks and pitfalls. Sensitivity and Simulation analysis are frequently essential to
understanding the full picture.
It is important for economic analysts to consider more than one future.
Costs of Delays in The Exploration
& Appraisal Portion of Field Life Cycle
Delays in exploration / appraisal always have a negative impact on project /
company profitability over the long-term project or field cycle. Economic and
risk analysis quantifies this impact.
Extending Field Life by Reducing

Operating Costs & Overheads
Economic analysis can identify when it is necessary to introduce structural
changes in order to extend the projects commercial life by reducing operating /
production costs.
Risk & Fiscal Analyses are Key Parts
of the Investment Decision Process
The economic structure of the oil and gas industry is intimately associated with
risk versus reward tradeoffs and fiscal designs.
Modern Portfolio Modelling Approach:

Economic, Risk and Strategy Analysis
In a portfolio approach projects are judged based on their contribution to long-term
strategy, and how they interact with the other projects in the portfolio, as displayed by
the feasible envelope, efficient frontier and probabilities of metrics being achieved.
This is a dynamic process.
Portfolio modelling &

management should
firmly link investment
decision-making at the
asset, portfolio and
merger / acquisition/
divestment levels to a
quantified corporate
strategy.
There are Many Different Reasons Why
Valuation & Risk Analysis are Required
The results of such analysis are almost always ultimately linked to assisting and
clarifying decisions. Some of the main reasons are:
 Establishing that a project can achieve acceptable profitability
 Comparing the value of projects & investment opportunities
 Allocating values to different categories of reserves
 Indicating threshold commercial field sizes in specific environments
 Distinguishing the most appropriate field development plans
 Testing the impact of different economic scenarios (e.g. oil price)
 Assessing the impact of costs and overheads on project returns
 Identifying value at different points along the supply chain
 Consider available options for optimising returns from reserves
 Evaluating merger, acquisition and divestment opportunities
 Justifying budgets, forecasts, business plans and strategic options
 Negotiating and comparing fiscal and contract terms
 Securing project finance and other forms of debt
 Reporting historical performance & forecasting to stakeholders
 Quantifying the impact of risk and opportunity on projects
 Valuing portfolios of oil and gas projects & assessing performance
We will address these reasons and several others during this course.
Petroleum Economic & Risk Analysis Aids

Decisions to Balance Risk & Reward
Balancing is never easy!!!
Economic & risk analysis is a fundamental process in strategic and operational

management of the oil and gas industry.
Petroleum Economics
Project Cash Flow & Income Components
David A. Wood
Simplified Flow Chart For The Financial

Process in a Typical Upstream Oil Company
The role of financial management is to optimise the value and use of the basic
reservoir of cash and its associated funds flow.
Financial management
involves funding decisions
in the raising of cash in
the form of equity and
debt.
It also involves the

efficient allocation of
funds between assets,
credit investments, etc.
Reserves do not appear

in this model but can
influence depreciation.
Focus of Economic Analysis
For an oil and gas company to prosper it has to find and/or acquire new
reserves and make a financial profit.
 E&P companies do not stay in business long without returning a financial

profit.
 Production cannot be sustained without new reserves to produce.
 Economic analysis must therefore be focused on increasing profits and

optimising profitability from their reserves.
 A key question is how do we define and measure profit?
Upstream Cash flow Components:

Influence Diagram – Role of Reserves
Costs are an important component controlling the overall value of projects and
reserves. Costs are distinguished as CAPEX & OPEX.
CAPEX Decisions, such as

project design or field
development often pivot on
cost, timing, efficiency and
capital constraints,
e.g. well design.
In the production stage

OPEX is often the focus in
determining efficiency,
profitability and viability.
Reserves and reservoir

characteristics have huge
influence on cash flow
components.
Basic E&P Economic Analysis
Techniques Are Straight-forward
None of the economic calculation techniques commonly applied are complex but
their analysis can become so.
Most economic evaluations readily establish:

 levels of capital investment required
 future cash flows
 national or local tax liabilities
 earned and paying interests
The complications arise in:

 ranking projects against each other
 allowing for existing commitments
 allocating & monitoring sources of funds
 identifying risks and opportunities
 correctly adjusting cash flow for uncertainty
 Estimating chances of success.
 market conditions and product price forecasting.
Petroleum Projects Require High Capital

Outlay to Achieve Long-term Returns
There is an unparalleled relationship of expenditure, risk, timing and revenue in
the oil and gas industry that distinguishes it from other industries.
E&P economic
analysis focuses on
the value of available
reserves and the
timing of their
production that
maximizes cash flow
and profits (earned
income) for those
holding interests in
those reserves.
Cash Flow Projections
Cumulative net cash flow is the basis for most economic analysis. It is calculated on
a “before and after tax” basis and has these major components:
 Cash Items: monies actually paid and received.
 Non-Cash Items: such as depreciation, depletion (North America), book

values used mainly for tax and accounting calculations.
 Royalties: property of the state either paid in money or product is not

technically a cash or non-cash item as it is never owned by the E&P
company.
Cash Flow Components - Cash Items

Monies actually paid and received can be subdivided into a number of
specific categories:
 Working interest E&P revenues
 Income from property sales (and their capital gains tax)
 Working interest local taxes
 Operating costs
 Overheads (corporate / operational, G&A, loan interest)
 Capital investments
 Land, lease and licence fees and bonuses
 Corporation taxes (investment tax credits)
 Special petroleum taxes (e.g. PRT in older UK licences)
 Debt capital and interest repayments

Cash Flow Combines Cash Inflows
with Cash Outflows
Inflows usually equate to production revenues but also may include asset sales.
Outflows include expenditures and taxes.
Taxable Income is Not Cash Flow but Profit

Adjusted by Accounting & Taxation Rules
Calculations of taxable income

depend upon accounting and
tax rules which vary from
country to country and
sometimes between E&P
contracts in the same country.
It is often referred to as Net

Income or Earnings (in US)
Calculation of Key Project & Corporate Accounting
Measures Applicable to Oil & Gas Projects
The term Mineral-Interest

Reserves is used to
distinguish projects from
those projects subject to
the terms of Production
Sharing Agreements
(PSAs).
Some companies focus

more on cash flow
performance (~EBITDA)
others more on earnings.
The Tax Burden in E&P Contracts Has

Many (Often Complex) Components
Taxable Income Is Usually
Not Cash Flow
Calculations of taxable incomes depend upon accounting and tax rules,
particularly involving the depreciation of capital costs.
Generic Corporate Tax Model

Calculations of taxable incomes, particularly in tax-royalty fiscal regimes, are usually
complex and require specialist tax advice.
Depreciation of Capital Costs
This is applied to costs for items that will benefit the company for more than a
single year. It is a system that spreads the costs of such items over each year of
its useful life or production unit.
 Depreciation can be calculated in a variety of ways some of which load

more depreciation on to the early years where the equipment is most useful
and its maintenance costs should be lowest. Methods allowed depend
upon prevailing legislation.
 Book value of capitalised assets is their original cost less the accumulated
depreciation. It should not be confused with market value or replacement
value.
 A gain or loss on the sale of an asset is computed by comparing the sale

price with the book value. These are included as extra line items on income
statements.
 Small items even though they may last several years are often treated as
an expense in the year in which they are purchased provided it does not
yield material errors.
Typical Asset Lives For DD&A Purposes

Asset lives will depend upon prevailing legislation, but example ranges are:
 Production plant including in-field flow lines and tangible well costs - 5 to 10
years.
 Intangible costs (sometimes a portion of these have to be capitalised rather

than expensed) – 5 years.
 Drilling equipment & vehicles – 5 years.
 Transmission / Trunk pipelines – 10 to 40 years.
 Refinery Plant & equipment – 10 to 20 years.
 Buildings – 20 to 30 years.
 Computer hardware and software – 3 to 5 years.
Depreciation & Calculation of
Book Value
Depreciation records are concerned with costs not value. Hence purchase price
less accumulated depreciation equals remaining cost but is termed the book
value. This is not a value but a remainder.
 Consider a machine that cost $60,000 and management estimates its useful life
to be 10 years and its salvage value after 10 years to be $10,000.
 On a straight-line depreciation basis the annual depreciation rate will be

($60,000 - $10,000) /10 which equals $5,000 per year.
 At the end of the second year an accumulated depreciation schedule for the
machine could be:
– Original purchase costs: $60,000

– 1st year depreciation allowance: $5,000
– 2nd year depreciation allowance: $5,000
– Total accumulated depreciation: $10,000
– Book Value: $50,000
Depreciation is a Key Non-cash

Component in Calculating Net Income
Amortisation of capital investments so as to spread costs over a period of time
for tax or accounting purposes. Methods are designed to recover capital costs
over the life of an asset. Some depreciation methods accelerate the amortisation
process (e.g. double declining balance; SYD; MACRS).
Depreciation methods used in E&P industry are:
– Units of Production (costs recovery linked to production and

reserves) - widely used for accounting purposes.
– Straight Line - costs recovered in equal fractions per year.
– Declining balance - various rates are applied - single(100%), 150%

& double (200%) rates used.
– Sum of the Years’ Digits (rarely used outside North America).
– MACRS -(modified accelerated cost recovery system) used for U.S.

federal income tax (FIT) capital cost depreciation
Depreciation & Capital Cost Recovery
Depreciation rate is important to project valuation in that it controls
how quickly capital investments are recovered from cash flow.
 From the investor’s point of view it wishes to recover all costs as soon as
possible. The best solution would be expensing all capital costs together
with operating cost (equivalent to a 100% annual depreciation rate applied
from the year of expenditure).
 If capital costs are depreciated over 5, 10, or 20-year periods discounted

cash flow values for a venture decrease as the annual depreciation rate
reduces.
 Governments like to have low annual depreciation rates as it increases

their tax revenues as companies show higher taxable incomes in the early
years of a project.
 This is a means of governments receiving a share of revenues from oil and

gas projects from early in the production life of a field development.
Different Rates of Depreciation

It is not unusual for different depreciation rates to be applied to different categories
of capital expenditure.
 Exploration costs (drilling & G&G costs) are often depreciated at 100%(i.e.
expensed) to provide investors with an incentive to make new and risky
investments.
 Development costs are often divided into categories such as tangible (plant
with a long life) and intangible (materials or services consumed in an
operation, e.g. drilling mud, wire-line services). The intangibles are often
expensed or subject to a more rapid depreciation rate.
 Allocation between categories can be arbitrary and subject to change. It is

the cause of many disputes with the tax authorities.
 UK authorities have in recent years reduced the depreciation rates applied to

intangibles on development wells in response partly to side-track technology
developments.
Depreciation, Depletion &
Amortization - DD&A
This originally North American concept is now also widely used in international oil
and gas accounting.
 Depreciation is a means of accounting for the recovery and allocation of costs
associated with fixed (tangible) assets over the deemed useful life of an asset.
Annual depreciation charge is deducted from revenue in the net income
calculation.
 Depletion is the same concept as depreciation but applied to purchase prices

(i.e. acquisition values) of mineral resources (e.g. oil & gas) enabling them to
be deducted for tax purposes over time.
 Amortization is the same concept as depreciation but applied to intangible

assets.
 Commonly these terms are used interchangeably and /or collectively as

DD&A.
 Depreciable life of specific assets is governed by rules specified in the

prevailing accounting and tax legislation.
Example DD&A Methodology Stated by

US Oil Company in a 10-K Return to SEC
The following extract comes from Apache Corp’s form 10-K submission of Feb,
2011 to SEC for year ending Dec 31st 2010:
Source: Apache Corp 10K 2010

DD&A is an Operating Expense
on the Income Statement
The following extract comes from Apache Corp’s condensed statement of operations
in its 10-K submission of Feb, 2011 to SEC for year ending Dec 31st 2010:
Source: Apache Corp 10K 2010
Depletion (DD&A) Calculated by

Unit of Production Method
DD&A is the only impact reserves have on the profit & loss (income) statement. The
unit of production annual depletion calculation can be expressed generically by the
equation: (C – AD – S) * P / R
Where:
– C = Capital cost of plant and equipment

– AD = Accumulated depreciation to date
– S = Salvage or residual value
– P = Annual production (boe)
– R = 1P Reserves Remaining at beginning of year (or 2P
reserves in Canada and many other countries)
The unit values that are deducted for tax purposes can be substantial (e.g. $2/boe
up to >$10/boe. The higher values may indicate higher cost / lower reserves than
originally expected. Good performers maintain DD&A charges below $5 / boe
particularly when calculated on a 2P basis. Merger and acquisition costs are
usually included in the depletion cost pool.
Petroleum Economics
Project Cash Flow and Income Components

(Exercise #1)
David A. Wood
Calculation of “Profit”, “Cash flow” & “Income”

Measures Applicable to Oil & Gas Projects
When a figure is referred to as “profit”, “cash flow” or “income” without qualification

or explanation it is important to distinguish what it is actually measuring. There
are several different possibilities!
Input Information for Calculating
Measures of “Profit”
When a figure is referred to as “profit”, “cash flow” or “income” without

qualification or explanation it is important to distinguish what it is actually
measuring. There are several different possibilities!
Petroleum Economics
Petroleum Reserves Categories & Valuation
David A. Wood
How Do We Know There are Reserves Out

There?
“Shell said the oil exists – if only they can find it. Trouble is, they can’t convince
the SEC”. Same applied in 2004 to El Paso, Forest, Nexen, Husky, etc…. Many
reserve write-downs occurred.
These headlines in the

general media and
cartoons emphasize the
popular view of how oil
reserves are measured
and how they exist in the
sub-surface.
Reality is more complex

and uncertain, but Shell
are damaged by both
popular image and the
technical reality.
Relevance of Resources Versus
Reserves to Petroleum Portfolios
Conventional versus Non-conventional

Petroleum Resources
SPE Oil & Gas Resource Committee (2007) place Ultra-heavy crude, tight gas
sands and shale gas in their conventional categories. They draw the horizontal
line lower.
Classification of Upstream
Oil & Gas Assets & their Reserves
Reserves Terminology
Commonly Applied in Valuation
 1P Reserves
– Proven Developed (PD)
– Producing (PDP)
– Non –producing (PDNP)
– Proven undeveloped (PUD)
 2P Reserves
– Proven plus Probable
 3P Reserves
– Proven plus probable plus possible
Petroleum Reserves Classification
SPE versus SEC
Until 2010 SPE and SEC have had different requirements for reserves reporting
that has caused many issues for petroleum companies registered on US stock
exchanges.
Petroleum Reserves Classification

SPE / WPC / AAPG / SPEE
This approach is in line with SPE /WPC / AAPG /SPEE guidelines and the
Petroleum Resource Management System (PRMS) approved in 2007 updated
November 2011.
Resource Classification Commences
with In-place Classifications
Culmination of two-year review approved in March 2007 (updated Nov 2011).
Bookable Oil & Gas Reserves Valued in

Production Asset Sales
Aligning Reserves Definitions with
Petroleum Project Cycle
This approach is in line with SPE /WPC / AAPG /SPEE guidelines and the
Petroleum Resource Management System (PRMS) approved in 2007.
SPEE = Society of
Petroleum
Evaluation Engineers
AAPG = American
Association of
Petroleum Geologists
Project-based Approach Works best for

Petroleum Reserves Valuation
Petroleum Resource Management System (PRMS, 2007) recognises the need for
much more than establishing resource volumes.
Categorizing Reserves by Levels of
Uncertainty – Key to Valuation
Petroleum Resource Management System (PRMS, 2007, 2011) acknowledges
deterministic and probabilistic methodologies. In practice integrating both approaches
is useful.
Forecasts and Valuation Scenarios
Valuations and decisions are based on the evaluators view of “Forecast

Conditions” – i.e. those assumed to exist during a project’s implementation.
Alternate valuation scenarios are typically considered in the decision process

and, in some cases, to supplement reporting requirements.
One sensitivity case commonly reviewed assumes “current conditions” will

remain constant throughout the life of the project (“constant case”).
Pivotal Role for Probable Reserves in
Acquisition Valuations
In some areas, probable reserves assume a key role in acquisition values.
Significant value is ascribed to probable reserves in:

Offshore, particularly in hostile or deep water environments.
where significant investment decisions for facilities and infrastructure
have to be made early in development.
Assets are immature and lots of undeveloped potential remains.
Internationally probabilistic reserves categories are applied.

2P reserves (probabilistic proved plus probable) is the reserve
estimate commonly where probable reserves are to form a significant
part of the assets to be acquired. Method is suited to valuing whole
fields rather than small parcels of land.
However, internationally it is also not unusual to discount or risk
probable reserves more heavily than proved reserves when calculating
acquisition values.
Why Do Companies Acquire Assets,

Merge or Divest?
Because the benefits out-weigh the downsides and growth or focus on material
assets can be achieved.
The most common reasons given by oil companies are to:
 achieve greater efficiency;
 consolidate and grow to meet increased competition;
 increase shareholder value;
 benefit from operational synergies;
 diversify asset portfolio;
 balance asset portfolio.
 Mergers and acquisitions do allow economies of scale and step-decreases

in G&A costs.
 Downsides are potential job or location cuts. Restructuring and relocation

often mean many voluntary and involuntary redundancies.
How Does an Acquisition or Divestment
Add Value to an Asset Portfolio?
Petroleum Economics
Discounting & Time-Value Considerations

(Exercise #2)
David A. Wood
Time-Value Considerations
Oil and gas projects are characterised by high capital investment in early years,
without revenue, followed by high revenue after production startup which gradually
declines in line with production towards field abandonment.
Rate at which costs are recovered impacts contractor’s value.
Present Value (PV) Concepts
Money to be received at some time in the future is said to have a present value
which is less than the amount received by the interest that could be earned on it in
the interim.
 The PV is the amount that could be invested at an interest rate such that the
amount plus the total interest earned equals the future value (FV).
 Future value (FV) = PV + (i * PV ) (where i is the interest rate for one

interest period and FV is the value at the end of that one interest period).
 Re-arranged to: FV = PV (1 + i)
 An example: FV = ($2,000) (1+0.15) = $2,300 so that $300 is the simple

interest at 15% on an investment of $2,000 (the principal).
Present & Future Values and

the Time Value of Money
PV and FV are related to each other through interest rates and discount factors.
 For example, if an interest rate (i) of 10% applies for one investment period
then a PV of US$10 million has a FV of US$11 million at the end of the
investment period:
FV = PV * (1 + i)
 In this example the FV of US$11million can be discounted to a PV of US$10

million at the start of the investment period by applying a discount factor
(1 + d) of 10%:
PV = FV / (1 + d)
Simple Versus Compound Interest
If the interest is withdrawn at the end of the period only simple interest (on the
principal investment) is earned the next period.
 If the interest is re-invested in subsequent periods it will earn interest itself in

addition to that earned by the principal, i.e. compound interest.
 Compound FV for a second period:
– = ($2,300)(1.15) = ($2,000)(1.15)(1.15) = $2,645
 Thus FV of a PV invested at an interest rate of i per year has the general

form:
– FV = PV (1 + i)n where n = number of years
– (1 + i)n is called the compound factor.
The Discount Factor

This is the reciprocal of the compound factor and represents one of
the most important concepts of cash flow analysis.
Applying the discount factor to the FV calculates its PV such that:
– PV = FV [ 1 / (1 + i)n ] = FV (1 + i) –n
– Hence the PV of an FV of $6,125 to be received at the end of three

years based on an annual interest rate of 7% is $5,000.
– $5,000 = $6,125 (1 + 0.07) –3
– In this case the 7% is called the discount rate.
Risking Cash Flow Profiles by Increasing
Discount Rate is Not Appropriate
Higher discount rates preferentially penalise later years in a cash flow profile.
Net Present Value (NPV) is the Sum of

Discounted Cash Flows for Each Period
A general solution for the NPV calculation is:
 where CFj is the annual net cash flow in year j, i is the discount
rate, n is the total number of time periods. Cash flow in the initial
period CF0 remains undiscounted. This can be more neatly
expressed as:
 Most spreadsheets have NPV functions. It is important to take

care that the initial investment and type of discounting applied to it
are appropriate.
© by David A. Wood
Net Present Value Profile Trends
Calculating the NPV’s of cash flows of projects to be compared at different discount
rates and viewing them graphically can discriminate.
Present Value Profile Trends

Projects that look the most attractive at one discount value may not do so at another.
Discrete Investment Functions
Interest earned on money in a deposit account is normally paid at set regular
(discrete) intervals. The example below shows an investment of $10,000
accumulating with interest earned at 6% per annum. It grows discretely at the end
of each annual investment period.
Discrete Versus Continuous Functions

Production from an oil or gas well accumulates continuously by the minute and over
a long period its cumulative production represents a continuous function (usually
with breaks for well service). The example here shows a well producing at an initial
rate of 10,000 bopd and declining exponentially at a rate of 20% per annum for 10
years.
Nominal Versus Continuous Compounding
Nominal interest is the annual interest rate if money is compounded annually.
If compounding is set at periods other than one year then the FV equation needs
re-stating:
– FV = PV [ 1 + (i / P)] n where P equals interest conversions per year and

n equals the number of interest conversions for the total investment period
and i equals nominal interest rate per year.
– $2,000 compounded quarterly at 6% per year becomes $2,000 [1

+(0.06/4)]12 after three years = $2,391. Annual compounding equals
$2,382.
– For continuous compounding: FV = PV (e in) where n is the number of i

interest periods. $2,000 after three years at 6% is: $ 2,000 (e 0.18) =
$2,394.
Various Compounding Outcomes

Common compounding methods are summarised in this table for an investment
period of one year, but with formulae that work for multiple years. In the
formulae shown “n” equals the number of years in the total investment period
(n=1 in the examples shown for just one year) and “i “equals nominal interest
rate per year:
Net Present Value (NPV): A Yardstick
Useful for Ranking Projects (Exercise #2)
You have the option to select one project for investment from projects X, Y and Z
and the discount rate for all three projects is 10% per annum.
 X costs $2million now and returns $3 million in 4 years.
 Y costs $2million now and returns $4million in 6 years.
 Z costs $3million now and returns $4.8 million in 5 years.
Calculate the NPV for each project, using the discount factor table provided.
Then use the NPVs to rank the projects in order (best to worst) and select the
best for investment.
Discount Factor Table

In practice a spreadsheet, calculator or economic software package would calculate
this for you.
Petroleum Economics
Rates of Return
David A. Wood
Rates of Return
An earned interest on the money invested.
 There are two quite distinct rates of return commonly used and
referred to:
– The accounting or book rate of return including return on net assets and
return on capital employed (ROCE) or return on average capital
employed (ROACE).
– The internal or investor’s rate of return (IRR) and its modifications.
 It is important not to confuse the two. Accountants, investors and

financial analysts often refer to the former.
 It is the later that interests petroleum economists and investors when

looking at project economics.
Book Rate of Return
This is a single-year performance measure usually extracted from financial
accounts.
 Book ROR = Profit/Year

Investment
 The average value for the total life of a multi-year project can however be
approximated as:
Book ROR = Profit Investment Ratio

Number of Years
 Such ratios are used for annual financial reporting purposes and corporate
performance analysis and are not suitable for economic decisions
concerning specific projects.
Investor’s Rate of Return (IRR)
The rate which will discount the cumulative cash flow to zero, before or after
taxes. Put another way it is the rate of return at which the PV of future returns
equals the initial outlay.
 “d” equals the IRR when:
  Rn (1+d) -n = 0 where n is the number of years and R is the net cash

flow in each year.
 For such a series of cash flows, a trial-and-error or iterative solution is

required to obtain the IRR; there is no direct solution with more than two
cash transactions.
 “d” is sometimes compared with a hurdle rate or minimum acceptable rate

of return (MARR). If it exceeds that value the project is viable.
Investor’s Rate of Return:
Appropriate Uses
Although widely used as an investment yardstick it has significant problems.
Advantages:
 Valid as a qualifying parameter.
 Widely used within industry.
 Does not depend on project magnitude.
Disadvantages:
 Assumes all monies can be & are reinvested at IRR.(but can be
modified for a specific re-investment rate – MIRR)
 Not valid as a ranking parameter.
 May not yield a unique solution.
 Gives no indication of project magnitude.
IRR and NPV

Reflect Time-Value Influences
Consider cash flows X and Y. The only difference is in the timing of the
investment, but note the impact on both NPV and IRR.
IRR and Discount Rate Relationship
NPV’s for a range of discount rates either side of the IRR.
Discounted Versus Undiscounted

Cash Flows
The undiscounted cash flow for each period is discounted back to its equivalent
value at the start of period 1 by the discount rate and formula.
Investor’s Rate of Return Example
For an interest hurdle rate of 6% project A requires an investment of $18,000 for

a $20,000 return one year later while project B involves an initial outlay of $2,000
for a return of $2,500 one year later. Which project should be selected for
investment?
 IRRA = (20,000/18,000) - 1 = 0.11 = 11%.

 IRRB = (2,500/2,000) - 1 = 0.25 = 25%.
 NPVA = -18,000 +(20,000/1.06) = $868.

 NPVB = -2,000 +(2,500/1.06) = $359.
 IRR suggests B is better than A; NPV suggests A is better than B. More

information than IRR in isolation is needed for a good decision.
 If there were 8 other projects like B then they would represent the best
investment of $18,000.
Investor’s Rate of Return is an Indicative

not a Definitive Yardstick
IRR is not a good yardstick for discriminating between projects or justifying
projects as this example shows.
IRR does not always

give a unique solution.
NPV is more realistic as it is

calculated at a
discount rate that is
meaningful to the
company concerned (e.g. its
investment hurdle rate or cost
of capital).
Investor’s Rate of Return
Excel versus Interpolation
Spreadsheets offer good IRR functions but it can be calculated by interpolation
or graphically. Table below uses mid-year discounting.
Example of Investor's Rate of Return Calculation
Present Present Present Present

Net Cash Value Value Value Value
Year Flow (PV10) (PV15) (PV20) (PV25)
0 -500 -500 -500 -500 -500
1 400 381 373 365 358
2 100 87 81 76 72
3 100 79 71 63 57
Totals 100 47 25 5 -13
21.29% IRR (Excel)
21.28% quick hand calculation
 [5 / (5+13)] * (25 -20) +20 = 21.28%
 Interpolation must not be over more than 10 percentage points.
IRR Does Not Always

Provide a Single Solution
There are two IRR points for this project. Both are mathematically correct – one ~
5% the other ~29%. The shape of the graph shows that for discount rates between
these two values the project is profitable.
IRR & MIRR (ERR):
The Reinvestment Issue
A calculated IRR is not actually earned unless positive cash flows
from each period are reinvested at the IRR rate. Consider the following investment:
Actual "i" Earned May Not Be the IRR

MIRR – modified IRR function
Year Net Cash Flow PV@: 38% incorporates a re‐investment
0 ($1,000) ($1,000) rate so overcomes this
1 $680 $465 shortcoming of IRR.
2 $680 $318
3 $680 $217
MIRR Excel function returns the
Totals $1,039 $0
-in
modified internal rate of return
PV = FV * e 0% IRR
for a series of periodic cash
If $680 is taken out each year and not re-invested: flows. It considers both the cost
then FV= 3* $680 = PV * e 3i of the investment and the
then FV= $2040 = $1000 * e 3i
interest received on
then Ln (2.040) / 3 = i = 23.8% reinvestment of cash.
If $680 is taken out each year and re-invested at MIRR sometimes called external

rates less than 38% then 24%< i <38% rate of return ERR.
David Wood & Associates
MIRR / ERR Provides

a More Realistic Rate of Return
The formula is, however, quite difficult to visualise.
MARR = minimum acceptable rate of return (hurdle rate).
Petroleum Economics
Payout Time or Payback Period
David A. Wood
Delays Erode Value

It is not only the magnitude of the cash flow components that influence value, it is
also the timing of the cash flow elements:
Time Related Yardsticks
Such measures have a calendar significance:
 Project life. This is the length of a project, usually in years. It is related to

the time horizon of a corporation’s strategy and its long and short-term
goals.
 Pay-back or pay-out period. This is the time, usually in years, for a

project to return the after-tax investment. It is the point at which the
cumulative net cash flow becomes positive.
 Discounted pay-out time. Payout calculated using discounted revenues

and investments
 Time to first revenue. This is the time from first investment to first income.
Useful for those companies requiring operating cash flow.
Pay Back Period or Payout

Payout is the time at which the cumulative cash flow, discounted or undiscounted
(depending on selected definition), becomes positive. Most analysts quote
undiscounted payback times.
Advantages:
– Is a measure of liquidity.
– Is a measure of risk exposure.
Disadvantages:
– No indication of what occurs after payout.
– Multiple payouts with staged investments.
– Reflects no magnitudes.
– Is affected only by total cash flow to that point and not by timing of that
cash flow.
Payout / Payback Calculations
Payout time indicates liquidity (risk) rather than profitability:
Simple Payout Calculation

Ignores Time-Value Considerations
Where:
Rk = revenue year k
Ek = expenditure year k
I = initial investment
Discounted Payout formula:
Petroleum Economics
Profit to Investment Ratios
David A. Wood
Cost to Benefit Ratios

These ratios divide returns by costs but have several options for calculation which can lead
to confusion.
 Defined using different values for the investment, which may be the same for any one
project:
 Net cash flow/maximum negative position
 Net cash flow /risk capital (also referred to as risk capacity and number of
times investment returned (NTIR).
 Net cash flow /development capital
 Net cash flow/total investment
 These may be before-tax or after-tax values and both or either numerator and
denominator may be calculated on a discounted or undiscounted basis depending on
the preferred definition.
Cost to Benefit Ratios:
Pros & Cons
These are widely used investment efficiency indicators.
Advantages:
– Measure magnitude of cash flow (profit) per dollar invested
– Discounted values give a measure of the efficiency of the use of capital;

can be used as a ranking parameter
– Independent of project magnitude
Disadvantages:
– Give no indication of time flow of money
– May not reflect total investment
– Do not reflect project magnitude
Undiscounted Benefit to Cost Ratios
These are widely used because they are easy to calculate.
Return on Investment:
 ROI = Cumulative Net Cash Flow

Maximum Negative Position
Profit to Investment Ratio:
 PIR = Cumulative Net Cash Flow

Total Investment
Discounted Benefit to Cost Ratios
Discounted ratios are more useful ranking yardsticks, particularly when capital is
rationed. What costs are included in the denominator needs to be clear.
Discounted Return on Investment:
 DROI = NPV of Cash Flow

Maximum Negative Cumulative PV
Discounted Profit to Investment Ratio:
 DPIR = NPV of Cash Flow

PV of Total Investment
Profitability Index:
 PI = NPV of Cash Flow

PV of Capex only
Benefit to Cost Ratios Compared

Ranking of projects can vary depending upon which ratio is used.
Examples of Cost Benefit Ratios To Describe Cash Flows
Year
Project
I
Project
II
Project
III
Project
IV
When capital is constrained
0 ($500) ($500) ($100) ($500) discounted cost to benefit
1 $100 $200 $100 $100
2 $100 $200 $100 $200
ratios are the best measures
3 $100 $200 $100 ($500) to use to discriminate
4 $100 $200 ($400) $500
5 $100 $200 $200 $400 between projects.
6 $100 $0 $100 $300
7 $100 $0 $100 $0
8 $100 $0 $100 $0 Note: it is important to
9 $100 $0 $100 $0 discount investment
10 $100 $0 $100 $0
Net Cash Flow $500 $500 $500 $500
Cost to Benefit Ratios ROI requires calculation of
not
First Investment Payback (years) 5.0 2.5 1.0 reached cumulative cash flow to
Next Investment Payback (years)
not
reached
not
reached 5.0 4.5
establish maximum negative
ROI 1.000 1.000 2.500 0.714 cash flow exposure.
PIR 1.000 1.000 1.000 0.500
DROI10 0.309 0.590 2.000 0.273
DPIR10 0.309 0.590 0.650 0.191
Misleading Benefit to Cost Ratios
It is important to check how they are calculated. Promoters can make the ratios
appear more favorable than they are:
Well Costs 175,000

Completion Costs 95,000
Total Investment $270,000
Gross Revenue $922,000

Operating Costs 20,000
Net Revenue $902,000

Cash Flow $632,000
Two benefit /cost ratios could be presented:

 Promoter’s “PIR” = 902 / 270 = 3.34
 Actual PIR = 632 / 270 = 2.34
Petroleum Economics
Risk and Opportunity Analysis
David A. Wood
Uncertainty: Risk and Opportunity

Because of the common misuse of the term risk it is appropriate to distinguish clearly
what we mean by the terms risk and uncertainty. The term “opportunity” can help to
clarify our understanding.
 To many people “risk” means a “potential for loss”

 Positive outcomes from risk can equate to opportunity
 Uncertainty implies outcome is unknown (usually within limits)
 Uncertainty suggests potential for loss (risk) or gain (opportunity)
 The chances for loss are sometimes discrete and easy to distinguish
 In most cases outcomes cover a wide grey (continuous) spectrum
 Interactions between many continuous uncertainties are complex
 Risk is highly non-linear in its outcomes
 Combining the impact of risk events is not a simple additive process
 Some uncertainties are dependent upon or impact others
Discrete & Continuous
Components to Risk
Not all uncertainty is captured by continuous probability distributions.
Example shows an
exploration prospect
with a 10% chance of
success and a range of
possible reserves
outcomes if successful.
There is uncertainty associated with both discrete and continuous aspects of risks
Probabilistic Approaches Help But

Rarely Capture All of the Uncertainty
Much that uncertainty in nature follows normal distributions. Situations that
compound many individual uncertainties tend to follow lognormal distributions, but it
is difficult to capture all potential contractual, human, social and political impacts and
uncertainties in such distributions.
Upstream Risk & Opportunity
is Multi-faceted
It is useful to consider the

collective impact of these
uncertainties in an holistic risk
assessment.
Updated from: David Wood et al. World Oil, September 2007
Exercise: Extreme Risks

Extreme risks need to be addressed, particularly in the upstream oil and gas sector?
 Try to identify some of the possible extreme /catastrophic events that should be
considered?
 What contingency steps / actions might be taken to respond if such events

should actually occur?
Risk Diagram Showing the Shareholder
and Judicial Scrutiny Regions
Shareholders and many operations managers often focus more on events with
greater likelihood of occurrence. When extreme events (“black swans” /
catastrophes) occur inquiries are more likely to be focused on high impact - low
likelihood events. Risk management systems need to address the full spectrum of
events.
Potential Events, Actual Incidents

and Risk Management
The relationship between potential events and actual incidents requires clarification.
It is always better to focus on preventing (or exploiting) potential events rather than
managing incidents from a control viewpoint.
Risks Usually Outweigh Opportunities
Once a project is underway the downside risks are usually greater than the upside
opportunities. But it is important not to lose sight of the fact that opportunities exist.
Three Broad Types of Risk

Assessment Prevail in Industry
Some organisations resist moving to a quantitative approach.
 Qualitative
 Semi-quantitative
 Quantitative
Moving to more quantitative techniques does not have to mean involving more
complexity, time and cost.
Pure & Speculative Risks Compared
For pure risks, hazards or threats are objects, substances, activities, behaviours or
situations capable of causing harm. Managing pure risks can result, at best, in no harm
outcomes from a specific hazard or threat.
Speculative risk events involve a

greater spectrum of choice and
uncertainty of outcomes.
For speculative risk management
success often means optimizing
financial, political or other
outcomes from speculative
investments of various kinds and
avoiding loss or disadvantage.
Because pure and

speculative risks often
overlap and interact, creating
artificial boundaries between
them may be inappropriate.
Risk Profiling – Traffic Light Analogy

Risk profiling (or mapping) is a good starting place for risk identification.
Risks should be plotted on

a gross basis – i.e. before
mitigation actions are taken
- in order to ensure
resources are deployed to
manage them.
On a net basis - i.e. after
mitigation actions are taken
-all risks should plot in
manageable squares
The impact needs to be assessed in terms of key objectives.
Bowtie & Butterfly Diagrams
Link Risks to Causes & Impacts
Useful for identifying multiple outcomes and multiple causes for events. Focuses
mitigation strategies on the ultimate causes of identified risks.
David Wood et al. World Oil, September 2007
Addition Rule of Probabilities

If the outcomes of two events are mutually exclusive the addition rule determines
their combined probability of occurrence.
 This rule states that the probability that one or another of two or more
mutually exclusive outcomes will occur is the sum of their separate
probabilities.
 Consider the probability of rolling a 1 with a single die. It is one of six

alternatives so the probability is:
P(1) = 1/6 or 16.67%.
 The probability of rolling a 1 or a 5 with one roll of the die. The events are
mutually exclusive so the addition rule applies:
P(1 or 5) = 1/6 + 1/6 =1/3 or 33.33%
Multiplication Rule of Probabilities
If the outcomes of two events are independent of each other the multiplication rule
determines their combined probability of occurrence.
 This rule states that the probability of two or more independent events
having specific outcomes is the product of their separate probabilities.
 Consider the probability of rolling a double 1 with a single roll of two dice. It
is one of six alternatives on one die together with one of six independent
alternatives on the other die. The probability on each die remains:
P(1) = 1/6 or 16.67%.

P(1 and 1) = 1/6 * 1/6 =1/36 or 2.8%
 There are 35 other combinations for two die.
Possible Outcomes With Two Dice
Probability of throwing a 7 with two dice = 6/36 = 16.7%

Probability of throwing a 7 or a 3 = (6/36) + (2/36) = 22.2%
Probability of two straight sevens = (6/36)*(6/36) = 2.8%
Chance of Finding Some Hydrocarbons
Multiplication Rule For Geological Risk
Estimating the chance of success, is most consistent when several discrete
probability estimates of independent geological attributes are combined to yield a
chance factor by a semi-quantitative justification.
Since the chance of success is much less than the chance of failure
most of the time one or more of the geologic controls will be lacking.
Probability of Wildcat Success
A geological chance of
success (Pdiscovery) of 25%
may only equate to a
commercial chance of
success (Pcommercial success ) of
15% because of reserve size
and also: technological,
economic infrastructure,
fiscal terms and political risks
Development Threshold Field Size
The difference between technical and commercial success is the development
threshold field size. The higher this threshold size the greater the difference
between the chances of commercial and technical success.
Threshold field size will vary

according to:
1. Cost related factors:
•Reservoir depth
•Number of wells
•Reservoir quality
•Water depth
•Proximity to infrastructure
2. Product related factors:

•Oil and gas prices
•Product quality
3. Fiscal terms
Two-step Approach to E&P

Chance of Success
Step 1: Sub-surface Chance Factor (GCF)
Step 2: Above-ground Chance Factor (ECF)
Sub-surface Chance Factor:
Greater than ECF as it is easier to find small fields
Usually expressed as a percentage chance of success
Above-ground Chance Factor:
Probability of accumulation being of economic size
log-normal field size distributions help to estimate it
Political, fiscal, market, technological issues etc., etc.
Key Economic Success Factors
Chance of Geologic Success will vary from basin to basin and prospect to prospect.
It is unlikely to be higher than 25 to 30% in wildcat prospects.
Chance of Economic Success will also depend upon:

– Fiscal Terms
– Depth to Pay
– Reservoir performance & well flow rates
– Location of field relative to infra-structure
– Complexity of development engineering
– Quality of hydrocarbon and its market
– Proximity to market (for gas)
– Prevailing oil, gas or product prices
– Political and business environment
Aspects of Economic Risk Factors

The economic risk factors can be as difficult to estimate as the geologic risk factors.
 Technological Risk: risk of drilling problems or of achieving the well path and
flow rate performance expected.
 Oil & Gas Price Risk: large effect on NPV’s.
 Project Over-Run Risk: cost and time variances.
 Political risk: risk of civil unrest in a country delaying or preventing

development of a discovery (e.g. Iraq, Libya, Nigeria, Sudan, Syria, Yemen
etc.). But there are also many political and regulatory risks in OECD countries.
 Fiscal risk: risk of government introducing new tax or changing the cost
recovery mechanism that will make economics of a discovery less favorable
or even uneconomic.
Petroleum Economics
Capital Budgeting Techniques & Yardsticks

(Exercise#3)
David A. Wood
Most Investment Opportunities

Require Analysis
Few opportunities are good investments just by inspection.
Analysis is required for:
– Very large investments.
– Complex investments inter-related with and incremental to existing

projects with several choices or possible outcomes.
– Marginal investments.
– Incremental investments
– High-risk investments.
– New venture investments (new geology, new industries, new

markets).
– Capital budgeting: selecting the best projects to pursue when funds

are limited and it is possible to fund all profitable projects
Investment Yardsticks
(Economic Key Performance Indicators)
Investment yardsticks are the various criteria used to help in measuring, comparing
and describing investment opportunities.
Comparative investment evaluation implies:
– The expectation of future profits, usually involving both uncertainty and

risk associated with two or more mutually exclusive investments.
– Income generated over a period of time from each potential investment.
– A freedom of choice among investments, i.e., the discretion to select

the best from various opportunities.
The Ideal Investment Yardstick

A single ideal yardstick which properly ranks each investment opportunity would
have the following characteristics:
– It would illustrate the effect on corporate profits of making a specific

investment and incorporate an assessment of risk.
– It would isolate only those investment opportunities which are

acceptable within the confines of a defined corporate strategy.
– It would always make the correct choice from a group of mutually

exclusive opportunities.
Unfortunately, no ideal yardstick exists. Several yardsticks are necessary for

comparative investment evaluation. Wise decisions are more likely when
measuring an opportunity from several viewpoints.
Cash Flow Yardsticks
Not Involving Discount Factors
Cash flow components themselves provide potential yardsticks:
 The investment—both before and after tax (if investment tax credits are
available). A unit basis (i.e., pence/therm or $ / barrel.) is sometimes used for
pre-tax investments.
 Maximum negative cash flow. This is largest sum of money, out-of-pocket at

any one time.
 Ultimate net positive or negative cash flow. This is the cumulative net cash
flow (or actual value profit) from a project. It is the sum of inflows minus
outflows.
 Ultimate net cash flow to investment ratio. This is the cumulative net cash
flow divided by the cumulative maximum negative cash flow.
 Profit (Income) -to-investment ratio. This is the total actual value profit
divided by investment. Complicated by profit and investment not always being
defined in the same way, but usually with accounting rules included.
Time Related Yardsticks

These have a calendar significance.
 Project life. This is the length of a project, usually in years. It is related to

the time horizon of a corporation’s strategy and its long and short-term
goals.
 Pay-back or pay-out period. This is the time, usually in years, for a

project to return the after-tax investment. It is the point at which the
cumulative net cash flow becomes positive.
 Time to first revenue. This is the time from first investment to first income.
Useful for those companies requiring operating cash flow.
Time-Value Related Yardsticks
that Incorporate Discounting
These yardsticks reflect the time value of money:
 Present value profit (loss) or Net Present Value (NPV). This is the total of
a discounted net cash flow stream.
 Present value profiles. These are curves resulting from plotting present
value profits versus a range of discount rates.
 Investor’s rate of Return (IRR). This is the discount per cent which reduces
a cash flow stream to zero. Also MIRR
 Discounted profit-to-investment ratio (P/I). This yardstick measures

investment efficiency. The investment should also be discounted if the
investment stream goes beyond year zero.
Yardsticks Extracted from

Financial Statements / Accounts
These are rarely good economic discriminators for single projects. They are
company specific and are clouded by accounting principles.
 Booked investment. These are the items that accounting principles allow to
be capitalized in the financial accounts or “corporate books”.
 Annual, cumulative and average booked net income (earnings). The net
profit (or loss) reported to shareholders on the profit and loss statement is the
booked net income.
 Earnings Before Interest & Tax (EBIT) and EBITDA (also excluding
depreciation) now commonly used in conjunction with project cash flows to
assess a project’s economic potential.
 Annual or average booked rate of return. The booked net income divided
by the average net booked investment is the booked rate of return.
Traditionally return on net assets has been used for one or several years.
 Return on Capital Employed (ROCE or ROACE) includes long-term debt

with assets as capital employed and is widely used as a yardstick for
company wide investment performance.
Investment Yardsticks Commonly Used
It is important to use a range of investment yardsticks.
The yardsticks [KPIs] that the E&P investment analyst generally consider are:
– Magnitude of investment & maximum financial exposure

– Time scale of project (length of cash flow stream)
– Time to pay back
– Cash flow (annual, total and cumulative trends)
– Discounted indicators to establish the time-value (PV, NPV, IRR)
– Investment efficiency - profit/investment ratios
– Risk capacity – total cash flow divided by risk capital
– Risk adjusted indices – expected monetary value (EMV)
Interpretation of Investment Yardsticks For

Project Ranking & Investment Thresholds
A value of an investment yardstick may be considered to be good or acceptable
in some circumstances but unacceptable in others.
Consider the values of the yardsticks in the context of:
– Risk - technical and / or political risks often overwhelm all other

aspects of an investment opportunity.
– Availability of capital to undertake projects.
– Corporate strategy - short and long-term goals and corporate

attitude to risk.
– Number of available opportunities and competition for them.
Exercise to Rank Projects
Using Investment Yardsticks
As an E&P manager, you must decide which of 8 projects labelled A to H are profitable
and compatible with your company's strategic goals and objectives. Your technical
team and economic analyst have evaluated and submitted the projects shown below
for your consideration and approval under the current exploration budget.
Exercise: Investment Yardsticks

The following investment yardsticks have been calculated from the project cash flow
profiles for 8 projects (A to H):
Ranking Projects:
Use Yardsticks to build a Matrix
Construct a ranking matrix in tabular form of the projects based on a selection of
the nine most useful investment yardsticks. Rank 1 = best; Rank 8 = worst. Rank
the projects using letter codes (A to H):
Which Projects (A to H)
Should be Selected?
Use the matrix you have constructed to help you to list the projects that would be
selected under the following conditions assuming and there are no other
investment opportunities available:
I. Capital limited to a total $180 million investment budget and your company’s
cost of capital is 9%.
Projects?
Total Investment?
@9% discount rate NPV?
II. Capital limited to a total of $105 million, your cost of capital is 15%.
Projects?
Total Investment?
III. Same as II but Project E is in a country where a civil war has started?
Projects?
Total Investment?
Should be Selected?
IV. No limit on capital resources and your cost of capital is 9%.
Projects?
Total Investment?
V. Capital is limited to US$60 million and the board has issued an initiative to
improve investment efficiency and shorten payout time. Cost of capital
remains at 9%.
Projects?
Total Investment?
VI. Same as 5 but corporate directives say that projects maximizing P/I
discounted @9% should be prioritized and a longer term view adopted.
Projects?
Total Investment?
Should be Selected?
VII. You have only projects E & B left from which to make a selection. You
are capital limited with other reinvestment opportunities having a Profit /
Investment ratio discounted at 9% equal to:
(a) 0.6 (b) 0.50 (c) 0.4
VIII. You decide to rank the projects in order of their liquidity (i.e. those that
provide maximum positive cash flow in the shortest period of time) and
take the four most attractive.
OMV’s Prefered Yardsticks
For Economic Analysis
Petroleum Economics
Which Oil & Gas Prices Should be Used to Value

Assets?
David A. Wood
Short-term Oil & Gas Price Drivers
 Global supply and demand (commodities & products)
 Refinery surplus capacity
 OPEC surplus capacity
 Market perception
 Weather
 Unexpected supply disruptions
 Stock-building in consuming markets (particularly OECD)
Long-term Oil & Gas Price Drivers
 Non-OPEC new sources. e.g. deepwater Gulf of Mexico, Caspian
 Demand growth in developing economies: China, India
 Global and regional economic cycles
 New technologies e.g. fuel cells, gas-to-liquids (GTL), substitutes
 Expanding demand for natural gas, LNG, GTL, Gas-to Power
 Unconventional oil and gas exploitation (high-cost supply)
 Renewables, alternatives, biofuels take market share
 Politics, geopolitics and politics (with a small “p”)
Crude Differential Trends Enable

Arbitrage Opportunities in Markets
2006 2007 2008 2009 2010 2011
Oil Market Report, IEA 2005 to 2011
U.S. Long-term Price Forecasts
by EIA for 2011 to 2035
In real terms EIA sees natural gas prices rising modestly in real terms ($2009) to
2035 reaching about US$7.0/mmbtu. Over-optimistic? 3Q-2011 Henry Hub spot
natural gas price was about $4.0/mmbtu. Crude oil forecast to rise to $(2009) 125 by
2035 in the EIA’s reference case. Note the large uncertainty for oil forecast.
U.S. Light Sweet Crude Forward Curve

28 October 2011
CME quotes nine years forward (six years monthly and final 3 years for June and
December). WTI moderate contango.
U.S. Light Sweet Crude Forward Curve
9 September 2011
CME quotes nine years forward (six years monthly and final 3 years for June and
December). WTI moderate contango.
Brent Crude Oil Forward Price Curve

September 2011
Steep backwardation.
Spot & Forward Curves Evolve
Real & Nominal Crude Oil Prices Show

Volatility Since the 1970’s
Short-term versus Long Run
Crude Oil Prices (Nominal & Real)
OPEC Reference Basket (ORB)

The “new” OPEC Reference Basket (ORB), introduced on 16 June 2005, is
currently made up of the following: Saharan Blend (Algeria), Girassol (Angola),
Oriente (Ecuador), Iran Heavy (Islamic Republic of Iran), Basra Light (Iraq),
Kuwait Export (Kuwait), Es Sider (Libya), Bonny Light (Nigeria), Qatar Marine
(Qatar), Arab Light (Saudi Arabia), Murban (UAE) and Merey (Venezuela).
Notes:
As of January 2006: The Weekly, Monthly, Quarterly & Yearly averages are
based on daily quotations.
As of January 2007: The basket price includes the Angolan crude
"Girassol".
As of 19 October 2007: The basket price includes the Ecuadorean crude
"Oriente".
As of January 2009: The basket price excludes the Indonesian crude
"Minas".
As of January 2009: The Venezuelan crude "BCF-17" was replaced by the
crude "Merey".
OPEC Reference Basket Price Historical
1998 to 2011
Historical annual average ORB prices and comparisons to Brent.
1998 $12.28/bbl
1999 $17.48/bbl
2000 $27.6/bbl US$ / barrel
2001 $23.12/bbl
2002 $24.36/bbl
2003 $28.1/bbl
2004 $36.05 /bbl
2005 $50.64 /bbl
2006 $63.18 /bbl
2007 $69.08/bbl
2008 $94.45 /bbl
2009 $61.06/bbl
2010 $75.59/bbl
Dated Brent $54.52 (2005Avg)
Dated Brent $65.14 (2006 Avg)
Dated Brent $97.26 (2008 Avg) www.opec.org
2011 OPEC Reference Basket Price

The new OPEC Reference Basket (ORB) introduced in June 2005 is made up of
twelve crudes: Saharan Blend (Algeria), Girassol (Angola), Oriente (Ecuador), Iran
Heavy (Islamic Republic of Iran), Basra Light (Iraq), Kuwait Export (Kuwait), Es
Sider (Libya), Bonny Light (Nigeria), Qatar Marine (Qatar), Arab Light (Saudi
Arabia), Murban (UAE) and Merey (Venezuela).
Indonesia withdrew to US$ / barrel

observer status from OPEC
in 2008.
Prices based on daily quotes

since Aug 2009.
Note that OPEC crudes are

not traded on any exchange
so do not represent
internationally traded
benchmarks.
www.opec.org
OPEC Reference Basket (ORB) Price
Relative to Benchmarks
The OPEC basket price follows Brent.
2010 2011
OPEC Market Report April,2011
US Natural Gas Forward Curve

28 Oct 2011
UK & US Forward Gas Curves
2006 and 2008
Hedging & Margin Erosion

Fully (over?) valued acquisitions executed in a high commodity price environment
can present future profitability risks for buyers.
 Near-term commodity price risk can be partially mitigated in an acquisition

through an aggressive hedging program.
 Longer-term issues do arise if prices continue to rise (e.g. in hindsight

companies that hedged in 2003 / 2004 sacrificed much upside in 2005/2006).
 Hedging provides top line protection (reduces leverage) should prices ease.
It enables leveraged buyers to repay debt finance.
 Hedges cannot, however, protect a company from rising costs or "bottom-up"

margin erosion.
 Equity of companies that hedge aggressively can often trade at significant

discounts to that of their unhedged peers. Puts pressure on management to
fund the next acquisition(s) in a more leveraged manner?
Petroleum Economics
Valuing Incremental Investments
David A. Wood
Analysis of Incremental Investments

Often there are more than two investment alternatives on offer. An unrealistically
positive NPV or other yardstick may result if the options are considered in isolation
rather than on an incremental basis.
Examples of incremental investments are:
– Drill a prospect versus farmout the prospect
– Complete versus abandon well
– Develop versus sell field discovery
– Install enhanced recovery systems versus deplete field
– Offshore pipeline versus shuttle tanker to produce field
– Upgrade /simplify plant versus keep existing facilities
– Install Electric Submersible Pumps (ESPs) versus keep beam pumps,

screw pumps, jet pumps or gas lift.
– Etc……
Analysis of Field Development:
Case A – No Secondary Recovery
Analysis can provide additional insight for decisions by focusing on incremental
benefits or sacrifices associated with different project options.
Analysis of Field Development:

Case B – With Secondary Recovery
Incremental Analysis of Field Development:
Case B versus Case A
Cash Flow Analysis

of Drilling Opportunity
This considers a straightforward upfront equity investment to drill the well.
Cashflow Analysis of Drilling Opportunity
Year Production Revenue Expenses NCF PV15 NCF

Barrels (Values in 000's) Pre-tax Pre-tax
0 0 $0 $0 ($10,000) ($10,000)
1 1000 $20,160 ($1,000) $19,160 $17,867
2 550 $11,090 ($1,080) $10,010 $8,117
3 300 $6,100 ($1,160) $4,940 $3,483
4 175 $3,350 ($1,260) $2,090 $1,281
5 100 $1,840 ($1,360) $480 $256
Totals (yrs1 to 5) 2125 $42,540 ($5,860) $36,680 $31,004
Net Totals (yrs 0 to 5) $26,680 $21,004
ROI: 2.67
Note: IRR function calculates back to year 0 IRR: 143%
Discount factor applied mid-year from year 1 DROI: 2.10
Drill versus Farmout Options
Analysed Incrementally
It is often not necessary to calculate the incremental case as decisions can be
based on relative NPVs of two or more alternatives. However the incremental value
between two options can often provide useful additional insight.
Farmout Option Where Farminee Pays All Well Costs -Farmor has 25% Back-in Option at Payout
Values in 000's Drill Case Farmout Case Incremental Case

Investment $10,000 Investment $0 Investment $10,000
Year Drill NCF PV15 NCF Farmor NCF PV15 NCF Incr. NCF PV15 NCF
A B A-B
0 ($10,000) ($10,000) $0 ($10,000) ($10,000)
1 $19,160 $17,867 $2,290 $2,135 $16,870 $15,731
2 $10,010 $8,117 $2,503 $2,029 $7,508 $6,088
3 $4,940 $3,483 $1,235 $871 $3,705 $2,612
4 $2,090 $1,281 $523 $320 $1,568 $961
5 $480 $256 $120 $64 $360 $192
Totals (yrs1 to 5) $36,680 $31,004 $6,670 $5,420 $30,010 $25,584
Net Totals (yrs 0 to 5) $26,680 $21,004 $6,670 $5,420 $20,010 $15,584
ROI: 2.00
Note: IRR function calculates back to year 0 IRR: 114%
Discount factor applied mid-year from year 1 DROI: 1.56
Petroleum Economics
Inflation, Buying Power, Money of the Day & Real Values
David A. Wood
Cost Inflation: Significant Impacts

on Oil & Gas Industry
Oil industry cost inflation

since 2005 has impacted
upstream and
UCCI: Equipment that cost $100
in 2000 costs $230 at end 3Q
downstream industry
2008 ($218 at end 1Q 2011) acting as drags on
development leading to
DCCI: Equipment that cost
$100 in 2000 costs $176 at
project cancellations and
end 1Q 2008 ($192 at end 1Q delays.
2011)
Costs escalated through

2008 despite economic
slowdown. World steel
demand down 15% in
2009. Activity and
inflation increased again
2010 to 2011.
Inflation and Cash Flow Calculations
If a 15% rate of return is desired and 10% /year inflation is forecast:
Cashflow Analysis of Investment Opportunity With 10% Inflation of Revenue and Expenses
No inflation considered in calculating net cash flow Cash flow adjusted for 10% inflation
Values in 000's PV25 NCF Revenue Expenses NCF PV15 NCF NCF PV15 NCF
Year Pre-tax Pre-tax Pre-tax Pre-tax Pre-tax
0 ($10,000) $0 $0 ($10,000) ($10,000) ($10,000) ($10,000)
1 $4,651 $6,000 ($800) $5,200 $4,849 $5,454 $5,086
2 $2,361 $4,000 ($700) $3,300 $2,676 $3,807 $3,087
3 $1,374 $3,000 ($600) $2,400 $1,692 $3,046 $2,148
4 $779 $2,000 ($300) $1,700 $1,042 $2,373 $1,455
5 $293 $1,000 ($200) $800 $427 $1,228 $655
Totals (yrs1 to 5) $9,458 $16,000 -$2,600 $13,400 $10,686 $15,908 $12,430
Net Totals (yrs 0 to 5) ($542) $3,400 $686 $5,908 $2,430
ROI: 0.34 0.59
Note: IRR function calculates back to year 0 IRR: 14.8% 23.4%
Discount & inflation mid-year from year 1 DROI: 0.07 0.24
Implication of this calculation is that factoring in inflation increases value!

Adjustments to the discount rate are required.
Allowing for Inflation in Cash Flows

It is not correct to simply add the inflation rate to the discount rate to compensate
for inflation (but when inflation rates are very low it makes very little difference to
the analysis).
A composite discount rate accounting for inflation is provided by:
– (1 +r) = (1+ i)(1 + f) where i is the desired rate of return, f is the

rate of inflation and r is the composite discount rate. If i = 15% and
f = 10% then: r =26.5% (not 25%).
However there are complications:
– Costs and product prices often inflate at different rates. This is

particularly so in the petroleum industry.
– In after tax calculations some components (e.g. depreciation) are

not adjusted by inflation in many fiscal regimes.
Money of the Day (MOD or Nominal)
Cash Flow Values
It is usually more effective and realistic for economic analysis to inflate cash flow
components separately and then to deflate the resulting combined cash flow before
applying discount factors.
Costs are adjusted for inflation using the formula:
– FVm =FVt * (1+fc)n
– where: FVm is money of the day value, FVt is today’s value, fc is the
annual rate of inflation for costs and n is the number of years. (n-0.5 can
be used for mid-year inflation factors)
– fp is substituted for fc to give an equation for prices.
Future inflated cash flows calculated by combining the inflated components are
said to be expressed in money of the day or nominal terms.
Real Cash Flow Values

Money of the day cash flows can be deflated before applying
discount factors to provide cash flows in real rather than nominal terms.
Money of the day or nominal cash flows are deflated back to today’s values (or
values of any specified period) by adjusting for inflation using the formula:
– FVr =FVm * (1+d)-n
– where FVm is money of the day value, FVr is the real value, d is the
annual rate of deflation and n is the number of years. (n-0.5 can be used
for mid-year factors).
– unlike the inflation factors which are cost and price specific for the
industry the deflator should be related to broader economic inflation
indicators to reflect forecasts for the effective buying power of money.
Oil & Gas Prices are Often Expressed
in Both MOD (Nominal) and Real Terms
Two forecasts for natural gas prices in Canada at Alberta Hub. Real terms is in the
money of year 1. MOD terms is in the money of each year including inflation.
The effects of inflation can be removed by deflating the cash flows to real $ year 0.
Buying Power Concept –

Supplier Example
Buying power is synonymous to the expression of future cash flows PV’s or of

future cash flows in terms of current monetary values.
A supplier buys 1000 valves in year 1 at $30 each and fits them into a
simple surface meter that is sold for $100. His other materials and overhead
costs are $30,000. For year 1:
Suppliers First Year Cash Flow
Sales: 1000 metres $100,000
1000 Valve Costs ($30,000)
Other Costs & Expenses ($30,000)
Profit taken ($10,000)
Net cashflow for reinvestment $30,000
The supplier reorders the valves to find they are now $50 each (a 66.7%
increase). His $30,000 will now only buy 600 valves. His money is now only
worth 600 * $30 = $18,000 in year 1 terms
Equation to Calculate Buying Power
The equation also has to consider the potential earning power of year 1 money.
The situation for the supplier is worse than it appears because he has also
foregone interest that could have been earned on the original $30,000
investment. If that interest (i) is say 10%:
– PV10 ($30k) = ($30k)(0.9091) = $27,273
– This has to be combined with the effective value of the ($30,000)

to the supplier (i.e. the inflation rate, f) to calculate the buying
power.
– BPVi = CFn*[(1+i)(1+f)] -n is the general buying power equation,

where n is number of years.
– BPV10 = $30K*[(1 + 0.1)(1 + 0.667)] -1 =$16,331
Real Rate of Return

There is another relationship between the desired discount rate and inflation rate that
is used to calculate the rate of return in real terms.
Equation to calculate real rate of return is:
– S = (i - f)*(1 + f) -1
where i is the nominal rate of return, f is the inflation rate of investment costs
and S is the real rate of return.
If a cash flow with f=10% has a nominal rate of return of 23.4%. The real rate
of return was:
– (0.234 - 0.1)*(1+ 0.1) -1 = 12.2%
The same equation can be re-arranged to give the nominal rate of return
needed for a desired real rate:
– i =S + f(1 + S) e.g. 0.15 + 0.1(1+ 0.15) = 26.5%
Petroleum Economics
Inflation Indices
David A. Wood
Constant or Real Price Terms

By expressing values in terms of prices of a particular year it removes price inflation
or fluctuation and gives volume information but expressed in monetary terms, i.e.
output in real or constant prices.
 Current prices, nominal prices and nominal terms or values include the
effects of inflation.
 Volumes, constant prices, real prices and real terms or values exclude any
inflationary influences.
 Price indicators used to convert between current and constant prices (to
deflate) are sometimes called price deflators.
 Any series of numbers can be converted into index numbers with a base of
100 by: 1) selecting a reference base year value; 2) dividing that number by
100; 3) dividing all the numbers in the series by the result of step 2.
Constant Versus Current Dollar
Energy Costs
Calculating Price Indices

Any series of numbers can be converted into index numbers with a base of 100 by:
1. Selecting a reference base year value
2. Dividing that number by 100
3. Dividing all the numbers in series by result of step 2.
Index numbers have no units. This avoids distracting units and changes
are easier to assess.
Current & Constant Price Indices
& Price Deflators
Index numbers have no units. This avoids distracting units and changes are easier
to assess.
Indices: Points To Be Aware of

Basis for weighting indices and assessing the effect of the base year selected.
 Frequently two or more indices are combined to form one composite index
(e.g. Purchase Price Index PPI or Consumer Price Index CPI). The
different components are weighted according to their contribution to the
index in the base year.
 Composite indices can become distorted if one component becomes much

more or much less significant in terms of its contribution compared with that
in the base year. Always check when an index was last re-based and
whether there were significant changes in its components.
 Two or more indices will always meet at the base period because they both
equal 100. This can be misleading. Always check where the base is
located. This is known as illusory convergence.
Index Numbers – Do Not Be Fooled
By Illusory Convergence
The base year selected will arbitrarily control when current and constant price
indices converge.
Contract Prices & Tariffs are Often

Escalated Periodically Using Composite Indices
Long-term product sales and pipeline tariff contracts sometimes include indices to
adjust prices each year (or quarter). This protects buyer and seller from inflation and
other changes in market conditions.
 Composite indices such as PPI are often used in long term sales and
transport contracts to take account of inflation and changes in market
conditions. For example a price formula in a UK long-term gas contract was:
P = IP[0.4(X/X0)+0.2(E/E0)+0.25(G/G0)+ 0.15(H/H0)]
 Where P is the inflated price, IP is the base price, X is Producer Price Index,
E is the industrial electricity index, G is the gas oil index and H is the heavy
fuel oil index. X,E, G & H are all quoted in UK Government statistical
publications. The base year index (denominator)values have a 0 suffix.
 All components to such indices should ideally be appropriate to the market

and be based to relevant years.
Volume and Price Usually Determine Value
When interpreting economic figures it is important to distinguish between the effects
of inflation and the real level of economic activity.
Economic indicators measure one of three things:
– Volume - e.g. barrels of oil.

– Price - e.g. market price of 1 barrel of oil.
– Value - e.g. market value of oil produced in 1 year.
The relationship between them is simple:

– Volume * Price = Value.
– Inflation indices enable us to express price and value at different

periods of time.
Petroleum Economics
Estimating Values & Costs and Budget Cost Control

(Exercise #4)
David A. Wood
Oil Price Forecast –

Energy Specialists 1998
Actual
Price
We are worse (as individuals or groups) than we think we are at forecasting!
Costs in an Upstream
Oil & Gas Perspective
Costs are not usually the most important influence on overall project value. Oil
price, reserves & production rate and even exchange rates often have largest
impact on NPV. Tornado charts are useful to display sensitivities.
In the case of a single
asset, project level and
corporate level cost
drivers often have less
impact on long term
profitability than revenue
drivers.
For LNG, deep water and

marginal field
developments costs are
more important but
usually remain subordinate
to the revenue and
production drivers.
Can use absolute numbers and / or percentages

Tornado Charts Display

Relative Importance of Costs
Capital expenditure is a key project driver for deepwater Nigerian prospects.
Absolute numbers and percentages are usefully displayed.
Spider Charts Widely
Used for Sensitivity Analysis
Spider Charts Interpretation:

Steep Trends Indicate High Sensitivity
Opportunities to Simplify Old Facilities
& Reduce Operating Costs
As production / revenues decline in mature fields management must seek changes to
the operation that reduce OPEX and extend field life.
Fixed costs can often be

reduced by facilities
rationalisations in stages
as a field matures.
Variable costs often

fluctuate over the life of a
project and may
increase as break-even is
approached as economies
of scale are lost.
Eliminating Bias from

the Estimation Process
Systematic bias — the tendency for us to consistently overestimate reserves or
underestimate costs — permeate the upstream oil & gas industry!
 Two biases that commonly bedevil our geotechnical forecasts are:
– over-confidence — setting predictive ranges too narrow, resulting

in frequent surprising outcomes.
– over-optimism — motivational bias, caused by excessive zeal in

“selling” the prospect prompted by perceived competition from
the prospects of others.
Common Estimating Trend of Increasing
Costs Through Project Life
The challenge is to
predict realistic cost
early in the project. The
cost curve here shows
a common estimating
trend, a pattern of
increasing costs from
one phase of the
project to the next.
Reasons for Poor Early Cost Estimates

Most common ailments or root causes are optimistic estimates and schedules,
lack of experienced personnel, lack of time, lack of money, manipulative access
to funding and / or poor execution.
 Optimistic early estimates may secure project sanctioning, but once

exposed after commitments are secured may reveal that the sanctioned
project is uneconomic.
 Poor early estimates once quoted are difficult to replace in contracts with
better defined and possibly more expensive.
 A poor early estimate can result in a loss of credibility between the client
and estimator.
Cost Estimating Phases & Accuracies
Early estimates should not be over-defined to a degree that is excessive for that
estimating phase.
Contingency Versus Accuracy

Contingency is the amount added to the base estimate to achieve a P50 cost. The
P50 cost has a 50% probability of either under-running or overrunning the final actual
cost. Contingency is an allowance for costs expected to occur but currently
undefined and unknown.
Contingency does not allow

for costs associated with
scope growth or premises
changes.
The amount of contingency
applied should be an owner-
defined cost and
responsibility based on an
empirical method, one which
documents the process and
provides some explanation-
justification to support the
allowance.
Cost Risk Analysis Example
Example of a pre-FEED cost risk analysis performed on a GOM deepwater subsea
tieback project (excludes costs of drilling and completion).
Yale & Knudson, Deepwater Technology, Jan 2006
Probabilistic Approaches
to Cost Estimate Uncertainties
It is useful to clearly indentify what is involved in cost estimate contingencies and

uncertainties. Probabilistic distributions offer a useful technique to do this that can
be sampled in simulation analysis.
The Time to Influence Expenditure
is During the Planning Stage
Authority for Expenditure (AFE)

Essential for Cost Control & Approvals
AFE system is widely used in the oil and gas sector because of joint ventures.
All joint venture parties are

expected to sign off an AFE
produced by the project
sponsor or operator.
By doing this all parties
formally approve project
costs which are documented
and explained in the AFE.
AFE Process, Cash Calls
& Cost Control Report
 The AFE is a document describing the scope of work and associated costs required for a
project. It usually includes:
– Cost estimate breakdowns of the items of expenditure needed to complete work
– Timing and duration of activities involved
– A total of the base case project cost with contingencies and any escalation factors
associated with inflation to provide “a cost estimate for approval”
 Details including a project description and economic justification to support the cost
estimate are usually included in a brief 3 to 4 page document.
 Participants in the joint venture are expected to give their formal signature/ approval to the
AFE within a specified period, commonly 30 days. They are then cash called by the
operator to provide their shares of the required funds.
 If expenditures during the project seem likely to exceed 10% of the approved cost then a
supplemental AFE is issued. A cost control report is prepared at the end of the project.
80:20 and 95:60 Rules of Thumb

Provide Useful Guides for Cost Control
Concentrate efforts on the 20% of key items / services that drive the project and
minimize time and overhead spent on the 40% of items that represent only 5% of
the costs.
Petroleum Economics
Introduction to Upstream Fiscal Terms & Contract Types
David A. Wood
Parties & Agreements Commonly

Involved in Petroleum Field Projects
Note: 1. Lenders can be banks and or multi-lateral agencies (e.g. IFC)

2. Offtake here includes transportation, throughput & processing.
Strategic Objectives of Fiscal Design
& Types of Fiscal Agreement
Key Government and Contractor Aspirations

HOST GOVERNMENT CONTRACTOR / IOC
 Maximise/optimise its share of the  Build equity and maximise value

economic rent for the shareholders
 Ensure good governance (safety,  Maximise return on investment

environment & corporate) and its share of reserves and
production
 Avoid undue speculation and
corruption  Provide fiscal stability and
flexibility
 Create competitive investment
climate  Reward risk taking
 Sustain growth and development  Minimise bureaucracy, fiscal

complexity (ambiguity) &
 Create employment, training and corruption
commercial opportunities for its
nationals  Offer progressive taxation
Overall Government Takes from Petroleum
Production Varies Substantially
Governments need to retain the ability to adjust fiscal designs to meet changing
conditions.
Most governments
open new areas for
licensing, re-licensing,
or for contract by IOCs
in stages over time.
Often such activity is

linked to bidding
rounds. It is useful for
the governments to
retain rights to adjust
fiscal terms associated
with new licensing.
Components of Government Take

in Terms of Economic Rent
Government’s and IOCs shares of economic rent.
Progressive and Regressive
Fiscal Elements & Government Risk
Progressive Fiscal Structures

Respond to Changing Conditions
Progressive fiscal structures take more for the state when prices are high or
costs are low.
Regressive Fiscal Structures
Less Flexible in Changing Conditions
Regressive fiscal structures will damage commerciality in harsh economic conditions.
Royalty Can Become a Significant Burden

The regressive nature of royalties is easy to demonstrate:
 With a gas price of $10 /

mmbtu, a 20% royalty
accounts for 50% of the gross
profit of a field costing
$6/mmbtu to produce.
 With a crude oil price of

$15/mmbtu, the royalty share
of profit decreases to 33.3%
 With a crude oil price of

$20/mmbtu the royalty share
of profit decreases to 28.6%.
 This graph illustrates the

regressive impact of royalties
on profits.
Time-Value-Cost Analysis of Oil & Gas
Projects & Fiscal Terms
Cross plotting, on a per

barrel basis, discounted
contractor cash flow (NPV)
and full project costs
reveals much more about
the economic performance
of specific projects and
contract terms.
Such plots are useful

negotiating aids for both
contractor and
government.
Such plots can be

enhanced by incorporating
assessments of risk.(i.e.
using EMV instead of
NPV).
Licence Agreement Terms Influencing

Financial & Economic Performance
 Contract area / prevailing law
 Duration of phases / contract management / voting rights
 Relinquishment Schedule / accounting procedures & currencies
 Land rentals ($/km2) / employment obligations
 Exploration obligations and work commitments
 Bonuses (signature, training, production, reserves thresholds)
 Royalty (% of gross production- perhaps sliding scale)
 Cost Recovery Allocation (% of gross revenue)
 Uplift Allowances of Capital Costs (% of eligible costs)
 Overhead and debt interest cost allowances
 Custom’s duties and other local levies and employment taxes.
 Cost Amortization (%/yr depreciation rates for cost categories)
 Profit Oil or Gas Split (% usually a sliding scale)
 Domestic Market Obligation – subsidy to world market price
 Ring fencing (of costs and/or revenues); oil / gas price caps
 Income Tax (% of contractor profits)
 Tax Credits for additional capital expenditure (e.g. exploration)
 Withholding / Remittance Tax (% of profits remitted overseas)
 State Participation / back-in option (% of joint venture group)
 Rights of Assignment / dispute resolution / arbitration
Long-term Fiscal and Contractual
Stability Often Proves to be Elusive
Key issues:
Alignment
Empathy
Understanding
Trust
Long-term
Perspectives
Flexibility
Sustainability
E&P Licence Areas and Unitisation

Offshore UK quadrants of 1 degree latitude by 1 degree longitude are subdivided
into 30 blocks of about 250 sq. km.
Original Unitisation of Nelson Field

22 / 06a: 43.29%
22 / 07: 0.75%
22 / 11: 53.33%
22 / 12a: 2.63%
Nelson Field
Joint Development Zones
Nigeria / Sao Tome JDZ
Unitisation- Definition of Process
“A process to facilitate the equitable distribution of volumes to the

stakeholders of a petroleum accumulation, and to share in the benefits
of production, revenues and the costs of obligations inherent in the
development and production within the oilfield.”
Petroleum Economics
Production Sharing & Cost Recovery (Exercise #5)
David A. Wood
Division of Proceeds from

Oil & Gas Production Sharing Contracts
This scheme considers how the profit and cost components from oil (or gas) fields are
divided on a full project basis.
Contractor Take: Government Take
The division is simplistic as it

ignores the time value of money
and risk versus reward concepts
Time-Value Considerations For
Cost Recovery Mechanisms
Oil and gas projects are characterised by high capital investment in early years,
without cash flow, followed by high cash flow after production startup which
gradually declines in line with production towards field abandonment. Rate of cost
recovery impacts contractor’s value.
Production Sharing Contracts:

Basic Fiscal Components
Over time PSCs have changed substantially and today many have complex features
to refine the production sharing process. In its most basic form a PSC has four main
fiscal properties.
1. Contractor often pays a royalty on gross production.
2. Contractor is entitled to a pre-specified share (e.g. 40 percent) of production

for cost recovery (termed cost oil).
3. The remainder of the production, so called profit oil, is then shared

between government and contractor at a stipulated share (e.g. 70%
government: 30% contractor) or on a sliding scale.
4. In some contracts income tax is paid from the government’s share. In

others the contractor has to pay income tax on its share of profit oil. In some
contracts (e.g. Nigeria) a pre-specified share of production is designated for
the payment of tax and termed tax oil.
PSA Take & Cash Flow Breakdown
Average Over Field Life
Taxation, cost recovery

(allocation and depreciation)
and state participation all have
significant impact on the
economic performance of
upstream oil and gas contracts.
Some taxes may be paid from

the Government’s share to
attempt tax stability.
PSC Take & Cash Flow Breakdown (1a)

Average Over Field Life – Good Cost Oil
Signature and other

bonuses should also
be included in the
State Take.
This average barrel
over the life of the field
ignores the effects of
depreciation.
In this example cost
recovery is sufficient
to recover the cost of
the average barrel,
but it may not be
enough to recover the
all the costs in the
early years of
David Wood & Associates production.
PSC Take & Cash Flow Breakdown (1b)
Average Over Field Life – Good Cost Oil
recovery (E) is
sufficient to recover the
cost of the average
barrel, but it may not
be enough to recover
the all the costs in the
early years of
production.
Gross revenue is split

approximately:
•62% to State
•7% to Contractor
•31% to Costs
PSC Take & Cash Flow Breakdown (2a)

Average Over Field Life – Poor Cost Oil
Cost recovery
allocation is reduced
here to 25%. It is now
not sufficient for all the
costs to be recovered.
Unrecovered costs
remain in a cost pool.
Contractor has spent
$6 but only recovered
$4.25.
Contractor’s take and
cash flow are
significantly reduced.
PSC Take & Cash Flow Breakdown (2b)
Average Over Field Life – Poor Cost Oil
recovery (E) is insufficient
to recover the cost of even
the average barrel in a single
period.
The State’s Take and cash
flow are the same. The
contractor’s are not, because
contractor is funding upfront
capital costs.
Gross revenue is split
approximately:
•69.5% to State
•-0.7% to Contractor
•31.2% to Costs
•But nearly one-third of
those costs (10% of gross
revenue) are not recovered
in a single period.
Yearly Price Fluctuations Influence

Reserves Booked Under PSCs
Higher the product price the lower the number of barrels to satisfy the cost oil
allocation. Remaining barrels go into profit split.
Contractor: Government Takes & Interests
“Bookable” in Financial Statements
The tax component is

also accepted as a
bookable component
in some PSCs
Bookable
In Financial
Statements
Exercise to Calculate Revenue Split
For Example Production Sharing Terms – Fill in the Gaps!
David Wood Exercise #5
Petroleum Economics
Funding Criteria: The Cost of Capital

& Oil & Gas Finance
David A. Wood
Cost of Investment Capital is Usually

Complicated by Taxation Issues
Tax allowances for debt and equity sources of capital are usually different.
 The simplest case is: all money is provided by a single lending agency at a
single rate.
 The cost of capital is the before-tax or after-tax interest charge, e.g: A

bank loan at 10%
– Cost of Capital = 10% before tax.
– Cost of Capital = (10)(1 - 0.29) = 7.1% after tax.
 Note that in most countries the government effectively subsidises

borrowing by allowing corporate tax relief on loan interest.
Cost of Investment Capital:
Weighted Average Cost of Capital
The weighted-average cost of investment capital (WACC), from all sources, is
usefully expressed as a percentage interest cost, not as an absolute currency
amount.
 A second simple case of investment money derived from three separate

lending agencies:
 Bank A: 100 M$ at 10%

 Bank B: 200 M$ at 12%
 Bank C: 300 M$ at 15%
 Cost of Capital = [(100)(10) + (200)(12) + (300)(15)]/600

= 13.17% before tax.
 Cost of Capital = (13.17)(1 - 0.29) = 9.35% after tax.
Cost of Debt Plus Equity

Investment Capital (1)
Most companies fund ventures with both debt and equity making the cost of
capital calculation more complex. All sources of capital funds have associated
costs that must be consider in calculating WACC.
 A third, real world case, is a public corporation with debt (loans, bonds, etc.)
and equity (stock/traded shares) capital. In this case, the cost of capital can
be estimated as:
[(% Equity) * (Growth Rate + Dividend Rate)]

+ [(% Debt) * (Interest Rate)]
 Consider such a corporation trying to maintain a 10% stock value growth

rate and paying a 4% dividend. Debt consists of 75% in 7% bonds and 25%
in 15% short-term notes. The debt : equity split is 40 : 60 and the percent
equity is 60, for a debt/equity ratio of 0.67.
Cost of Debt + Equity Investment Capital (2)
Most large companies fund ventures with both debt and equity.
 Cost of Capital = (0.6)(10 + 4) + (0.4)[(0.75)(7) + (0.25)(15)]

= [8.4/(1 - 0.29)] + 3.6
= 15.43% before tax
 Cost of Capital = 8.4 + (3.6)(1 -0.29)

= 10.96% after tax
 Growth and dividend payments are accomplished with after-tax funds so

before tax calculation requires tax adjustment (which will increase the
equity cost pre-tax).
 After taxes, debt capital is cheaper than equity capital, even at relatively
high interest rates for borrowing.
Link Discount Rate To Cost of Capital
Most companies fund ventures with both debt and equity.
 Prudent practice dictates that investments not be made in projects returning

less than the cost of capital.
 Therefore, the minimum investor’s rate of return for qualifying projects, as

well as the appropriate minimum discount rate for present value
calculations, is the cost of capital.
 IRR, PV and NPV should all be determined on an after-tax basis and with
risk and inflation prefigured into the net cash flow stream and not
incorporated into the required rate of return or discount rate.
Simplified Flow Chart For The Financial
Process in a Typical Upstream Oil Company
The role of financial management is to optimise the value and use of the basic
reservoir of cash and its associated funds flow.
Financial management
involves funding
decisions in the
raising of cash in the
form of equity and
debt.
It also involves the

efficient allocation of
funds between assets,
credit investments, etc.
Providers of Project Finance to

Major Energy Projects
Energy investors and commercial banks make the major funding contributions.
OECD Export Credit Agencies
Export credit agency contributions as debt or guaranties help to reduce
project risk.
www.exim.gov (U.S.A)
www.ecgd.gov.uk (U.K.)
http://www.oekb.at (Austria)
LIBOR and EURIBOR
Benchmark lending rates.
 The Libor is the average interest rate that leading banks in London charge
when lending to other banks. It is an acronym for London Interbank Offered
Rate. Banks borrow money for various time periods(up to one year) and
they pay interest to their lenders based on certain rates. The Libor figure is
an average of these rates. The Libor rate is announced daily at 11 a.m.
And is used by financial institutions to fix their own interest rates (when
lending to others), which are typically higher than the Libor rate. LIBOR is
therefore a benchmark for finance all around the world.
 Euribor is short for Euro Interbank Offered Rate. The Euribor rates are
based on the average interest rates at which a panel of more than 50
European banks borrow funds from one another. There are different
maturities, ranging from one week to one year.
Petroleum Economics
Hurdle Rates and Selection of Discount Rates
David A. Wood
How Do Organisations Select an

Appropriate Discount Rate?
Commonly applied discount rates are.
 Rate of interest paid on borrowed capital (i.e. the cost of debt capital).
 Full cost of capital, cost of debt plus equity.
 Effective rate of return offered from available competing investments or

from an existing portfolio.
 Minimum threshold effective interest rate desired for available investment

capital. Oil & gas equity investors generally want a greater return than they
can earn from less risky investments. (Equity therefore usually costs an oil
and gas company more than debt)
 The discount rate should not be less than the cost of the capital being
invested in the project.
What Discount Rate Should be Used?
Discounted cash flow calculations form the cornerstone of modern economic
analysis. However, there is often uncertainty as to what
discount rate should be used to calculate present values.
Different companies can have different criteria for selecting discount rates.
Commonly used rates are:
– Cost of capital
– Prevailing interest rates available for bank deposits or money market
– Arbitrarily selected values above cost of capital to represent

expectations of equity investors (e.g. 15% or 20%)
– These are often used and referred to as Hurdle rates or minimum

acceptable rate of return (MARR)
Invalid Discount Rates

Many companies mislead themselves by applying invalid rates to calculate the
discount factors used in their economic evaluations:
Inappropriate rates often applied are:
– Inflation rate
– An interest rate plus inflation
– An interest rate increased to account for risk
– An interest rate plus a desired return
Considerations such as risk, inflation and interest paid need to be included in

the cash flow calculation but not in the form of the discount factor which can
distort calculated present values.
Taking the Project Inventory
to the Portfolio Level
Risking Cash Flow Profiles by Increasing

Discount Rate is Not Appropriate
Higher discount rates preferentially penalise later years in a cash flow profile.
Discount Rate Versus Success Rate
Consider a cash flow profile discounted at several rates. The “cash flow” column is
undiscounted (i.e. zero rate)
For this cash flow profile the

relationship between the net
present values (NPVs - total
discounted values) is:
NPV@16% is 35% of the
undiscounted cashflow, 59% of
the NPV@8% and 76% of the
NPV@12%.
Increasing the discount rate to

compensate for perceived higher
risk will reduce the value by a
fixed amount which will usually
not correspond to the level of risk
associated with each of a number of
projects.
Risk-Weighted Prospect Cash-flows

Risk should be applied to cash-flows using risk factors (chance of success or
failure) not by raising discount rate.
Risked NPV@8%
for a chance of
success of 40% is
$11.5 million which
drops to $5.7 for a
chance of success of
20%.
Doubling the
discount rate from
8% to 16% only
reduces the NPV to
$8.8 million.
Petroleum Economics
Probabilistic Methodology & Techniques For Economics

& Risk Analysis
David A. Wood
Investment Yardsticks
Incorporating Evaluations of Risk
It is important to take risk into account in economic analysis:
 Expected monetary value (EMV). This is the combination of the net

present value of success weighted with the chance of success and the
present value (discounted cost) of a failure weighted with the chance of
failure.
 Risk-weighted profit (EMV) to investment ratio. This is the EMV

divided by the discounted total investment weighted for success plus the
discounted risk investment lost on failure and weighted for failure.
 Risk Capacity. This is the NPV divided by the PV of the risk capital.
 Statistics from calculated probability distributions. The interrelation of

numerous uncertainties is evaluated by the Monte Carlo simulation
mathematical technique.
Quantifying Risk: the Probability Scale
Quantifying risk on a numerical scale of probability offers a more systematic and
consistent approach to expressing risk than adjectives.
Replaces verbal expressions of outcome like “good” or “almost certain”.
Expected Monetary Value (EMV)

EMV is the average value obtained when all outcomes are weighted on the basis
of their respective probability of occurrence.
In an EMV calculation the sum of the probabilities must be 1.0 or 100%.
EMV is Not Usually the Value Realised
from a Single Trial
It is the average outcome (value) expected from a large number of ventures of the
same type.
 Consider tossing a coin: heads you win $100; tails you lose $100. The
expected outcome (EMV) from one toss is (+$100 * 0.5) + (-$100 * 0.5) =
$0. But from one toss that can never be the outcome. That EMV will be
the average result from repeated trials a large number of tosses.
 No two oil and gas ventures are exactly the same, in terms of probabilities
and outcomes. Therefore, even this average outcome cannot really be
expected.
 If each individual decision is made on the basis of optimising EMV, the

overall ultimate outcome can be expected to be the average of all the
individual EMVs.
 In an EMV calculation, the sum of the probabilities obviously must be 1.0

or 100 percent.
The Zero to One Sum Game

Exploration projects commonly have potentially multiple success and failure
outcomes. For example:
 Consider another exploration venture. A dry hole costs $1,000,000, and

there is a 60% probability that one dry hole will condemn the prospect,
with a complimentary probability of 40% that two dry holes will be
required. If a discovery is made, four outcomes are considered to be
possible:
 20% probability of losing $500,000 (discounted values).

 40% probability of making $500,000.
 30% probability of making $10,000,000.
 10% probability of making $20,000,000.
 There is a 70% probability (Pf) of finding no production and therefore Ps =

30% as:
Pf + Ps =1.0 = 100%
Example of a Two-stage EMV Calculation
Reduce the dry hole alternatives to one EMV for failure and the discovery
alternatives to one EMV for success then combine the two:
Decision rule using EMV: if EMV is positive it is a worthwhile

venture if EMV is negative it is not a worthwhile venture.
Calculating Probability of a Specific EMV

This also gives the maximum probability of failure.
 Pf + Ps =1.0 so Pf = 1 – Ps
 EMV = (Ps * NPV success)+ (Pf * NPV failure).
 Ps to achieve an EMV of +$1,000,000 is calculated:
 In millions: $ 1.0 = (Ps)(+$5.1)+(1 - Ps )(-$1.4)

this simplifies to: 6.5(Ps ) = 2.4
Ps = 36.9% and Pf = 63.1%
 This means that for the EMV to equal +$1,000,000 then the Ps value in
stage 2 of the calculation must equal 0.369.
Risk / Opportunity Models Often Need to
Combine Discrete & Continuous Probabilities
Combining discrete event likelihood estimates with continuous cost / value
consequence distributions is a key part of the expected value calculation process of
simulation models.
Simulation models also need

to incorporate timing
estimates and discounting
calculations to generate
valuations of projects
extending over many years.
Logic of when events occur

is a key part of the modelling
process. It is important for
the analyst to understand the
implications of any
assumption made in this
regard.
Risk Capacity, Risk –Reward Ratio

& EMV All Yield Valuable Information
If EMV & Risk-Reward Ratio > 0 then a project is commercially viable on a risked
basis. Values of zero indicate the minimum reserves threshold for a commercially
viable risked project.
NPV and Reserves Risk Need to be
Combined to Reveal Risked Values
It is instructive to review the full probability distributions to understand the range of
possible outcomes.
Risk Capacity Can Quickly Define

the Minimum Reserve Threshold
Cross plotting risk capacity and reserves risk against field size is a quick method of
identifying the minimum reserves threshold, i.e. where the curves intersect is
equivalent to the reserves size at EMV =0.
EMV:Risk-Reward Ratio Relationship:
Both = 0 at Minimum Reserve Threshold
Risk-Reward Relationships are

Influenced By Fiscal Terms
Expected Value theory weights the value of a successful project with the chance of
success and cost of failure with the chance of failure.
The discounted cash flow

(Net Present Value –
NPV) is the value of
success.
The risk capital

expenditure on exploration
measures the potential
cost of failure – i.e. the
dry hole cost.
Petroleum Economics
Decision Analysis, Decision Trees & Flexibility
David A. Wood
Decision Tree Nomenclature

Decision trees are a means of diagramming a series of decisions, events, and
outcomes to incorporate probabilities and EMVs.
 They make analysis of a tortuous sequence of decision alternatives

possible and presentable.
 They provide a permanent record of the analysis contributing to a

decision as it existed, or was thought to exist, at the time of an original
decision.
 Two node symbol convention is commonly used:
– Decision node, with actions taken (usually symbolised by a

circle)
– Event or chance node, with outcomes that occur (usually

symbolised by a square)
Decision Tree Preparation:
A Two-step Process
Decision trees should be constructed systematically.
 Step 1: Diagram and label the sequence of decisions, events, and

outcomes with the associated probabilities of each event and outcome.
 Probabilities associated with one chance node should sum to 1.0 (i.e. the
sum of all branches having the same origin equals 1).
 Step 2: Calculate expected monetary values and post them on the tree
by working from right to left.
 It is necessary to calculate and post the EMV of each event node and
leg.
Decision Trees: Step 1

A pictorial representation of a sequence of events and possible outcomes can
help make complex decisions. The “event” node is sometimes referred to as the
“chance” node.
Decision Trees: Step 2
EMV = (-2 * 0.7) + (2 * 0.15) + (15 * 0.1) + (75 * 0.05) = $4.2 mm
The EMV is placed by the event node and represents the risked value of
everything to the right of it, i.e. the value of what would follow from the
decision to drill. To maximise EMV decision here would be to drill.
Petroleum Economics
Monte Carlo Simulation Demonstration (Exercise#6)
David A. Wood
Quantitative Approaches Require

Probabilistic Models to Handle Uncertainty
Models are required to process economic and risk data provided as probabilistic
input distributions.
 Spreadsheets combined with simulation add-ins (e.g. Crystal Ball ,

@Risk ) or driven by self-built simulation and statistical analysis VBA
macros, offer a powerful tool to aid this analysis.
 Having defined the range of the expected cost / value distributions of

each event the simulation software transforms this into a distribution of
selected type and then samples that distribution in a statistically valid
way for a large number of model iterations or trials.
 In the oil & gas industry Monte Carlo simulation is widely used to model
uncertainty & value for field / prospect reserves, economics, risks and
portfolios as well as for cost, time, resource analysis in project planning.
 Simulation is also widely used in the financial sector to value financial

instruments.
Simulation Example: Purchase of
a Laptop & Software as Two Separate Items
Market research of 30 sources suggests that the price of the laptop required can
vary over a range of $700 to $1,700. A single average number does not adequately
describe this range or the shape of the distribution, but it does provide the best
estimate of price at $1,200
Simulation Example: The Two Separate Items

May Have Quite Different Price Distributions
Market research of 30 separate sources suggests that the price of the software
required can vary over a range of $500 to $1,500. The distribution is asymmetrical
with a positive skew resulting in mode (most frequent), median (P50) and mean
having different values. Cumulative Probability is calculated for each value to
provide a probability of the price being equal to or less than a certain value.
Analogy of Simulation Process
With Selection of Lottery Balls
Consider each of the 30 price samples for each item as the numbered balls inside
two separate lottery barrels.
 The laptop lottery barrel would contain 1 $700 ball but 6 $1,200 balls, etc.
The software lottery barrel would contain 1 $500 ball but 8 $700 balls.
 It is therefore 6 times more likely that a $1,200 ball will be drawn from the
laptop lottery barrel than a $700 ball.
 A well constructed simulation model samples the distributions in a similar

way, i.e. proportional to the frequency of occurrence. It uses cumulative
probabilities to do this.
 For each trial it then adds the value on the two samples drawn from the
“lottery barrels” or distributions to give the combined cost.
 The process then replaces all the balls and repeats the process for the
number of iterations (trials) specified.
Considerations Based Upon

the Two Cost Distributions
Prior to running a simulation analysis the following points can be deduced:
 Randomly buying the two articles in any store the chance of paying the
lowest combined price of $1,200 or the highest combined price of $3,200 is
much less than the chance of paying the combined average prices of the
two distributions.
 Cumulative probabilities are expressed on a scale of 0 (price is always

greater than that) to 1 (price is always less than that). If a total number of
30 is used to calculate the cumulative probability the highest price will have
a probability of 1
 Spreadsheet random number generators provide numbers randomly

between 0 and 1 (but never actually those two numbers exactly). If the
highest price has a probability of 1 it will never be sampled by a random
number in such a sequence.
 To overcome this a total of 31 is used to calculate the cumulative

probabilities shown in the previous graphs.
Random Numbers are Selected
to Represent Cumulative Probabilities
This simple model uses
VLOOKUP tables in
Excel to extract values
from the two price data
sets based on two
series of random
numbers.
A random number is
linked to a cumulative
probability and the price
associated with the next
Other trials omitted….. space constraints …… lowest cumulative
probability in the tables
adjacent to previous
graphs is selected.
The model then adds
the two prices derived in
each trial to provide a
combined price.
Output Distribution From

Monte Carlo Simulation Model
The output or forecast distribution is uneven (and in this case bimodal) with gaps
because limited number of trials make it statistically inadequate with results strongly
influenced by chance. Most sets of 50 trials show a single mode, but some are more
uneven than others. Many more trials are required to generate a statistically smooth
output distribution. Expressing this as a cumulative probability distribution provides
information on the chance of not paying more than a specific combined price. What
if the two price distributions are correlated?
Advantages of Monte Carlo Simulation
The main purposes of a simulation study are to generate a statistically valid
probability distribution(s) for the objective function(s) and to provide greater
understanding of the relationship between the input metrics and the objective
functions. Advantages of Simulation are:
 Mathematics is relatively straightforward and widely used, forming the heart of
diverse aspects of financial analysis (e.g. pricing options, corporate portfolio
models etc.).
 Spreadsheet functions & VBA code are mostly sufficient.
 Distributions encapsulate both optimistic and pessimistic estimates and limit

potential for forecasts being unduly biased in either direction. Bias is a
problem with single point estimates.
 More trials can be run in seconds to improve statistics.

 Models can usually be updated easily.
 Correlations and complex dependencies can be incorporated.
 The effort of using a model once established is low.
 People accept the technique and believe the results (sometimes too readily!!).
Monte Carlo Simulation Technique –

Step by Step For Cash flow Analysis (1)
A number of different input distributions are combined to calculate reserves and

prospect expected monetary values (EMVs) for a number of trials.
Monte Carlo Simulation Technique –
Step by Step For Cash flow Analysis (2)
A number of different distributions are combined to calculate prospect NPV’s &
EMV’s by the Monte-Carlo technique.
David Wood has published details of simulation applications in the Oil & Gas
Journal (e.g. OGJ 1 Nov, 1999; 23 Oct 2000 plus executive reports).
@risk
12
Caution Required For Monte Carlo Simulation
Model Structure & Interpretation
Frequency distributions generated by computer can be very believable despite
being based in some cases on meaningless input distributions.
 The computed frequency distributions for in-place hydrocarbons commonly

produced by simulation are only as good as the quality of the frequency
distributions assigned to the input variables.
 It is important to identify those variables which are dependent upon (or

correlated with) other variables and treat them as functions of those
independent variables.
 A geological example of dependent variables are porosity and water

saturation that are inversely correlated in many cases. Capital costs and
operating costs are positively correlated in some oil and gas projects (i.e. as
one increases so does the other).
 If porosity and water saturation are treated as independent then random

numbers will associate an unrealistic water saturation with a porosity in
individual iterations of the simulation.
Mechanics of Monte Carlo Simulation

Cumulative frequency distributions, random numbers and a large number of
iterations means many numbers to crunch and analyse.
 A Monte Carlo simulation requires that the uncertain variables be defined

as either discrete or continuous frequency (probability) functions.
 Numerous passes through the entire calculation are made. For each
calculation the value assigned to each variable is determined by a random
number sampling the variable distribution.
 A different random number is applied to each variable for each pass or

iteration of the model.
 In this way, each value utilized for each variable occurs according to its
prescribed frequency function for the distribution type selected.
 The result is a frequency distribution of the calculated metric.
Random Sampling of Independent Variables
For independent variables it is important that the random numbers selected to
sample each variable are random and distributed in accordance with the selected
distribution to approximate each variable.
Random sampling of two

uniform distributions cross-
plotted should appear similar
to the adjacent diagram.
Increasing the number of
sample trials should result in
filling the gaps and not
increasing the clusters.
Different mathematical
routines are available to
smooth sample point spread,
but these are beyond the
accuracy of the method for
most oil and gas problems.
Statistical Stability & Significance

of Simulations
Sufficient simulation passes should be made so that the standard deviation of the
calculated distribution is no longer changing significantly. Another rule to follow is to
run a simulation until the standard error of the mean (i.e. standard deviation / √
number of trials in the simulation) is less than 1% of the mean.
Decision Trees and Simulation
A Monte Carlo simulation derives a distribution which represents a large number
of possible outcomes rather than a few discrete outcomes of a simple decision
tree.
Exercise #6: Monte Carlo “Simulation”:

Two Variable / 10 Trial Problem
To illustrate the technique a simplistic calculation is required in this exercise
using just two variables defined as discrete distributions.
Example of Monte Carlo “Simulation”
Perform the 10 Trials (Exercise #6)
Net cash flow is calculated for each of ten iterations (trials) by multiplying the
$/barrel selected value by the reserves selected value. But firstly fill in the blanks
for the two variable columns.
Simulation Exercise #6
Sequence of analysis:
1. Select values for each trial
2. Use rules established in first table
3. Calculate net cash flow for each trial
4. Work out the mean of the net cash flow distribution
5. Arrange the results into a cumulative frequency distribution

Petroleum Economics

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Petroleum Economics

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INTEGRATED GRADUATE

OMV EXPLORATION & PRODUCTION GMBH

HOT Engineering GmbH

The Need for Petroleum Economics

Project Cash Flow & Income Components

Project Cash Flow & Income Components (Exercise #1)

Petroleum Reserves Categories & Valuation

Discounting & Time-Value Considerations (Exercise #2)

Payout Time or Payback Periode

Profit to Investment Ratios

Risk and Opportunity Analysis

Capital Budgeting Techniques & Yardsticks (Exercise #3)

Which Oil & Gas Prices Should be Used to Value Assets?

Valuing Incremental Investments

Inflation, Buying Power, Money of the Day & Real Values

Introduction to Upstream Fiscal Terms & Contract Types

Production Sharing & Cost Recovery (Exercise #5)

Hurdle Rates and Selection of Discount Rates

Probabilistic Methodology & Techniques for Economics & Risk Analysis

Decision Analysis, Decision Trees & Flexibility

Monte Carlo Simulation Demonstration (Exercise #6)

Overview of Course Objectives & Materials

Course Structure & Approach

 The course is structured into a sequence of

 Your participation is welcome.

 My preference is for an informal approach to

The course aims to be a stimulating & enjoyable experience for all!!

 Technical, commercial, training and senior corporate expertise

Outline structure of course - each day has a distinct theme.

The aim is to provide delegates with a

 Day 1 – Basic Analysis & Valuation Techniques

 Day 2 – Constructing Economic Evaluation Models

Morning Session 4.2

DAY 1 – Basic Analysis & Valuation Techniques

Afternoon Session 4.4

Morning Session 4.5

DAY 2 – Constructing Economic Evaluation Models

Afternoon Session 4.7

Afternoon Session 4.8

There is a lot of material to get

The Need for Petroleum Economics

Key Metrics Show Distinctive &

Economic and risk

 High rate of capital investment

 Long payback period

 High risk and uncertainty

 Multiple stages with deferrable decision

 Incremental information flows and

 Dependency upon volatile product prices

Cost – Time Cycle for Exploration

Major upstream companies are characterised by:

 Finite time in which to perform commitment work programmes

Which Development Option

The type of field facilities, number of wells,

Boundary Scenarios Can Frame

It is important for economic analysts to consider more than one future.

Extending Field Life by Reducing

Modern Portfolio Modelling Approach:

Portfolio modelling &

Petroleum Economic & Risk Analysis Aids

Balancing is never easy!!!

Economic & risk analysis is a fundamental process in strategic and operational

Project Cash Flow & Income Components