Asset evaluation
“Asset is a resource with economic value that an individual, corporation, or
Petroleum Economics
Upstream projects cash flow types
• Revenue: Income from sale and services
• Capex: Project development
• Opex: Project running costs
• Taxes: Payments to Government
country owns or controls with the expectation that it will provide a future
benefit.“
Three methods of asset evaluation:
• Book value: the value is based on cost. Current value relates directly to the
financial history of the asset.
• Market value: considers value in the context of a current transaction, which
would inevitably be constrained by market forces. The asset is converted to
currency.
• Cash flow: considers the future of the asset in terms of revenue and cost.
The asset is used to generate currency.
Production profiles
Production is the basis of revenue.
Time on plateau Project capex
Factors Exploration [pre discovery]
• Optimisation of use of facilities • Geology, geophysics and drilling
• Political risk Appraisal [pre commercial decision]
• Contract arrangements • Geology, geophysics, drilling, well-testing
Economic limit
• Reservoir characteristics Field Development
• Drilling, production wells, support structures, production facilities
Economic limit • Export facilities
• Production will terminate when production Field Modifications
costs = value of product • More wells, injection facilities, artificial lift, gas compression
Abandonment
• Seal off wells, removal of facilities
Economic limit

Project Opex Net Cash flow

Lease of facilities Net cash flow from investment is made up of a number of components some
positive, some negative, so that for example costs of drilling wells, laying pipelines
Platform operation, maintenance and transportation costs and building facilities along with operation costs must be counted alongside profits
Export costs: tariff payments, operation of tankers, pipelines and from selling oil or gas.
terminals Net cash flow is normally calculated for uniform time intervals - quarterly or half
yearly.
Workover operations on wells
Insurance and administration

2 8
Net Cash Flow
NCF(i) = Capex(i) + Opex(i) + Sales(i)
where
Capex(i) = Capital expenditure (drilling, facilities costs) for period i
Opex(i) = Operating expenditure (maintenance, transportation costs) for period i
Sales(i) = oil & gas sales income for period i
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Inflation (Real and Nominal indicators)
When considering value a number of factors must be taken into account -one of
these is inflation.
Inflation is a measure of the decreasing purchasing power of money with time
Cash flows can be described either as ‘nominal’ by quoting the actual cash flows in
each period or as ‘real’ cash flows by adjusting nominal cash flow for given period
to an equivalent cash flow at a fixed reference date by allowing for the cumulative
effect of inflation between the reference date and the given cash flow period.
2 11
Typical cash flow
2 10
Discounted cash flow (DCF)
Net cash flow must be adjusted to allow for the cost of capital needed to carry out
the project and develop the field.
Discount rate is either the cost to acquire additional capital (for example by
borrowing from a bank) or the return that could be obtained by investing in an
alternative opportunity (i.e. if the oil company has all, or part of, the capital needed
to develop the field it could alternatively have invested this in some other
opportunity).
2 12
Discounted cash flow (DCF) Effect of discount rate
Discounted Cash Flow (DCF) is calculated by The higher the discount rate assumed ,the less profitable the project will
appear. Typically in the oil industry discount rates between 6 and 10 %
used. The effect of this is shown below:

where
NCF = net undiscounted cash flow for period i
rD = discount rate (fraction)
n = number of time intervals

2 13 2 14

Comparison of discounted and undiscounted

Net Present Value (NPV)
cash flow
Net Present Value is defined as the total present value of a series of cash flows
discounted at a specific rate to specific data.
It is therefore a cumulative cash flow

2 15 2 16
Net Present Value (NPV) NPV as cumulative DCF
If cash flows are in real terms (allowing for inflation) then a real NPV is generated. discounted cash flow & NPV10 (real) & total cash flow
(3% infla on)
If nominal cash flows are used (not allowing for inflation) then a nominal NPV is 1200
generated.
1000 DCF (real) at
The discount rate and the nominal or real basis should always be quoted. discount rate of
800 10.00%
So we can have for example: Cum DCF (real) at
600 discount rate of
• NPV10 (real), NPV0 (real),

mm $
10.00%
400
total discounted
• NPV10(nominal), NPV0(nominal) capex
200
0 NPV 10.00%
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
-200
-400 years
2 17 2 18

Real Rate of Return (RROR) Real Rate of Return (RROR)

Real rate of Return (RROR) sometimes known as internal rate of return (IRR) In case shown below RROR=22%
Real rate of return = the discount rate which must be applied to cash flow to reduce At anything below 22% discount rate the project becomes economic ( NPV >0) in
NPV real to zero terms of RROR.
The higher RROR the more robust a project
real rate of return (RROR) - NPV at 10% real rate of return (RROR) - NPV at 22%
R=10% R=22%
Calculated by increasing discount rate (r) until NPV >0 1500 1500
DCF (real) at DCF (real) at
1000 discount rate of 1000 discount rate of
10.00% 22.00%
Cum DCF (real) at Cum DCF (real) at
500 discount rate of 500 discount rate of

mm $
mm $

10.00% 22.00%
total discounted total discounted
0 capex 0 capex
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
NPV 10.00% NPV 22.00%
-500 -500

-1000 years -1000 years

2 19 2 20
Payback time and Maximum exposure Profitability Index (PI)
The Payback time of a project is the length of time that will elapse before the cumulative PI= Profit to Investment Ratio
undiscounted real cash flow becomes positive (ie. before this costs outweigh income). Profit to Investment ratio (PI) – the discounted real PI is defined as
Maximum cash exposure is defined as the maximum negative undiscounted cumulative real net
cash flow.

where all the discounting is done at the same rate . This is sometimes known as ROI (return on
investment) as it is a simple measure of return on investment . It is independent of the time which
limits its usefulness as an economic indicator. It is always used in conjunction with other indicators.

Obviously PI should be greater than one

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Profitability Index (PI)

Higher PI probably more important for a small company who will not want
Large amounts of capital ‘frozen’ for a long time.
Dependence of NPV and PI on capex
comparison of NPV and PI with capex
1600
1400
6 RISKED ECONOMIC INDICATORS
5
1200
4
1000
NPV

PI

800 3
NPV
600
2
PI
400
1
200
0 0
0 200 400 600 800 1000

capex
2 23
Expected Monetary Value Expected Monetary Value
All of the above indicators assume a single production outcome. In reality there is
always uncertainty in predicted production profiles and oil or gas prices which Expected Monetary Value (EMV) is defined as:
should be taken into account in decision making.
When a single 'best estimate' case only is used the indicator is known as an un-
risked indicator, the indicator 'Expected Monetary Value' is a risked indicator. which is the weighted sum of the NPVs corresponding to different possible
outcomes
where
r = discount rate
Pi is the probability of outcome i
The sum of the probabilities must = 1
A normal assumption would be that we take three outcome cases P(P90 case) = 0.25,
P(P50 case) =0.5 , P(P10case) = 0.25

Estimated Monetary Value Expected Monetary Value

So that in this case: EMV(x) is the weighted sum of the NPVs corresponding to different possible outcomes.

𝑛 P90 case (downside)

EMV(10) = 0.25 * NPV10(downside) + 0.50 * NPV10(best est.) + 0.25 *NPV10(upside)

rate
𝑃𝑖 ∗ 𝑁𝑃𝑉(𝑥)𝑖
P50 case(best estimate)
𝑖

We then have a project monetary value (effectively an NPV10(real)) adjusted to where P10 case (upside)

allow for both technical and economic uncertainty or either one alone. x = discount rate
The result will depend on the relationship between the three cases which can skew
time
Pi is the probability of outcome i
the EMV up or down from the base case NPV.
P50 (median)
The sum of the probabilities must = 1

Relative Probability
mean

P90

Risked as well as unrisked cases should always be presented when investment A normal assumption would be
decisions are to be made. P(P90 case) = 0.25, P(P50 case) =0.5 , P(P10case) = 0.25 P10

1 2 3 4 5 6 7 8 9 10 11 12 13
2 27
Reserves (Tcf)
 EMV examples Effect of various parameters
effect of variation in discount rate effect of oil price
1.6 45%
Downward skew EMV = NPV(50%) Upward skew $2,400,000
1.4
$2,400
$2,200,000 $2,200 40%
1.2

EMV = $20 mm EMV = $22.5 mm $2,000,000

1
$2,000
35%

NPV 10
EMV = $15 mm $1,800,000 $1,800

NPV
0.8

P/I
45 NPV
35 $1,600,000 0.6 NPV $1,600 30%
35 40 $1,400,000 RROR
30 0.4 P/I $1,400
30 35 25%
$1,200,000 0.2 $1,200
25 25 30 $1,000,000 0 $1,000 20%
20 20 25 5 7 9 11 13 70 80 90 100 110

$mm
$mm

15 20 % oil price $/bbl

$mm

15
10 15 discount rate
5 10
10
0 5 effect of reserves
5
-5 downside best estimate upside effect of cost
0 0 45%
-10 downside best estimate upside 45% $2,400
downside best estimate upside $2,400
-15 $2,200 40%
$2,200 40%
$2,000
$2,000 35%

NPV 10
35% $1,800

NPV 10

RROR
$1,800 NPV
$1,600 30%
$1,600 30% NPV
$1,400 RROR
$1,400 RROR 25%
25% $1,200
$1,200
$1,000 20%
$1,000 20% 90 100 110 120 130 140 150
1000 1200 1400 1600 1800 2000 reserves (mmbbl)
costs

Uncertainties
relative effect on NPV10 of uncertainties in oil price,
facilities costs and reserves effect of plateau rate
4 2.5
$2,200 3.5
2
3
$2,000
2.5 1.5

NPV10 $ billions

AP/I
2
$1,800 NPV10
NPV10

1.5 1
oil price
P/I
1
$1,600 cost 0.5
0.5
$1,400 reserves 0 0
0 50 100 150

$1,200 plateau rate mboepd

0.8 0.9 1 1.1 1.2
variation around base case
Summary
• Decisions on investment will be made on
the value of a project
• This ‘value’ is judged by a combination of a Investment Decision
number of parameters:
• Net Present Value (NPV)

DEPRECIATION
• Expected Monetary Value (EMV)
• Real Rate of Return (RROR)
• Profit to Investment Ratio (PI)
• Payback time
• All need to be taken into account in Full
Investment Decision (FID)
INPUTS
Production profile –from the Reservoir Engineer
Capital Expenditure profile (CAPEX)
Operating costs (OPEX)
Taxation
Oil/gas price assumptions
Discount rate
Assumptions on inflation

Depreciation Depreciation
Companies invest capital in exploration and appraisal activities
Net Book Value with depreciation
120

When a field is discovered it is added to company value as an Intangible Asset (as where 100

distinct for tangible assets such as facilities) Di = depreciation in year i

80

NBV
60

NBVi = net book value of field at start of year i 40

Once a field starts production you must allow that this value obviously depreciates. (1P)i = proved reserves at start of year i 20

(1P)i revisions= any revisions to proved reserves

7
10

13

16

19

22

25
years

qi = production in year i

NBVi+1 = NBVi –Di ( the net book value at the start of year i+1)
Proved reserves = 1P reserves
2 36
Depreciation
• All reserves are regularly re-estimated.
• We would normally expect 1P reserves to gradually increase to the 2P number as the field is
produced.
• If production data shows the field performs better than expected so that 1P reserves can be
increased more than expected this results in less depreciation and better NBV in the annual
company reports. FINANCIAL ARRANGEMENTS
• If production data shows the field is not as good as expected, so that 1P reserves must be
decreased, NBV will decrease more than expected and company value will decrease.
• Proved reserves can change due to either technical of economic factors
• For example a drop in oil prices will mean that the economic field life will decrease so that 1P
reserves decrease
• Significant decrease here is known as Impairment

2 37

Government arrangements with oil companies Production Sharing Agreement

• Straight taxation A type of contract signed between the government and the oil company.
• Royalties Their first implementation similar to today's was in Indonesia in the 1960s. Today
• Production sharing contracts they are often used in the Middle East and Central Asia The country's government
awards the execution of exploration and production activities to an oil company.
• Buy back agreements The oil company bears the mineral and financial risk of the initiative and explores,
develops and ultimately produces the field as required.
Production Sharing Agreement
When successful, the company is
permitted to use the money from
produced oil to recover capital and
operational expenditures, known as
"cost oil". The remaining money is
known as "profit oil", and is split
between the government and the
company, typically at a rate of about
80% for the government, 20% for the
company.
Example of tax arrangements PRT (UK)
Royalty
PRT is a direct tax collected in the UK.
PRT is charged on "super-profits" arising from the exploitation of oil and gas in the
UK and the UK's continental shelf. After certain allowances, PRT is charged at a rate
Cost of oil
of 50% (falling to 35% from 1 Jan 2016) on profits from oil extraction. PRT is
charged by reference to individual oil and gas fields, so the costs related to
Company oil Government oil
OPEX developing and running one field cannot be set off against the profits generated by
another field.
PRT is charged in addition corporation tax, which is also payable by companies
involved in oil exploration and production, although PRT is deductible in calculating
CAPEX Profit tax profits for corporation tax purposes.

Royalty is a payment made to the owner of a resource and is normally fixed as part of a licence
agreement. It is a payment directly related to volume or to sales [rather than to profit].
2 42

‘Buy back’ agreements Economic indicators spreadsheet (on Moodle)

Oil & gas production Well and Facilities costs Economic input
Buy back Agreements are short term Risk Service Contracts between a National Oil Rates (input
oil rate
as values)
gas rate
(factions
costs
of Facilities costs) well cost $10 mm
economic parameters

Company (NOC) and an International Oil Company, IOC, and is for petroleum oil rate bopd
gas rate
mmscf/d
wells drilled
in each year
Facilities
(fraction spent oil produc on

Exploration and/or Production rights. The IOC is a Contractor to NIOC and never year
0 6,108 7.33E+01 8
in year)
0.5
14,000
12,000
failities cost
annual opex
$400 mm
$1.00 mm
Discount rate
Price Elevation, %
10.00%
3.00%

gains Equity Rights in oil or gas ,being reimbursed in cash after completing an
1 11,662 1.40E+02 8 0.5 tax rate 40.00%
2 11,662 1.40E+02 0 0 10,000 oil price/stb $ 60
3 11,662 1.40E+02 0 0 gas price $/mmscf 4.00 NPV RATE 13.00%

agreed scope of work. The Reimbursement includes cost recovery and an agreed
8,000

o il ra te b o p d
4 11,662 1.40E+02 0 0 NPV ($mm) = 1,369.99
5 11,662 1.40E+02 0 0 6,000 PI= 1.50

Rate of Return. 6
7
8
11,662
11,662
11,662
1.40E+02
1.40E+02
1.40E+02
0
0
0
0
0
0
4,000
2,000 discounted cash flow & NPV10 (real) & total cash flow
9 11,662 1.40E+02 0 0 0 (3% infla on)
10 7,954 9.55E+01 0 0 1600
0 5 10 15 20 25 30
11 3,726 4.47E+01 0 0 1400 DCF (real) at
years discount rate of
12 3,113 3.74E+01 0 0 1200

Example - Iran 13 2,710 3.25E+01 0 0 10.00%

1000 Cum DCF (real) at
14 2,382 2.86E+01 0 0
discount rate of
15 2,111 2.53E+01 0 0 800
gas rate mmscf/d

mm $
10.00%
16 1,884 2.26E+01 0 0 total discounted
600
17 1,691 2.03E+01 0 0 2.00E+02 capex
18 1,527 1.83E+01 0 0 400
19 1,385 1.66E+01 0 0 200 NPV 10.00%
1.50E+02

g a s ra te (m m s cf/ d )
20 1,247 1.50E+01 0 0
0
21 0 0.00E+00 0 0 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
22 0 0.00E+00 0 0 1.00E+02 -200 years
23 0 0.00E+00 0 0
24 0 0.00E+00 0 0 5.00E+01
25 0 0.00E+00 0 0
26 0 0.00E+00 0 0 0.00E+00
27 0 0.00E+00 0 0 0 5 10 15 20
28 0 0.00E+00 0 0 -5.00E+01
2 43 29 0 0.00E+00 0 0 2 years 44
recovered 5.14E+07 6.17E+05
stb mmscf