ECONOMIC DECISION TOOLS IN THE GLOBAL PETROLEUM (OIL AND GAS) BUSINESS

BY

ISAAC F. ODEDERE, FNMGS

ENTROIT ENERGY LIMITED

LAGOS
1.0 Introduction: Decision Analysis, Why?

1.1 Why do we take decisions?

The purpose is to help a decision maker think systematically about complex problems and to improve
the quality of the resulting decisions e.g. the decision to acquire a 3D seismic instead of drilling with 2D.

Decisions is defined as the act of making up one’s mind to take a certain action; capital budgeting,
choice between alternative ways of allocating resources

Terminologies in decision making

Objective: An indication of the preferred direction of movement e.g. minimize cost, maximize
net worth, minimize the most possible outcome

Event: An event is one possible outcome of an experiment. Conditional or independent events.

Outcome criteria: also called economic indicator

Risk

Human attitude towards money

Risk attitudes (risk averse, risk seeker and risk neutral)

1.2 5 Distinct phases in decision making (Peter Druncker)

Defining the problem

Analyzing the problem

Developing alternative solutions

Deciding upon the best solution

Converting the decision into effective action

Newerdxxx, it also displayed decision analysis as follows

Basic development phase

Deterministic phase

Probabilistic phase

Information phase
Prior

Information Basis Deterministic Probabilistic Information Decision

phase phase Act
Development phase
Creative

Stage

New Information

Information Achieve
gathering Additional information

A model without any probabilistic components is called a deterministic model. The output is determined
once the set of input quantities and relationship have been specified. It treats critical uncertainties. This
leads to sensitivity analysis in variables.

Probabilistic phase: Assigning probabilistic distributions to the critical uncertain events and variables i.e.
incorporating uncertainties => expected values are calculated

Information phase: The results of the first three phases reviewed evaluate the cost of rexxxxxx
additional information. Preposterior analysis: initial optimum is obtained. The principle of dominance or
elimination, chooses the best economic alternative.

Decision??

Decision analysis results are presented in decision trees, probability distribution, inference diagrams,
sensitivity analysis (spider diagram) plots, etc.
1.3 Decision making environments

Certainty, uncertainty and risk

Certainty: When complete information is available for an outcome resulting from each decision
alternative under consideration. Best estimate of values

Risk: If the decision alternatives under consideration is expected to result in several probable outcomes
and the probability of each outcome can be assessed, such situation is referred to as decision under risk.
Specify a probability distribution over possible outcomes – probabilistic

Uncertainty: If the same situation occurs but analyst has no idea of the probabilities to be assigned to
each possible outcome – subjectively assigned unlikely, probably, impossible, expected, most likely etc.
=> adjectives

2.0 Key Points

2.1 Investment analysis involves economic, financial and intangibles

Economic analysis/evaluation/engineering economy evaluates the merits of the investment situations

from the profit and cost/economic viewpoint i.e.

Financial analysis refers to where the investment funds for the proposed investments will be obtained
(personal or corporate funds, borrowing from a bank, having a corporate funded debt, offering of bonds
and debertures, going public and common stock) i.e. to enable us compare alternative investment
choices, profit maximization => maximization of the future worth of available investment dollars: 2
classification.

Revenue (income producing investment)

Service (income producing investment)

Intangible analysis involves investments that can’t be quantified easily in economic terms (legal, safety
considerations, public opinion or goodwill, political consideration in foreign ventures,
ecological/environmental factors, uncertain regulatory or tax law conditions, water pollution, etc.)

2.2 Firm Objectives

- Maximization of total profits (or minimization of loss for the short run periods)

- Expansion in production capacity

- Increase in market share or in value of assets

- Diversification of activities

- Vertical and horizontal integrations

- Continuous survival of the firm

2.3 Capital Expenditure in the Oil and Gas Company

- Exploration for oil and gas

- New oil and gas fields development

- Infill drilling

- Facilities replacements/upgrades

- Installation of new facilities such as artificial lift systems and pressure maintenance

- Secondary and enhanced oil recovery projects

- A variety of downstream projects

Judging the attractiveness of any investment

3 main elements: Investment amount, the operating benefits and economic life

2.4.0 Capital budgeting

- Capital refers to expenditure for the purchase or expansion of physical assets

- Budget refers to a plan that details projected inflows resulting from projected outflows
- Capital budgeting is the process of analyzing the projects and deciding whether they should be
included in the capital budget. Deliberate allocation of present resources with the expectation of future
returns.

- Large commitments of funds

Finance source B

Finance source D

Finance source A Finance source C

Common pool of sources of

finance

Project 2 Project 3 Project 4

Project 1

Courtesy: Investment appraisal page 2

 - Retained profits in the form of depreciation
- Other retained profit for the coming year
- Sale proceeds of surplus/redundant assets
- Grants / collective assistance
- New loan
- Issue of new shares

3.0 Profitability criteria

3.1 Objective is to be able to summarize and convey to management in a single parameter an indication
of the level of profit expected from the project (drilling)

- No single criterion tells everything

- Choose from sxxxx of criteria which tell management the maximum information about economic and
profit factions

- No risk involved i.e. certainty prevails

Firm’s equity appreciation assured no CSR (Corporate Sustainable Responsibility). Non trxxxxx motives
i.e betterment of society, social needs, etc. are considered.

-Other names; profit indicators/ economic yardstick/decisions. Criteria, measure of profit ability.
Measures of investment limits/profitability yardstick.

-Two kinds of yardsticks; screening and ranking: accept or reject

- screening determines which ventures meet minimum qualification

- ranking determines which of the two or more mutually exclusive venturesis the most desirable from
the point profitability

-Time value of money

3.2 Attractiveness of any investment

- investment amount

- The operating benefits

- The economic life: +ve net benefits expected cash flow beyond 25 years?

- It should provide a means of telling whether profitability exceeds some minimum, such as the cost of
capital or/and forms average (or desired) earning rate

- It should include quantitative statements of risk (probability numbers), if at all possible

- It will be desirable to have the criterion reflect the factors such as corporate goals, decision making risk
preference and the fxxxx asset pxxxxx -> preference
3.3 Some General Observations about Probability

Analysis

- Equity represents assets of firm or the firm’s treasury. Cash flows are movement of money into,
or out of treasury.
- Value of money in treasury is determined by rate at which funds can appropriate or grow in
value. Growth is obtained by continuous reinvestment of the money.

3.4 Criteria

3.41 Payment (Payback) or Breakover Point

- It measures the speed with which invested funds are returned to the business i.e

- The time required for the cumulative net earnings to equal initial investment

- The shorter the period the better

- Note that funds available for capital expenditure are limited compared with the opportunity

- It is easy to calculate, and interpret by managers

- When a high degree of uncertainty exists as to how long the profitability of a proposed venture will
continue into the future.

- Two methods:

(i) Requires accumulating the negative net cash flows (NCF) each year until it turns positive. The partial
payback period in the year when NCF turns positive is calculated by interpolating between the two
1
values: cum -ve NCF years + X – (-ve NCF)
+ ve NCF −¿ ¿
(ii) Plotting the cumulative net cash flow versus time. The payback period is read at the intersection of
the timeline at zero cumulative net cash flow.

- Form negative quadrant into positive quadrant

Shortcomings:

- It does not consider income (benefits) to be obtained after the payment period.
- It gives the timing of the returns that occur prior to and after initial date
- It only has meaning if no substantial investments are made after the initial investment.
- It obviously fails as a ranking yardstick
- It doesn’t concern with profitability i.e. investment to provide profit, the useful economic life
beyond payback period is important e.g. two investments of $150,000 each with equal payback
periods of 3 years.
Project A does not generate any cash flow after the payback period while project B generate
$60,000 in three years after the payback period. Therefore, project B is preferred.
Opportunity loss occurs of the economic life and payback period are equal.
Examples 3.4.1 Use the following data for the payback period

Drilling costs: $1,500,000

Future series of cash flow (revenues) generated by the investment

Year Cash flow (Revenue) $

1 1,000,000
2 800,000
3 600,000
4 400,000
5 200,000
6 100,000

3,100,000

Cash flows are after tax ; the end of year convention is used , and annual compounding the
average opportunity rate is assumed to be 15% per annum.
Using the above data, calculate the payback period for the prospect.

Solution:
Investment: $1,500,000
Unreviewed portion of investment after the first year
$1,500,000 - $1,000,000 = $500,000

Fraction of second year is required to recover this remaining balance

$ 500,000
= 0.625
$ 800,000

Therefore, the payback period is 1.625 years

Example 3.42 Data for two alternative projects A and B are given below. Select one of the
projects based on the payment criterion.

Project A Project B
Investment 250,000 250,000

Annual Income 50,000 75,000

Payment (years) 250,000 250,000

=5 =3.35
50,000 75,000

Project B with a shorter payment would be better investment proposal.

 Example 3.4.x

Drilling costs: $740,000

Future series of cash flows (revenues)
Generated by the investment

Year Cash flow & Revenue

1 500,000
(Cash Flows are after tax and
2 400,000 after payment of all royalties
and operating expenses)
3 300,000

4 200,000

5 100,000
1,500,000

- For purposes of discounting, assume the revenues are received at year end, and that our
company uses annual compounding.
- Average opportunity rate of company: 15% per year (this is the rate at which future cash flows
can be reinvested when recieved)

Solution:

Unrecovered portion of the investment after first year: 740,000 – 500,000 = 240,000

240,000
Fraction of second year required to recover this remaining balance: =0.6
400,000
Therefore, payment time for this prospect = 1.6 years

Example 3.4.12

The directors of SAAC Olumare Oil Company set a maximum period of three years within which any
investment must be paid back. They are proposing to invest $200,000 in a machine to save labour costs
of $50,000 per year. The machine is expected to have a useful life of six years. Starting at the point of
time when the investment is made called year 0 (which is in effect the start of year 1), the annual cash
flows at each year end can now be set out and payback period calculated.

Calculation of the payback period:

Year Annual Cash Flow ($) Cumulative Cash Flow

0 -200,000 -200,000

1 +50,000 -150,000

2 +50,000 -100,000

3 +50,000 -50,000

4 +50,000 0 Payback period

5 +50,000 +50,000

6 +50,000 +50,000

The payback period is four years, when compared with the three year criterion set, resulting in the
rejection of the investment.

3.42 Profit-to-Investment Ratio

- Ratio of total net profit (undiscounted) to the investment. It is a dimensionless number telling
management the amount of new profit generated per dollar invested.

- Also called return-on-investment (ROI)

Example 3 above

Total net revenue: 1,500,000

Investment: 740,000

Total net profit: 1,500,000 – 740,000 = 759,200

759,200
Profit-to-Investment ratio: =1.02
740,000

-Also called Average Return on Investment (AROI) or Accounting Rate of Return (ARR)

Annual average cash flow∨savings

- Average Return on Investment =
Net investment Outlays
Gross revenue−tax−LOE
= economic life
investments
Properties of ROI

- The technique does not account for the time value of money
- The average process ignores the length of the life of the alternative being evaluated
- It does not give any indication about the size of the initial investment
- No indication of the value of the project (i.e no contribution to wealth maximization effort)
- The technique is not additive to the average annual cash inflows from the two projects have to
be first added together then divided by the total investment of the two projects to arrive at the
ROI of the total investment in the two projects.
- It does not provide any indication of equal exposure to risk and uncertainty.
- The ROI is not comparable with the cost of capital of the investment (i.e. opportunity cost or
interest rate)
- Denomination is well cut for a single well ; development of a field, etc. (total expenditure / the
maximum amount of cash investment is not yet recovered => maximum xxx of pocket cash)

Example 3 above

I −C
P/$ invested =
C

From example 3 4 2 1

I = $3,100,000 (total net revenue)

C = $1,500,000 (Investment)

Total net profit = $3100000 - $1500000 = $1,600,000

Profit to Investment ratio

1,600,000
=1.067∨106.7 %
1,500,000
Some companies use the net income to investment ratio

$ 3,100,000
Net income to investment ratio = =2.067∨206.7 %
$ 1,500,000

- Select prospects that maximize profits per unit of money invested

- AGIP calls it NTIF (No of times (T) investment (I) is Returned (R))
3.4.3 Net Present Value

- Present value of cash surplus (profit) or present worth profit

- This is obtained by subtracting the present value of periodic cash outflows from the present value of
periodic cash inflows.

- Present worth is calculated using the weighted average cost of capital of the investor: discount rate or
minimum acceptable rate of return. The rate at which future revenues can be reinvested – the earning
rate of future invested capital.

- Alternative use of funds: bank saving account e.g. at 5% => investment to generate at least the 5%
interest.

- In a more simple form

- Decision rule is to accept the projects which maximize NPV profit, and reject all projects having a
negative NPV profit. When NPV is positive, investment generates revenue that is equal to the positive
present worth.

- Consider investment in pollution control, NPV is always negative, but to meet required standard,
economies aim to reduce the negative NPV to as small as possible.

Mathematically,

S1 S2
NPV = + - I0
¿¿¿ ¿¿¿

OR

( )
n
St
NPV ¿ ∑ t
−I 0
t=1 (1+i d )

Where

St = the expected net cash flow (gross revenue – LoE - taxes) at the end of year t

I0 = the initial investment xxxxx at time zero

Id = discount rate, i.e the required minimum annual rate of return in new investment

N = the project economic life in years

 - Capital outlays stretch more than one period. Therefore, the above formula is modified as :

(( ) )
n
NCPt
NPV ¿ ∑ t
t=1 1+i d

- Cash flow takes place continuously till end year/ mid year

Spreadsheets inbuilt NPV in Excel

= NPV (Rate, NCF1, : NCF) end of year

= NPV (rate NCF1, NCFn * (1 + id)0.5)

- If NPV is positive, accept the proposal

- If NPV is negative, reject the proposal
- If NPV is zero, the analyst will be indifferent because the proposal generally have the same
returns as the alternative use of funds.

Characteristics of NPV
- Not a trial and error solution. No possibility of multiple rates of return.
- NPV has all of the desirable features of rate of return; time value of money; reinvested
assumptions, the use of probabilities to consider risk in a quantitative and explicit manner
(expected monetary value, EMV)
- It considers cash flow over the economic life of the investment.
- It does not give any indication about the size of the initial investment (i.e. NPV of a $100
investment may be $100, and the NPV of a $10,000 investment may also be $100)

As with rate of return , the NPV profit is independent of absolute size of cash flows.

e.g.

Project A Project B

NPV of revenue 2,500,000 300,000

Initial investment 2,400,000 200,000

NPV Profit $100,000 $100,000

Both have same NPV profit. Under limited capital, constraints, a DM prefers project B, since investment
is less => N
- The same discount rate does not have to be used for the entire period of cash flows. It
fluctuates in money market.
- The NPV assumes all cash flows are reinvested at the weighted average or opportunity costof
capital
- The NPVs are additive: 10 projects with NPV of $10, the total will be $100.
- NPV can be used to evaluate purchase vessel lease option strategies in which all cash flows are
negative. Preferred choice: strategy having lease negative NPV.
- Discount rate is usually set by top management bearing in mind of the following:
(i) Future investment opportunities and their anticipated rules of earning
(ii) If investment capital is borrowed, it must at least exceed the interest rate of the loan
(iii) Should at least exceed the average cost of capital
(iv) Corporate growth objectives- the rate at which management has set for annual growth
rate of treasury.

Example 3.4.31

Year Net Cash Flow $ Discount Factor i 0 = 15% (year end) Discount cash flow i 0=0.15

0 - 740,80 1.0000 +740,800

1 +500,00 0.8700 +435,000

2 +400,000 0.7560 +302,400

3 +300,000 0.6580 +197,400

4 +200,000 0.5720 +114,400

5 +100,000 0.4970 +49,700

__________

NPV i0 = 0.15 => +358,100

This means if we spend the $740,800 to purchase the five annual cash revenues, the investment
is equivalent to making a 15% per year return plus increasing our net present worth by $358,100
when NPV is positive, it is the amount by which our net worth is increased in addition to making
a rate of return equal to the discounting rate used in the NPV calculation.

Example 3.432

Using the example above, under payment time, drilling cost is $1,500,000 with an average
reinvestment opportunity rate of 15%, calculate the net present value profit of the cash flow
 Year Net Cash Flow $ Discount Factor i 0 = 0.15% (year end) Discounted cash flow

0 -1,500,000 1.0000 -1,500,000

1 +1,000,000 0.8696 +369,960

2 +800,000 0.7561 +604,580

3 +600,000 0.6575 +394,500

4 +400,000 0.5718 +228,720

5 +200,000 0.4972 +99,440

6 +100,000 0.4323 43,230

__________

NPV i0 = 0.15 => +740,730

- Makes 15% return plus increase our net worth by $740,730

Example 3.433 The directors of Niger Oil Company are considering investing $150,000 for the
purchase of a machine. Profits from the machine before charging any depreciation are expected to be
$60,000 in each of the first four years, falling to $40,000 in year 5 and only $20,000 in year 6. At the end
of year 6, the machine will be scrapped with zero salvage value. The company has a real cost of capital
of 20 percent which is used to appraise all their investments. Calculate the NPV at 20% to demonstrate
whether the investment meets the 20% required rate of return.

Year Net Cash Flow $ PV Factor at 20% Present Value

0 - 150,000 1.0000 -150,000

1 +60,000 0.8330 +49,980

2 +60,000 0.6940 +41,640

3 +60,000 0.5790 +34,740

4 +60,000 0.4820 +28,920

5 +40,000 0.4020 +16,080

6 +20,000 0.3350 +6700

__________

NPV i0 = 0.20 => + $28,060

The NPV surplus of $28,060 means that the rate of return is more than 20% rate of interest used.

3.44 Discounted Profit to Investment Ratio (DPR)

Dimensionless ratio obtained by dividing NPV profit discounted at it by the NPV of investment. Other
names: discounted profit ratio, net present value profit to investment ratio, profit value index (PVI)
The ratio is imparted as the amount of discounted profit generated (in excess of a rate of return equal to
io) per dollar invested. NPV α IRR fail to reflect the size of initial investment efficiency, which is not
measured. For example, using the earlier example: $358,100

Investment $740800

358150
Discounted profit to investment will be =0.483
740,800
NPV
Profitability index is mathematically given by:
PV of capital investment

Both NPV and IRR fail to reflect the size of the initial investment. Dimensionless ratio by dividing the
present value of future operating cash flows by the present value of the investment. It shows the
relative profitability of an investment or the present value of benefits per the present worth of every
investment.

Consider this:

Option A Option B

PV of xxxx M$ 100 1000

Net Present Value, M$ 100 1000

100
PIA = 1+ =2.0
100
100
PIB 1+ =1.10
1000
The PI = 2.00 means total return on the investment is $2, where $1 is the cost and $1 is the net gain in
PV terms.

- Projects with the highest PI values generate the largest cumulative NPV that can be accumulated
from the available present worth investment dollars

Variation of PI

- Present value ratio (PVR)

- Present value index (PVI)
- Discounted Profit to investment ratio (DPIR)
- Investment efficiency (IE)

The PVR is the ratio of the NPV to the present value of capital investment rather than the ratio of the PV
of the future operating cash flows to the PV of the capital investment.
 NPV
PVR =
PV of capital investment

- Accept all independent investment proposals with PI greater than one and reject less than one

Characteristics/Properties of PI

- Share all the advantages of NPV

- It provides a measure of profitability per dollar invested – limited budget constraint
- Suitable measure of value of ranking and comparing investment opportunities
- It is not representative of true earning potential of an investment, thus contributing to the
portfolio maximization effort.

3.45 Internal Rate of Return (IRR)

- Reported as a percentage rather thana dollar figure such as NPV

- discounted cash flow rate of return (DCFROR)

- Rate of Return (RoR)

- Internal Yield (IY)

- Marginal Efficiency of Capital (MEC)

- Investor’s Method

- Profitability Index (PI)

- Average Annual Rate of Return (AARR) Agip

- Earning Rate ER (SPDC)

IRR is the discount rate at which the net present value is exactly equal to zero.

- The present value of cash inflows is equal to the present value of cash outflows
- It is the interest rate received for an investment consisting of payments (negative values) and
income (positive values) that occur at regular periods i.e. interest rate which equates the value
of all cash inflows (revenues) to the cash outflows (expenditures) when cashflows are
discounted or compounded to a common xxxxxx time.
- Calculation of IRR annually in 2 ways: trial and error and graphically
- (a) trial and error – 2 interest rates
 NPV A
1RR = ( 1 RR B−1 RR A ) +1 RR A
NPV A −NPV B

NPVA = positive NPV

NPVB = negative NPV
1RRA = interest rate associated with NPVA
1RRB = interest rate associated with NPV B
No linear interpolation

(b) IRR graphically: 3 to 5 NPVs are calculated at different interest rates. Plot these on cartesian
coordinate graph paper. A line is drawn through the point

Example 1

NPV profile

Percent 0 5 10 15 20 25 30 35

NPV M$ 399.25 215.60 90.01 0.06 (66.81) (118.00) (158.11) (190.13)

IRR is between 15% and 20%

0.06
IRR = ( 20−15 )+15
0.06− (−66.81 )
≈15% Not = not linear

Computer usage

Microsoft Excel

= IRR (values, guess)

E.g. IRR (M10: M25) – iterative technique

Result is accurate within 0.00001%.

If guess is omitted, to be 0.1 (10%)

- Accept if calculated IRR is greater than the alternative use of funds or cost of capital
- Reject if the calculated IRR is less
- If the investment is financed by 100% borrowed capital, the RoR should at least exceed the
interest rate being paid in the loan.
- If IRR is greater than the required RoR, the NPV is positive
 - If IRR is less than the required RoR, the NPV is negative
- If IRR is equal to the required RoR, then NPV is zero

Dual or Multiple Rates of Return

- Advance payment/high terminal cost

- Rate acceleration projects
- Conventional cash flow
- Non conventional cash flows
(a) - - + + + or - - - + + + +
(b) + - - + + + or - + + + -
(c) Income or savings precede costs (+ -) dual
(d) Investment – income – investment (- + -)
(e) Income – investment – income (+ - +)

Example on IRR

A ship mining company invests $70 Ƣ at time zero to generate net revenue of $40 Ƣ per year for five
years. During the sixth year, the company has to spend $140,000 in order the restore the land to its
original condition. Calculate the IRR of this investment. Assume year end discount.

0 => -70,000

1 => 40,000

2 => 40,000

3 => 40,000

4 => 40,000

5 => 40,000

6 => -140,000

-$10,000

The NPV undiscounted at 0% is -$10,000

The net revenue is an annuity

1+ ie t −1
Pv = A v [ t
i e ( 1+i e )
Let’s use 5%
t
1+ ie −1 1
NPVe 5% = -70 + 40,000 – 140000 ( )
t
i e ( 1+i e ) 1+ ie t

1+0.055−1
= -70000 + 40000 −140000 ❑ ( 1+0.05 ) 6
0.05 (1+ 0.05 )5 ❑

= -70000 + 40000 (4.3295) – 140000 (0.7462)

= - $1288

Rates % $ NPV

5 - 1288

10 2605

15 3560

20 2739

25 871

30 1582

35 4329

40 7187

6.2% 26.78%

Range of i.e.
 - Wherever dual IRR exists, use NPV for decision making. If = IRR (values, guess) function is used.
MS Excel will only calculate the first one if the NPV is +ve
- Another example: Heavy oil field recovery very small, rate low => steam injection to improve oil
recovery.
See nmen pp 323
- Project rate of return and overall growth rate (salient features)

Characteristics of IRR
1. Accounts for the time value of money: Compounds interest rates on saving accounts, loans,
etc.
2. It considers cash flows over economic life of the investment
3. It does not give any indication of the size of the initial investment. Better to invest in lower
yielding, layer size projects.
4. No direct indication of the value of the investment
5. IRR are not additive
6. IRR can be calculated for the following
Cash flows are all positive
Cash flows are all negative
Total undiscounted revenues are less than the investment
When cumulative cash flow stream goes negative more than twice
7. Assumption is that the IRR is reinvested at that calculated IRR, which may not be so.
8. The timing of cash flows Is significant, more sensitive to timing than others.
9. IRR is not affected by delay in project start dates e.g. NPV = $100,000, a delay 2 year will a
reduction of 100 (1 + IRR) -2. The IRR does not change.
10. Conflicting ranking when used for ranking mutually exclusive investments or selecting non-
mutually exclusive investments.
11. Unlike NPV, risk (probability) can not be incorporated mathematically in the equation.
12. It can be computed for before and after tax
13. Trial and error solution

Unit Technical Cost (UTC) or Long-Run Marginal Cost (LRMC) or Fxxxxxd Cost

- Ratio of total cost (OPEX + CAPEX) over the economic life of a project to the total expected
reserves from the project $/b/d
- $/stb, $/MMBtu, $/MScf, $/ton, $/boe
- $70/stb and $4.25/MScF then 16.47 MScf ≅ \bbl of oil equivalent (BoE)
1 ton of NGL is 8.57 barrel of oil equivalent (BoE). Dollar per barrel of oil equivalent. $/BoE
- BoE: 5.615 cubic feet of gas is equivalent to one barrel of oil equivalent. I metric ton of NGLs is
equivalent to 0.1342 barrel of oil equivalent
- Reserve oil, curve rates and gas
- TC may be undiscounted and/or discounted using discount rate as in NPV
- TC is independent of prices of products involvedxxx

Pp 196: use/insert Table 3.17 as example

- Illustrated example use (Table 3.17)

Capex and Opex (LOE) = 1090.87 mm $
Net oil and gas reserves 13.858 mstb and 119.751 mmscf
Product prices $60/stb and $550/mscf
Gas production converted to BoE 60/5.5 = 10.91

UTC Calculation
1. Convert 119.751 MM Scf to BoE
119.751
Total reserves = 13,858 + =24,834.26 Boe
10.91
2. Calculate the undiscounted unit technical cost as
Unit total cost in BoE
750000+ 340870
= = $43.93/BoE
24834.26
3. If it is only an oil producing well, then $/stb and $/BoE are equal. If it is predominantly gas
750000+ 340870
well, technical cost will be calculated in $/MScf. UTC in Stb =
13.858
4. Discounted unit technical cost the product stream and the total cost are discounted using
the 10% discount factor
5. Discounted oil production = 8.62 mstb
Discounted gas production (net servixxxx = 75.13 mmscf)
Discounted cost (xxoE + CAxxEX) = $163.06 + 681.82 = 844.88 ms
Discounted unit technical cost in BOE

$ 844.88
= 75.13
8.62+
9.778

844.88
=
16.304

= $ 51.82 per BoE

481+4.88
Discounted Unit Technical Cost in STB =$ 98.0 xxx stb
8.61

Decision rule
 Accept: If the discounted TC in $/BOE < the expected oil price over the economic life of the
project.

Reject: If the discounted TC in $/BOE is higher than the expected oil price

The UTC can be calculated graphically of NPV (calculated at various prices) versus the
respective prices.

The product price at the intersection of NPV = 0is the desired technical cost.

- PV x costs = PV of gross revenue

n n
costs gross revenue
∑ (1+id )
t =∑
(1+id )
t
i=1 t =1

n
production X price
=∑
i=1 (1+i )t

n
production
= price ∑ t
i=1 (1+id )

n n
costs
Therefore, price UTC = ∑
(1+id)
t÷ ∑ production
(1+id)
t
i=1 i=1

Excel functions can perform this too

3.47 Netback Value

- Agreement between the seller and the buyer contracts (LRMC for Seller) make money. How much the
buyer can pay for the resource.

- 3 different methods to calculate netback value for pricing a feedstock or fuel

- Netback pricing is the contractual arrangement in which the price of the feedstock or fuel is based
upon the processed products.

- Technically, NBV is defined as the present value of the net benefits of a project (excluding the cost of
gas/feedstock used) divided by the present value of the volume of gas consumed.

- NBV is the maximum price that the consumer is willing to pay for the fuel.

- Approaches:

(a) Base year and ROI approach

(b) Long run marginal cost approach

(c) Indexed netback pricing

- Using the table below as illustration

Year -1 -2 -3 1 2 3 4 5
Sales gas 0 0 0 10500 10500 10500 10500 10500
volume mm
btu/d
Methanol price - - - 320 320 320 320 320
$M/T
Methanol prod - - - 300 300 300 300 300
xxxx/day
Operating cost - - - 3.20 3.20 3.20 3.20 3.20
(OPEX) MM$
4% of CAPEX
Capital 20 32 28 - - -
expenditure
(CAPEX) MM$
ROR 15%

3.48 GROWTH RATE OF RETURN (GROR)

- Equity rate of return

- modified internal rate of return (MIRR)

- Appreciation of equity rate of return

- Baldwin method

- Procedure

 Specify the rate at which the future net revenues can be reinvested once they enter
firm’s treasury i0
 Compute each of the annual net revenue to the end of the project life, year, n (gives
future value of cash flows)
 Solve the following equation for the growth rate of return, igr

(Original Investment) (1 + igr)A

{ Future values of cash flows

compounded at io
¿
year n ¿
}
Where n is the life of the project in years

B= ( FVIof=PV
positive cash flow
of CAPEX ) 1/t
-1

GRR:

For continuous compounding:

GRR =
1
t
ln {
B=FV of positive cash flow
I =PV of Capex }
Example 1: Original investment of $268600. Appreciation of equity rate of return
calculation. For example prospect.

Year Net Cash Flow No of years Compound Appreciated value of

reinvested interest factor net cash flow at year
10% end of project (year
10)
1 132900 9.5 2.475 328900
2 132900 8.5 2.247 298600
3 97600 7.5 2.045 199600
4 69200 6.5 1.859 128600
5 23500 5.5 1.689 39700
6 28600 4.5 1.536 43900
7 15900 3.5 1.397 22200
8 9400 2.5 1.269 11900
9 5600 1.5 1.153 6500
10 1900 0.5 1.049 2000
1081900

$268600 (1 + iae)10 = $1,081,900

Iae = 0.1495
= 15%

Example 2: End of Year

Year Reinvestment Project A Project B

Years NCF S1 FV 10% NCF FVE 10%
0 0 -1000 0.00 -1000
1 9 210 495.17 750 1768.46
2 8 210 450.15 750 1607.6
3 7 210 409.23 0.00
4 6 210 372.03 0.00
5 5 210 338.21 0.00
6 4 210 307.46 0.00
7 3 210 279.51 0.00
8 2 210 254.10 0.00
9 1 210 231.00 0.00
10 0 210 -210.00 0.00
1100 3346.86 3376.15
IRR 16.40% 31.87%

NPV e 10% 290.36 301.68

GRR e 10% 12.84 12.94
PI 1.29 1.30

FVA in year one = $210 (1+0.10)9 = $495.17

FVA in year two = $210 (1+0.10)8 = $450.15 and so on
FVB in year one = $750 (1+0.10)9 = $1768.46
FVB in year two = $750 (1+0.10)8 = $1607.69

[
GRRA = (
3346.86 1 /10
1000 ]
) −1 ×100 = 12.84%

[
GRRB = (
3376.15 1 /10
1000 ]
) −1 ×100 = 12.94%

Example 3: pp 12 Peter Expel Economics and risk analysis

- Adjusted net present value (ANPV): ‘xxxxxxx’
- In multinational setting
- International variation in capital structure type
Subsized project financing, xxxx guarantee, insurance
- Political and currency risks
- Project systematic risk
-