MSc - Petroleum Production Engineering

Facilitated by
Dr Mohammed Kishk
BSc (Hons.), MSc, PhD

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Complicating Factors

•Price Changes

•Multiple Currencies

•Taxes

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 Price Changes

• Cost engineers build up estimates of project CAPEX from

the detail of engineering designs.
• They use norms to capture indirect costs such as transport,
storage and handling of materials.
• Ultimately project CAPEX can be broken down into
elements which are primarily driven by, for example,

the cost of steel,

day rates for specialist personnel.
• Estimators of project OPEX and abandonment costs use
essentially the same methods.
• In the upstream oil and gas industry, unit costs can be
subject to rapid and significant change, both upward
(inflation) and downward (deflation).
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 Handling Price Changes
Constant Value Money:
Possible future changes in unit costs are ignored, e.g. to
cost a tonne of steel in Year 2 at the same unit price as a
tonne of steel in Year 1

Money of the Day (Nominal Terms):

Estimates in different years are prepared by applying
escalation rates (of individual inputs, or of unit costs of a
line item) to constant value money (of the base year).

Money of Today (Real Terms):

Estimates in different years are adjusted in terms of the
purchasing power of the sums of money concerned, i.g.
deflated.

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 Handling Price Changes
Constant Value Money:
Possible future changes in unit costs are ignored, e.g. to
cost a tonne of steel in Year 2 at the same unit price as a
tonne of steel in Year 1

Money of the Day (Nominal Terms):

Estimates in different years are prepared by applying
escalation rates (of individual inputs, or of unit costs of a
line item) to constant value money (of the base year).

Money of Today (Real Terms):

Estimates in different years are adjusted in terms of the
purchasing power of the sums of money concerned, i.g.
deflated.

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 Price Changes & the Discount Rate

If a company uses real terms cash flow forecasts as the

basis of its project economic evaluations, it needs to
adjust its minimum discount rate, r, accordingly.

1+ r
rf = -1
1+ i
Where i is the inflation rate and rf is the adjusted rate known
as the ‘net of inflation’ or ‘after inflation’ discount rate.
Note that an economic model will rarely be written entirely in
real terms, as tax calculations are almost always conducted
in MOD.
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 Price Changes: main points

• Recognising the categories of project cost likely to be subject to

differing escalation;
• Understanding the market drivers of these escalation rates as an
aid to forecasting them;
• Keeping clear the distinction between escalation and general
inflation;
• Remembering to apply an MOD discount rate to an MOD cash
flow forecast and an RT discount rate to an RT one;
• Taking extreme care over taxation logic in RT economic models
with no explicit MOD tax computations;
• Balancing the need to have RT discount rates no lower than the
RT weighted average cost of capital, and not so high as to pay
insufficient attention to field life cycle costs, while avoiding
frequent changes of economic evaluation policy. 8
 Multiple Currencies

• Many upstream oil and gas projects involve costs

incurred in more than one currency.
• Also, as crude oil is priced in US dollars, any oil
producer based outside the USA and not refining all its
own production receives sales proceeds in a currency
which is not the monetary unit in which it prepares its
statutory accounts, or that in which it makes most or all
of its payments.
• Thus, currencies have to be converted in order to bring
all receipts and payments into the monetary unit
concerned.
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 Multiple Currencies, Cont.

• This requires one or more exchange rate

forecasts.
• it is very common for a company’s corporate
planners to forecast a step change in an
exchange rate a few years out from the base year
(Year 1).
• This implies that the exchange rate is out of
equilibrium, and that equilibrium is forecast to be
re-established in a few years time.
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 Multiple Currencies, Cont.
Imagine that the heavy lift barges for an asset abandonment are to
be contracted from the Netherlands, and to be paid for in Euros.
The Euro/Dollar exchange rate is currently 0.9 Euro per dollar, and
is expected to change abruptly to 1.1 Euro per dollar in the middle
of Year 4:
Year 1 2 3 4 5 6
Heavy Lift Barges (Euro) 0 30 0 88 40 0
Exchange Rate Euro/Dollar 0.9 0.9 0.9 1.0 1.1 1.1
Heavy Lift Barges (Dollar) 0 33 0 88 36 0
Drilling Rigs 0 32 0 29 62 33
Radioactive Scale Handling 10 21 22 36 23 0
Shipping 10 44 48 106 32 0
General Offshore Labour 35 68 107 150 76 0
TOTAL 55 198 177 409 229 33
Discount Factors (17% pa) 1.0 .85 .73 .62 .53 .46
Discounted Total Cost 55 168 129 254 121 15

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 Multiple Currencies: main points

• Consciously developing all the required exchange rate

forecasts and incorporating them into an accurate cash
flow model ultimately based in the currency in which
funds are raised;
• Understanding the significance of an RT exchange
rate forecast

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 Taxation

• Every project is subject to, or potentially subject to,

taxation.
• By taxation or tax we mean Government Take in the
broadest sense, even though some payments may be
collected by Customs and Excise and other authorities
outside the main fiscal one
• Compulsory payments into various funds, or expected
expenditure on infrastructure such as roads and bridges
which are not strictly part of a project, may not normally be
considered to be taxes.
• There are two main models for oil and gas taxation
systems, the concessionary and production sharing.
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 The Concessionary Model

• The concessionary tax system is common in North

America, Western Europe and Australasia. It is
characterised by:

Limited front end payments;

Royalty;

Special petroleum taxes;

Corporation tax;

Limited carrying of the Government interest in
project expenditure.

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 The Production Sharing Model

• The production sharing tax system is common in the less

developed countries (LDCs). It is characterised by:

Significant front end payments;

Royalty;

Cost oil or gas for company cost recovery, often subject
to an annual limit;

Profit oil or gas split between government and company
(hence “production sharing”);

Corporation tax;

Significant carrying of the Government interest in project
expenditure.

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 Taxation & the Discount Rate
• Just as inflation affects the minimum discount rate for project
economic evaluation, so does tax.
• Suppose a company’s funding is derived 50% from loans at 8%
pa and 50% from equity at a cost of 16% pa.
• Interest payments on loans are an allowable cost against
Corporation Tax in its home country, the CT rate being 30%, and
dividend payments are not allowable against CT, being paid out
of after tax profits.
• The after tax cost of capital is
0.5 x 8% x (1-0.3) + 0.5 x 16% x (1-0.0) = 10.8% pa.
• These are MOD discount rates, and if inflation in the home
country is forecast to be 2% pa, corresponding RT discount rates
are 9.8% pa before tax (1.12/1.02 = 1.09804) and 8.63% pa after
tax (1.108/1.02 = 1.08627).
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 Taxation : main points
• Understanding the detailed taxation rules, including tax payment
delays, and modelling them accurately;
• Modelling in advance reasonable tax accounting behaviour in the few
cases where options exist;
• Distinguishing between cash flow based taxes and profit based ones;
• Remembering the possibility of non CT paying status;
• Remembering to use an after tax discount rate with an accurate cash
flow forecast including tax, and a pre tax discount rate with an
approximate cash flow forecast ignoring tax;
• Making some adjustment for the economic penalty of delayed tax reliefs
against CAPEX when evaluating the results of pre tax economics;
• Balancing the need to have after tax discount rates no lower than the
after tax WACC, and not so high as to pay insufficient attention to LCC;
• Allowing for any withholding tax affecting funds repatriated to a
company’s base country.
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 Topic Summary

•Price Changes

•Multiple Currencies

•Taxation

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 The Incremental Method
Incremental & “Stand Alone” Evaluation Methods

Shifts in Abandonment Dates

Tax Timing

Project Boundaries

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 The Incremental Evaluation Method

• Incremental economic evaluation of a proposed project

involves adding the cash flow forecast for the project to
the collective forecast of the future annual cash flows
for all of an organization’s existing activities.
• Then the economic outcomes, with and without the
project, are compared.
• It is generally sufficient to use the combined existing
activities of the relevant asset as the base case,
instead of those of the whole company.
• Exceptions include ‘interlinked assets’; more than one
asset in ‘tax ring fence’.
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 The Stand Alone Evaluation Method

• The alternative to incremental evaluation is the “stand

alone” evaluation basis.
• The project is studied in isolation.
• This should only be considered in accurate work when
the practitioner is confident that abandonment dates,
tax timings and any other relevant parameters are not
perturbed by the project, ie that its benefits and costs
are small enough not to perturb them.
• Defining the boundaries of a project is very important.

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 Shifts in Abandonment Dates
Table 2. (Base case), $m RT Year 1.

Year 1 2 3 4 5 6
Oil production (mb/d) 124 78 43 33 21

Oil sales ($20/bbl RT) 905 570 314 241 153

CAPEX -90 -80

OPEX -294 -320 -263 -200 -119

Decommissioning -315

Tax -256 -112 -30 -21 -18 95

Cash flow after tax 265 58 21 20 16 -220
Disc. factors (15%) 1.0 .87 .76 .66 .57 .50
Discounted cash flow 265 50 16 13 9 -110

NPV= $243m. 23
 Shifts in Abandonment Dates
Table 1. PWU (Stand Alone Basis), $m RT Year 1.
Year 1 2 3 4 5 6
Oil production (mb/d) 19 13 -11 -21

Oil sales ($20/bbl RT) 140 93 -80 -153

CAPEX -22

OPEX -6 -6 -6 -6

Decommissioning -5

Tax 2 -51 -33 34 61 2

Cash flow after tax -20 83 54 -52 -98 -3
Disc. factors (15%) 1.0 .87 .76 .66 .57 .50
Discounted cash flow -20 72 41 -34 -56 -2
NPV= $1m. 24
 Shifts in Abandonment Dates
Table 3. (Base case+PWU), $m RT Year 1.
Year 1 2 3 4 5 6
Oil production (mb/d) 124 97 56 22

Oil sales ($20/bbl RT) 905 710 407 161

CAPEX -112 -80

OPEX -294 -326 -246 -125

Decommissioning -320

Tax -254 -163 -70 -11 102

Cash flow after tax 245 141 91 25 -218

Disc. factors (15%) 1.0 .87 .76 .66 .57 .50

Discounted cash flow 245 123 69 16 -124

NPV= $329m. 25
 Shifts in Abandonment Dates
Table 4. (Incremental), $m RT Year 1.
Year 1 2 3 4 5 6
Oil production (mb/d) 19 13 -11 -21

Oil sales ($20/bbl RT) 140 93 -80 -153

CAPEX -22

OPEX -6 17 75 119

Decommissioning -320 315

Tax 2 -51 -40 10 120 -95

Cash flow after tax -20 83 70 5 -234 220
Disc. factors (15%) 1.0 .87 .76 .66 .57 .50
Discounted cash flow -20 73 53 3 -133 110

NPV= $86m. 26
 Shifts in Abandonment Dates

• Thus a significant increase in NPV can arise from

advancement of the abandonment date without
reduction in the hydrocarbon reserves produced.

A small decrease in NPV caused by bringing
forward the abandonment itself.

A big after tax saving of the OPEX that would have
been paid during the period of the advancement.

The impact of the acceleration of the production
profile, and of reductions in pre-abandonment
OPEX.
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Tax Timing
Table 5. P2/W2 Stand Alone, $m RT Year 1.
Year 1 2 3 4 5 6
Oil sales ($20/bbl RT) 40 64 56 48 40

CAPEX -60

OPEX -4 -20 -20 -8

Royalty -5 -8 -7 -6 -5

Profit oil to government -10 -16 -14 -11 -23

Corporation tax -3 -3 -1 -4

Cash flow after tax -42 17 14 19 12

Disc. factors (15%) 1 .870 .756 .658 .572 .497

Discounted cash flow -37 13 9 11 6

NPV= $2m. 28
 Tax Timing
Table 6. Base Case, $m RT Year 1.
Year 1 2 3 4 5 6
Oil sales ($20/bbl RT) 992 848 720 624 536

CAPEX -582 -168

OPEX -65 -94 -93 -75 -41

Royalty -124 -106 -90 -78 -67

Profit oil to government -244 -259 -375 -330 -300

Corporation tax -104 -86 -7 -1 -34

Cash flow after tax -582 287 303 155 140 94

Disc. factors (15%) 1.00 .870 .756 .658 .572 .497
Discounted cash flow -582 250 229 102 80 47

NPV= $130m. 29
 Tax Timing
Table 7. Base Case+P2/W2, $m RT Year 1.

Year 1 2 3 4 5 6
Oil sales ($20/bbl RT) 1032 912 776 672 576

CAPEX -582 -228

OPEX -69 -114 -113 -83 -41

Royalty -129 -114 -97 -84 -72

Profit oil to government -252 -256 -396 -354 -325

Corporation tax -108 -95 -6 -33

Cash flow after tax -582 246 333 164 151 105
Disc. factors (15%) 1.00 .870 .756 .658 .572 .497
Discounted cash flow -582 214 252 108 86 52
NPV= $126m. 30
 Tax Timing
Table 8. Incremental CFs, $m RT Year 1.

Year 1 2 3 4 5 6
Oil sales ($20/bbl RT) 40 64 56 48 40

CAPEX -60

OPEX -4 -20 -20 -8

Royalty -5 -8 -7 -6 -5

Profit oil to government -8 3 -21 -24 -25

Corporation tax -4 -9 1 1 1

Cash flow after tax -41 30 9 11 11

Disc. factors (15%) 1.00 .870 .756 .658 .572 .497

Discounted cash flow -36 23 6 6 5

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NPV= $4m.
 Tax Timing

• The true after tax cash flow for the company is

accelerated in comparison with the stand-alone
evaluation, because profit oil payments to the
government are delayed.
• This is because the rest of the asset provides oil
production which can be taken earlier as cost oil for
the incremental wells.
• whereas on the stand alone basis the project has to
wait until the P2/W2 have produced enough oil to
cover their own costs.
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 Project Boundaries

Associated Costs and Fiscal Allocations

• The need for the inclusion of all relevant costs
associated with a project, and also the requirement
that these should not be overstated.
• A project can acquire incremental tax reliefs without
having corresponding incremental costs.
• The adoption of the incremental method when
evaluating a given project is likely to trigger
consideration of associated costs and of fiscal
allocations from elsewhere, whereas using the stand-
alone approach is not.
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 Project Boundaries
Piggy Back Projects

P ro je ct A 2
Mobilisation

Demobilisation
P ro je ct A 1
P ro je ct A 2

P I = 1.7 P I = 1.1

P ro je ct A 1 P ro je ct A 2

P I = 4.0 P I = 0.9

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 Project Boundaries
Contingent Projects ‘upside potential’

P ro ject B P roje ct C

N P V = $ 25 0 m N P V = $1 5 0 m
1

P ro ject B
P roject C
2
N P V = $ 25 0 m

N P V = $ 15 0 m

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 Project Boundaries
Joint Benefits Shared ‘upside potential’

Join t
P rod u ced W ater U p grad e
B en efits
N P V = $150m
N P V $50m

S u b sea
B ase C ase W ells
N P V = $500m P 2 an d W 2
N P V $100m

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 Topic Summary
Incremental & “Stand Alone” Evaluation Methods

Shifts in Abandonment Dates

Tax Timing

Project Boundaries

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