CGE 660

ENGINEERING ECONOMICS OF
OIL & GAS OPERATIONS
Chapter 3 INFLATION &
ESCALATION
BY: H U S N A H AYAT I
D E PA RT M E N T O F O I L A N D G A S E N G I N E E R I N G
FA C U LT Y O F C H E M I C A L E N G I N E E R I N G
UITM SHAH ALAM

COURSE LEARNING OUTCOMES

Topic
Time value of money
Types of money
Inflation Consumer Price Index (CPI)
Escalation
Exchange rates
By the end of this chapter, the students will be able to:
Appreciate; explain the concept of Time Value of Money and apply the concept in project
management.
Explain the inflation concepts and analyze its impact to economy.

Definition
Project : an investment opportunity generating cash flows over time
Cash Flow: the movement of money (in or out) of a project
Interest: used to move money through time for comparisons. The rent for loaned money
Cash Flow Diagram: Describes type, magnitude and timing of cash flows over some horizon
Principal: P : capital
Amount invested or loaned

Interest Rate: i
Rental charge for money defined as a percentage of principal per time period

Compounding Period
Defines how often interest is calculated (may not be paid, however)

Length of loan/investment: n periods

TIME VALUE OF MONEY

The perceived value of money varies with the timing of its
receipt and expenditure.
Theidea that money available at the present time is worth
more than the same amount in the future due to its potential
earning capacity.Thiscore principle of finance holds that,
provided money can earn interest, any amount of money is
worth more the sooner it is received.
The early receipt of money would be preferred due to
investment opportunities, purchasing power, security and
flexibility for personal circumstances.
Investment opportunity is considered as the most important
element in the analysis of time value of money.

TIME VALUE OF MONEY

Interest is the basis of investment analysis. Interest is the income to the
owner of money and cost to the one who borrows. Interest can be in the
form of:
1. Fixed Interest
2. Simple Interest
3. Compound Interest
Applications of Compounding:
1. Computation of terminal value of an investment
2. Shifting cash flows in time to facilitate comparison or aggregation.
3. Calculating or monitoring the account balance.
4. Computation of escalating costs or prices.
5. Ranking of investments on the basis of terminal value.

FIXED INTEREST
Fixed Interest - Does not take into account factor of time. Value is constant
regardless of long or short period.
For example a 10% fixed interest on $100 will generate $10 regardless of
when it will payout. Interest of this nature has not determinate rate and thus
a loan of $100 for 18 months would be more beneficial than a loan of $100
for 6 months. The loaner will still have to pay out $10 regardless.

SIMPLE INTEREST
Simple Interest is defined as a constant proportion of the initial amount per
period:

An

= payment received after n years

Ao

= initial amount invested

= investment duration of certain years

= simple interest rate

For example : An investment of $100k taken at 10% interest for 10 years

no compounding
An = $100k (1+ (10 x 0.1)) = $100k (2) = $200k

COMPOUND INTEREST
Compound Interest is defined as proportion of the accumulated debt or
investment. The interest charged or paid in the current year includes a
proportion of interest incurred in previous years.

COMPOUND INTEREST
For example: An Investment of $100k at 10% interest for 10 years
Year

Capital

Interest

Payback

$100k

$110k

Ao = Initial amount invested = $100k

(0.1*$100
k)

$110k

$121k

= Investment duration of 10 years

(0.1*$110
k)

$121k

$133k

= Compounded interest rate of 10%

(0.1*$121
k)

$133k

(0.1*$133
k)

$146.3k

An = $100k (1 + 0.1)10 = $100k (2.594) = $259.4k

An = Payment received after 10 years

10

$259.4k

NOMINAL ANNUAL INTEREST

Oftentimes, compounding is done at more than once per year
(semi annually, monthly, weekly or daily).
Period interest is the proportional interest which is added after
each compounding period. These periods may be any length of
time, but should normally be equal in length.
Nominal [approximate] interest is the period interest, times the
number of periods in a year. Thus, if 1% is added monthly, the
nominal interest rate is 0.01 * 12 = 0.12

NOMINAL ANNUAL INTEREST

Investment growth annually calculated based on the following equations :
Annual Growth
Nominal Growth
Let j
p

= Nominal interest

= Compounding periods per year

j/p = Period interest

NOMINAL ANNUAL INTEREST

Example:

100K invested for 10 years with monthly compounding.

An = Payment received after 10 years
Ao = Initial amount invested
n = Investment duration of 10 years
j = Compounded interest rate of 10%
p = 1 if annual compound and 12 if monthly compounding
Annual Growth, = 100k (1+ 0.1)10 = 100k (2.594) = 259.4k
Nominal Growth, = 100k (1+ 0.10/12)12*10 = 100k (2.707) = 270.7k

EFFECTIVE RATE
The Effective Interest Rate, Effective Annual Interest Rate, Annual
Equivalent Rate (AER) or simply Effective Rate is the interest rate
on a loan or financial product restated from the nominal interest
rate as an interest rate with annual compound interest.
It is a rate used as standard, by which to compare different
compounding schemes. The effective annual interest rate for an
investment is the rate of interest, which, if applied once per year
would generate the same growth as that investment.

EFFECTIVE RATE
Let i = Effective Annual Interest
Compare the two compounding equations:
Compound Interest
Compound Interest with Nominal Growth
Thus,

EFFECTIVE RATE
Example:

You are offered a credit card and the interest rate on the card is
1.5% per month.
The nominal rate is 12 x 1.5 % = 18% per year.
Effective interest rate;
= (1 + 18%/12)12 - 1
= (1 + 0.015)12 - 1
= (1.015)12 - 1
= 0.1956 = 19.56%
* For the same nominal rate, what is the effective interest rate for daily
compounding?

DISCOUNTING
Discounting is the inverse of compounding.

An

= Future value

Ao

= Present value

(1+ i )-n = Discount factor

i

= Discount rate

= Duration

Application of discounting
1. Computation of the present value of a single or a series of future cash
flow.
2.Screening and ranking of investments on the basis of present value.

ANNUITY
Annuity

is a uniform payment every year for a period of time.

The present value of an annuity is:

P=
P

RANKING INVESTMENTS
An investor has $1250 with these following investment options:
Option 1 : Deposit the money in a bank account to receive a
compound interest of 5%.
Investment value received after 10 years is,
A10 = 1250 (1.05)10 = $2036
Option 2 : Invest the money in a small company, which will pay
$3500 after
10 years.
Investment value received after 10 years is,
Lump sum payment of $3500

RANKING INVESTMENTS
Option 3 :
Use the money to buy a pension which will pay out $250 per
year for 10 years.
The money can be invested in the bank with
Year
Cash Flow
Compound Factor
Terminal Value
compound
interest
5%.
2

250

(1+0.05)9

387.83

250

(1+0.05)8

369.36

250

(1+0.05)7

351.78

250

(1+0.05)6

335.02

250

(1+0.05)5

319.07

250

(1+0.05)4

303.88

250

(1+0.05)3

289.41

250

(1+0.05)2

275.63

10

250

(1+0.05)1

262.50

11

250

(1+0.05)0

250.00

Total

3144.47

RANKING INVESTMENTS
Evaluate the present value of Option 2 and Option 3 for discount rate at 5%.
Evaluate the investment options for interest rate of 10%.

MOD VS RT
Money of the Day (MOD), also known as "Current Dollar", "As Spent Dollar",
"Escalated Dollar". MOD Dollar is also used in budgeting purposes. The
actual economic calculation is carried out in MOD Dollars.
Real Term Dollar (RT), is the "Constant Dollar in discussing about income.
Reference year must be specified such as RT 2002, RT 2003, etc. In
economic analysis, RT Dollars is used to report profitability.
n : numbers of period
I : interest per perriod

Converting RT to MOD:
Value (MOD) t + n = Value (RT)t *
( 1+ i )n
Value (RT)

where; i = escalation rate, n = number of years from today

Value (MOD)

ESCALATION
Future costs or prices are commonly modelled as a compounded
series.

Example :
The current oil price is $100/bbl. Calculate the oil price
after 10 years if
prices are rising at 3% per year.
= $100/bbl * (1 + 0.03)10 = $134.39/bbl

INFLATION
The prices of most goods and services change over time. Inflation is the
rate at which the general level of prices for goods and services is rising,
and, subsequently, purchasing power is falling. Central banks attempt to
stop severe inflation, along with severe deflation, in an attempt to keep the
excessive growth of prices to a minimum
As inflation rises, every dollar will buy a smaller percentage of a good. For
example, if the inflation rate is 2%, then a $1 pack of gum will cost $1.02
in a year.
Most countries' central banks will try to sustain an inflation rate of 2-3%

INFLATION
There are several variations on inflation:
Deflation is when the general level of prices is falling. This is the opposite of inflation.
Hyperinflation is unusually rapid inflation. In extreme cases, this can lead to the
breakdown of a nation's monetary system. One of the most notable examples of
hyperinflation occurred in Germany in 1923, when prices rose 2,500% in one month!
Stagflation is the combination of high unemployment and economic stagnation with
inflation. This happened in industrialized countries during the 1970s, when a bad
economy was combined with OPEC raising oil prices.

CUSTOMER PRICE INDEX (CPI)

Costs of products and services in the E&P sector usually
increase over time.
The Consumer Price Index (CPI) or Retail Price Index (RPI) is a
key inflation indicator and used to estimate purchasing power
in the economy. It is a measurethatexamines theweighted
average of prices ofa basket of consumer goods and services,
such as transportation, food andmedical care.
The CPI is calculated by taking price changes for each item in
the predetermined basket of goods and averaging them; the
goods are weighted according to their importance.Changes in

CUSTOMER PRICE INDEX (CPI)

CPI is usually calculated by a government body such as the
Department of Statistics or National Reserve Bank etc.
A variety of consumer goods and services are reviewed to
calculate this value. Usually, the CPI is announced/listed
monthly.
Sometimes referred to as "headline inflation

INFLATION MEASUREMENT
Commodi
ty

Qty in Fixed Basket

(Units)

Food

500

1.00

500

1.25

625

Clothing

200

5.00

1000

6.00

1200

Fuel

50

2.00

100

3.00

1500

Total

2002

1600

2012

1975

PLANNING FOR INFLATION

Planning for inflation wise costing of projects taking into account current
economic conditions
Fixed Price Contract fixed supplier/customer.
Fiscal Drag ( Inflation & Taxation ) delay in the payment of tax

TUTORIAL
1 5 (WHITEBOARD)
6. A company has borrowed an amount of MYR30 MM from the bank in 2014. The money
will be released in three (3) phases in January 2015, January 2016, and January 2017.
Repayment for the loan has to be made in four consecutive years, from January 2019 until
January 2022. If the interest rate is fixed at 12% per annum, calculate the annual
repayment.
7. Determine the interest rate, i, if an amount of MYR 1000 was invested in 2004 and
generate, RM 2158.93 in 2014.
8. The Retail Price Index increased from 440 to 625.7 in the period of 10 years. Analyze
the period of the time for purchasing power of the investment to double at the annual
compounded rate in (7).