DAY 5 MORNING

COMMERCIAL ASPECTS OF OIL INVESTMENT PROJECT

COMMERCIAL ASPECTS OF OIL PROJECT

Time value of money Economic analysis concepts Economic measures Cashflow model

Commercial Aspects of Oil Investment Projects

COMMERCIAL ASPECTS OF OIL PROJECT

Applicable to all capital projects regardless of the dollar value Provides effective and consistent evaluation of investment opportunities Determines the most financially attractive projects Critical to financial decision-making

Commercial Aspects of Oil Investment Projects

COMMERCIAL ASPECTS OF OIL PROJECT

The focus is on capital investment analysis Also used in:
Asset valuation & acquisition Strategic & technical planning Asset divestment Opportunities for improved efficiencies

The results of his evaluation process are dependent upon the validity and reliability of the assumptions used in the analysis Therefore it is critical that the assumptions be carefully and realistically formulated
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COMMERCIAL ASPECTS OF OIL PROJECT

Other Considerations for Financial Decision Making
Strategic implication of project Envionmental implication Enhancement of the companys reputation Social/societal responsibility Political considerations

Commercial Aspects of Oil Investment Projects

COMMERCIAL ASPECTS OF OIL PROJECT

TIME VALUE OF MONEY
Present value theory This concept states that a dollar today is worth more than a dollar tomorrow since the dollar can be invested to earn money in the interim period Future dollars in cash flow schedules are therefore discounted The higher the discount rate, the less the future dollar is worth today

many years ago

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today

many years in future

COMMERCIAL ASPECTS OF OIL PROJECT

Typical Oil Project Economics
$ daily output rate + t capital spending Production Forecast Reserves (boe) $ Net PV Cashflow

t $ t $ t

Opex forecast $

product prices

t PSA/PSC or royalties t

Commercial Aspects of Oil Investment Projects

COMMERCIAL ASPECTS OF OIL PROJECT

All project economic analysis should be performed based on these concepts:
Net Cash Flow to oil company
The cash flow from investment proposals must be analyzed on a comparable basis in order to determine which proposals have the greatest economic value to my company. Therefore all investments should be evaluated on the basis of after-tax dollar cash flow to my company. A projects cash flow should include all foreign tax effects (income and remittance taxes) and any extra government income tax.

Weighted Average Cost of Capital (WACC)

This is the rate used to discount future project net cash flow. The cost of capital is the weighted average after-tax cost of debt, preferred and common stock in my companys capital structure. The WACC is calculated by the finance department and issued by the comptroller.

Commercial Aspects of Oil Investment Projects

COMMERCIAL ASPECTS OF OIL PROJECT

Economic Analysis Concepts
Current Dollar Basis
All cash flow should be stated in current dollars (actual amounts which are expected to be expended or received each year). Current dollar forecasts represent changes due to inflation and any real price change above or below inflation. The rates used should be consistent with the most recent forecast provided by the operating company.

Foreign Currency Exchange Rates (FOREX)

Forecasted cash flows based on local currencies should be converted into the disclosure currency (dollar or rupiah) using the current exchange rates.

Commercial Aspects of Oil Investment Projects

COMMERCIAL ASPECTS OF OIL PROJECT

Economic Analysis Concepts
Full Cycle or Full-Life Economics
Economic value of an asset that was acquired in the past and had its value enhanced through additional investments

Results do not represent the current economic value to the firm since the analysis includes prior investment, revenue and expenses
Results include the benefit of hindsight and are useful to improve decisions made in the future

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Commercial Aspects of Oil Investment Projects

COMMERCIAL ASPECTS OF OIL PROJECT

ECONOMIC MEASURES
The following four measures are commonly used in project analysis. Each one provides important information on the attractiveness of a project
Net Present Value (NPV) Present Worth Payout (PWP) Discounted Cash Flow Return on Investment (ROI) or After-Tax Internal Rate of Return (IRR) Present Worth Index (PWI)

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Commercial Aspects of Oil Investment Projects

COMMERCIAL ASPECTS OF OIL PROJECT

Net Present Value (NPV)
The net present value is the economic value expected to be generated by the project at the time of measurement. It represents the value being added to the company by making the investment. Always used in various discounted rates:
NPV5, NPV7, NPV10, NPV 15

Decision Rule: NPV > 0

at least NPV> $1

Limitations
Not a good indicator of the significance of a project

Dependent on cost of capital used. If cost of capital is over or underestimated, the decision could result in selection of wrong project
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COMMERCIAL ASPECTS OF OIL PROJECT

Present Worth Payout (PWP)
Payout measures the time (days or months or years) that the net investment will be at risk. The longer the payout period, the more change for some unfavorable circumstance to occur Limitations:
disregards cash flows received after the payout period. It does not directly measure the value created by the project
Dependent on cost of capital used.

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Commercial Aspects of Oil Investment Projects

COMMERCIAL ASPECTS OF OIL PROJECT

Discounted Cash Flow Return on Investment (ROI) or After-Tax Internal Rate of Return (IRR)
Measures the efficiency of the project in producing value without reference to pay predetermined cost of capital. The discount rate which equates the projects discounted net cash inflows with its discounted net cash outflows Decision Rule:
IRR > Cost of capital (at what rate you borrow money)

Limitation:
favors projects with a quick payout or short term in future

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Commercial Aspects of Oil Investment Projects

COMMERCIAL ASPECTS OF OIL PROJECT

Present Worth Index (PWI)
PWI measures the relative attractiveness of projects per dollar of investment. The ratio of the present value of cash inflows to the present value of cash outflows. Designed to address the limitation of NPV Limitations:
Not a good indicator of the significance of a project
Dependent on cost of capital used. If cost of capital is over or under estimated, it could result in selection of wrong project.

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Commercial Aspects of Oil Investment Projects

COMMERCIAL ASPECTS OF OIL PROJECT

Measu res
Net Present Value (NPV)

Strength / Purpose
Measures the economic value expected to be generated by the project at the time of investment. It represents the value being added to the company by recommending this investment Measures the time that the net investment will be at risk. The longer the payout period, the more chance for some unfavorable circumstance to occur. Also a value indicator. If a projector that is expected to last 10 years has a 3-year payout, then 30% of the projectors life is committed to recouping investment and 70% is creating value for the company Measures the efficiency of investment capital. For every $ invested, how efficient is it in producing value. Best measure for comparing & deciding between mutually exclusive projects Measures the efficiency of the project in producing value without reference to any predetermined cost of capital. When compared to the cost of capital, ROI/IRR can be an indication of how effective a particular project is in adding value

Weakness / Limitations
Does not consider time length to achieve that value. Is dependent on cost of capital used.

Present Worth Payout (PWP)

Only measures the project result up to the time of payback. Disregards any cash flow received after payback. Is dependent on cost of capital used. Not a measure of risk, but of time.

Present Worth Index (PWI)

Is dependent on cost of capital used. If cost of capital is over or under estimated, it could result in selection of wrong project

ROI or IRR

Many reasons why an investment with a lower ROI/IRR could be preferred to a higher one. ROI/IRR assumes that project cash flows are reinvested at the same rate of return as the project generates. Favors projects with a quick payout or short term in nature. Useful indicator when considered with the other 3 for comparing projects

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Commercial Aspects of Oil Investment Projects

COMMERCIAL ASPECTS OF OIL PROJECT

Fiscal Model
Contracts
Concession contract Participation joint-venture agreement Production sharing agreement Service contracts

Royalties & Taxes

Royalties & tariffs Federal, state and local taxes (including severance taxes) Foreign tax credit Wind fall taxes (e.g. carbon dioxide emission related)

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Commercial Aspects of Oil Investment Projects

COMMERCIAL ASPECTS OF OIL PROJECT

Fiscal Model
Depreciasion, Depletion & Amortization (DD&A) Recovery of the cost of a fixed asset by allocating the cost over the estimated life of the asset Methods
Straight-Line Decline Sum of the Years Digit

Declining Balance
Double Declining Balance Unit of Production

Restoration and abandonment, salvage value

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Commercial Aspects of Oil Investment Projects

COMMERCIAL ASPECTS OF OIL PROJECT

Input Elements
Cost Structure
Capital Expenditure (Capex) Operating cost estimate over the life of the project (Opex)
+ Variable Opex + Fixed Opex + Overhead

Revenue
Reserve based Production Forecast (boe/d vs. time)
+ Rate Acceleration (weighted depletion during the lifespan) + Additional by products

Price forecast ($/boe, $/mscf or $/j or $/btu)

+ Locked-in contract vs. market price

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Commercial Aspects of Oil Investment Projects

COMMERCIAL ASPECTS OF OIL PROJECT

Capital Expenditure (Capex)
Cash expenditures required to obtain the forecast benefits of a project, e.g., acquisition of a property, plant, equipment, development costs, construction costs, etc. For example oil and gas development geoscientists and engineers define and plan and cost out the optimum way to exploit the asset:
number of wells to be drilled over life cycle size of processing facilities pipelines facilities to bring the products to point of sale

contingency (between 5 ~ 10%)

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Commercial Aspects of Oil Investment Projects

COMMERCIAL ASPECTS OF OIL PROJECT

Operating Expenses
Fixed Operating Expenses
Expenses directly attributable to the projects operations but unrelated to the level of activity, e.g. maintenance, manpower, etc.

Variable Operating Expenses

Expenses directly attributable to the activity level of the projects operations, e.g. fuel, power, feedstock cost, etc.

Overhead Expenses (G&A)

Increases or decreases in expenses in general administrative (G&A) functions which are indirectly attributable to the project, e.g. research and development, accounting, computer. Sometimes consultants

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Commercial Aspects of Oil Investment Projects

COMMERCIAL ASPECTS OF OIL PROJECT

Production Forecast
For example for an oil and gas prospect, a multidisciplinary asset development team made up of geoscientists and engineers predict: Recoverable reserves (EUR) Reservoir performance Optimum economic method of development Production profile Time schedule for future investments

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Commercial Aspects of Oil Investment Projects

COMMERCIAL ASPECTS OF OIL PROJECT

Price Forecast
In todays era of price volatility, future price forecast are now as important if not more important than other engineering analysis in producing sound evaluation of projects To ensure consistency in project economic analysis, prices used in the analysis should be based on the prices provided by the company in its periodic long term price forecast letter or other specific forecasts approved by the company Always performance sensitivity at the minimum EUR/rate forecasts, capex overrun, find the break-even $/boe price, or run cash flow schedule at the lowest price

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Commercial Aspects of Oil Investment Projects

COMMERCIAL ASPECTS OF OIL PROJECT

US First Purchase's Crude Oil Price

100

90

80

70

60

$/bbl

50

40

30

20

10

0 1900

1913

1927

1941

1954 Year

1968

1982

1995

2009

2023

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Commercial Aspects of Oil Investment Projects

COMMERCIAL ASPECTS OF OIL PROJECT

US Wellhead First Purchase Natural Gas Price

9.00

8.00

7.00

6.00

$/mscf

5.00

4.00

3.00

2.00

1.00

0.00 1920

1930

1940

1950

1960

1970 Year

1980

1990

2000

2010

2020

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Commercial Aspects of Oil Investment Projects

COMMERCIAL ASPECTS OF OIL PROJECT

West Texas Intermediate (WTI) Crude Oil Price
dollars per barrel 200 180 160 140 120 100 80 60 40 20 0 Jan 2009 Historical spot price STEO price forecast NYMEX futures price 95% NYMEX futures price confidence interval

Jul 2009

Jan 2010

Jul 2010

Jan 2011

Jul 2011

Note: Confidence interval derived from options mark et information for the 5 trading days ending June 3, 2010 Intervals not calculated for months with sparse trading in "near-the-money" options contracts

Source: Short-Term Energy Outlook, June 2010; Reuters News Service; and CME Group
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COMMERCIAL ASPECTS OF OIL PROJECT

Henry Hub Natural Gas Price
dollars per million btu 14 12 10 8 6 4 2 0 Jan 2009 Historical spot price STEO price forecast NYMEX futures price 95% NYMEX futures price confidence interval

Jul 2009

Jan 2010

Jul 2010

Jan 2011

Jul 2011

Note: Confidence interval derived from options market information for the 5 trading days ending June 3, 2010 Intervals not calculated for months with sparse trading in "near-the-money" options contracts

Source: Short-Term Energy Outlook, June 2010; Reuters News Service; and CME Group
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COMMERCIAL ASPECTS OF OIL PROJECT

Fiscal Model
Analysis is based on estimating the expected timing and amount of a projects cash flow elements Because it is developed from estimates, contain uncertainties. The uncertainties should be quantified through the use of sensitivity analysis

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Commercial Aspects of Oil Investment Projects

COMMERCIAL ASPECTS OF OIL PROJECT

Cash Flow Model
Cost Recovery Profit Split Bonuses
Signature bonus Production bonus

Most of these line items may be negotiable

Terms
Exploratory period Production period Extension Termination

Exclusion of areas Minimum work program

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COMMERCIAL ASPECTS OF OIL PROJECT

Sensitivity Analysis
Sensitivity analysis indicates the effect of a change in the magnitude or timing of individual cash flow elements
Wage change Price fluctuation Investment amount and timing Operating cost (equipment depreciation & increased cost) Crude & gas production

Tax rate or other government take

A high and low case should be included as sensitivity Probabilistic risk economics is another type of sensitivity analysis

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Commercial Aspects of Oil Investment Projects

COMMERCIAL ASPECTS OF OIL PROJECT

Total Sales Volume

Contractor Share

Inflation

Price

Start-up Delay

Capex

Production Profile

Opex

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

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Commercial Aspects of Oil Investment Projects

COMMERCIAL ASPECTS OF OIL PROJECT

Commercial Analysis Does NOT Comprise Subsurface Risk Analysis; it brings the commercial perspective into the business decision. So never let commercial analysis to take over the decision making process Always weigh the risk matrix of uncertainties from subsurface and commercial sides together. Many times commercial exercises could help mitigate the irreducible subsurface risks

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Commercial Aspects of Oil Investment Projects