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CGE 660 COURSE LEARNING OUTCOMES

ENGINEERING ECONOMICS OF OIL &


Topic
Time value of money
GAS OPERATIONS

Types of money
Inflation Consumer Price Index (CPI)
Escalation
Exchange rates
Chapter 3 INFLATION & ESCALATION 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
BY: H U S N A H AYAT I J A R N I & N O R R O S L I N A R O S L I
management.
D E PA R T 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 Explain the inflation concepts and analyze its impact to economy.
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

Definition TIME VALUE OF MONEY


Terms Definition Money is a valuable commodity.
Project An investment opportunity generating cash flows over time The perceived value of money varies with the timing of its receipt and expenditure.
Cash Flow The movement of money (in or out) of a project The idea that money available at the present time is worth more than the same
Interest Used to move money through time for comparisons. The rent for loaned money amount in the future due to its potential earning capacity. This is core principle of
Cash Flow Diagram Describes type, magnitude and timing of cash flows over some horizon finance.
Principal, P Amount invested or loaned; Capital The early receipt of money would be preferred due to investment opportunities,
Interest rate, i Rental charge for money defined as a percentage of principal per time period purchasing power, security and flexibility for personal circumstances.
Compounding period Defines how often interest is calculated (may not be paid, however)
Investment opportunity is considered as the most important element in the analysis of
Periods, n Length of loan / investment time value of money.

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TIME VALUE OF MONEY FIXED INTEREST
Interest is the basis of investment analysis. Interest is the income to the owner of money and Fixed Interest - Does not take into account factor of time. Value is
cost to the one who borrows. Interest can be in the form of:
1. Fixed Interest
constant regardless of long or short period.
2. Simple Interest For example:
3. Compound Interest
A 10% fixed interest on $100 will generate $10 regardless of when it
Applications of Compounding: will payout. Interest of this nature has not determinate rate and thus a
1. Computation of terminal value of an investment loan of $100 for 18 months would be more beneficial than a loan of
2. Shifting cash flows in time to facilitate comparison or aggregation. $100 for 6 months. The loaner will still have to pay out $10 regardless.
3. Calculating or monitoring the account balance.
4. Computation of escalating costs or prices.
5. Ranking of investments on the basis of terminal value.

SIMPLE INTEREST COMPOUND INTEREST

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COMPOUND INTEREST NOMINAL ANNUAL INTEREST
For example: An Investment of $100k at 10% interest for 10 years Often times, compounding is done at more than once per year (semi annually,
An = Payment received after 10 years
Year Capital Interest Payback monthly, weekly or daily).
1 $100k (0.1*$100k) $110k
Ao = Initial amount invested = $100k Period interest is the proportional interest which is added after each
2 $110k (0.1*$110k) $121k
compounding period. These periods may be any length of time, but should
n = Investment duration of 10 years 3 $121k (0.1*$121k) $133k
normally be equal in length.
i = Compounded interest rate of 10% 4 $133k (0.1*$133k) $146.3k

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Nominal [approximate] interest is the period interest, times the number of
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periods in a year. Thus, if 1% is added monthly, the nominal interest rate is
An = $100k (1 + 0.1)10 = $100k (2.594) = $259.4k 0.01 * 12 = 0.12.
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8 I.e. nominal annual interest rate of 12% based on monthly compounding


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means a 1% interest rate per month (compounded).
10 $259.4k

NOMINAL ANNUAL INTEREST NOMINAL ANNUAL INTEREST

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EFFECTIVE RATE 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 DISCOUNTING

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DISCOUNTING EXAMPLE 1 EXAMPLE 2
If you will get $65 from somebody at 10% discount rate, what is the present Which option is better?
value?
To get $110 next year, or to get $110 now. The discount rate is 5%.

x 10 % x 65
TODAY 1 YEAR
1 . 10 x 65
$104.76 5% disc $110
x 59 . 09 This is the value now. The PV.

$105 So this is the


5% int $110.25 better option.

TUTORIAL TUTORIAL
Which option is better if the rate is 5%? Which option is better if the rate is 2%?

Payment Option 1 Payment Option 2 Payment Option 3 Payment Option 1 Payment Option 2 Payment Option 3
Year 0 $100 $20 Year 0 $100 $20
Year 1 $50 Year 1 $50
Year 2 $110 $35 Year 2 $110 $35

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ANNUITY 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,
In some cases, the PV of the cash flows is known and the A needs to be estimated. This is Lump sum payment of $3500
often the case with home or automobile loans, where the borrower receives the loan
today and pays it back in equal monthly installments over an extended period of time.

RANKING INVESTMENTS INFLATION


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 compound interest 5%. The prices of most goods and services change over time. Inflation is
Year Cash Flow Compound Factor Terminal Value @ Year 10 the rate at which the general level of prices for goods and services
1 250 (1+0.05)9 387.83 is rising, and, subsequently, purchasing power is falling. Central
2 250 (1+0.05)8 369.36 banks attempt to stop severe inflation, along with severe deflation,
3 250 (1+0.05)7 351.78
in an attempt to keep the excessive growth of prices to a minimum
4 250 (1+0.05)6 335.02
5 250 (1+0.05)5 319.07 As inflation rises, every dollar will buy a smaller percentage of a
6 250 (1+0.05)4 303.88 good. For example, if the inflation rate is 2%, then a $1 pack of gum
7 250 (1+0.05)3 289.41
will cost $1.02 in a year.
8 250 (1+0.05)2 275.63
9 250 (1+0.05)1 262.50 Most countries' central banks will try to sustain an inflation rate of
10 250 (1+0.05)0 250.00
2-3%
Total 3144.47

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INFLATION Hyperinflation
There are several variations on 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
Deflation is when the general level of prices is falling. This is the opposite of hyperinflation occurred in Germany in 1923, when prices rose 2,500% in one
inflation. month!
Stagflation is the combination of high unemployment and economic stagnation The government printed large amount
with inflation. This happened in industrialized countries during the 1970s,
of money during WW1 without the
when a bad economy was combined with OPEC raising oil prices.
resources to back it up. It was even
worst when they lost in the war.
It caused political instability, misery of
the people, and war.
Example: A postage stamp value is 5
billion mark

German children playing


with money

Woman burning paper money for heat

Money used as toiet paper in Zimbabwe

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ESCALATION 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 measure that examines the weighted average of
prices of a basket of consumer goods and services, such as
transportation, food and medical 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 CPI are used to
assess price changes associated with the cost of living.

CUSTOMER PRICE INDEX (CPI) PLANNING FOR INFLATION


CPI is usually calculated by a government body such as the Planning for inflation wise costing of projects taking into
Department of Statistics or National Reserve Bank etc. account current economic conditions
A variety of consumer goods and services are reviewed to Fixed Price Contract fixed supplier/customer.
calculate this value. Usually, the CPI is announced/listed Fiscal Drag ( Inflation & Taxation ) delay in the payment
monthly. of tax
Sometimes referred to as "headline inflation

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The Different Between Inflation,
INFLATION MEASUREMENT Deflation & Escalation
Commodity Qty in Fixed Basket (Units) 2002 2012 Inflation is defined as a persistent rise in the prices of a CPI type
Food 500 1.00 500 1.25 625 basket of goods, services and commodities that is not offset by
Clothing 200 5.00 1000 6.00 1200 increased productivity.
Fuel 50 2.00 100 3.00 1500
Deflation refers to a persistent drop in prices.
Total 1600 1975
Escalation on the other hand refers to a persistent rise in the price
of specific commodities, goods or services due to a combination of
inflation, supply/demand and other effects such as environmental
and engineering changes.

MOD VS RT MOD VS RT
There are 2 basic techniques can be used to handle both inflation and Money of the Day (MOD), also known as "Current Dollar", "As Spent Dollar", "Escalated Dollar".
escalation properly in economic analysis: MOD Dollar is also used in budgeting purposes. The actual economic calculation is carried out
in MOD Dollars.
1. Escalated Dollar Analysis: refers to actual dollars of revenue or cost that will be realized or
incurred at specific future points in time. Other terms used are Current Dollar, Inflated Real Term Dollar (RT), is the "Constant Dollar in discussing about income. Reference year
Dollar, Nominal Dollar, Dollar of the Day or Money of the Day (MOD). MOD Dollar is used must be specified such as RT 2002, RT 2003, etc. In economic analysis, RT Dollars is used to
in budgeting purposes. The actual economic calculation is carried out in MOD Dollars. report profitability.
Value (MOD)
2. Constant Dollar Analysis: refers to hypothetical constant purchasing power dollars n : numbers of period
I : interest per perriod
obtained by present worthing of escalated dollar values at the inflation rate to some Converting RT to MOD:
arbitrary point in time, which often is the time corresponds to the beginning of the
project but may be any earlier point in time. Other terms used are Real Dollar, Deflated Value (MOD) t + n = Value (RT)t * ( 1+ i )n
Dollar or Real Time Money (RT). Real Term Dollar is the "Constant Dollar in discussing
about income. Reference year must be specified such as RT 2002, RT 2003, etc. In Value (RT)
economic analysis, RT Dollars is used to report profitability. where; i = escalation rate, n = number of years from today

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MOD VS RT MOD VS RT

Cost at initial Cost in Year 1 Income in Year 2


MYR 100 MYR 150 MYR 400

MOD Value Determination


At initial year, Value (MOD)0 : MYR 100 x (1 + 0.2)0 = MYR 100

At 1st Year, Value (MOD)1 : MYR 150 x (1 + 0.2)1 = MYR 180

At 2nd Year, Value (MOD)2 : MYR 400 x (1 + 0.2)2 = MYR 484

MOD VS RT MOD VS RT
Example 2: Convert the MOD values to RT values assuming an Example 3: Given the oil price is MYR60 per barrel. Explain the
annual inflation of 15%/year. differences of oil price for real term and money of the day term.
MOD Cost at initial MOD Cost in Year 1 MOD Income in Year 2 RT drilling cost : real drilling cost on the current year.
MYR 100 MYR 180 MYR 484 MOD drilling cost: project the future cost which will be escalated based on
escalation rate.

Example 4: Calculate the MOD of the drilling cost on the fifth year if
RT Value Determination
the escalation rate is 5% each year.
At initial year, Value (RT)0 : MYR 100 x (1 + 0.15)-0 = MYR 100
At 1st year, Value (RT)1 : MYR 180 x (1 + 0.15)-1 = MYR 157
At Year 2, Value (RT)2 : MYR 484 x (1 + 0.15) -2 = MYR 366
MYR60 x (1 + 0.05)5 = MYR 76.58 per barrel

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END OF SLIDE

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