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Basic Petroleum Economics

by Mari Kvaal

August 2004 3rd PPM Philippines Case Study Workshop 1

Objectives

Š Basic knowledge and techniques for performing


investment analysis
Š Use the tools and concepts on petroleum investment
projects
Š A field development project
Š An exploration project
Š Be able to understand the concepts used and do the
economic calculations needed in the case study.

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Investment decisions

Š Investment decisions are among the most important


decisions that a company/government can make

Š capital intensive
Š irreversible
Š high risk/uncertainty

August 2004 3rd PPM Philippines Case Stydy Workshop 3

Decisions through the life-cycle of a petroleum project

In all these phases


you have to make
DROP decisions.
Apply/bid
license .
DROP
Accept
work
DROP
progr
3D
seismic DROP
Drill a
Investment analysis wild-cat
Appraisal DROP
is used as a management tool
when making such Develop

decisions
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Investment analysis
..main economic terms
Š Investment analysis- main economic terms

Š Cash flow
inflation
time value of money
uncertainty

Š Economic Decision Criteria


net present value
internal rate of return (IRR)
payback & maximum exposure?

August 2004 3rd PPM Philippines Case Stydy Workshop 5

Main elements in economic investment analysis

Idea
Establish a cash flow forecast
Nominal/real values
Consider the uncertainties
Analysis Discount the cash flow
Net Present Value
Invest

Make a Drop
decision

Wait
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Investment analysis
..main economic terms
Š Investment analysis- main economic terms

Š Cash flow
inflation
time value of money
uncertainty

Š Economic Decision Criteria


net present value
internal rate of return (IRR)
payback & maximum exposure?

August 2004 3rd PPM Philippines Case Stydy Workshop 7

Cash flow
..the starting point of an investment analysis

Š What cash flow will be generated in & out?

Š Why concerned about the cash flow?


Š Investor invests $ today (outflow)
hoping to harvest more
$ in the future (inflow)

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Cash flow
…annual cash flow
Budgeting techniques are used to calculate the projects
cash flow for each year:

Year 1:

Income
- costs
= Net cash flow
August 2004 3rd PPM Philippines Case Stydy Workshop 9

Cash flow
…over the lifetime of the project

Income Income Income


- costs - costs - costs

= Net cash flow = Net cash flow = Net cash flow

Year
t
August 2004
0 1
3rd PPM Philippines Case Stydy Workshop
2 10

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Cash flow
...an oil investment - the investment project’s cash flow
Cash inflow (income)
1200

1000

800

600

400

200

-200

-400

-600
1 3 5 7 9 11 13 15 17 19 21 23 25 years
Cash outflow (costs)
August 2004 3rd PPM Philippines Case Stydy Workshop 11

Cash flow
..comparing cash flow elements over time

Š We can’t simply add up inflow and outflow, due to

Š Inflation

Š Time Value of Money

Š Uncertainty

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Cash flow
..inflation

Š As long as there is inflation, the consumers’


purchasing power (i.e. what you can buy) for 10$
will be reduced the later you receive the money.

Š You could buy more for 10$ in 1960 than in 2004


- and probably more in 2004 than in 2010

Š We adjust for inflation by using real values instead


of current values
August 2004 3rd PPM Philippines Case Stydy Workshop 13

Cash flow
..inflation - from current to real values (to deflate)

2004 2005 2006


Current -1000$ 212$ 449$
value
Real 2004 -1000$ 212/(1+0,06)$ 449/(1+0,06)2$
value = 200$ = 400$

Expected inflation is 6 % per year

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Cash flow
..inflation
Cash inflow (income)
1200

1000

800

600

400

200

-200

-400

-600
1 3 5 7 9 11 13 15 17 19 21 23 25 years
Cash outflow (costs)
August 2004 3rd PPM Philippines Case Stydy Workshop 15

Cash flow
..inflation - an example

Š A friend ask to borrow 350$


today and pay you back 400$ in
this way:

Š 100$ the year after and so on the


next three years

Š If the inflation rate is 5 % per


year, is this a good deal?
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Cash flow
..inflation - an example
Nominal Real
An example
values values
This year -350
+1 100 You
+2 100
+3 100
+4 100

Sum 50 Friend
STAVANGER 31.08 - 22.10 1998

…so far so good


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Cash flow
..inflation - an example
Nominal Real
An example
values values
This year -350 -350
+1 100 95 You
+2 100 91
+3 100 86
+4 100 82

Sum 50 4 Friend
STAVANGER 31.08 - 22.10 1998

…so far so good


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Cash flow
..comparing cash flow elements over time

Š We can’t simply add up inflow and outflow, due to

Š Inflation

Š Time Value of Money

Š Uncertainty

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Cash flow
..Time value of Money

Š Even after you have adjusted for inflation, it is not


correct to simply add up inflow and outflow of the
project.
Š Assume the bank offers an interest rate equal to 5 %.
2004 2005
Example 1 1$ 1$5cent

Example 2 92,5cent 1$

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Cash flow
..Time value of Money – an example

Bank deposit: $ 100


Annual interest rate: 10 %

After 1 year: V1 = $100 * (1 + 0.10) = $110.0


After 2 years: V2 = $110 * (1 + 0.10)
= $100*(1 + 0.10)*(1 + 0.10)
= $100 * (1 + 0.10)2
= $121.0
After 3 years: V3 = $121*(1 + 0.10)
= $100*(1 + 0.10)3
= $133.1
etc
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Cash flow
..Time value of Money – end value
Vn = the amount of money we can take out
of the bank after n years

Vo = the amount of money we put in


the bank today

r = a fixed interest rate in % per year

Vn = Vo (1 + r)n
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Cash flow
..Time value of Money
Š Money received today is worth more than money
received in the future:

Š Money today can immediately go to consumption or


investment and so give an interest income

Š If you have to wait, you miss the interest income or you


have to wait with your consumption

People are impatient


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Cash flow
..comparing cash flow elements over time

Š We can’t simply add up inflow and outflow, due to

Š Inflation

Š Time Value of Money

Š Uncertainty

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Cash flow
..uncertainty

Š There is always some uncertainty in investment


analysis. The future cash flow can not be projected
with certainty at the time of investment.

Š As long as today is more certain than the future, there


is a third reason to prefer money today instead of
tomorrow - we are risk averse

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Cash flow
..uncertainty - risk premium

Š By investing in a diversified (varied) project


portfolio, you can lower your total risk exposure

Š Only the change of risk an individual project


contribute to an investment portfolio is relevant for
compensation.

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Cash flow
..uncertainty - risk premium

Š Risk averse companies will demand a compensation


for taking risk - they want a risk-premium.

Š You can express this by correcting the discount-rate

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Cash flow
…discounting

Vn = Vo (1 + r)n
Vn
Vo =
(1 + r)n

To calculate the present value is often called


discounting

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Cash flow
..present value

Calculating the Present Value (PV) of an amount is the


opposite operation of calculating the end-value

0 T
Time
End-value V0 VT ?

Present value ? V0 VT

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Cash flow
..discounting a cash flow - Net Present value -an example

1 Calculate separately the 2 Add together the


present value of all the cash discounted cash flow
flow elements elements
Time 0 1 2 -100 + 75 + 62 = 37
Cash flow -100 80 70

Present value: The net present value of


-100 the cash flow of the
80/(1.06)
75
70/(1.06)2 project is 37
62
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interest rate is 6%3rd PPM Philippines Case Stydy Workshop 30

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Cash flow
..discount rate

Š Discount rate – the rate used to determine the present


worth of future value by discounting.

Š The choice of discount rate reflects the cost of capital


Š Time Value of Money
Š Uncertainty

Š Banks usually use the interest rate as a discount rate

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Cash flow
..discount rate
Cash inflow (income)
1200

1000

800

600

400

200

-200

-400

-600
1 3 5 7 9 11 13 15 17 19 21 23 25 years
Cash outflow (costs)
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Cash flow
..Net Present Value – an example

Nominal Real NPV


values values 7%
This year -350 -350
+1 100 95
+2 100 91
+3 100 86
+4 100 82

Sum 50 4

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Cash flow
..Net Present Value – an example

Nominal Real NPV


values values 7%
This year -350 -350 -350
+1 100 95 89
+2 100 91 79
+3 100 86 71
+4 100 82 63

Sum 50 4 -48

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Cash flow
..a summary

Š Future in- and outflow have to be discounted to be


comparable.
Š The present value of a project is the sum of
discounted cash flow elements.
Š You have to use the rate of return of the best
alternative use of money as the discount rate.
Š Then the net present value means the increase in value by
choosing this project instead of the best alternative.

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Investment analysis
..main economic terms
Š Investment analysis- main economic terms

Š Cash flow
inflation
time value of money
uncertainty

Š Economic Decision Criteria


net present value
internal rate of return (IRR)
payback & maximum exposure?

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Economic Decision Criteria

Š In this part we will see how we can use cash flow and
discounting to decide whether a project is economic
or not.

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Economic Decision Criteria


..discounting a cash flow - Net Present Value -an example

1 Calculate separately the 2 Add together the


present value of all the cash discounted cash flow
flow elements elements
Time 0 1 2 -100 + 75 + 62 = 37
Cash flow -100 80 70
The net present value
Present value: of the cash flow of the
-100 project is 37
80/(1.06)
75
70/(1.06)2
62
August 2004
interest rate is 6%
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Economic Decision Criteria
..Net Present Value

Š The Net present value (NPV) concept says:

Š Accept all projects with NPV > 0


Š Reject all projects with NPV < 0
Š If NPV = 0, we are indifferent between accepting or rejecting the
project

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Economic Decision Criteria


..Net Present Value – an example
Discount rate: 10%

Project Cash flow Present Value

A (-200, 120,140) 25
B (-390, 270, 220) 37
C (-600, 300, 350) -38

The net present value concept:


Accept project A
Accept project B
Drop project C
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Economic Decision Criteria
..Internal Rate of Return

Š The discount rate that yields NPV=0 defines the


Internal Rate of Return (IRR)

Š Accept all projects with IRR > discount factor


Š Drop all projects with IRR < discount factor
Š If IRR = discount factor we are indifferent

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Economic Decision Criteria


..Present Value Profile – an example

Š If we go back to project A we have a real cash flow of


(-200, 120, 140) million $. The net present value as a
function of the discount rate, can be written as:

NPV = -200 + 120/(1+r) + 140/(1+r)2

Š If we put in different values for r we can come up with


a present value profile

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Economic Decision Criteria
..Present Value Profile – an example
Discount Discounted cash flow Present Value
rate (%)

0 -200+120/(1.00)+140/(1.00)2 60
5 -200+120/(1.05)+140/(1.05)2 41
10 -200+120/(1.10)+140/(1.10)2 25
15 -200+120/(1.15)+140/(1.15)2 10
18.9 -200+120/(1.189)+140/(1.189)2 0
20 -200+120/(1.20)+140/(1.20)2 -3
25 -200+120/(1.25)+140/(1.25)2 -14

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Economic Decision Criteria


..present value profile – an example
NPV
7 0

6 0

5 0

4 0

3 0

2 0

1 0
IRR
0
0 5 1 0 1 5 1 8 ,9 2 0 2 5
-1 0

-2 0
Discount rate

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Economic Decision Criteria

Š Maximum Exposure
Š The maximum negative cash flow on a project.

Š Pay-back
Š The time required for an investment to generate sufficient cash
flow to recover the initial capital investment

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Economic Decision Analysis


..summary
Š The results and the quality of the economic analysis
depend on
Š The quality of the cash flow elements
Š Whether the discount rate reflects the best alternative value of the
money

Š Then NPV is the best suited decision criteria, and


positive NPV means that the project is profitable.

Go ahead with the investment!


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