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PETROLEUM ECONOMICS
ECONOMIC
INDICATORS
(E&P Project Economic Evaluation)
Course Outcomes
Having worked through this chapter the
Student will be able to:
Describe two methods of economic indicators
Describe the underlying concept of key economic
indicators for undiscounted method, such as payback
period, maximum capital outlay, terminal cash
surplus, and profit to investment ratio.
Describe the underlying concept of key economic
indicators for discounted method, such as net
present value, internal rate of return, discounted
payback, and profitability index.
Describe the significant of net present value and
internal rate of return for investment decision
making.
Describe the application of economic indicators for
Economic
indicators are
devices which
reduce a net cash
flow projection to
single numbers in
time.
Cost
Profit
a. Project Screening
Comparing all projects with a set of company
investment criteria to identify suitable candidates for
investment
b. Project Ranking
Comparing all acceptable projects and placing in rank
order for investment purposes
Payback Period
Maximum Capital Outlay
Terminal Cash Surplus
Profit to Investment Ratio
2. Discounted method
Note:
All the measures are norisk profitability criteria. It
is assumed that all of the
projected cash flows and
expenditures are guaranteed
to occur at the exact time
specified
1. Undiscounted method
(c)
(d)
(a)
(b)
and Taxes.
MCO
Short Exercise:
Cash flow
Performan
ce
No
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
Year
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Cash
flow
-24
-102
-316
-321
10
245
448
113
223
197
152
146
126
114
101
94
84
77
69
72
-56
9
Total
1461
Payback period?
Maximum capital outlay?
Terminal cash surplus?
Profit to investment ratio?
Solution.
Year
Durati
on
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
Year
Proje
ct Cash flow
1994
-24
1995
-102
1996
-316
1997
-321
1998
10
1999
245
2000
448
2001
113
2002
223
2003
197
2004
152
2005
146
2006
126
2007
114
2008
101
2009
94
2010
84
2011
77
2012
69
2013
72
2014
-56
2015
9
Total
1461
2000
Net cash
flow
-24
-126
-442
-763
-753
-508
-60
53
276
473
625
771
897
1011
1112
1206
1290
1367
1436
1508
1452
1461
1500
1000
Net Cash Flow
500
0
2 4 6 8 10 12 14 16 18 20 22
1 3 5 7 9 11 13 15 17 19 21 23
-500
Project Durations (years)
-1000
2. Discounted method
Features of NPV
Features
of NPVof NPV
Features
Present value of a simple investment
Net cash flow $MM =
(investment)
Time =
0
-100
Time =
Invested in Bank $MM =
0
-100
We lost 10 $MM if investing in the Bank
Time =
1
+120
Time = 1
+110
Features of NPV
At discount rate of 10%, the investment
is $10 better than putting the money in
the bank
We would have to put $109 in the bank to
get the same return as the investment!
DIFFERENT INPUTS
Bank
$10
9
Alternative
Investment
$100
$120
Features of NPV
In the case of investments other than banks,
there would be a risk attached to the investment
and the discount rate would be correspondingly
greater than the bank rate
When we make an NPV calculation, we are
implicitly making a comparison with alternative
investments and calculating how much better or
worse the project is than those alternatives
the timing,
Short exercise:
Solution
12%
0
- RM7500
NPV
3yrs
NPV
4yrs
NPV
5yrs
The calculation of
NPVs for the
Foinaven project at 0,
10, and 20 %
discount rate.
This constitute a
trial and error
sequence, with NPV
reducing from 1460
to 321 and minus 44.
Graphical
By plotting NPV profile and find intercept on x axis
Example of NPV profile of Foinaven project
18%
- 44
Extrapolation
Iterative calculations to find zero NPV
Significant of
IRR
A measure of growth rate
A measure of investment efficiency
Short Exercise:
The BIG Fish company decided to choose an
investment with has a return of RM 5000 after
15 years with initial investment RM 800. What
is the IRR if interest rate is 12% per annum.
What is your recommendation for the
investment? (hint: use Graphical method)
Solution:
IRR calculation using graphical method, we should define another 2 NPV values.
Assume we use 13% and 15% interest rate,
12
%
13
%
15
%
12%
RM 113.48
13%
RM 0.55
150
100
50
NPV
0
-500.1
-100
-150
0.11
0.12
0.13
Interest rate
0.14
0.15
0.16
15%
RM 185.53
Using graphical
solution below, the IRR
is when NPV= 0) and is
about 13%.
-200
-250
5%
0% 10%
Profitability Index
also known as profit investment ratio (PIR)
(PI)
is the ratio of present value of
future cash flow to investment of a
proposed
project.
It is a useful tool for ranking projects because it
allows you to quantify the amount of value created
per unit of investment.
PV of future cash flow
Profitability Index =
Initial investment
Short Exercise:
Calculate the net present value and
profitability index of a project with a
investment of $20,000 and expected net cash
flows of $3,000 a year for 10 years. The
project's required return is 12%. Is the project
acceptable using NPV and PI?
Solution:
1. Project Screening
IRR 0
PI
2. Project Ranking
Ranking decision is taken by several consideration:
a. Resources Limitation
Projects comparison
Ranking Parameters
1. NPV as Ranking Criterion
with
high IRRfor
may
generatesequences
income very quickly
IRRProject
is useful
indicator
investment
amongst opportunity.
3. PI as Ranking Criterion
Example:
Suppose an investment will cost $ 90,000 initially
and will generate the following cash flows:
Year 1: 132,000
Year 2: 100,000
Year 3: -150,000
The require return is 15%. Should we accept or
reject the project?
As a petroleum economist you are asking to use
NPV and IRR for answering this.
Solution:
i = 15%,
NPV NPV = -90,000 + 114783 + 75,614 98,627
= $ 1,770
If i = 10%,
NPV = -90,000 + 120,000 + 82,645 112,697
= $ -52
IRR
If i = 25%,
NPV = -90,000 + 105,600 + 64,000 76,800
= $ 2,800
If i = 45%,
NPV = -90,000 + 91,034 + 47,562 49,202
= $ -606
By Graphical method:
THE END
&
THANK YOU