SPE 163007

Evaluating the Impact of Depreciation Methods and Production Decline Patterns on

Deepwater Economics: A Case Study of Nigeria
Emmanuel I. Onwuka, SPE, AUST; Omowumi O. Iledare, SPE, LSU Center for Energy Studies; Joseph C. Echendu, SPE,
AUST

Copyright 2012, Society of Petroleum Engineers

This paper was prepared for presentation at the Nigeria Annual International Conference and Exhibition held in Abuja, Nigeria, 68 August 2012.

This paper was selected for presentation by an SPE program committee following review of information contained in an abstract submitted by the author(s). Contents of the paper have not been reviewed by the
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Abstract the production decline, UOP depreciation gives earliest

Upstream petroleum industry remains one of the most prolific in
terms of technology and risk capital transfer and rewards.
Consequently, governments all over the world try to formulate
fiscal regimes that could favourably attract investments to
petroleum provinces in their jurisdiction. Fiscal systems that are
progressive tend to find a common ground for both government
and the contractor by optimizing efforts and benefits. Nigeria
belongs to a region of low-risk hydrocarbon discovery relative to
the world average. Therefore, the government designs fiscal
regimes that would seemingly extract more economic rent from
the development of its petroleum resources. This paper
investigates the impact of some of the technical instruments in the
Nigerian PSC on rewards from deepwater investments.
Discounted economic models are developed for two petroleum
sharing contracts in Nigeria- the 2005 PSC and the interagency
team (IAT) redraft of the 2008 Petroleum Industry Bill (PIB)-with
due consideration to the three Arps production decline profiles.
Different tangible CAPEX depreciation methods are imposed on
the models and profitability indicators are estimated. Monte Carlo
simulation analysis is applied to resolve the stochastic nature of
some model input variables.
Simulation results show that maximum reward is observed when
Unit of Production (UOP) depreciation method is applied in the
redraft 2008 PIB; while straight line depreciation (SLD) gives
better economic metrics for the 2005 PSC keeping all the terms of
the contractual arrangements constant. These results could be
applied in formulation of petroleum fiscal policies like the PIB by
making cost depreciation a form of incentive. It is found that for a
specific fiscal contract, cost depreciation method influences
economic indices when used in project evaluation. Irrespective of
contractor-payout while the net present value is negatively
impacted by accelerated extraction.
Introduction
Exploration & Production business in Nigeria started in 1938
when Shell DArcy was granted a prospecting licence. However, it
became prominent shortly after the company completed the first
well, Oloibiri 1 in 1956. Since then, crude oil reserves have
increased to 37.2 billion barrels, representing 2.7% of world total
reserves as of January 1, 2012. These reserves are found in
offshore and onshore basins in Nigeria. Following the world trend,
the potential for offshore oil and gas production in Nigeria has
increased in comparison to onshore operations in recent years. But
investment in the deepwater requires huge risk capital. Therefore,
the investor is naturally attracted to a clime that guarantees him
early return on investment as well as maximum economic benefit.
According to Iledare (2010), the structure and conduct of the
global E&P industry have changed significantly over the years; to
the extent that the search for and development of petroleum
resources have become mostly driven by the attractiveness of
fiscal regimes rather than geological prospectivity only. The
petroleum fiscal system (PFS) contains the terms and conditions
that govern E & P business, constituting an important factor that
influences investors project evaluation. It can only be said to be
natural for petroleum provinces with low exploration and
discovery risks to crave for more access to gross revenue.
For example, the government of Brazil on discovering large oil
reserves in the pre-salt areas of Santos Basin proposed to change
the fiscal system from R/T to PSC because exploration risk in this
2 SPE 163007
basin is very low. Evidently, government wants larger share of
Production (Lima et al, 2010). Similarly, Nigeria over the years
has set up different series of PSCs with the more recent ones
attracting more revenue to government. And once again, in August
2008 government started a process of changing the terms of the
current fiscal regime. This proposed fiscal system, popularly
called the Petroleum Industry Bill (PIB), is the work of the Oil and
Gas Implementation Committee (OGIC) sent to the National
Assembly for passage into an Act.
The hitches surrounding the passage of this bill insinuate that risks
and rewards in the E & P business have not been adequately
harmonized. Therefore, this calls for thorough and insightful
petroleum project re-evaluation that would bring about empirical
evidence that reflects reality and hence leads to informed decision
making.
Petroleum project evaluation involves determining the volume of
reserves that is recoverable within prevailing economic and
technological realities. This is done for tax accounting, financing,
budgeting and unitization purposes as well as setting of
depreciation and decline rates for future production predictions.
In the study of petroleum project evaluations, many researchers
including Lima et al. (2010), Vikas et al (1997), Iledare (2010)
and Oyekunle (2011), by assumption, built cash flow models
based on production forecasts that are predicated on exponential
decline pattern, which is widely accepted as conservative and easy
to compute. This evaluation assumption is oblivion to the fact that
production decline pattern is a natural phenomenon controlled by
complex petrophysical and fluid behavioural tendencies of the
reservoir. Consequently, there is a need for a thorough re-
evaluation of all petroleum production decline options including
hyperbolic and harmonic decline patterns. However, irrespective
of the decline pattern encountered, it is also necessary to consider
investment costs in terms of all methods of depreciation not just
straight line spread method, as commonly assumed during
economic evaluations, especially when the fiscal system does not
specify depreciation options.
This paper evaluates the effects the IAT redraft PIB and the
existing 2005 PSC may have on the economic rewards of
deepwater investment with emphasis on the impact of production
decline methods and the cost depreciation patterns on project
economics and government take statistics. To achieve this,
production and cost assumptions reflecting Niger-Delta offshore
basin are applied to formulate spreadsheet discounted cash flow
models for these two production sharing contracts in Nigeria.
Theoretical Background
The availability of petroleum resources drives the desire to
venture into oil and gas investment. Petroleum resources represent
the stock of hydrocarbon deemed extractable in an undefined
future. The resources presumed recoverable under currently
known technology and economic conditions are referred to as
proved reserves. Eggleston (1962) documented that proved crude
oil and natural gas reserves are generally classified under two
categories or divisions:
Proved developed reserves
Proved undeveloped reserves
Generally speaking, proved reserves must be recoverable with a
high degree of confidence if estimated by deterministic methods.
It must have at least a probability of 90 percent that the actual
recovery exceeds the estimated quantities, if probabilistic methods
are used. For the most part, probable and possible reserves cannot
be used for economic evaluation as they do not constitute
bankable assets (Deloitte, 2003). Therefore, serious consideration
is given mainly to proved reserves in petroleum project evaluation.
Estimating Reserves Volumes
Reserves estimating methods usually are categorized into three
families:
1. Analogy
2. Volumetric,
3. Performance techniques.
The performance technique methods usually are subdivided into
simulation studies, material-balance calculations, and decline
curve analyses.
Reserves estimation by analogy is a way of characterizing
reserves in a field by assuming production forecast in adjacent
field with similar properties. Forrest (1985) stated that if little or
no production from the target formation exists, then statistical data
from wells completed in formations having characteristics
anticipated for the target zone are used.
Mian (2002) identified reserves estimation by volumetric
analysis as a method used in the early life of a reservoir. He
recognized that reservoir heterogeneities are a commonly
overlooked factor which makes the volumetric estimates often
different from those obtained by evaluating performance. The
data required for estimating the initial oil in place N, are formation
thickness (h, feet), drainage area (A, acres), porosity (!, fraction),
formation oil saturation (So, fraction) and oil formation volume
factor (Bo, RB/STB). The following equation is used in estimating
the initial oil in place.
!!"#! ! ! !!" !"
!! !!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
!!"
Where!!!" !!"!!"#!!"#$%&'"(!!"#$%!!"#$%"#&'(.
For gas reservoir, the initial gas in place, G is calculated by the
following equation.
SPE 163007
!"#$%! ! ! !!" !"
!! !!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
!!"
Where !!" !!"!!"#!!"#!!"#$%&'"(!!"#$%&!!"#$%&!!!"! !"#!
Reserves estimation by reservoir simulation requires that the
reservoir be divided into units called cells. For each cell,
permeability, porosity, thickness, elevation, saturation (initial),
initial pressure, rock compressibility and other reservoir properties
are assigned. According to Ogbe (2011), petroleum reservoir
simulation is the planning, construction and operation of a model
whose behaviour approximates the behaviour of the actual
reservoir. It involves building of models. This means that for each
reservoir, a unique model must be built. For reservoir simulation
to be successful there has to be sufficient data of very high quality,
which would be inputted into the model in order to have a good
history match. It has been observed that obtaining a good history
match is not easy. Consequently, performance prediction generally
depends on quality history match. It has the advantage of handling
different rock and fluid properties in different areas of the
reservoir. It can also predict production from individual wells.
Once history match is obtained, quality reserves estimation can be
guaranteed.
Reserves estimation by material balance is a method of
petroleum evaluation in which the reservoir is considered to be
zero dimensional, hence evaluated using a tank model. It is based
on volume to volume replacement of the reservoir fluid extracted.
It works on a very simple computational principle as presented in
the equation below.
Volume entering-Volume leaving=Net change in Volume
As simple as it may look, much data is required to account for any
change in fluid volume in the reservoir. In computation, there
must be an understanding of the drive mechanism prevailing in the
reservoir. This means it can be used later in the life of the
reservoir, as drive mechanism can only be ascertained if there is
on-going reservoir fluid flow. This is a very accurate method if
there are enough data for computation. Data required includes
pressure, production history, fluid properties and rock properties.
The advantages include that there is no assumptions necessary for
areal extent, thickness or recovery factor. However, accurate
pressure data are not easy to come by.
Reserves estimation by decline curve analysis is a procedure
used for analysing declining production rates, and forecasting
future performance of oil and gas wells. It involves curve-fitting
the past production performance using rate time data and
extrapolating the curve to predict future performance. The
assumption is that the conditions surrounding past production
remain the same in the future. Compared to other methods, decline
curve analysis requires minimum amount of data.
3
According to the Arps conceptual framework, a reservoir can
decline naturally in any of these three ways:
Exponential
Hyperbolic
Harmonic
Fetkovich (1980) developed a comprehensive set of type curves to
enhance the application of decline curve analysis. These curves are
variants of a hyperbola. Poston (2009) recognized that in order to
locate a hyperbola in space one must know the following three
variables.
The starting point on the y axis. (qi ), initial rate.
(Di ).the initial decline rate
The degree of curvature of the line (b).
Applying this Arps concepts, (b = 0) defines the exponential case,
(0<b<1) for the hyperbolic case, and (b = 1) for the harmonic case.
McCray (1975) expressed the general equation of a hyperbola as
shown in equation 4 below.
!
!
!" !"
! ! !!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
!"
Setting the decline exponent b to 0, 0<b<1 and 1 and solving
(3) equation 4 would yield the Arps decline equations for
exponential, hyperbolic and harmonic production decline curves
respectively. This is summarized in Table 1. Exponential decline
is easier to compute and presents conservative estimates of
production with respect to time. According to Lin et al (1982),
hyperbolic decline is the most realistic but difficult to compute
due to two unknowns in its equation (Di and b) while the
harmonic is rarely encountered in natural reservoirs.
Petroleum Production Economics
The previous section discussed estimation of reserves and
production performance as being the first step to an economic
analysis of a petroleum venture. Subsequently, the investor is
interested in knowing the interplay between the hydrocarbon
market price and the actual costs of extraction and handling. The
resultant economic metrics would determine whether the venture
adds value to the corporation.
The price of crude oil and in some cases the price of natural gas to
a large extent drive E & P activities and they are the most
uncertain economic items of interest in the economic evaluation
process. In addition, the cost of production varies from one
location to another. The fiscal regimes may stipulate how these
4 SPE 163007
costs are treated. For example, the 2005 PSC in clear terms
stipulates that depreciation shall be by 5-year straight line,
whereas, the IAT redraft PIB section 400 sub 4 states that the
contract shall determine the treatment of the recoverable costs,
including whether costs shall be expensed or depreciated, the
method of depreciation and the treatment of pre-production costs.
A recoverable cost can either be expensed or depreciated for cost
recovery and tax calculation purposes (IAT, 2009).
CAPEX Depreciation Options
For the purpose of this paper, depreciation is defined as a loss in
the value of an asset over its useful life. It is a method of
redistribution of tangible costs over a period of time, called useful
life, for income tax calculation purposes. The different methods of
depreciation applied for the purpose of this paper are:
Straight line depreciation (SLD)
Declining balance depreciation (DBD)
Sum of years digit depreciation (SOY)
Unit of production depreciation (UOP)
There are other variants of depreciation methods which could
involve switching from one method to the other.
Straight Line Depreciation (SLD): This method involves
distributing depreciable cost equally over the useful life of the
asset. Given depreciable cost, C, the useful life, t and the salvage
value, S, of the asset, Straight Line Depreciation (SLD) is given
by equation 5.
!!!
!! ! !!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
! different sets of PSC used in the deepwater ventures. These are
Where !! is the depreciation factor.
Declining balance depreciation (DBD): This method is used
when it is certain that the benefits derived from the asset decline
over time. As standalone, this method is an accelerated
depreciation method. A switch to straight line method is allowed.
There are different types of DBD: 200%, 175%, 150% and 125%
declining balance methods. In order to obtain a fixed percentage
depreciation rate, any of these methods could be divided by the
useful life of the asset. The initial value (cost) of the asset is then
multiplied by this factor. The result obtained is subtracted from
the initial cost of the asset to determine the book value of the asset
in the following year. This process is repeated until the useful life
of the asset is complete. However, a constant comparison with
SLD is made each year and the greater between the two
depreciation deductions is taken.
Sum of years digit depreciation (SOY): A declining charge is
applied to the depreciable cost each year. The declining charge is
determined by dividing the remaining useful life of the asset by
the sum of the years digits (SOYD) calculated as shown in
equation 6.
! !!!
!"#$ ! !!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!! !
!
Where t, is the useful life of the asset.
SOYD is then used in the calculation of the depreciation given
cost, C, the remaining useful life, !! and the salvage value of the
asset, S. Thus
!! ! !!!! !
!! ! !!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
!"#$
Unit of production depreciation (UOP): When an asset loses
value not because of time lapse but due to the service it renders,
then its depreciation is best determined using UOP depreciation.
The unit of comparison is not time but the total life time activity,
A of the depreciable asset. This is determined as ratio of the
annual production, !! , to total production, !! , attained during
the useful life of the asset. Thus
!! ! !!!! !
!! ! !!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
!!
Nigerian Petroleum Fiscal System Overview
According to Johnston (2003), there are two major classifications
of petroleum fiscal system in the world. These are
Concessionary or Royalty & Tax (R/T) system
Contractual system
In Nigeria, Joint venture agreements (JVA) and PSC are mostly
operational. JVA is basically R/T with government participation.
Most deepwater operations are under PSC regimes. Nigeria has
1993, 2000 and 2005 PSCs. The petroleum industry bill when
passed into an Act will be listed alongside the existing PSC series.
The summaries of terms and instruments in the 2005 PSC and the
Proposed PIB 2009 are presented in Tables 2 and 3, respectively.
Methodology
The spreadsheet modelling approach similar to that adopted by
Mian (2002), Johnston (2003) and Iledare (2010) was used in this
study. Assumptions of a prolific deep offshore field with huge
crude oil reserves, good recovery factor, reasonable peak
production capacity and decision-based decline patterns were
made.
Production profile was first developed by transforming all the
Arps equations, as summarized in Table 1, into an automated
spreadsheet-based program. This program generates production
forecasts under exponential, hyperbolic and harmonic decline
conditions, automatically. The profile reflecting the three phases
of production is as shown in Figure 1.
Oil price was applied to the production forecasts to generate gross
revenue. The price was made to be either real or nominal by
SPE 163007
applying the GDP price deflator as may be necessary in order to
account for inflation.
Front loaded government payments, FLGT, were determined from
the gross revenue and eligible technical costs based on the
stipulations of the two contractual contracts, which are: PSC 2005
and the IAT redraft PIB 2009. These payments include royalties,
rentals, signature bonuses, NDDC and institutional levies where
applicable.
Total technical costs were treated in two ways: exploration
CAPEX and operating costs were expensed hence recovered in the
year they were incurred; development CAPEX was depreciated
hence they were spread beyond the year expended. Depreciation
method applied was an option between SLD, SOY, DBD or UOP
in the model as described earlier.
Cost recovery specifications of the fiscal regimes were duly
imposed on the model. Eligible recoverable costs were determined
and removed from the cost oil which was obtained by removing
the royalties from the gross revenue and multiplying by cost
recovery limit factor. This was used to recover all eligible costs in
a production year. Costs not recovered were carried forward
indefinitely until they were fully recovered. The difference
between the gross revenue and the cost oil gives the profit oil.
Excess cost recovery, ECR, is the cost oil after all the eligible
costs have been recovered. ECR and the profit oil were shared
between the host government and the contractor based on
respective fiscal provisions presented in Tables 2 and 3.
The before income tax (BIT) cash flow was developed in the
model by applying certain taxes and levies, which are not the
federal income taxes. These were strictly defined by the respective
fiscal systems, given that tax deductible items could vary from one
fiscal system to another. For PIB 2009, the BIT is basically a cash
flow for Nigerian Hydrocarbon Tax (NHT) calculations. For the
2005 PSC, it is basically a cash flow for education tax
calculations. The host government BIT take, !"#!"# , was
obtained as the sum of FLGT, share of profit oil and the non-
federal income tax, while the contractor BIT take, !"!"# !!was
obtained by subtracting !"#!"# !and technical costs from gross
revenue.
The after income tax (AIT) cash flow was calculated in the model
by applying the federal income tax to assessable profit, as defined
by the respective fiscal systems. In PIB 2009, the AIT cash flow
includes calculations for corporate income tax (CITA) and
education tax. It was also observed in the model that NHT is not
deductible for CITA calculations. In 2005 PSC, it involves
calculations for petroleum profit tax (PPT).
The host government AIT take, !"#!"# , for the PIB 2009 model
was the sum of !"#!"# , CITA and education tax, while in 2005
PSC, it was the sum of !"#!"# , host government share of profit
oil (!"#!" ) and PPT. The contractor take in both fiscal regimes
was the difference between gross revenue and the sum of the
!"#!"# and technical costs.
5
To measure the economic performance of a deep water venture,
profitability indicators were included in the model. These are
objective measures of the economic worth of the investment. They
include
Net present value (NPV)
Payout Period (PP)
Growth Rate of Return (GRR)
Front Loading Index (FLI)
Net Present Value (NPV): This is also known as present value of
cash surplus or present worth. It is obtained by subtracting the
present value of periodic cash outflows from the present value of
the periodic cash inflows. It is normally calculated at a discount
rate, id which should reflect the value of the alternative use of
funds. It is given as
!
!"#!
!"# ! !!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
! ! !! !
!!!
Where !"#! ! !"#!!"#!"#$%&'!!"#!!!"#$!!"!!"#!!"#$!!!
This study adopted the year end discounting method to arrive at
NPV. As a decision criterion, NPV is desired to be positive in
project ranking.
Payout Period (PP): This is also referred to as the breakeven
point. It is the expected number of years required for recovering
the original investment. At this point, the receipt exactly equals
the cash disbursements. On its own it cannot provide a yardstick
for meaningful decision making. Low payback is desirable in
decision making. It is calculated by the following equation.
!!!!"!!"#!
!! ! !"#! !!"!!"# !"#$% ! ! !!!!!!!!!!!!!!!"!
!!"!!"# ! !!!"!!"#!
Growth Rate of Return (GRR): Since many managers believe IRR
is not a reliable profitability indicator, then GRR was introduced.
It is also referred to as equity rate of return or modified IRR. GRR
resolves the shortcomings of IRR like trial-and-error calculations,
reinvestment rate assumptions etc. In terms of PI, it is thus
calculated.
!"" ! !"
!
! ! ! !! ! !!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
Equation 11 is based on annual compounding. A project is
desirable if GRR is greater than the hurdle rate, !! .
Front-end Loading Index (FLI): This throws more light on the
spread in the discounted and undiscounted takes. FLI of zero
indicates an ideal condition in which a fiscal system presents no
front-end loading at all. The higher the FLI, the more front-end
loaded the fiscal regime becomes. The fiscal conditions that
present very high FLI becomes less attractive to the contractor.
FLI is calculated from equation 12.
6 SPE 163007
!"#$%&'()*!!"#$%&'$&(!!"#$
!"# ! ! !!!!!!!!!!!!!!!!!!!!!!"!
!"#$%&'(")*#!!"#$%&'$&(!!"#$
These economic metric measures were used as outputs to perform
sensitivity analysis on various input parameters using two methods
Monte Carlo simulation via @RISK
Designed model manual variations.
Results and Discussions
This section presents deterministic as well as stochastic results for
both 2005 PSC and PIB 2009 obtained by various input variations
in the models developed.
Base case assumptions
The following assumptions were made to arrive at the
deterministic results presented in this section. These include
Real oil price of $80/STB
Price and cost escalation of 1%
Hurdle rate of 12.5%
All development and facilities costs were 100% depreciated
Total CAPEX was taken to be 20% of the production worth of
the field size and operating cost was about 9.4% of annual
production.
Field size of about 200MMSTB
Percentage of production before decline was 32.7% of
ultimate recovery.
Peak capacity was fixed at 0.04% of field size per day and
lasted for two years
Production build up lasted for three years from 1000 STB/D
till peak capacity.
Economic limit was constrained at 100 STB/D
The hyperbolic decline curve exponent, b was taken to be
0.5194
Gas production was considered uneconomic.
1000 m of water depth fiscal terms and conditions were
invoked.
Empirical Results
Twelve input scenarios are created in the models by varying the
four depreciation methods against the three production decline
patterns for each fiscal system. For the purpose of this study, the
terms of the fiscal regimes are made constant, that is to say that
terms such as royalty rates, tax rates and other levies are not in any
way varied but used as stipulated by the fiscal regimes. This
means that the economic performance presented in this paper is a
strict functional variation of the twelve decline-depreciation
scenarios created. The results (profitability indicators) are
discussed as either best case or the worst case on the basis of the
scenario variations.
Deterministic Results for PIB 2009
Table 4 shows the summary of economic measures obtained using
the base inputs assumed. The best case contractor NPV of $557.63
million was obtained as the production was made to decline in
exponential manner while UOP CAPEX depreciation option was
imposed on the cash flow model, whereas the worst case NPV of
$26.11 million was obtained as the production declined in
harmonic manner given DBD CAPEX depreciation option.
Similarly, the best case payout period of 7.72 years was obtained
as the production was made to decline in exponential manner
while imposing the UOP CAPEX depreciation option on the
model. Harmonic DBD scenario presented the worst payout
period of 9.74 years. On the basis of FLI, similar pattern was
observed; the exponential UOP scenario presented the best case
result of 0.055 while harmonic DBD scenario gave the worst
case performance of 0.207.
The results indicate that no matter how the reservoir declines, if
unit of production CAPEX depreciation option is imposed on the
cash flow evaluation, the investor receives the best possible
reward from his investment. This is supported by the fact that the
PIB 2009 has royalties and profit sharing tied to production. Using
UOP CAPEX depreciation option in this fiscal regime can
effectively cushion the effect of host governments high rent
extraction. This depreciation method ensures that at the peak of
production, the proportion of cost to be recovered by the investor
is maximum despite huge royalty imposition. It is only natural and
fair to recover more cost when production is more and vice versa.
Contrarily, using other depreciation methods in this fiscal regime
would amount to more economic rent to the host government as
the cost recovery economics may not encourage the contractor in
terms of NPV, payout period, FLI and discounted takes.
This paper indicates that host governments can imbed in fiscal
systems of this nature, CAPEX depreciation options as forms of
incentive to the contractor. This way, the front-end loading index
of the fiscal regime could become more progressive.
Deterministic Results for 2005 PSC
Table 5 is the summary of the objective functions given the
assumed base inputs. The presentation pattern established above
would be followed in this section. The best case contractor NPV
of $540.95 million was obtained as the production was made to
decline exponentially while SLD CAPEX depreciation option was
imposed on the cash flow model, whereas the worst case NPV of
$180.32 million was obtained as the production declined
harmonically given DBD CAPEX depreciation option. Unlike the
NPV, the best case payout period of 7.66 years was obtained as
the production was made to decline in exponential manner while
imposing the UOP CAPEX depreciation option on the model. Just
like in the PIB 2009 fiscal system, the harmonic DBD scenario
presented the worst payout period of 9.09 years. Better FLI was
obtained in the 2005 PSC than in the PIB 2009. The exponential
SLD scenario presented the best case result of 0.020 while
SPE 163007
harmonic DBD scenario gave the worst case performance of
0.099.
If the reservoir declines either exponentially or harmonically, the
SLD CAPEX depreciation option would present marginally, the
best NPV and FLI while hyperbolic decline production evaluated
by UOP CAPEX depreciation option would give the best NPV and
FLI. However, irrespective of the production decline pattern
encountered, UOP depreciation would present the best payout
period as most of the CAPEX invested would be recovered during
the assumed three-year peak production period. This cannot be
said to be true for other depreciation options that are not sensitive
to variation in production levels. However, the NPV and FLI may
not follow production trend as royalty and profit sharing are not
tied to production but to water depth and R-factor respectively.
The economic performance of other scenarios would lie between
the best and worst case results presented here. For example, if a
decline is hyperbolic, irrespective of the CAPEX depreciation
option chosen the NPV ranges from $26.11 million to $557.63
million for PIB 2009 and $180.32 million to $540.95 million for
2005 PSC.
The Stochastic Results
In order to resolve the uncertainties inherent in some of the input
variables, Monte Carlo simulation method was applied using
Palisade @RISK, an MS Excel add-in. Probability distributions
were imposed on the inputs to reflect their behaviour ( range of
values) in a given probability domain.
Table 6 presents a summary of the inputs considered and their
assumed distributions.
Recovery factor was assumed to have a normal distribution with
35% of original oil in place as mean value.
The field size was given lognormal distribution with values
ranging from 2475 acres to positive infinity.
Initial production rate was assumed to have normal distribution
with 1000stb/d as mean value.
The peak capacity was given a lognormal distribution with 0.04%
of field size as minimum value.
Total CAPEX and crude oil price were given triangular
distribution in which minimum, most likely and maximum values
were as defined in Table 6.
Finally, cumulative production before decline is assigned a
lognormal distribution whose value ranged from 20% to 50% of
the ultimate recovery.
For each of the twelve scenarios established, 5000 iterations of the
statistical inputs were carried out in two simulation runs to
7
estimate stochastic values for NPV, payout period, GRR and FLI
for each PSC under consideration.
The Stochastic Results for PIB 2009
The stochastic results from the best case input scenario are in
consistent consonance with those obtained from the deterministic
approach. This was observed when production was made to
decline exponentially as UOP CAPEX depreciation option was
employed in the cash flow analysis.
This combination presented a maximum payout period of 8.06
years. The economic performance showed a minimum contractor
NPV of $135.92 million and a maximum of $639.61 million.
There was a 50% confidence that FLI would be between 0.064 and
0.077 with corresponding GRR range of between 14.44% to
15.25%. The summary of the results for the best case scenario is
presented in Figure 2 to Figure 5.
The worst case scenario just like in the deterministic approach was
obtained when a production declined harmonically with cash flow
evaluation that employed DBD CAPEX depreciation option. The
result showed a minimum NPV of -$304.28 million and a
maximum of $ 258.56 million. There was 50% chance that the FLI
would be between 0.21 and 0.28. The minimum period to recover
initial capital investment was 9.7 years.
The best case scenario presents economic metrics that are highly
favourable to the contractor as the minimum NPV is positive. Also
the front-end loading effect of the fiscal regime on the contractor
economics is very mild and acceptable. However, the worst case
scenario presents harsh economic conditions to the contractor who
could lose immensely going by the negative minimum NPV
results. If at all the initial cost can be recovered, it will take a very
long time as indicated by the payout period.
It can be easily observed that the stochastic results confirm those
presented in the deterministic approach.
The Stochastic Results for the 2005 PSC
The results for the 2005 PSC model revealed that on the average,
exponentially declining production evaluated by SLD method
yielded the best economic metrics for the contractor when
compared with other decline depreciation scenarios examined.
This combination gave a maximum payout period of 8.53years
with a minimum contractor NPV of $130.93 million and
maximum of $765.71 million. The maximum FLI observed was
0.091 with a 50% confidence that the GRR would go between
14.47% and 15.22%. However, for quicker investment payout, the
UOP depreciation represented the best option irrespective of the
decline pattern undertaken by the production. The summary of the
best case is presented in Figures 6 to 9.
The worst case scenario is similar to that observed in the
deterministic analysis. The harmonic decline-DBD CAPEX
depreciation presented minimum contractor NPV of -$50.78
million and a maximum of $412.62 million. The observed
8 SPE 163007

maximum FLI was 0.36 while there was a 50% chance that payout Stream. All opinions, errors, findings and recommendations
period would go between 9.11 years and 9.41 years. expressed in this paper are those of the authors.

The best case results present a highly favourable economic metrics Nomenclature
to the contractor considering the profitability indicators used in
this research. If production declines in a way that is not AIT After Income Tax
exponential there are possibilities of making losses no matter what BIT Before Income Tax
depreciation method is employed. This risk may increase as CAPEX Capital Expenditure
decline goes from exponential to hyperbolic and finally to CITA Corporate Income Tax
harmonic. It can only make sense to use depreciation methods that CPI Consumer Price Index
can mitigate any economic regressiveness or uncertainty that may CT Contractor Take
arise from any production decline pattern presented by natural CUM. Cumulative
phenomena taking place in the reservoir. DBD Declining Balance Depreciation
DCT Discounted Contractor Take
Generally, stochastic results show that the contractor has slightly ECR Excess Cost Recovery
more favourable economic metric measures under 2005 PSC than FLGT Front Loaded Government Take
in the PIB 2009 cash flow model. It is also noted that considering G Original Gas in Place, scf
the NPV sensitivities, very high cumulative production before GDP Gross Domestic Product
decline, impacts negatively on NPV of the contractor as shown in GRR Growth Rate of Returns
Tornado charts of Figures 4 and 8. This means that depleting the HGT Host Government Take
reservoir at a very high production rate will lead to more crude oil HC Hydrocarbon
being bypassed in the reservoir. Consequently, secondary recovery IRR Internal Rate of Returns
measures become imminent early in the life of the reservoir and JVA Joint Venture Agreement
hence more cost implications. This may lower the net cash flow of N Original Oil in Place, stb
the venture and subsequently the NPV. NCF Net Cash Flow
NHT Nigerian Hydrocarbon Tax
Summary and Conclusions NPV Net Present Value
PFS Petroleum Fiscal System
Discounted cash flow models have been successfully developed PI Profitability Index
for 2005 PSC and PIB 2009 fiscal systems. PIB Petroleum Industry Bill
PO Profit Oil
Production decline patterns and tangible CAPEX depreciation are PPT Petroleum Production Tax
successfully integrated into the models. These have tremendous PROD. Production
impact on rewards of investment. PSC Production Sharing Contract
R/T Royalty and Tax
Both deterministic and probabilistic results can be obtained from SLD Straight Line Depreciation
the models developed. SOY Sum of Years Digit Depreciation
TC Technical Cost
The deterministic results under PIB 2009 show that applying UOP UOP Unit of Production Depreciation
method of depreciation to a reservoir declining exponentially ai Initial Decline Rate, per time
offers the most favourable economic metric measures to the qi Initial Prod. Rate, stb/time
contractor, while SLD method is the most favourable under 2005 qt Prod. Rate at any time t, stb/time
PSC, given the same production decline pattern. Np Cum. Prod., stb
b Hyperbolic exponent.
The stochastic results also give similar trends as the deterministic
results. However, it becomes clearer that 2005 PSC would allow
the contractor a higher maximum discounted take.

Contractor NPV is negatively impacted given very high proportion

of reserves produced before production decline commences.

Acknowledgments
The authors would like to acknowledge the support of Petroleum
Technology Development Fund and the management of African
University of Science and Technology, Petroleum Engineering
 SPE 163007 9

References 22. Ogbe D. O., Reservoir Simulation, Lecture material, AUST,

2011.
1. Arps J.J. Analysis of Decline Curves. TRANS AIME Vol. 23. Oyekunle A.A, Impact of the Petroleum Industry Bill on
160, 228 247, 1945 deepwater Economics, SPE 150774, 2011.
2. BP world energy statistics, 2011 24. Poston S., A two-day lecture on Decline Curves sponsored by
3. Center for Energy Economics, Fiscal Terms for Upstream Hamilton Group Company, 2009.
Projects An Overview, University of Texas at Austin. 25. Vikas S., Eppink J., Godec M. Application of a
4. Department of Petroleum Resources, Business Opportunities Decision-Making Model for Economic Evaluation of
in Nigeria and the E&P Environment, A Paper Presented at Production-Sharing Contracts in India, SPE PAPER 38780,
International Oil and Gas Business Days Conference, Norway, 1997.
August 26 -28, 2003.
5. Egbon F., Offshore Technology, AUST-Total lecture manual,
2011.
6. Eggleston W. S., AIME, What are Petroleum Reserves? SPE
Paper 255, 1962.
7. Fetkovich M. J., Decline Curve Analysis using Type Curves,
SPE 4629, 1980.
8. Financial Reporting in the Global Mining Industry, Deloitte
Toche Tohmastu Publication, 2003.
9. Forrest A. G., Oil and Gas Reserves Classification, Estimation
and Evaluation, SPE Distinguished Author Series, 1985.
10. Iledare O. O., Evaluating the Impact of Fiscal Provisions in
the Draft Petroleum Industry Bill on offshore E&P Economics
and Take Statistics in Nigeria. SPE 136972, 2010.
11. Iledare O.O, Advanced Petroleum Economics lecture notes.
African University of Science and Technology, Abuja, 2011.
12. Inter- Agency Team, Petroleum Industry Bill (PIB) redraft,
2009.
13. Johnston D., International Exploration Economics, Risk and
Contract analysis, PennWell Books, 2003.
14. Lima G.A.C., Ravagnani A.T.F.S.G., Schiozer D.J.,
Proposed Brazilian Fiscal System for Pre-Salt Production
Projects: A Comparative Study of Gain and Loss of
Government and Companies, SPE PAPER 139311, 2010.
15. Lin C., Rowland D. A., Determining the Constants of
Hyperbolic Production Decline by Linear Graphical Method,
unsolicited issue, 1982.
16. McCray A. W., Petroleum Evaluations and Economic
Decisions, Prentice-Hall Inc. publications, 1975.
17. Mian M.A., Project Economics and decision Analysis,
volumes 1, PennWell Corporation, 2002.
18. Mian M.A., Project Economics and decision Analysis,
volumes 2, PennWell Corporation, 2002.
19. Muscolino R., Rizzo C.A., Mirabelli G., The Cost Recovery
Oil in a Production Sharing Agreement, SPE 25844, 1993.
20. NNPC Annual Statistic Bulletin, 2010.
21. Nwonodi C., Eluozo B. A., Kwelle S. O., A Stochastic
Approach to Offshore Stranded Gas Project Investment
Analysis in Nigeria, OWA conference and exhibition, 2008.
10 SPE 16300

Table 1: Arps Decline Equations

EXPONENTIAL HYPERBOLIC HARMONIC

DECLINE !! ! !! !! ! !!
!! !! !! !!
RATE,(!!! ) !! !! !! !! !!!!! !!
! !! ! !"
!" !! !! ! !! !! ! !! ! !!
PROD.RATE, !! !"#!!!!! !! !! !!
!
(!! ) ! ! !!! ! ! ! ! !! !
CUM.PROD, !! ! !! !! !! !!!!! !! !!
!! !"
(!! ) !! !!! !! ! !! !! !! !!

Table 2: Typical 2005 PSC Fiscal Terms and Instruments (source: Nwonodi et al, 2008)
SPE 163007 11

Table 3: Typical Redraft PIB 2009 Fiscal Terms and Instruments.

A=EF?GE-DE-^=?J/C
=>? TFGJAF?-IF6
!"#$%&'($)*( !" #$%!&" $!" !" #$%!&"
'()*'+, &-.-$/012 $-.-!-/012 3!/012 &-.-#&&//4512 3#&&//4512
6*788'9-97:,+ &-.-!/012 !-.-$&/012 3$&/012 &-.-$&&//4512 3$&&//4512
;,,<-97:,+ &-.-!&/012 !&-.-#&&/012 3#&&/012 &-.-!&&//4512 3!&&//4512
A=EF?GE-DE-^F?JC
=>?-@A>BC-@CA- IF6-@A>BC-
DD? A=EF?GEH-" @CA-//DGJ A=EF?GEH-"
K&-.-KL& & K&-.K$ &
KL&-.-K#&& &%M1K K$-.KL &%$1#&4,(:)
K#&&-.-K#M& #$N&%$1K KL-.-K#O #&N&%#!1#&4,(:)
K#M&-.-K#P& $&N&%#1K K#O-.-K#P #PN&%#&1#&4,(:)
6@CB>F?-@A=;JBG>=T-F??=QFTBC6
FACF- F??=QFTBC BJ/%-@A=;%-U//D08V
_X(UKO&1D08H-O&"-'5-@+X4,V #&
=T6[=AC
_X(UK#$1D08H-O&"-'5-@+X4,V aL!
_X(UKO&1D08H-O&"-'5-@+X4,V $&
6[F??=Q-QFGCA
_X(UK#$1D08H-O&"-'5-@+X4,V a#!&
;CC@-QFGCA _X(U-K-L1D08H-O&"-'5-@+X4,V 788-<+'2%-?,`,8)

;C;JBG>D?C-Z=ACS@ R&"
CS@CT;>GJAC BF@CS =@CS
FBGJF?-Z=AC>IT-CS@ L!" !&"
F??=QFD?C-Z=AC>IT-CS@ R!" P&"
@A=;JBG>=T-F??=QFTBC-@CA-6GD K-----------------L%&&
F??=QFD?C-@A>BC-?>/>G O&"
T>I%-[B-GFS-UT[GV O&"
B>GF O&"
C;JBFG>=T-GFS $"
;>6B=JTG-AFGC #O"
A>ZG-K1D08 &%!
T;;B O"
@A=Z>G-6[FA>TI
T<-U//D08V L!& #&&& $&&& 3$&&&
"-6*7+, &%$ &%O &%M (,W':X708,
ACTGF?6
?>BCT6C-UK1)\]/V
ECFA @C? @@? @/?
# #& #&& #&&&&
$ #& #&& #&&&&
O #& O&& #&&&&
M #& O&& #&&&&
! #& !&& #&&&&
YN #& !&& #&&&&
12 SPE 163007

Table 4 Summary of the deterministic economic metrics for PIB 2009

)#)&A/+/A&(03+/A")%(A)B+!0C+>669
)3A,"(0$ 2A!(7 2A350,A+&#!A !"#$%&'#()*+ ,!-'.//* 0(( !0 1(( 23& 450

+.*%&+&/'"-0
8 )52 :78: ;6:7<< >;796D 87=8 8<7;D 8@766D 676?:

> 2C2 :7@< <<=7:9 >=7;6D 87>? 8<7>D 8;7=6D 676:<

= )$# :7?; <;?7@< >=79;D 87>? 8<7=D 8;7@6D 676:8

< %$! @7@> ;;@7?= >:7=6D 87=? 8<7:D 8@796D 676;;

; )52 :7:< =8@7?9 >6796D 87>6 8=7>D 8=7==D 6786<

!)*+#,%-'(

? 2C2 97>: ><=7<: 8:7=:D 878< 8=76D 867;:D 678=8

@ )$# 9789 >;97<: 8:7::D 878; 8=78D 887>6D 678>?

: %$! :78= <6?7;? ><7;;D 87>: 8=7;D 8?78<D 676@<

9 )52 976: 88:79: 8?76=D 876: 8>7:D ?79@D 678;9

!"#$%&'(

86 2C2 97@< >?788 8=7>6D 876> 8>7?D 87?8D 67>6@

88 )$# 97?: <>78 8=7?;D 876= 8>7?D >7;:D 6789:

8> %$! :7<< >=67?9? >67<<D 878@ 8=78D 8>7<;D 6786;

Table 5: Summary of the deterministic economic metrics for 2005 PSC

)#)&C/+/C&(03+/C")%(C)D+!)3+:66@
)3C,"(0$ 2C!(7 2C350,C+&#!C !"#$%&'#()*+ ,!-'.//* 0(( !0 1(( 23& 450
+.*%&+&/'"-0

= )52 ;76: ++++++++@867>@ :97;8A =7?? =87<A =;76;A 676:6

: 2B2 ;78< ++++++++8<>7:9 :@7:=A =7:9 =87?A =<7=<A 676??

? )$# ;786 ++++++++89<7=8 :@7<:A =7:; =87?A =<7?@A 676?6

8 %$! 97<< ++++++++@?<79= :;7@@A =7?@ =87;A =97?=A 676:?

@ )52 ;7<: ++++++++?;?7:9 :?7:>A =7:8 =?78A =<768A 676?6

!)*+#,%-'(

< 2B2 ;7;8 ++++++++?6;7<; :6796A =7=; =?7:A =?78=A 676@:

9 )$# ;7;6 ++++++++?=<7@? :=76;A =7=> =?7:A =?796A 67689

; %$! ;7=: ++++++++?;>7<8 :87@9A =7:9 =?7@A =@78<A 676:;

> )52 ;79< ++++++++:<67;? :67:9A =7=9 =?7=A =@7::A 676<=

!"#$%&'(

=6 2B2 >76> ++++++++=;67?: =978;A =7== =:7>A ==76>A 676>>

== )$# >768 ++++++++=;;7@8 =97;?A =7=: =:7>A ==7@8A 676>:

=: %$! ;7<6 ++++++++::>7@: :678?A =7=< =?7=A =:7?;A 676<:

SPE 163007 13

Table 6: Stochastic variable assumptions

Name Worksheet Cell Graph Function Min Mean Max

RiskNormal(0.35,0.035,RiskTruncate(0.1,0.
STOIIP
Recovery factor F10 6),RiskStatic(0.35),RiskName("Recovery 10% 35% 60%
INPUT
factor"))

STOIIP RiskLognorm(247.5,247.5,RiskShift(2475),R
FIELD SIZE H9 2475 2722.5 +!
INPUT iskStatic(2475),RiskName("FIELD SIZE"))

INPUT RiskNormal(1000,100,RiskStatic(1000),Risk
Initial Prod.rate C8 -! 1,000 +!
PROD. Name("Initial Prod.rate"))

RiskLognorm(0.00004,0.00004,RiskShift(0.
INPUT
Peak capacity G7 0004),RiskStatic(0.0004),RiskName("Peak 0.040% 0.044% +!
PROD.
capacity"))

COST
TOTAL CAPEX C1 RiskTriang(0.2,0.25,0.3,RiskStatic(0.2)) 20% 25% 30%
OUTLAY

Category: OIL PRICE, $/STB

FISCAL
OIL PRICE, $/STB / NOMINAL C6 RiskTriang(60,80,100,RiskStatic(80)) 60 80 100
TERMS

Category: Production before decline

Production before decline / Ur=N*Er STOIIP RiskLognorm(0.0327,0.0327,RiskTruncate(0

E15 20.0% 26.0% 50.0%
= INPUT .2,0.5),RiskStatic(0.327))

*+,-4567-)&%"8-)
+!"

*!"

)!"
!"#$%&'#()*+,-.)/0,12$)

(!"

'!"

&!"

%!"

$!"

#!"

!"
$!#!" $!#$" $!#&" $!#(" $!#*" $!$!" $!$$" $!$&" $!$(" $!$*"
!"#$%&'#()3-+")

,-./010234"" 56.178/49:" 537;/09:"

Figure 1: The typical production Profile

14 SPE 163007

25.0% 50.0% 25.0% 25.0% 50.0% 25.0%

224 286 14.44%15.25%
0.010 70
0.009
60
0.008

0.007 50

0.006
40
0.005
30
0.004

0.003 20
0.002
10
0.001

0.000 0

12%

14%

16%

18%

20%

22%

24%

26%
100

200

300

400

500

600

700

NET PRESENT VALUE @ 12.5%/ GROWTH RATE OF RETURN /

CONTRACTOR($MM) CONTRACTOR

Figure 2: NPV @ 12.5% for PIB 2009 Exponential UOP Figure 3: GRR for PIB 2009 Exponential UOP

25.0% 50.0% 25.0%

24.8% 50.1% 25.1%
7.682 7.826
TOTAL CAPEX -0.57 4.0

Recovery factor 0.52 3.5

FIELD SIZE 0.47 3.0

2.5
Peak capacity 0.37
Production before decline / 2.0
-0.05
Ur=N*Er = <0.=>"
1.5
Initial Prod.rate 0.03 ?198=44"
OIL PRICE, $/STB / 1.0
-0.03
NOMINAL
0.5
0.2

0.4

0.6
-0.6

-0.4

-0.2

-1E-15

0.0
7.2

7.3

7.4

7.5

7.6

7.7

7.8

7.9

8.0

8.1

NET PRESENT VALUE @ 12.5% Regression Fit Comparison for Payout Period,
Chart Years

Figure 4: Typical Tornado chart for PIB 2009 NPV Figure 5: Payout period for PIB 2009 Exponential UOP
SPE 163007 15

25.0% 50.0% 25.0% 25.0% 50.0% 25.0%

238 317 14.47% 15.22%
0.007 80

0.006 70

0.005 60

50
0.004
40
0.003
30
0.002
20
0.001
10

0.000 0
100

200

300

400

500

600

700

800

13%

14%

15%

16%

17%

18%

19%

20%

21%

22%
NET PRESENT VALUE @ 12.5%/ GROWTH RATE OF RETURN /
CONTRACTOR ($MM) CONTRACTOR

Figure 6: NPV for 2005 PSC Exponential SLD Figure 7: GRR for 2005 PSC Exponential SLD

25.0% 50.0% 25.0%

OIL PRICE, $/STB / 7.925 8.212
0.49 2.5
NOMINAL

Peak capacity 0.48

2.0
Recovery factor 0.43

FIELD SIZE 0.39 1.5

TOTAL CAPEX -0.39

1.0
Initial Prod.rate 0.06
Production before decline / 0.5
-0.03
Ur=N*Er =

0.0
-0.4
-0.3
-0.2

0
0.1
0.2
0.3
0.4
0.5
-0.1

7.4

7.6

7.8

8.0

8.2

8.4

8.6
NET PRESENT VALUE @ 12.5% Regression chart PAYOUT PERIOD, years

Figure 8: Typical Tornado chart for 2005 PSC NPV Figure 9: Payout period for 2005 PSC Exponential SLD