 The petroleum exploration is a
classic case of decision making
Module 3a: Economic Evaluation
and Decision Making
 Most exploratory wells lead to dry
holes & are abandoned.
 Only a fraction of wells lead to
commercial discovery of new oil &
gas fields.
 Since dry holes outnumbers the wet
wells, it is more common to land into
failures rather than success.
 Our present success ratio is 1:4
under high risk & uncertainties
where input is more or less
deterministic but the output is
always probabilistic.
 A sound “business decision” makes
a project economically viable (i.e., it
will produce profits satisfying the
economic yardsticks of the
company).
 In most cases, an Oil and Gas
Company invariably has more
opportunities than Capital to fund
these opportunities.
 Therefore, it needs a method to
compare the opportunities and be
able to rank them using some
economic criteria.
1
 What is Risk?
 On the basis of economic It is related to the consequences of
criteria, the opportunities that hazard.
rank the highest are selected for Risk has two variables:
funding. (a) Magnitude of consequences
(b) Frequency or Probability of the
 Engineers, geologists and occurrence.
management work together to
decide on the optimum project. So, Risk = Magnitude of
consequences × Frequency of the
occurrence. 6

Risk = Magnitude of
consequences × Frequency of
the occurrence
 Risk is the possibility of an “event
occurring” that will have an impact
on the achievement of objectives.

 We should also understand that

Risks ( residual Risk) are inherent
in every forward-looking business
decision.
Where, C1 ----- Ck = Magnitude of Consequences
and P1 …… Pk = Frequency of the occurrence

2
 “Risk” is present when future
There are two main ways to identify
events occur with measurable
risk:
probability.

• Retrospectively
 “Probability” is the likelihood that a
particular incident will occur.
• Prospectively.
 “Uncertainty” is the range of
“possible outcomes” of an event.
CONT…….

Prospective risks
Retrospective risks:
 Prospective risks are often harder
 Retrospective risks are those that to identify.
have previously occurred, such as
incidents or accidents.
 These are the risks that have not
yet happened, but might happen
 Retrospective risk identification is
sometime in the future.
often the most common way to
identify risk, and the easiest.
CONT…….

3
Prospective risks ( Cont….)
Methods for identifying prospective risks
include:
1. Brainstorming with staff or external
stakeholders
2. Researching the economic, political, Methods of Risk Analysis
legislative and operating environment.
3. Conducting interviews with relevant
people.
4. Undertaking surveys of staff or clients
to identify anticipated issues or
problems

Two methods of Risk analysis to Qualitative risk analysis

determine level of risk:

• Qualitative  Relies on subjective judgment of

consequence and likelihood (i.e.
• Quantitative. what might happen in a worst case
scenario).
 The most common type of risk
analysis is the “qualitative
method”.

4
 Methods for qualitative risk analysis:
Advantage:
 Qualitative risk analysis is simple
 Brainstorming
and easy to understand.
 Interviews / and / or questionnaires
Disadvantages:  Checklist
 It is subjective and are based on  Risk register
intuition, which can lead to forming
 Risk Mapping
of bias and can degrade the validity
of the results.

Risk register Risk register Software:

 A Risk Register is a Risk Management
tool commonly used in Project
Management and organizational risk 1. STATURE Software (DYADEM Co.)
assessments.
 Risk Register (also referred as Risk Log)  Excel Spreadsheet can also be
acts as a central repository for all risks used
identified. It includes information like:
 Risk probability.
 Impact
 Counter – measures
 Risk owner etc.

5
Risk Mapping:
 Risk mapping is a technique used to
present “identified risks and
determine what actions should be
taken toward those risks”.
 “Clear Risk Manager” is the software
for Risk Mapping.
Quantitative Risk Analysis
Large, complex projects involving
leading edge technologies often
require extensive quantitative risk
analysis. Main techniques include:
 Common Traditional Investment
Methods
 Decision tree analysis
 Simulation ( Monte Carlo)
 Sensitivity analysis

Some Definitions
Capex:
 Petroleum projects often have long • Stands for Capital Expenditure.
time horizons covering more than • It is incurred on the development
20 - 30 years depending on amount of oil and Gas Field.
of extractable reserves, production
rates and other economical Opex:
considerations. • Stands for Operating Expenditure.
• It is incurred in producing oil or
gas from the field.
CONT……. CONT…….

6
Gross Revenue:
Annual Production × Product Price
NCF:
• Annual Net Cash Flow.
• Calculated by subtracting Royalty,
Capex, Opex and Taxes from Gross
Revenue.
NCF = Gross Revenue – Royalty -
Capex- Opex - Taxes
Time Value of Money(TVM)
 e.g. You can invest your dollar for one
year at a 6% annual interest & you can
accumulate $ 1.06 at the end of the year.
 You can say that the future value of 1
dollar is $1.06 at 6% interest in one year
period.
 It also says that the Present Value of
$1.06 you expect to receive after one
year is $1.
CONT…….
Time Value of Money (TVM)
 TVM is an important concept in
economic evaluation.
 It is based on the concept that a
dollar that you have today is worth
more than the promise or
expectation that you will receive
from that dollar in the future.
Why Money Has Time Value?
 Time value of money is the economic
principal that a dollar received today has
greater value than a dollar received in the
future.
 Eg. Suppose you were given the choice
between receiving $100,000 today or
$100,000 in 100 years.
 Which option would you rather take?
Clearly the first option is more valuable.
WHY??????
7
 Why Money Has Time Value?
1. No Risk:
 There is no risk of getting money back that you
already have today.
2. Higher Purchasing Power:
 Because of inflation, $100,000 can be exchanged
for more goods and services today than
$100,000 in 100 years.
 Put another way, just think back to what
$100,000 could buy you 100 years ago. $100,000
in 1914 would be the equivalent of roughly
$2,300,000 today.
Basic Time Value of Money Formula
The most fundamental TVM formula is:
FV = PV x (1 + (i / n)) ^ (n x t)
FV = Future value of money
PV = Present value of money
i = interest rate
n = number of compounding periods
per year
t = number of years
Why Money Has Time Value?
3. Opportunity cost :
 A dollar received today can be invested now to
earn interest, resulting in a higher value in the
future.
 In contrast, a dollar received in the future can
not begin earning interest until it is received.
This lost opportunity to earn interest is the
opportunity cost.
 So, Time Value of Money into two fundamental
principals:
 More is better than less.
 Sooner is better than later.
Example
Assume a sum of $10,000 is invested for
one year at 10% interest. The future value of
that money is:
FV = PV x (1 + (i / n)) ^ (n x t)
FV = $10,000 x (1 + (10% / 1) ^ (1 x 1)
= $11,000
FV = Future value of money; PV = Present
value of money; i = interest rate; n = No. of
compounding periods per year; t = No. of
years
8
Example Net Present Value (NPV)
 The formula can also be rearranged to
find the value of the future sum in present
day dollars.  Net Present Value (NPV), is
 For example, the value of $5,000 one year
defined as the difference between
from today, compounded at 7% interest, the sum of the “discounted cash
is: flows” expected from the
So, PV = $5,000 / (1 + (7% / 1) ^ (1 x 1) investment and the amount initially
= $4,673 invested.

 NPV is the technique and uses the

concept of TVM
CONT…….

Net Present Value (NPV) …… Cont.
 The discount rate refers to the interest
rate used in discounted cash flow
(DCF) analysis to determine the
present value of future cash flows.

 The discount rate in DCF analysis
takes into account not just the time
value of money, but also the risk or
uncertainty of future cash flows; the
greater the uncertainty of future cash
flows, the higher the discount rate.
 Thus, NPV is the present value of future
net cash flows for a given discount rate.
 The Net Present Value (NPV) of a project
or investment is defined as the sum of
the present values of the annual cash
flows minus the initial investment.
 As an investment criteria, the
Companies look for investment
opportunities which yield the highest
NPV.
 The formula for NPV is

9
C1 …… Cn = Cash Inflow i.e. Return
C0 = Cash Outflow i.e. Amount Initially
Invested.
K = Discount Rate
The Net Present Value (NPV) Concept says :
• Accept all projects whose NPV is +ive or NPV > 0 .
• Drop all projects with NPV < 0
• If NPV = 0, we are indifferent between accepting or
dropping the project.
• The NPV method can be used to select between
projects. The one with the higher NPV should be
selected.

A simple explanation of the discount rate

used in DCF analysis

 Let's say you expect $1,000 in one year.

 NPV is one of the most robust financial
evaluation tools to estimate the value of an
investment.
 To determine the present value of this
$1,000, (i.e. what it is worth to you today),
you would need to “discount it” by a
particular interest rate.

10
A simple explanation of the discount rate
used in DCF analysis ( Cont……_)

 Assuming a discount rate of 10%, the

$1,000 in a year's time would be
equivalent to $909.09 to you today
=1,000 / (1+ 0.1) =1000/1.1 = 909.09

CONT…….

e.g. How to calculate NPV?

I have invested :
Rs.100 Ist Year
Rs.200 2nd Year
Rs.300 3rd Year
To calculate NPV, we have to calculate
PV factor of every cash flow on a
discount rate of 9% (say)
CONT……. CONT…….

11
P.V. Factor = 1/(1+r)n Thus, NPV = Total PV – C0
where, r = Discounted rate of interest, n = No. of
= 491.7 - 600
Years.
CF PVF PV = - 108.3
100 0.917 91.7
200 0.842 168.4
300 0.772 231.6 Since the NPV is negative, So this
Total = 600 Total PV = 491.7 option is not commercially viable.

1/(1+9/100)1 = 1/(1+0.09)1 = 1/1.09 = 0.917

1/(1+9/100)2 = 1/(1+0.09)2 = 1/(1.09)2 = 1/1.188 = 0.842

1/(1+9/100)3 = 1/(1+0.09)3 = 1/(1.09)3 = 1/1.295 = 0.772

Once decided to make a investment, Investment Efficiency

on what basis or what criteria would
 It is also known as “Present Value
you make your decision?
Index”, “Profitability Index” or
Some basic criteria are : “Discounted Profit – to - Investment
(1)NPV (2) IRR (3) Investment Efficiency Ratio”.
(4) Pay back period
i.e. 1. Which investment has a higher NPV?
 It can be used as a criterion to accept
2. Which investment has a higher IRR? or reject an opportunity.
3. Which investment has higher investment
efficiency?
 It is used to evaluate the efficiency
4. Which investment has a lower Pay back of an investment.
period? CONT…….

12
 Investment Efficiency :
e.g. Case I Case II
Investment 200,000 100,000
NPV 500.000 400,000
• Calculated by dividing NPV by capital Investment Efficiency = NPV / Investment
expenditure or Investment
Hence, Investment Efficiency for:
Case I = 500,000/200,00 = 2.5
Case II = 400,000/100,00 = 4 (CHOOSE)
Investment efficiency will be:
Positive if NPV is positive
Negative if NPV is negative

Internal Rate of Return (IRR) Internal Rate of Return (Cont…..)

 The IRR of an investment is
the discount rate at which the net
present value of costs (negative cash
flows) of the investment equals the net
present value of the benefits (positive
cash flows) of the investment.
 As the discount rate increases then the
NPV is reduced.
 At a specific discount rate, the NPV is
reduced to zero. This discount rate is
called the internal rate of return (1RR).
 The higher the IRR, the more robust the
project is, that is the more risk it can
withstand before the IRR is eroded down
to the level of the cost of capital.

13
Internal Rate of Return Internal Rate of Return (Cont……)
(Cont…..)
 If the project IRR does not
meet the cost of capital,
then the project is unable  It can also be defined as the discount
to repay the cost of
financing.
rate at which the present value of all
 IRR is therefore often used
future cash flow is equal to the initial
as a screening criterion. investment or in other words, the rate
 One way of calculating the at which an investment breaks even.
IRR is to plot the NPV
against discount rate, and
to extrapolate/interpolate to
estimate the discount rate
at which the NPV becomes
zero.

Internal Rate of Return (Cont….) Internal Rate of Return (Cont….)

 The higher a project's IRR, the more
desirable it is to undertake the project.
 Assuming all projects require almost the
same amount of up-front investment, the
project with the highest IRR would be
considered the best and undertaken first.
To find the internal rate of return, the
discount rate that makes the following
equation zero has to be calculated.
Where NPV= 0 and IRR is the discount
rate that makes NPV=0.

Co = Initial Investment

14
 Internal Rate of Return (IRR)
Internal Rate of Return (IRR)
• Accept all project with IRR > discount • Lets say that Co. A uses the IRR to evaluate
Factor investment opportunities and make a decision
regarding the probability and viability of a
• Drop all project with IRR < discount project.
Factor (i) An initial investment of is $50,000
(ii) The cash inflows for four years will be
• If IRR = Discount Factor, We are • Year 1 : $15,000
indifferent • Year 2 : $ 20,000
• Year 3 : $ 25,000
The higher a project's internal rate of • Year 4 : $ 18,000
return, the more desirable it is to (iii) The cost of capital is 15%
undertake the project.

Time Cash Flow Discounted Discounted Discounted Discounted Time Cash Flow Discounted Cash Discounted Cash
Cash Flows Cash Flows Cash Flows Cash Flows Flows (10%) Flows (20%)
(10%) (15%) (19%) (20%)
Period 0 -50,000.00 -50,000.00 -50,000.00
Period 1 15,000.00 13,636.36 12,500.00
Period -50,000.00 -50,000.00 -50,000.00 -50,000.00 -50,000.00
0 Period 2 20,000.00 16,528.93 13,888.89
Period 15,000.00 13,636.36 13,043.48 12,605.04 12,500.00 Period 3 25,000.00 18,782.87 14,467.59
1 Period 4 18,000.00 12,294.24 8,680.56
Period 20,000.00 16,528.93 15,122.87 14,123.30 13,888.89 NPV 28.000.00 11,242.40 - 462.96
2
Period 25,000.00 18,782.87 16,437.91 14,835.40 14,467.59
3
Period 18,000.00 12,294.24 10,291.56 8976.04 8,680.56
4
NPV 28.000.00 11,242.40 4895.82 539.77 - 462.96
Here, we can see that a discount rate of 19% gives around $500 NPV
whereas, a 20% discount rate gives a $ - 462 NPV.

We can therefore understand that the IRR is somewhere in the middle or

around 19.5%.

15
Internal Rate of Return (Cont…..)
The higher a project's internal rate of
return, the more desirable it is to
undertake the project.
 As such, IRR can be used to rank
several prospective projects a firm
is considering.
 Assuming all other factors are equal
among the various projects, the
project with the highest IRR would
probably be considered the best
and undertaken first.
ROI (Return on Investment):
 The Return on Investment (ROI), is a
comparison ratio of the money
gained or lost on an investment to the
amount of money invested.
16
 To calculate ROI, the benefit (return) of an
investment is divided by the cost of the
investment. The result is expressed as a % or a
ratio.
ROI is used to evaluate the Thus, ROI can be calculated as:
efficiency of an investment.

It is used to compare the efficiency

of a number of different
investments. Return on investment is a very popular metric
because of its simplicity.

Pay Back Period

ROI > 0 when the investment is profitable
ROI < 0 when the investment is at a loss
If an investment does not have a positive ROI, or
if there are other opportunities with a higher ROI,
then that investment should not be undertaken.
 While starting any business venture or
introducing any new product in the
market, it is important to determine its
payback period.
 Pay Back Period is the length of time in
which the initial cash outflow of an
investment is expected to be recovered
from the cash inflows generated by the
investment.
 It is one of the simplest investment
appraisal technique.

17
Pay Back Period (Cont…..) Advantages:
 The payback period of a given 1. Payback period is very simple to
investment or project is an calculate.
important determinant of whether to 2. It can be a measure of risk inherent in
undertake the position or project, a project.
as longer payback periods are
typically not desirable for
investment positions.

 When cash inflows are uneven, we

need to calculate the cumulative net
cash flow for each period and then
use the following formula:

18
Q. Find the payback period for the cash flows given as
below: Decision Rule:
year Cash flow ($)

0 -30,000
1
2
10,000
9,000
Accept the project only if its payback
3
4
8,000
4,000
period is LESS than the target
year Cash flow Cumulative cash flows payback period.
($)
0 -30,000 -30000
1 10,000 -30,000+10,000= -20,000
2 9000 -20,000+9,000= - 11,000
3 8000 -11000+8000= - 3,000
4 4000 - 3000+4000= 1,000
Payback period= 3 + (3000/4000)
= 3+ (3/4*12) to change into months multiply by 12
=3+9
=3 years 9 months

Disadvantages:
EMV:
 Expected Monetary Value.
Payback period does not take into
 Also known as Risked NPV.
account the time value of money which
is a serious drawback since it can lead  It represents weighted average of
to wrong decisions. possible NPVs of all outcomes from
an event in which weights represent
probabilities of outcomes.

19
Uncertainty: P10:
 The range of possible outcomes for  10% chance that the actual result
an event. will equal or exceed this value.
Probability:
P50:
 The likelihood that a particular
 50% chance that the actual result
outcome will occur.
will equal or exceed this value.
Risk:
P90:
 The likelihood of failure or loss and
 90% chance that the actual result
is related to the consequences of
will equal or exceed this value.
hazard.

Fiscal Terms (Cont.)

Fiscal Terms
Negotiation for Terms and Conditions

E & P Co. Host Govt. Terms negotiated with the host

government for revenue sharing in the
event of commercial production from
It Includes: an oil or gas lease in exchange for
•Revenue Sharing Terms. gaining exclusive rights to explore,
•Bonus Incentive Terms. develop, produce and sell HCs from
•Royalty Terms. the said lease.
•Payment of Taxes Terms.

20
 Fiscal Terms (Cont.)

Generally consists of making bonus

payments (pegged to achieving
certain production levels and
cumulative production), Royalty and
Tax payments.

21