PETROLEUM

ECONOMICS
BY

G.C.ENYI
SCHOOL OF COMPUTING, SCIENCE AND
ENGINEERING
UNIVERSITY OF SALFORD
MANCHESTER, UK.
 AIMS

To introduce the basic concepts

and background for the financial
and economic assessment of
projects within the petroleum
industry.
 OBJECTIVES
Be able to calculate the NPV of a project
including the collection of all necessary
data, carry out Decision Tree Analysis and
be able to select the best option from
several possibilities.
Be able to assess risk and uncertainty
related to projects and carry out
probabilistic resource calculations.
Be able to carry out simple portfolio
management decisions under conditions of
uncertainty, including economic, technical
and political risk.
 TEXTS
Petroleum Evaluations and Economic
Decisions: Arthur W. McCray, Prentice-
Hall, Englewood Cliffs, New Jersey.
Risk Analysis and Management of
Petroleum Exploration Venture: Peter
R. Rose, AAPG, ISBN 0-89181-663-1.
Economics of Worldwide Petroleum
Production: F.H. Allen and R.D. Seba,
OGCI, ISBN 0-930972-17-1.
 OUTLINE
INTRODUCTION

ESTIMATION OF OIL AND GAS RESERVES

CASH FLOW ANALYSIS

TIME VALUE OF MONEY

PROFITABILITY OF A VENTURE

PRODUCTION ECONOMICS

RISK AND UNCERTAINTY

 INTRODUCTION
The Engineering economy and engineering
economics or engineering economic analysis
are all used interchangeably to denote the
study of the economics of engineering
systems.

Engineering economy is an applied economics

course. Since the application is engineering
systems this economics course is taught by
engineering faculty.

As future engineers, no matter what type, you

will sooner or later have to deal with problem
situations similar to the ones covered in this
course. At the end of the course you will be
 ECONOMIC
DECISION
Why
WhyI need do toIdoneed
economics?
to study
"Is it not enough for me to be a
economics?
good engineer? I am not an
"Is it not enough for me to be
accountant.
a good
I will engineer?
ask the I am
accountant in mynot an
accountant.
company to do that work for me.
I will ask the accountant in
my company to do that work
 ROLE OF THE PETROLEUM
ECONOMIST
To advise on the economic attractiveness
of these opportunities, taking into
account the many uncertainties
regarding reservoir behavior,
development costs, future energy prices
and relationships with governments.

He will also be involved in some or all of

the following activities:
- Lease Bidding
- Selection of "best" option
- Reporting
- Unitization discussions
- Fiscal changes
 ECONOMIC ANALYSIS AND
DECISION MAKING

The primary objective of any business

organization (oil and gas) is not merely to
produce goods and services (oil and gas) BUT
rather to make a profit the maximum profit.

OTHERS
- Expansion in production capacity

- Increase in market share

- Diversification of activities

- Continuous survival of the organization

RELATIONSHIP WITH OTHER
DISCIPLINES
WHERE IS THE MISSING LINK ?
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DISCIPLINES
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 DECISION MAKING
ENVIRONMENT
The environment within which
decision making takes place can be
logically divided into three parts or
states:

Certainty
Risk
Uncertainty
 DECISION MAKING
ENVIRONMENT
Certainty exists when one can specify
exactly what will happen during the
period for which the decision is being
made.
Risk refers to a situation where one can
specify a probability distribution over
possible outcomes.
Uncertainty refers to the condition when
one cannot specify the relative likelihood
of the outcomes.
 WHY DO WE MAKE
ECONOMIC EVALUATION
1 Prioritize projects.
2 Re-evaluation of priorities in allocation of
investment funds by
the company.
3 Planned change in development or
production methods that
consequently may affect the production
rate and ultimate
recovery.
4 Assessment of value of assets for taxation
purposes.

Whatever the reason for conducting an

 WHY DO WE MAKE
ECONOMIC EVALUATION
The economic analysis should
lead toward an unbiased answer
to two questions:

1 Does the particular

investment project seem to
satisfy the stated objectives of
the firm?
 WHY DO WE MAKE
ECONOMIC EVALUATION

Even if there were only one

investment opportunity under
review, it must favourably
compare with other profit-
generating activities This is the
concept of opportunity cost the
advantage forgone due to
alternative use of investment
 CHARACTERISTICS OF OIL
AND GAS RESOURCES
In addition to factors normally considered in capital
investments, some of the characteristics of oil and gas
that may affect the results of economic analysis are:

1 The long lead time from geologic discovery to

full use of the resource (5 12 years)
2 The political and social environment in the
region ( takeovers, shutdown of operations)
3 Tax burden and special allowances customary
in oil and gas accounting
4 The heterogeneous nature of deposits ( no two
deposits are identical)
5 The nonrenewable nature of oil and gas
resources
 ASPECTS OF LEASING
* OIL AND GAS ARE MINERALS AND PART OF
LAND:

HOME GOVERNMENT (HG) OR LANDOWNERS

(LO) LEGAL RIGHT

IF HE SAYS NO THEN NO SHOW.

In some countries Govt owns the mineral rights

and only Govt can explore the minerals unless it
transfers right to another. If this happens we say
that Govt gives another a CONCESSION.

THREE COMMON OPTIONS FOR HG/LO

 LEASE INTEREST
-There will be written agreement b/w HG (lessor) and the
Petroleum company (lessee) granting legal interest in HG
property.

-The right will revert to LO at the end of the lease term.

-The lease is granted for explicit period (primary term) and for
as long as petroleum is found in paying quantity.
-The LO reserves certain rights and privileges

* Bonus payment *
Royalty payment

* Reversion of right *
Surface rights
 MINERAL RIGHTS

- LO is the owner of mineral right.

- LO may choose to develop or sell

right to
mineral to second party through
a lease.

ROYALTY INTEREST

- LO is granted fraction of
production free of costs
 LICENSES AND LEASES

OIL-EXPLORATION LICENSE (OEL)

A non-exclusive right to explore for and produce petroleum within

area of grant. Whoever finds oil first reports to the HG/LO. Others
will leave.

OIL-PROSPECTING LICENSE (OPL)

Exclusive right to explore and prospect for petroleum within area

of grant

OIL-MINING LEASE (OML)

Permits lessee use of land to explore and dispose of petroleum

discovered within leased area.
 TYPE OF OIL AND GAS
CONTRACTS

* CONCESSIONARY
- Allows private (coy) ownership of oil
and gas discovered through transfer of
rights and payments of bonuses,
royalties, taxes to Govt.

- No more prevalent
 TYPE OF OIL AND GAS
CONTRACTS

* JOINT VENTURE
- Risk shared by Govt and Coy

- Objective is to increase HG take

- Better control of your money and

assets
PE OF OIL AND GAS CONTRAC
PRODUCTION SHARING
CONTRACT (PSC)
-Coy assumes risk of exploration

- At commercial discovery, Govt steps in and

becomes partner.

- Production first used to repay expenses (cost

oil).

- Coy then receives share of remainder ( to be

determined by contract)
PE OF OIL AND GAS CONTRACT
* SERVICE CONTRACTS (SC)
-Principle is same as PSC

-Service Coy takes care of exploration

- At discovery, Govt pays actual

exploration cost, but remains sole owner
of discovered reserves.

-Govt may buy part of the production

ESTIMATION OF OIL AND GAS
VolumetricRESERVES
Method
This is applied in a new field for rough
estimates. No production history is required.
We need only geological data like porosity,
water saturation etc.

Where:A = Area of the reservoir (Acres); h = Formation

thickness (ft)
= Porosity ; Swi = Water Saturation
Boi = Initial oil formation volume factor (res
bbl/STB)
Bgi = Initial gas formation volume factor (res ft3/Scf)
G = Gas initial in place (Scf)
WORKED EXAMPLE

A well was drilled into an oil reservoir. Well logs

indicate that the reservoir has a thickness of 105 feet,
average porosity of 18.5 percent and average water
saturation of 25 percent. Analysis of offset wells
production in the area indicate that this well will drain
160acres with a recovery efficiency of 15 percent, and
the initial oil formation volume factor is 0.8 STB/res
bbl. What are the recoverable oil reserves.

SOLUTION

N = [7758 x 160 x 105 x 0.185 x (1-

0.25) x 0.15] / 1.25

N = 2,170,068 STB
 CASH
FLOW
 TERMS AND CONCEPTS
*Revenues funds received by the coy during the
period under consideration

*Costs and Expenses money spent by doing

business that must be paid from the revenues received
by the coy.

*Tangible costs Expenditures for items such as well

equipment, casing, wellhead etc. These costs are
charged against income through depreciation.

*Intangible costs Expenditures not represented by

physical equipment (Items with value but you can not
touch). They are not capitalized for tax purposes.
 TERMS AND CONCEPTS
*Depreciation decline in value of equipment due to
wear and tear of normal use.

*Royalty right to oil and gas in place that entitles its

owner to a specific fraction in kind or cash.

*Salvage value amount of money realised at the

time a used item is sold.

*Amortization costs of certain assets (patents,

pollution control devices) are charged against income
over a period of time.

*Cost Depletion reduction in value of the

 TERMS AND CONCEPTS
*Farm-out the assignment (subcontract) of
part or all of an oil, natural gas or mineral
interest to a third party which gives the
farmees a potential profit that they would not
otherwise have access to. Government
approval is required.

*Working capital money set aside to be

drawn on as needed to facilitate and insure
smooth operation. The net flow of working
capital in and out of the operation is zero. Each
company determines the proper amount of
 EXPENDITURES
The total expenditures incurred in producing oil and gas wells may be
divided into two groups:

- the total capital cost (expenditure)

- the total operating cost (expenditure)

TOTAL CAPITAL EXPENDITURE (CAPEX)

The total cost of installed facilities which cannot be deducted for tax
purposes, but for which depreciation is allowed by the tax authorities.
It includes all expenditures required to drill and complete the well and to
provide the well with production facilities required to lift the oil and gas from
the bottom of the well to the surface and to transport it from the well head to
the terminal.
Also included are all future expenditures required to keep the well on
production (other than operating costs).
 TOTAL CAPITAL EXPENDITURE (CAPEX)
It includes costs such as:

Drilling costs (including casing)

Well equipment (well head connections, tubing, lift equip)
Installation of pumping units
Gathering lines and tanks
Water and gas injection systems
Compression stations

CAPEX are classified as tangible or intangible expense:

Tangible expenses are cost of physical equipment and are tax deductible
only by depreciation.

Intangible expenses are expenditures not represented by physical

equipment. These items are not capitalised for tax purposes (eg: land
survey, site development, access roads, well logging/testing, etc)
 OPERATING COSTS (OPEX)
The expenditure incurred by producing an oil or gas well after it has been drilled and
completed is called the operating cost. It is divided into two categories:

DIRECT OPERATIND COSTS

These are costs (expenses) directly chargeable to individual leases except taxes.
Labour and material costs for operation, maintenance, workovers, gas processing
plants, salt-water disposal systems and injection plants.

TAXES
Vary widely throughout the world.

Severance taxes: They include conservation and production taxes. They are levied by
governments and are based on production volume

Ad valorem taxes: These include property taxes

 OVERHEADS

Costs not directly assigned to any unit of production but are

incurred as a result of general operations (R&D, Administration
and Management, Debt interest).

INCOME TAXES
The net revenue before income tax (net revenue after
expenses) is determined by subtracting total expenditures
before income tax from total revenue. The council, state and
federal taxes are subtracted from the net revenue before
income tax to give after tax net cash flow.
 CASH FLOW
DIAGRAM
Dividends to
shareholders
Borrowed capitals
Income from
Corporat Patents, R&D
Cash flow ion cash Outside investment

R&D

Working Direct
capital investment

Sales Operating costs

revenue Operations

Depreciation Gross profit

Depletion
Amortisation

Other deductions
Taxable income Income tax
Net profit
 CASH FLOW
ANALYSIS
Companies involved in the exploration
and development of crude oil and natural
gas have the option of choosing between
two accounting approaches: the
"successful efforts" (SE) method and the
"full cost" (FC) method. These differ in the
treatment of specific operating expenses
relating to the exploration of new oil and
natural gas reserves.
 CASH FLOW
ANALYSIS
The accounting method that a company
chooses affects how its net income and
cash flow numbers are reported.
Therefore, when analyzing companies
involved in the exploration and
development of oil and natural gas, the
accounting method used by such
companies is an important consideration.
 CASH FLOW
The ANALYSIS
successful efforts (SE) method allows a
company to capitalize only those expenses
associated with successfully locating new oil and
natural gas reserves. For unsuccessful (or "dry
hole") results, the associated operating costs are
immediately charged against revenues for that
period.
The alternative approach, known as the full cost
(FC) method, allows all operating expenses
relating to locating new oil and gas reserves -
regardless of the outcome - to be capitalized.
 CASH FLOW
ANALYSIS
According to the view behind the SE
method, the ultimate objective of an oil
and gas company is to produce the oil or
natural gas from reserves it locates and
develops so that only those costs relating
to successful efforts should be capitalized.
Conversely, because there is no change in
productive assets with unsuccessful
results, costs incurred with that effort
should be expensed.
 CASH FLOW
ANALYSIS
On the other hand, the view represented by
the FC method holds that, in general, the
dominant activity of an oil and gas company
is simply the exploration and development of
oil and gas reserves. Therefore, all costs
incurred in pursuit of that activity should first
be capitalized and then written off over the
course of a full operating cycle. The choice of
accounting method in effect receives
regulatory approval.
 NEW PROJECT CASH FLOW
+PROFILE
Abandonment
Cumulative Cashfows

Redevelopment
0
Appraisal time
Production
Exploration = Final Investment Decision
(incl. economics)

= Economic Analysis

Primary
Development
 NET CASH FLOW (NCF)
CALCULATIONS

NCF = Gross Revenue

- royalty
- operating expenses (well repairs/work-over )
- overheads (internal costs)
- taxes (property/severance/conservation) -
production or not.
- capex

= Net Revenue after expenses

- state and federal income tax
= Net Cash Flow
 NET CASH FLOW (NCF)
CALCULATIONS

NCF = Gross Revenue

- Expenses (opex,
overhead, royalty, taxes )
- Depreciation
- Depletion
- Capex
= Taxable Income
- Income taxes
For Accountant = NET PROFIT
+ Depreciation
+ Depletion
For Economist = NET CASH FLOW
 WORKED EXAMPLE
From volumetric calculations, the recoverable reserves for a proposed well are
15 million barrels of oil. A joint venture agreement between the host
government and the IOC allows the host government 51% of the after tax profit.
Determine the host government take if the following economic conditions
prevail.
Oil price = $18 / bbl; Capex = $ 75 million; Opex = $ 30 million; Royalty = 20%;
Depreciation = $ 50 million; Tax rate = 75%.

SOLUTION
Revenue = 15 million x $18 = $ 270.00 million
Royalty (20% of Revenue) = 54.00 million **
Opex = 30.00 million
Capex = 75.00 million
Depreciation = 50.00 million
Before tax profit = 61.00 million
Tax (75%) = 45.75 million **
After tax profit = 15.25 million
JVA ( 51%) = 7.78 million **
HG take = 107.53 million
 DEPRECIATION
DEPLETION AND
AMORTIZATION
Depreciation, Depletion and Amortization are the
means of recovering investment in certain types of
property in before tax basis.

DEPRECIATION
A reduction in the value of an asset over time, due in particular
to wear and tear. It is a non-cash expense that reduces the
value of an asset over time. Provision should be made for
depreciation of fixed assets.
 DEPRECIATION
DEPLETION AND
AMORTIZATION
Depreciation, Depletion and Amortization are the
means of recovering investment in certain types of
property in before tax basis.

METHODS OF COMPUTING
DEPRECIATION

Straight Line

Double Declining Balance

 WORKED EXAMPLE
A drilling bit with an estimated life of 5 years is purchased for
$33,000. Its salvage value at the end of the fifth year is estimated
to be $3000. Calculate the annual depreciation using the three
methods.
SOLUTION

In DDB, the permissible allowance

during the fifth year is $1277. The
Cumu can not exceed the equipt
cost less its salvage value.
 EFFECTS OF
DEPRECIATION ON CASH
FLOW
The accounting method that a company
chooses affects how its net income and cash
flow numbers are reported. Therefore, when
analyzing companies involved in the
exploration and development of oil and
natural gas, the accounting method used by
such companies is an important
consideration. The computation of
depreciation and its effect on cash flow is
shown in the next slide.
 WORKED EXAMPLE
A B
C
Sales $1,000,000 $1,000,000
$1,000,000
Operating Cost 200,000 200,000
200,000
Depreciation 50,000 50,000
000,000

Taxable Income 750,000 750,000

800,000

Income Tax (50%) 375,000 375,000

400,000

Net Revenue 375,000 375,000

400,000
 DEPRECIATION
DEPLETION AND
AMORTIZATION
DEPLETION
An accounting method that companies use to allocate the cost
of extracting natural resources such as, minerals and oil from
the earth. Depletion is calculated for tax-deduction and
bookkeeping purposes. Unlike depreciation and amortization,
which mainly describe the deduction of expenses due to the
aging of equipment and property, depletion is the actual
physical depletion of natural resources by companies.
Cost depletion is calculated by taking the property's basis, total
recoverable units and number of units sold into account.
Percentage depletion looks at the property's gross income and
 METHODS OF COMPUTING
DEPLETION
After the life of the well. How will the
operator survive? HG/LO should give
some allowance to keep going until new
discovery Concept of Depletion.

Cost Depletion
Percentage Depletion (% of Gross
Income/Revenue)
50% of Taxable Income

NOTE:
 COST DEPLETION

Where:

CD = Annual cost depletion allowance

B = Adjusted basis of the property ( C
CDprev)
P = Units of production sold or for
which payment was
received during tax year
R = Recoverable units of production
remaining at the
 WORKED EXAMPLE
The purchase price of a producing property was
$150,000. Engineering estimate of the
recoverable reserves is 1,000,000 barrels.
Determine the cost depletion if the yearly
depletion for two years in the life of the project
is 50,000 barrels.

SOLUTION
For Year 1: Production = 50,000 bbls
Cost Depletion = $150,000{ 50,000 /
1,000,000} = $7,500

For Year 2: Production = 50,000 bbls

 PERCENTAGE DEPLETION

Specified % of Gross Income

Calculate 50% of taxable income

before depletion

Can not exceed 50% of taxable

income before depletion
 EXAMPLE 1

COMPUTATION OF DEPLETION ALLOWANCE ASSUMING

PERCENTAGE DEPLETION (15%)
 DEPRECIATION
DEPLETION AND
AMORTIZATION
AMORTIZATION
It refers to spreading an intangible asset's
cost over that asset's useful life. For
example, a patent on a piece of oilfield
equipment usually has a life of 17 years. The
cost involved with creating the equipment is
spread out over the life of the patent, with
each portion being recorded as an expense
on the company's income statement.
 CLASSWORK
Consider an oil field to be developed. The first and second year
outputs were 3.6 and 1.8 million barrels of crude oil respectively
and the per barrel cost of the oil was $24.00. One-eighth of this
amount was paid as royalty to the landowner. The first and
second year operating costs were $18,000 and $9,000
respectively, overheads was $8,000 each year, taxes for years 1
and 2 were $7,600 and $3,800 respectively. Depreciation
allowance was $7,500 yearly while depletion was $8,000 for
year 1 and $4,000 for year 2. The capital investment for this
field was $22,000. Assuming income tax at 50%, generate the
field cash flow.
 SOLUTION
The revenue and cost items are listed and the cash flows generated in
thousands of dollars are shown.
Year 1 Year 2
Revenue 75,600 37,800
Operating costs -18,000 -9,000
Overheads -8,000 -8,000
Taxes -7,600 -3,800
Depreciation -7,500 -7,500
Depletion -8,000 -4,000
Taxable income 26,500 5,500
Income tax at 50% -13,250 -2,750
Net profit 13,250 2,750
Depreciation +7,500 +7,500
Depletion +8,000 +4,000
Capital investment -22,000 0
After Tax Net 6,750 14,250
 TIME VALUE OF
MONEY
A basic concept in economic analysis is that
money has a time value. A sum of money now
is normally worth more than an equal sum of
money at some future date.

Long lead time between initial investment in

exploration and development of oil and gas
resources and the inflow of revenue when the
fields are fully productive implies dealing with
TIME VALUE OF
MONEY
 INVESTMENT
TERMINOLOGY
The Principal is the amount of
money borrowed
or invested.

The terms of a loan are the length

of time or
number of periods the loan is
outstanding and
the repayment rate.
INTEREST FORMULAS
The symbols used for interest
formulas are:

i = interest rate per interest

period (%)
n = number of interest periods
(years)
P = present sum of money ($)
F = future sum of money form n
interest
 SINGLE PAYMENT COMPOUND
AMOUNT FACTOR
If a capital sum P (the principal) is placed on compound interest
at a rate i compounded annually. What will it grow to in n
years?

Principal for first year = P

Interest for first year = iP

Sum at the end of first year = P + iP = P(1 + i)

Interest for second year = iP(1 + i)

Sum at the end of second year = P(1 + i) + iP(1 + i)

= P(1 +2i + i2)
= P(1 + i)2
Similarly, for n years:

The Sum Fat the end of n year = F = P(1 +

 SINGLE PAYMENT PRESENT VALUE
(WORTH) FACTOR
The present value is the worth today of $P due
sometime in the future. It is the amount that
must be deposited at compound interest today
to grow to $F in the future. It is the reciprocal
of compound amount. It is expressed as:

The factor 1/(1 +i)n is the single payment

present value factor.
This process of converting future income into
present value or present worth is called
discounting. The single payment present value
iscountFacor1/i
D DISCOUNT
FACTORS

j
Convert future values of revenue,
expense, or
investment into present values

Used in the calculation of ROR, NPV,

and DPI
 SINGLE PAYMENT PRESENT VALUE
(WORTH) FACTOR

EXAMPLES
1) If a sum of $25,000 is invested at the interest rate
of 8% per year for 10 years, what will it grow to?

P = $25,000, i = 8%/yr, n = 10 yrs , F?: F=

25,000(1 + 0.08)10
=
$53,972.50

2)To receive $10,000 in the future 20 years from now,

how much should I deposit today at 10% interest per
 Example Present Value

Assume you have a choice of

receiving $65,000 today or $70,000
one year from now. You could invest
the $65,000 in a 9% interest bearing
account. Which do you take?

PV = $70000 / (1+0.09)1 = $64,220 <

$65,000

or

FV = $65000 * (1+0.09)1 = $70,850 >

 CONTINUOUS INTEREST
FORMULAS
Many people believe that it is more
representative of actual business
conditions to treat those transactions
which occur fairly uniformly throughout
the year as continuous cash flows.

Because these cash flows are

continuous and earnings are created
uniformly through the year, interest is
also treated continuously in such cases.
CONTINUOUS CASH FLOW AND
CONTINUOUS COMPOUNDING
PROFITABILITY OF A
VENTURE
This is the yardstick for measuring
the productivity of individual
investment. Companies usually
consider the possible benefits they
may derive from ventures before
investing money. The financial
benefits, expressed by the
profitability of the investments are
PROFITABILITY OF A
VENTURE
There are two kinds of yardsticks:

Screening which ventures meet the

minimum qualifications to be considered
for investment.
Ranking which of two or more
mutually exclusive ventures is the most
desirable.
 PROFITABILITY OF A
VENTURE
PAYOUT (PAYBACK) PERIOD

This is the time required for the cumulative net earning to equal
the initial investment. It measures the speed with which invested
funds are returned to the business.
The shorter the period, the better and the higher the project is
rated.

PROJECT A
B
Investment 250,000
250,000
Annual Income 50,000
75,000
 DISCOUNTED PROFIT-TO-
INVESTMENT
RATIO (DPR)
It is defined as the ratio of total net profit to
the investment.

i = minimum acceptable
ROR

It is used when money is limited but you

have
several investments options.
PROFITABILITY OF A VENTURE
NET PRESENT VALUE (NPV)
The net present value (NPV) or net
present worth profit is the algebraic sum
of all net cash fows when discounted to
time zero using a single discounting rate.

STRATEGY FOR SELECTION

1)Accept projects that maximize NPV
profit and reject all project having
negative NPV profit (except to meet
certain objectives pollution control to
 WORKED EXAMPLE
The cost of putting a well on stream is $1,500,000. The after tax
cash flows generated by the investment for six years are:

Year Cash Flow

(Revenue) ($)
1 1,000,000
2 800,000
3 600,000
4 400,000
5 200,000
6 100,000
Total 3,100,000
The end of year convention is used. Annual compounding is also
used. Using an average reinvestment rate of 15%, calculate the net
present profit of the cash flow.
 SOLUTION

CONCLUSION
The NPV discounted at 15% is positive. This means
that the six years cash revenues are preferred to our
initial investment of $1,500,000 if the discount rate is
15%. If we invest the $1,500,000 we would make a
15% rate of return plus increase our net worth by
 NET PRESENT VALUE

(NPV)
The NPV takes account of all earnings
throughout the expected life of the asset.
When comparing alternatives with different
expected lives, assumption is made in the
evaluation of the future rates that a
companys fund can earn.
For this criterion, it remains a problem to
determine the minimum acceptable rate of
return that projects are expected to earn to
justify investment of the businesss funds.
The rate of return should be above the cost of
capital to the firm. If not, no need to invest.
 NET PRESENT VALUE
(NPV)
The minimum acceptable rate of return to
use in the NPV calculation is usually set by
top management after consideration of at
least some of the following factors:
1.Future investment opportunities and their
anticipated rate of earnings.
2.If investment capital borrowed, i* must at least
exceed the interest rate of the loan, or should at
least exceed the average cost of capital.
3.Corporate growth objectives (the rate at which
management has set for annual growth rate of
treasury) should be taken into account.
MID-YEAR PAYMENT
 EXAMPLE (MID-YEAR PAYMENT)
The capital cost of natural gas treatment plant is $31,000 and the earning life
of the plant will be 6years. The net incomes in these 6 years will be $5,000;
$12,000; $13,000; $12,000, $12,000, and $8,000 respectively. Calculate the
undiscounted per cent profit and payout time, the discounted values using a
discount rate of 10% and the rate of return. Assume that income is paid as a
lump sum at the midpoint of the year.

SOLUTION
From the Table: Undiscounted Profit = $62,000 - $31,000 = $31,000

Undiscounted % Profit = $31,000/$31,000 x 100 = 100%

Similarly: Discounted Profit = $46,554 - $31,000 = $15,554

Discounted % Profit = $15,554/$31,000 x 100 = 50.2%

From the graph of Cumulative profit versus time:

Undiscounted Payout time = 3.15 years

Discounted Payout time = 3.65 years

Plotting the Cumulative discounted net income against various discount rates gives
the project ROR as 27.6%

Capital cost of project

ROR
 DISCOUNTED CASH FLOW
RATE OF RETURN
(DCFROR)
It is defined as the discount rate that makes the NPV of
a project equal to zero. It is also known as internal rate
of return (IRR), rate of return (ROR). It is expressed as:

Or in the continuous form as:

 PROCEDURE TO CALCULATE
DCFROR
It is calculated by a trial-and-error series of
calculations

List the annual cash flow.

Select a discount rate and list the discount

factors.

Calculate the present value of each annual

cash flow and
add the discounted values to obtain the NPV
of the cash
 WORKED EXAMPLE
The cost of putting a well on stream is $1,500,000. The after tax
cash flows generated by the investment for six years are:

Year Cash Flow

(Revenue) ($)
1 1,000,000
2 800,000
3 600,000
4 400,000
5 200,000
6 100,000
Total 3,100,000

The end of year convention is used. Annual compounding is also

used. Calculate the DCFROR for the cash flow .
 SOLUTION
This involves trial and error computation. The
final stages of the computation are as follows:
 SOLUTION
Interpolating between 0.35 and 0.45:

DCFROR = 0.35 + {105,112/(105,112 +

100,587)} (0.10)

= 40.11%

Hence investing $1,500,000 to buy the

future series of six annual revenues is
equivalent to investing $1,500,000 in a
project that pays 40.11% compound
 PRESENT VALUE PROFILE
Much of the confusion that results from the
use of profitability criteria can be eliminated
by plotting the present value profit versus
the discount rate.

This curve is called the present value profile.

The present value profile for the prospect

considered in the last worked example is as
shown below.
PRESENT VALUE PROFILE
 PRESENT VALUE PROFILE
The point where the profile crosses the
discount axis is the ROR of about 40%.

For discount rates less than 40% , NPV is

positive hence accept if the cost of
capital is less than 40%.
For discount rates greater than 40%, NPV
is negative, hence reject the prospect.

Changes in the initial investment simply

shift the profile in the vertical direction by
 PROFITABILITY OF TWO
PROPOSALS
Compare the profitability of the following two
investment proposals:

Proposal A: An investment of $100,000 today to

receive $120,000 continuously in one year.

Proposal B: An investment of $100,000 today to

receive $200,000 continuously in seven years.

Use continuous compounding method.

 Profitability of two
investments proposals
Data for preparation of the present value profile are shown
below using the continuous compounding relationship.
Rate NPV of NPV of
(j) A B

0 20000 100000
5 17049 68750
10 14195 45833
15 11434 23821
20 8762 7629
25 6176 -5574
30 3673 -16424
35 1250 -25412
40 -1096 -32915
45 -3368 -39229
50 -5567 -44583
 Profitability of two
investments proposals
The present value profiles for proposals A and B are shown
below
 Profitability of two
investments proposals
Proposal A has a discounted cash flow
rate of return of 37.5% and a net profit
of $20,000 while Proposal B has a
discounted cash flow rate of return of
22.8% and a net profit of $100,000.

Using the profit-to-investment ratio, B is

a better option than A. However, P/I does
not reflect the time-rate pattern of
income from the prospects. This is one of
 Profitability of two
investments proposals
The discounted cash flow rate of return
indicates A to be better proposal, while the
NPV at 15% indicates B to be the better
proposal.
The present value profiles give the whole
picture. The profile intersect at a discount rate
of 19.5%. This is the break-even point.

NOTE:
B/w: 0-19.5: B is good At 19.5:
Both are good
 CONFLICT BETWEEN PROFIT
INDICATORS
> Determine (Y-X)
> Handle by PV indicator

For PV @ 10%: Project Y is better than X

DCF : Project X is better than Y

Which ONE do we choose?

Determine the PV of (Y-X); if positive then Y is better.

 INCREMENTAL CASH FLOW

Note
Primary production is better since it has lower
PBP and higher P/I at i of 20%.
If i =20%, and (Y-X) is 28%, then we can do
waterfooding (optional).
If i = 30%, and (Y-X) is 28%, then do not
 ACCELERATION PROJECTS
An acceleration project is defined as a project applied to an
already existing profitable venture in order to bring future net
income forward in time.

The economic justification for accelerating lies in the fact that

the accelerated income is earned in fewer years than the un-
accelerated, so that discounting will have less effect on the
accelerated than un-accelerated. Hence discounted profit from
the accelerated project might exceed that from the original
project.

Problems when no new reserves are generated.

The existence of two ROR further complicates the

interpretation of the profit indicators.
 EXAMPLE
The estimated future net incomes for a certain project
are shown below. The project is under consideration
for acceleration, and the estimated future net incomes
are also shown. The capital cost involved in
undertaking the acceleration is $3000. Determine the
discounted profit and payback time, draw a curve of
difference in cumulative discounted net incomes
(accelerated less un-accelerated) against discount
rate, and find the rate of return if the earning power of
the company is 10% per cent/year. Assume that
income is paid as lump sum at the midpoint of the
year.
SOLUTION
A graph of cumulative discounted net incomes for both accelerated
and un-accelerated are shown. From the graph, payback time is about
0.45 years.
The difference between the total annual income of accelerated and un-
accelerated is $4098. Allowing for $3000 needed to start the project the
discounted profit is $1098 or 36.5%

Cost of acceleration Project

A graph of the difference in total discounted net incomes against
discount rate crosses the discount rate axis twice giving rise to
two ROR at 6 and 255%. The project is acceptable between the
two limits and rejected outside the limits

Cost of acceleration project

ROR ROR
 RISK AND UNCERTAINTY
Risk refers to a situation where one can
specify a probability distribution over
possible outcomes.
Uncertainty refers to the condition when
one cannot specify the relative likelihood of
the outcomes.
Many of the things that we do fall into these
categories. The drilling of an exploratory oil
well is only an example where both the cost
and the uncertainty regarding success are
so great that they cannot be ignored.
 RISK AND UNCERTAINTY

There are no decision methods that

eliminate risk and uncertainty. The
utilisation of the methods discussed
here will provide the necessary tools
to evaluate, quantify and understand
risk and uncertainty so that engineers
and managers can devise a decision
strategy to minimise the firms
exposure to risk and uncertainty.
 RISK AND UNCERTAINTY
Where uncertainties are great, and where
there is no recognised way of taking them
into account, decision making becomes
difficult.
Judgment of some kind must be made. One is
forced to make assumptions and predictions,
otherwise there is no basis for a decision.
The criteria used may be adjusted upward or
downward according to the feelings about
particular ventures.
 RISK AND
UNCERTAINTY
When an organisation undertakes project in which it has little or no recent
experience, there will be three distinct areas of uncertainty.

-Timing of the project and the cash flow it is expected to generate

- Direct outcome of the project ( accomplishment)
- The side effects of the project (its unforeseen consequences)

There is little one can do to eliminate the uncertainty. Decisions must be

taken in the face of the uncertainty.

We try to reduce such uncertainty by analysing the risk associated with it.

Risk analysis does not remove the ambiguity, it simply describes it in a

way that provides decision maker with a useful insight into their nature.
 RISK AND UNCERTAINTY
(CONTD)
A risk is any uncertain event that, if it occurs, could prevent the project
realising the expectations of the stakeholders as stated in the agreed
business case of the project definition.

A risk that becomes a reality is treated as an ISSUE

Every risk always has a cause and if it occurs, a positive or negative

consequence sets in.

Many risks are well hidden away in the schedule and unless you look for
them, will impact your efforts at a time you least expected.

WHAT IS IMPACTED ?

1)Cost the overall cost of the project.

2)Schedule the time the project will take.
3)Scope the project deliverables and quality of the work.
 STEPS TOWARDS RISK
ANALYSIS
1)ONE-POINT-ANALYSIS (Best Estimate)
2)WEIGHTED AVERAGE SENSITIVITY (Expected
Value)

ONE-POINT-ANALYSIS

Consider an opportunity to acquire an exploration concession for a

considerable sum of money. An analysis must first be made to
ascertain discovery that will offset all financial outlays and yield an
adequate return on expended capital.
The traditional approach is to perform the reserve in place using
volumetric reserve formula for best estimate values for the
individual petrophysical parameters. Through a combination of
experience, intuition, judgment and consensus the manager must
STEPS TOWARDS RISK
ANALYSIS
ONE-POINT-ANALYSIS
Risk treated as judgment factor
No quantitative assessment risk
Does not recognize possibility of failure

Example
Reserves
NPV
400 Mbbls
$6,000
 STEPS TOWARDS RISK
ANALYSIS

WEIGHTED AVERAGE SENSITIVITY

(Expected Value)
To aid decision making under conditions
of uncertainty, we assign a chance or
probability of occurrence to the possibility
of a certain outcome. These probability
are commonly used to quantify
uncertainty. It is important to realise that
 STEPS TOWARDS RISK
ANALYSIS
The following methods will help us to
obtain probability estimates:

1.Subjective probability estimates are a

common way of expressing the degree of
risk and uncertainty. The estimates
represent personal opinion based on
available statistical data or on the
analysts feeling.
2.The use of past success ratios is the
 STEPS TOWARDS RISK
ANALYSIS
The expected value (monetary, utility) of an outcome
is the product obtained by multiplying the probability
of occurrence of the outcome and the conditional
value (or worth) that is received if the outcome
occurs.
The expected value of an outcome is the algebraic
sum of the expected values of each possible outcome
that occur if the decision alternative is accepted.
It can be positive, zero or negative. It is the numerical
criterion used to compare competing decision
choices.
The decision maker must select only one of the
available alternatives
WEIGHTED AVERAGE
SENSITIVITY
Probability of occurrence assigned to outcomes
Probability must sum to 1.0
Best estimate assigned highest probability
Expected value (EV) obtained by weighting
Individual EV added to give project EV
Accept project if EV is positive

Example:

Reserves NPV
Probability EV

0 Mbbl 500 M
0.15 75 M
200 Mbbl 3,000 M
0.30 900 M
 Decisions and Probability
(Risk) graduate 1
A young graduate has received job offers from
two companies: Shell and Schlumberger. He
plans to work for 4 years, quit and return to
the university.
Shell offers $ 30k p/a, Schlumberger offers $
50k p/a.

Given above information, what should he do ?

 Decisions and
Probability (Risk)
graduate 2
The graduate should go for Schlumberger
because 4 * $50k is more than 4 * $30k

Shell FALSE 0
120 120
The Graduate Accept Job
200
Schlumberger TRUE 1
200 200
 Decisions and Probability (Risk)
graduate 3
The graduate decides to ask around a bit how
graduates that joint either Shell or Schlumberger some
years ago are doing today. His fact finding shows:
100% of those who joined Shell are still with the
company
80% of those who joined Schlumberger burned out
and quit, on the average after 6 months and need a 6
months recovery period. All then find a job paying
$85k.
20% of those who joined Schlumberger are still with
the company
Given above information, what should he do ?
 Decisions and
Probability (Risk)
graduate 4
The graduate realizes that his expectation
earning with Schlumberger is only [0.8x85 +
0.2x200] = $108k, $12k less than with Shell.
He should join Shell.

Shell TRUE 1
120 120
The Graduate(2) Accept Job
120
Burn out 80.0% 0
85 85
Schlumberger FALSE Survive
0 108
Doing fine 20.0% 0
200 200
 LIMITATIONS OF EMV
The assumption is that a decision maker will
want to choose a project that has the highest
EMV.
The analyses assume that decision makers will
want to play the average on all deals
regardless of the potential negative
consequences that might result. BUT IS THIS
TRUE?

Purely mechanical (judgment, experience of

Decision Maker NOT
incorporated)

Failure to take into account the different

financial circumstances
 UTILITY THEORY
Utility theory states that each individual has a
measurable preference when faced with
choices among alternatives uncertainty, which
is called his utility.

It has unit called utiles.

The relationship between utiles and dollars

is called an individuals utility function
(curve).

The function is strictly personal and differs

 UTILITY THEORY
It recognises that the second
increment of a substance may have
generally less value (utility) to a
person than the first increment.

Different people will of course have

different regard or desire for the same
substance.

Thus each person would have his

UTILITY CONCEPTS - RECOMMENDED
PROCEDURE
The recommended procedure for determining a persons utility
function is to find a point of indifference- when the decision
maker has no preference among several alternatives and
accepts them as possessing the same utility. This point is
determined by questioning the decision maker about his
preference when confronted with two monetary alternatives.

The zero point on the vertical scale is generally interpreted as a

point of indifference or neutrality about money.

Positive, upper values on the vertical axis denote increasing

desirability and the negative portion of the scale denotes an
increasing dislike for the corresponding amounts of money.
 UTILITY CONCEPTS PROPERTIES 1

The utility scale is dimensionless and its magnitude is arbitrary.

The horizontal scale can be in any units of money (NPV, etc).

The curve shows an increasing function and occupies the first & third
quadrants only.

The curve merely describes a persons preferences and attitudes for

money and does not imply a comparison among individuals. It does not
imply that he is wrong for having the attitude or that he should change
his attitude about money.

The shape of the curve reflects the attitudes and preferences of the
decision maker. If he was totally impartial to money his utility would be
a straight line passing through the origin.
SHAPES OF VARIOUS PREFERENCE CURVES

(b) Shows a conservation

attitude for risk taking.

(d) Shows a risk taking

attitude.

(f) Totally impartial to

risk Anything goes.
 UTILITY CONCEPTS PROPERTIES 2
The shape in the first quadrant indicates the decision
makers attitudes toward risks. A concave downward in the
first quadrant shows a conservative attitude for risk taking.

A curve that bends sharply upward in the first quadrant is

representative of a risking- seeking attitude.

Utility theory has the property of expectation. We can

compute expected utility value (EUV) for a decision
alternative by multiplying the utility values and the
probabilities of occurrence.

The EUV is the decision parameter used by the decision

maker to accept or reject the alternative. The decision rule
is to select the alternative that maximises EUV.
 EXAMPLE
A company is planning to embark on a drilling
venture. The possible outcomes of the venture
are given below and the utility curve of the
company is attached:

Outcomes Probability
Alternatives
Drill
Farm Out (1/8 RI)
Dry Hole 0.4 -200,000
0
5 BCF 0.6
+600,000 +50,000

Using the EMV concept, we obtain

TYPICAL CURVE FOR A COMPANY
Using the EUV computation gives:

EUV of Drill = (0.4)(-8) + (0.6)(4) = -0.80

utiles

EUV of Farm Out = (0.4)(0) + (0.6)(0.6) =

0.36 utiles

Farm Out is the preferred

choice.

The difference between the EMV and EUV

decisions occurs because the potential
loss of $200,000 overrides the potential
gain of $600,000.
 DECISION TREES
ANALYSIS
A line (pictorial) representation of a sequence
of events and possible outcomes.

The main problem is too many branches in the

future.
The point from which two or more branches
emanate is called a Node.
Two types of Node:

DECISION NODE: represented by a square. The

decision maker dictates which branch is taken.
 DECISION TREES

ANALYSIS
The trees normally reads from left to right and
are drawn in the same order as the actual
sequence in which the decision choices and
chance events occur in the real world.
The ends of a decision tree are called terminal
points. Indicating that there are no further
decisions or chance events beyond that point.
The evaluation of the outcomes starts from
the terminal point of each branch and moves
from right to left.
The decision criterion at any decision node is
to take the branch of alternative that
maximises expected value.
DECISION TREES ANALYSIS

Umbrella Problem

Chance Even
Node t
Stay
n
Rai Dry
No
Ra
rry ella in Unnecessa
Decisio a
C br ry
n Luema Burden
Node um ve
a brell Rain Get
No Wet
Ra
in
St
Dr ay
y
 DECISION TREE ANALYSIS
An investor is planning to buy a pizza
restaurant near the university campus. If he
buys the restaurant, there are three possible
outcomes: a low demand, a medium demand
and a high demand for pizza. There is a 60%
chance of a low demand with a resulting loss
of $25,000; a 30% chance of a medium
demand and realising a NPV profit of $50,000
and a 10% chance of a high demand and
realising a NPV profit $150,000. Calculate the
expected value of outcomes.
PIZZA
Low ($-
RESTAURANT 25,000)
Mediu ($50,00
y m 0)
B u
High ($150,00
0)
Don
t
Buy ($0)

Outcome Probability NPV

Low 0.6
-25,000
Medium 0.3
50,000
High 0.1
150,000

EMV of Buy = (0.6)(-25,000) + (0.3)(50,000) + (0.1)(150,000) =

+ $15,000
EMV of Dont Buy = $ 0
 EXAMPLE
A company has a nontransferable short-term option to drill on a certain plot of
land. This option is the only business deal which the company is involved
now. Two recent dry holes elsewhere have reduced the companys liquid
assets to $130,000, and John Doe the president of the company must decide
within two weeks if drilling is to commence by then. Doe has three possible
choices:
1 Drill immediately
2 Pay to have a seismic test run, then, depending on the result, decide
whether or not to drill.
3 Let the option expire

The cost of seismic test is $30,000 and the well can be drilled for $100,000.
Another oil company has promised to buy any oil discovered for $400,000. A
geologist states that there is a 0.55 probability that there will be oil if a well is
drilled immediately. Data on the reliability of seismic tests indicate that if the
test result is favourable the probability of finding oil will increase to 0.85, but
if unfavourable it will fall to 0.10. The geologist has also said that there is a
0.60 probability that the result will be favourable if a test is made. If you were
Mr. Doe what will you do?
 SOLUTION
The EMV at the top branch: (0.85)(+$400,000) + (0.15)($0) = $340,000
Compare with the EMV of dont drill = $100,000
(The maximum EMV of $340,000 is chosen for the top node.)

The EMV at the middle branch: (0.10)(+$400,000) + (0.90)($0) = $40,000

Compare with the EMV of dont drill = $100,000
(The maximum EMV of $100,000 is chosen for the middle node.)

The EMV at the bottom branch: (0.55)(+$430,000) + (0.45)($30,000) = $250,000

Compare with the EMV of dont drill = $130,000
(The maximum EMV of $250,000 is chosen for the bottom node.)

The EMV at the last top branch: (0.60)(+$340,000) + (0.40)($100,000) = $244,000

Compare with the EMV of dont drill = $250,000
(The maximum EMV of $250,000 is chosen for the last node.)
 Oil $400,000
Does Decision Drill
-$100,00
0
0.85
No Oil
0.15
able
t f avour Dont drill
Tes 0.6
c
mi Oil $400,000
seis 00 Test 0.10
ke ,0 unf avou 0.4 Drill
Ta t $30 ra 00 No Oil
tes ble -$100,0 0.90

Don Dont dri

ll 0.55
test t take s Oil $430,000
eism
ic
Drill No O 0.45
0
-$100,00 il

Dont drill

$340,000
Does Decision Tree 0
Oil 0.85 $400,000
Drill -$100,00
No Oil $0
0.15
e
rabl Dont dri
$244,000
t f avou 0.6 ll
Tes $100,000
c
mi $100,000 il 0.10 $400,000
eis Test 00
O
es unfa -$100,0
k
Ta t voura 0.4 Drill 0.90
ble No Oil $0
t s
e
Dont drill
Don $100,000

test t take s
eism Oil
ic 0.55
$430,000
0
-$100,00
Drill 0.45
$250,000 No Oil $30,000
Dont d
rill $130,000
DOES CHOICE

+$244,000 (REJECT)
t
ic te s
ei sm
es
Tak

Don
t Tak
e se
ism
ic test
+$250,000 (ACCEPT)

The two choices open to Doe are drill without seismic

for an expected net income of $250,000 OR drill with
seismic for an expected income of $244,000.

Doe should have his company drill immediately without

taking any seismic test.
 CONCLUDING
REMARKS
The uncertainties in geology will always
be as the Creator made them. How the
problems of decision making in petroleum
engineering are solved depend on how
well engineers and managers apply new
ideas, knowledge and technology.
Petroleum exploitation is always an
exciting and challenging game a game
of chance but also of change.
Chi U. Ikoku
THANK
YOU
AND

GOODLUC