MODULE 4

UPSTREAM PETROLEUM
ECONOMICS

1
Introducing Upstream Petroleum Economic Module
Seeing The Forest and The Trees

Your Learning Partner

Background…

To include Key Terms/ Guiding Principles

Include Pop Quizzes and Activities

2
Introducing Upstream Petroleum Economic Module
Learning Objectives and Assessment Criteria

At the end of the session, you will be able to …

• Describe overview of upstream project evaluation

• Describe the various analysis for economic
indicators and results
• Develop a basic economic modeling
• Communicate economic modeling results

3
Relating To Commercial Value Chain
Topics and The Commercial Value Chain

STRATEGY
EXECUTION
Pre-Entry Acquire Manage
(Assessment) (Farm-in/M&A) (E/D/P)

PART 1: Overview of Upstream Project Evaluation

• Overview Upstream Project Evaluation
• Technical input/Economic assumptions
• Concepts of Cash Flow
• Tax & Capital Allowances
• Fiscal Arrangements

PART 2: Analysing Economic Indicators and Results

• Economic Indicators
• Time Value of Money
• Risk & Sensitivity Analysis
• Decision Tree Analysis

4
Relating To Commercial Value Chain
Topics and The Commercial Value Chain

STRATEGY
EXECUTION
Pre-Entry Acquire Manage
(Assessment) (Farm-in/M&A) (E/D/P)

PART 3: Basic Economic Modelling

• Applying in Excel

PART 4: Communicating Economic Results

• Syndicate Preparation
• Syndicate Presentation

5
Upstream Petroleum Economic Module
Programme Schedule

Day Session Time Agenda

One (1) Part 1 8.00 am - 10.00 am • Overview of Upstream Project Evaluation
• Technical Data/Economics Assumptions

10.15 am - 12.30 pm • Concepts of Cash Flow

• Tax & Capital Allowances
1.30 pm - 3.00 pm • Fiscal Arrangements

Part 2 3.15 pm - 5.00 pm • Economic Indicators

• Time Value of Money

Two (2) 8.00 am - 10.00 am • Risk & Sensitivity Analysis

• Decision Tree Analysis

Part 3 10.15 pm - 12.30 pm • Basic Economic Modeling

1.30 pm - 3.00 pm • Basic Economic Modeling (cont’d)

Part 4 3.15 pm - 5.00 pm • Case Study Preparation

6
Upstream Petroleum Economic Module
Learning Objectives (Part 1)

• Understand (able to describe) the meaning of project evaluation and

steps involved in evaluating an E&P project
• Understand (describe) the various technical data necessary to perform
an E&P project evaluation
• Familiarise with the oil & gas price forecasts, inflation, and escalation
used in project evaluations
• Able to apply the concept of Cash Flow
• Know Petroleum Income Tax terms and calculations

• Tutorial
• Generate technical input data
• Calculate Cash Flow

7
Upstream Petroleum Economic Module
Learning Objectives (Part 2)

• Understand the various types of Fiscal Arrangements and its

computational logic
• Able to appreciate the concept of Time Value of Money
• Understand the underlying concept of key economic indicators such
as maximum cash sink, payout time, Net Present Value (NPV), Internal
Rate of Return (IRR)
• Identify various risks involved in a petroleum project
• Calculate the economic effect of each risk factor
• Comprehend the meaning of a decision tree, and the step-by-step
process involved in constructing a decision tree.

• Tutorial
• Develop Fiscal Arrangements computational logic
• Calculate key economic indicators
• Develop Spider plot, Construct Decision Tree
8
Upstream Petroleum Economic Module
Learning Objectives (Part 3&4)

• Able to develop simple economics model, conduct rigorous analysis

and rationalize the economic results.
• “Putting-All-Together” – Syndicate Exercise

• Interpret/extract/summarise various necessary technical data and

assumptions to be made on oil & gas price forecasts, inflation, and
escalation
• Perform key economic indicators such as maximum cash sink, payout
time, Net Present Value (NPV), Internal Rate of Return (IRR) etc.

• Build simple Economic model

• Case Study preparation

9
 PART 1

• Overview of Upstream
Project Evaluation

10
Overview of Upstream
Economic Evaluation

11
Economic evaluation determines project value and generates
profitability indicators …
e n e ed
w
Wh y
to do
c o n omic
e tio n?
a
evalu
To determine “economic health” of the
project for the purpose of :

To facilitate decision acquiring new petroleum acreages

making :
setting future exploration and
where to focus development strategies
efforts,
tracking asset performance
where to allocate
resources Recommendation of fiscal terms
and/or negotiation parameters
what is the optimal
development option determining free cash flow for
project financing

analyzing impact of new or revised

governmental regulations.

12
Different types of projects are being evaluated throughout the life of an oil/gas field

Strategy Acquire Manage Exit

Acquisition Exploration Development Production Abandonment

Valuing the Asset

Site restoration
• Prospect • Work over
valuation Campaign
• Value of • Infill program
Information
• Field Development
• Optimization
• Gas Sales
• Enhanced recovery
13
Understanding the evaluation process, requirements and results is important to
facilitate effective communication among team members

Technical Inputs Economic Results

Reserves Economic Indicators
Production eg. NPV, IRR
Capex
Opex
Economic Model
Tax & Capital Allowance
Fiscal Arrangement

Economic
Assumptions
Risk &
Price
Cost Escalation
Sensitivity
Inflation Analysis
Exchange Rate

14
Understanding the evaluation process, requirements and results is important to
facilitate effective communication among team members

Technical Inputs Economic Results

Reserves Economic Indicators
Production eg. NPV, IRR
Capex
Opex
Economic Model
Tax & Capital Allowance
Fiscal Arrangement

Economic
Assumptions
Risk &
Price
Cost Escalation
Sensitivity
Inflation Analysis
Exchange Rate

15
 The evaluation requires a set of techno-commercial assumptions which relate to the
development of the asset.

Fiscal &
Commercial
Terms

100%
450
Decision Tree Analysis
90% Aband Fund
80% Resource Distribution 400 Drilling
70% 350 Facility
$ Million MOD

60% 300 E&A

P(>x)

50% Opex
250
40% 200
30%
150 Expenditure Profile
20%
100
10%
50
0%
0 200 400 600 800 1,000 1,200 1,400 0
Prospective Resources (MMbbl) 2009 2013 2017 2021 2025 2029

Cumulative NCF
1500
400

350
1000

$ Million MOD
P90
300
P50
250 P10 500
'000 bpd

200

150 Production Profile 0

1 5 9 13 17 21 25
100
CPP -500
50
Development Concept
0
1 3 5 7 9 11 13 15 17 19 21 Drilling Requirement -1000

No of Year 16
 Various parameters under the different phases of the field life are incorporated to
simulate the expected life cycle value of the project

Acquisition Exploration Development Production Abandonment Exit

• Sunk cost • Abandonment Cost

• Acquisition • Timing of
costs • First year of abandonment
• Number of production • Salvage value
exploration and • Oil production
appraisal wells profile
• Well cost • Gas demand • Sunk cost
• Timing of forecast and • Future value
exploration and • Reserves matching gas
appraisal costs • Development scenarios delivery rates from
• Resource volume
• Capital expenditure (e.g. fields
• Probability of • Typical operating
structure, process
exploration cost
facilities, pipeline,
success
development drilling
cost)
• Number of development
well
• Expenditure phasing

17
 The results serve as one of the key consideration for decision making at different
evaluation GATES for the project

Acquisition Exploration Development Production Abandonment Exit

Operations Planning,
New business Seismic Acquisition/ De- New business
Feasibility Study Production
opportunities Processing/Interpretati commissionin opportunities
Performance &
on g Plan
Monitoring

Project Exploration Project

Upgrade and
Commercial Economic Economic Evaluation Economic Evaluation Commercial
Modification projects
Evaluation Evaluation Evaluation

To acquire To drill an exploration To proceed with To continue What price to

Economic Evaluation
or not well or not FDP or not operation or exit sell

If yes, FDP team To proceed with

project or not

Economic Evaluation

Which
development 18
Rigorous evaluation is necessary to support the petroleum investment decision which
is normally made under condition of uncertainty.

Significant degree of risk and uncertainty.

below the ground risk : presence of hydrocarbon, producible amount
above the ground risk : cost fluctuation, price volatility, stability
Substantial cash flows spread over a long period of time.
A very long lead time between expenditure and resulting revenue.
First production normally realized after more than 5 years from initial investment.
Capital intensive during the early stage.
Resources depleting with time.
EXPLORATION PHASE/ PRODUCTION
DEVELOPMENT PHASE
GAS HOLDING PERIOD PHASE

SEISMIC / WILDCAT / APPRAISAL

PROJECT SCREENING

PROJECT PLANNING

FEASIBILITY STUDY/CONCEPTUAL DESIGN

DETAILED DESIGN

PROCUREMENT

FABRICATION

DRILLING

HOOK UP &
COMMISSIONING
1 ST
PRODUCTION

YEARS 19
Tutorial 1 : Technical Data input for Economic Evaluation

Estimate the production and cost parameters for the following conceptual development
of Field ‘Sparco’
• Field ‘Sparco’, located south east of the
country, at 40 m water depth, with Gas
Speculative Resource (SR) of 100 Bscf
• Well test indicate well deliverability of 10
MMscf/d per well for the reservoir around
the area, with expected production decline
after 75% reserves already produced
• Gas sales agreement signed for 5 years for
40 MMscf/d. Processed gas to be evacuated
to sales point at Port Putra (25 km)
• Estimated well cost of $5 Million per well
• Require 1 Central Processing and 1
Wellhead Platforms to fully develop the
resources at a cost of $ 90 million.
• Pipeline cost estimate = $1 MM/km
• Opex is expected to be 4% of cumulative
Capex 20
202020
 Tutorial 1 : Technical Data input for Economic Evaluation

Estimate the production and cost parameters for the following conceptual development
of Field ‘Sparco’

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Total

No Wells

Gas Sales (MMscf/d)

Cum. Gas Sales/
(%)
Reserves
Facilities Cost (US$ MM)

Pipeline Cost (US$ MM)

Drilling Cost (US$ MM)

Total Capex (US$ MM)

Total Opex (US$ MM)

• Unit Development Cost (UDC) = US$ ____ /Kscf

• Unit Operating Cost (UOC) = US$ ____ /Kscf
• Unit Technical Cost (UTC) = US$ ____ /Kscf
21
 ECONOMIC ANALYSIS WORK-FLOW

Technical Inputs Economic Results

Reserves Time Value of Money
Production Economic Indicators
Capex eg. NPV, IRR
Opex
Economic Model
Net Cash Flow
Tax & Capital Allowance
Fiscal Arrangement

Economic
Assumptions
Risk &
Price
Cost Escalation
Sensitivity
Inflation Analysis
Exchange Rate

22
 Oil Price Forecasts

No forecast is a good forecast

Long term price forecast is more important to E&P company in making project
decisions. However, price escalation is subjective.
Most companies have own in house “CORPORATE” long term oil forecast,
approved by Senior Management.

W o rld C o n s u m p t io n , M M s t b /d
U S $ /b b l ( R e a l T e rm )

ses
a nd Increa
Oil Price Fluctuates Dem
World Production, CPI and Oil Price Trend
120 100

110

100
80
90

80

70 60

60
Average annual
50
increase ~ 14%
40
40 (2004 – 2014)
30 CPI decrea
ses
20
20

10

0 0
1980

1982

1984
1986

1988

1990
1992

1994
1996
1998

2000
2002

2004
2006

2008

2012
2014
2 0 10

Non-OPEC OPEC Brent CPI

Source : International Energy Outlook 2004 23

Gas Price Forecasts

Demand driven
Government Regulation for Power Sector
Project Requirement – profits at certain economic threshold, e.g. IRR = 18%
Fuel oil parity – pegged to other fuels, e.g. MFO or a basket of crude prices
(OPEC basket, etc)
Escalation per annum, e.g. percentage tied to CPI or Oil Field Machinery Index.

Historical Gas Prices

20
Japan LNG European Union
18 UK Henry Hub
16 Canada 45% MFO
14
12
$/mmbtu

10
8
6
4
2
-
96 9 97 9 98 9 99 0 00 001 0 02 003 0 04 00 5 0 06 0 07 0 08 0 09 0 10 011 012 013 014
19 1 1 1 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
Source : 2015 BP Statistical Review 24
Price Assumptions

PETRONAS Upstream economics assumptions are updated annually

Price
Oil price refers to BRENT
BRENT price forecast : Per KPBI as issued by Center/PCSB SP
For other crude types (Tapis, Miri Light, Labuan, Sudan, etc), price
differentials (premium or discount depending on crude quality as compared
to Brent
• e.g. Tapis priced at a premium to Brent where Tapis price = Brent + Tapis
Price Differential
• Sudan = Brent – Sudan Price Differential
Price assumed FLAT NOMINAL or MOD $
GAS : Per GSA or analog to existing GSA’s. If referenced to Fuel Oil or
Crude, basis for these will be KPBI
Escalation : Per KPBI
Inflation : Per KPBI
Exchange Rate : Per KPBI

25
Real Term and MOD Costs

All costs are estimated based on current Real Term (RT)

data and in TODAY’s dollars, often to Cost
referred to as “REAL TERM” dollars.
ESCALATE
Other terms include “Constant” dollars.
Money of the Day
Reference year must be specified such (MOD) Cost
as RT 2002, RT 2003, etc
During economic evaluation, to forecast
future year cash, costs are escalated to Costs (MOD) =Costs (RT) x
FUTURE or MONEY of the DAY (MOD) ( 1+e )n
dollars. e=escalation
rate
Other terms include "Current”, "As n = years
Spent", "Escalated“, “Nominal” dollars. ESCALATION

RT Dollars are converted to MOD dollars
using ESCALATION
Costs in MOD dollars are used
PETRONAS WP&B submission
• Perception of market factors that will
affect the cost of goods and services
for the industry.
in
• Driven by supply and demand

• Example : Cost of basic essentials

(eggs, chicken, etc) tend to go up
during festive seasons

26
Real Term and MOD Price

Oil and gas price forecasts can be Real Term (RT) Cost

quoted in RT or Nominal (=MOD)

dollars. INFLATE

RT prices are converted to MOD dollars Money of the Day

using INFLATION. (MOD) Price

In PETRONAS, price forecasts are

usually in MOD dollars, hence no
further inflation is applied. Price (MOD) = Price (RT) x ( 1+i ) n

I = inflation rate
n = years
INFLATION/DEFLATION
Consumer Price Index (CPI) is the ratio of
cost of purchasing a “basket” of consumer
items in that year to the cost of purchasing
the same “basket” in the Base Year.

Inflation reduces our ‘Purchasing Power’

Example 5 years ago, RM 100 can buy a

week’s grocery, today grocery for only 3
days.

27
 ECONOMIC ANALYSIS WORK-FLOW

Technical Inputs Economic Results

Reserves Time Value of Money
Production Economic Indicators
Capex eg. NPV, IRR
Opex
Economic Model
Net Cash Flow
Tax & Capital Allowance
Fiscal Arrangement

Economic
Assumptions
Risk &
Price
Cost Escalation
Sensitivity
Inflation Analysis
Exchange Rate

29
29
 We do economic evaluation to determine the economic merit of making an
investment

In simplest terms, a net cash flow forecast is a forecast of the CASH

balance after deducting all monies spent from monies earned.
The merit or the economic health of the project is measured using
economic yardsticks, derived from the project Net Cash Flow (NCF).

Net Cash Flow Equals to Cash Inflow minus Cash Outflow

Cash Amount Cash Amount Paid e.g.

Received in the Operating Cost, Capital
form of revenue Expenditure, Royalty,
e.g. Sales of Tax
Product

30
Concepts Of Cash Flow
NET CASHFLOW = CASH INFLOW - CASH OUTFLOW
Examples of Cash Inflow
(+) • Fiscal income:
– eg. sale of oil and gas
• Operating income:
– eg. tariff received
• Other income:
– eg. premium received
Examples of Cash Outflow
(-) • Capital expenditure (Capex):
– eg. platforms, facilities, wells
– asset life > 1 year
• Operating expenses (Opex):
– eg. maintenance, chemicals, fuel,
tariff paid
– asset life <= 1 year
• Fiscal costs:
– eg. royalty, taxes, duties, bonuses
• Other costs:
– eg. premium payments
31
Concept of Net Cash Flow
- Annual basis

36
Concept of Net Cash Flow
- Annual basis

37
Concepts Of Cash Flow

Sample of A Field Life Cycle Project

Net Cash
Cash Flow

Surplus

Net Cash
Deficit

Y Y Y Y Y Y Y Y

Royalty & Taxes

Surplus
Opex
Development Capex
Exploration Capex

EXPLORATION PERIOD DEVELOPMENT PERIOD PRODUCTION PERIOD

(-) G&G studies (-) Detailed Design (+) PSC revenues (cost oil, profit oil)
(-) Seismic (-) Construction/Fabrication (-) Opex
(-) Exploration Drilling (-) Hook-up/Commissioning (-) Development Drilling
(-) Development Drilling (-) PSC costs

38
 A sample of A Field Life Cycle Project
P r o d u c t u io n (M st b ) / C o st s ( U S $ M M )

Production
Period

eg. Total Production

= 50 MMSTB

200 Exploration Development

Period Period
150

100

120
50
eg. Expl. Capex 80
eg. Total Opex 40
18
0 =Y US$ 10 MM
-10 Y Y Y -11.7
Y = US$
Y 50 MM
-12.1 -12.4
Y -12.8
Y

-50
eg. Dev. -80
Capex
= US$ 260 MM
-180
-10

-15

-20 Exploration Capex Development Capex Opex Surplus

• Unit Finding Cost (UFC) = Exploration Capex / Total Production = $ 10/50MMSTB = $0.20/BBL
• Unit Development Cost (UDC) = Development Capex / Total Production = $260/50MMSTB = $5.20/BBL
• Unit Operating Cost (UOC) = Total Opex / Total Production = $ 50/50MMSTB = $1.00/BBL
• Unit Technical Cost (UTC) = [Total Capex + Total Opex ] / Total Production
39
= UFC + UDC + UOC = $0.20 +$5.20 + $1.00 = $6.40/BBL
Concepts Of Cash Flow

Cash Flow Model versus Financial (Accounting) Model

• Net Cash Flow Model

$10,000 $10,000 $10,000 $10,000 $10,000
simulates actual flow of
cash for each year.

TOTAL
CAPEX
$40,000

• Financial Model depreciates $10,000 $10,000 $10,000 $10,000 $10,000

the asset over the assumed
life of the asset.
• This result in a different profit
picture.
1/5 1/5 1/5 1/5 1/5
Cost Cost Cost Cost Cost
$8,000 $8,000 $8,000 $8,000 $8,000
33
TUTORIAL 2 : Generate Technical Input Data

Suppose you have been assigned to conduct an economic analysis for a Country
A with relatively high inflation rate. The following costs data have been collected if
we were to develop it today. What would be our technical input data be ?
Platform : US$ 80 Million spread over Year 1 and 2

Drilling : DM 120 Million spread over Year 2 and 3

Drilling costs will increase 10% p.a. in Real Term (RT)

Facilities : Pesos 1 Billion in Year 1

Pesos 4 Billion in Year 2
Pesos 1 Billion in Year 3

Pipeline : US$ 5 Million in Year 1

US$ 30 Million in Year 2

Fixed Opex : 6% of Cumulative Capex to be paid in Pesos being indexed to

local inflation rate

Variable Opex : US$ 1.50/bbl Real Term (RT) being indexed to local inflation rate
Oil Price : US$ 18/bbl, will increase by 2% p.a. in Real term (RT)

Inflation rate : US$ 9% p.a.; DM 6% p.a. and Pesos 25% p.a.

Exchange rate : 105 Pesos per 1 US$; 70 Pesos per 1 DM

41
TUTORIAL 2 : Generate Technical Input Data

Suppose you have been assigned to conduct an economic analysis for a Country
A with relatively high inflation rate. The following costs data have been collected if
we were to develop it today. What would be our technical input data be ?

Costs Data in RT Pesos Billion (1/1/Year 1) Year 1 Year 2 Year 3 Year 4

Oil Production Forecast Bbl/d 40,000 80,000
Platform US$ Mill
Facilities Pesos Bill.
Pipeline US$ Mill.
Drilling DM Mill.
Platform RT Pesos Bill.
Facilities RT Pesos Bill.
Pipeline RT Pesos Bill.
Drilling RT Pesos Bill.
Total Capex RT Pesos Bill.
Fixed Opex @ 6% Cum. Capex RT Pesos Bill.
Variable Opex @ US$ 1.50/bbl RT Pesos Bill.
Pesos Escalation factor 25%
Capex MOD Pesos Bill.
Opex MOD Pesos Bill.

42
 Concepts Of Cash Flow

NET CASHFLOW = CASH INFLOW - CASH OUTFLOW

Cash In
Royalty
Tax Rate x
Opex
( Cash In
2 Tax – Royalty
Capex – Opex
– Capital
Cash Out 1
Allowance )
3 Net Cash Flow After Tax

Approach :
1. Determine Capital Allowance schedule
2. Calculate Tax
3. Perform Net Cash Flow calculation

Note:
(1) Example from a Royalty-Tax fiscal regime
32
Tax & Capital Allowance

• The most common types of Depreciation/ Depletion/ Amortisation to

calculate Capital Allowance :

1. Straight Line method

- Claimable in Equal amounts over number of years

2. Declining Balance method

- Claimable based on yearly fixed percentage of the unrecovered capital
at the end of the year

3. Depletion/Unit of Production method

- Claimable based on the fraction of remaining reserves produced during
the year

45
Tax & Capital Allowance

Straight Line Method

Example : Capex to be depreciated at 25% p.a., First Production in Year 2

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Total

Annual Production 4 10 10 9 7 40
Capex 100
Depreciation Rate 25%
Capex to be Depreciated 100
Capital Allowance 25 25 25 25 100

46
Tax & Capital Allowance

Declining Balance Method

Example : Capex to be depreciated based on 25% of the non-depreciated balance,

First Production in Year 2

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Total

Annual Production 4 10 10 9 7 40
Capex 100
Depreciation Rate 25% 25% 25% 25% 25%
Capex to be Depreciated 100 75 56 42 31
Capital Allowance 25 19 14 11 31 100
Balance Non-depreciated 75 56 42 31 0

Note :

Since the production ends in Year 5, the remaining non-depreciated will be capitalised fully.

47
Tax & Capital Allowance

Depletion/Unit of Production Method

Example : Capex to be depreciated based on the ratio of the annual production to

the reserves at the beginning of the year times the non-depreciated
balance, First Production in Year 2

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Total

Annual Production 4 10 10 9 7 40
Reserves @ 1st January 40 36 26 16 7
Annual/Reserves 10% 28% 38% 56% 100%
Capex 100
Capex to be Depreciated 100 90 65 40 18
Capital Allowance 10 25 25 22 18 100
Balance Undepreciated 90 65 40 18 0

48
Tax & Capital Allowance

• Straight Line method allow constant CCA claim compared to Declining

Balance and Depletion/Unit of Production methods
Capital Allowance

40
Straight Line Declining Balance Depletion
31
30
25 25 25 25 25 25 25
22
20 19
18

14
11
10
10

0
Year 1 Year 2 Year 3 Year 4 Year 5

49
Tax & Capital Allowance

Tax Losses Carry Forward

Example:

Year 1 Year 2 Year 3 Total

Net Income Before Tax 60 120 120 300
(less) Capital Allowance (110) (80) (80) (270)
(equal) Taxable Income (50) 40 40 30
Tax Payable @ 40% (20) 16 16 12
Tax Losses Carryforward (20) (4) - -
(less ) Tax Paid - - 12 12
Net Income After Tax 60 120 108 288

50
Tax & Capital Allowance

Tax Deductible Tax Creditable

Revenue – Cash In 100.0 US$ MM Revenue – Cash In 100.0 US$ MM

(less) Royalty (30.0) US$ MM (less) Royalty (30.0) US$ MM
(less) Bonus (10.0) US$ MM Income Before Tax 70.0 US$ MM
Income Before Tax 60.0 US$ MM (less) Capital Allowance (10.0) US$ MM
(less) Capital Allowance (10.0) US$ MM Taxable Income 60.0 US$ MM
Taxable Income 50.0 US$ MM Tax Payable @ 38% (22.8) US$ MM
Tax Payable @ 38% (19.0) US$ MM (less) Bonus (10.0) US$ MM
(less) Tax Paid (19.0) US$ MM (less) Tax Paid (12.8) US$ MM
Income After Tax 41.0 US$ MM Income After Tax 57.2 US$ MM

51
TUTORIAL 3 : Calculate Cash Flow

The following offshore oil development project is being proposed. What would be
your approach to address the opportunity ?

Production Data : First Oil beginning of Year 3

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9

Annual Oil Production 5 15 15 10 2.5 1.0 0.5

Technical Costs :

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9

Platform 30 30
Facilities 15 30
Tangible Drilling 10 15 10 4
Intangible Drilling 20 32 15 5
Fixed Opex 8 14 15 15 15 15 15
Variable Opex US$ 0.40/bbl produced

Oil Price forecast : US$ 20/bbl, expected to remain constant thereafter

Terms and Conditions : Royalty 25%

Tax rate 20%, Tax losses not allowed
Capital Allowance – Straight line at 25% p.a.,
Only start after First Oil production
52
TUTORIAL 3 : Calculate Cash Flow

The following offshore oil development project is being proposed. What would be
your approach to address the opportunity ?

1 Capital Allowance Calc. Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9
Platform
Facilities
Tangible Drilling
Total Capex
CA Year 1 Capex @25%
CA Year 2 Capex @25%
CA Year 3 Capex @25%
CA Year 4 Capex @25%
Total CA

2 Tax Calc. Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9
Cash In
Royalty
Opex
Income Before Tax
Total CA
Drilling costs Expensed
Taxable Income
Tax Paid @20% 53
TUTORIAL 3 : Calculate Cash Flow

The following offshore oil development project is being proposed. What would be
your approach to address the opportunity ?

3 Net Cash Flow Calc. Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9
Cash In
Royalty @25%
Opex
Capex
Tax
Cash Out
Net Cash Flow

54
 PART 2

• Analysing Economic
Indicators and Results

55
Different types of petroleum arrangement are being adopted in different parts of the
world.

PETROLEUM AGREEMENTS

CONTRACTUAL
CONCESSION SYSTEMS
SYSTEMS

Concession Agreements Production Sharing

Service Contracts
Contracts

Pure Service Risk Service

56
Fiscal Arrangements
Typical Characteristics of Fiscal Arrangements
Concessionary System
• Oil companies owns the
production
• Contractors pay royalty and
tax to the government
Contractual System
• Government has the sole ownership of
petroleum resources.
• Oil companies are assigned as contractors
• Contractors furnish all risk capital. In
return, contractors will be allowed to
recover the cost upon production
• For Production Sharing Contract: remaining
profit (after cost recovery) is shared
between government & contractors
• For Service Contract: remaining profit
belongs to government; contractors will be
compensated through unused cost oil as
their ‘remuneration’
57
Fiscal Arrangements

Project

Project
Example: Revenue = $100 Cash Flow
Cost = $ 40

Revenue

Costs
= $40 $40
(less)
Opex

(less)
Net Take Capex
= $60 $60
(equals)

Net Cash
Flow

58
 Fiscal Arrangements

Concession Agreement

Example: Revenue = $100

Cost = $ 40 Royalty
@10%
$10

Costs
= $40 $40
Government
Contractor Take = $30
Take
= $30 $30

Tax
$20 @40%

Cost = $40 *Net Govt. Take

Government Take = $30 = 50%
Contractor Take = $30
59
Fiscal Arrangements

Concession Agreement

Project Contractor’s State/Government

Cash Flow Cash Flow Cash Flow

Revenue

(less)
Royalty

(less) (less)
Opex

(less)
Tax

(less) (less)
Capex

(equals) (equals) (equals)

Net Cash Net Cash Net Cash

Flow Flow Flow
60
Fiscal Arrangements

Concession Agreement

Example: Morocco Production Concession Agreement

• Royalty: 10.0%

• Corporate Income Tax rate: 35% of taxable income

• Production Bonus (non-tax deductable):

US$ 1.0 MM for first production
US$ 2.0 MM for production exceeding 50 MSTB/D US$
3.0 MM for production exceeding 100 MSTB/D
US$ 5.0 MM for production exceeding 200 MSTB/D

61
Fiscal Arrangements

Concession Agreement

Example: Pakistan Production Concession Agreement

• Royalty: 12.5%

• Corporate Income Tax rate: 55% of taxable income

(Capital Allowances: Tangible Capex depreciated at the rate of 10%pa)

• Workers Participation Fund (WPF):

= 5% of net income before tax less capital allowance

• Workers Welfare Fund (WWF):

= 2% of net income before tax less capital allowance less WPF

• Production Bonus (non-tax deductable):

- First Level = US$ 1.0 MM for first production
- Second Level = US$ 3.0 MM for production exceeding 300 MMSCF/D
- Third Level = US$ 5.0 MM for production exceeding 600 MMSCF/D

62
TUTORIAL 4 : Fiscal Terms Computational Logic

Concession Agreement

Provide the logic for Contractors’ Net Cash Flow calculations using the provided input
variables

Input Variable Computational Logic

Gas Sales Revenue – Cash In
Gas Price Royalty
Capex Opex
Opex Income Before Tax
Royalty Rate Capital Allowance
Depreciation Rate Taxable Income
Tax Rate Tax Paid
Income After Tax
Capex
Cash Out
Net Cash Flow After Tax

63
 Fiscal Arrangements

Production Sharing Agreement

Cost Bank and Cost Recovery Concepts

• Cost Bank = balance of cost to be recovered

Deposit Withdrawal • Cost Bank = Unrecovered Cost

• Opex BANK • Cost • Cost Bank = Current Cost Bank Balance

• Capex Recovery (+) Total Cost for the period
(-) Cost Recovered

150 Cost Ullage Opening Balance

$ Million

Cost Addition
125 Cost Oil Ceiling

100
Costs above ceiling are
75 carried to next period

50
Cost Oil Ullage Costs below ceiling are
25 recovered during the
period
0
1 2 3 4 5 6
65
Fiscal Arrangements

Production Sharing Agreement

Sliding Scale Profit Split Concept

50
Project
Existing
40
kstb/d

Rate State Cont

30
> 20 kstb/d 50 50
20
2nd 10 kstb/d 40 60
10
1st 10 kstb/d 30 70
0
Gross Rate 30 35 25 15 7
First 10 kstb/d 7.0 7.0 7.0 7.0 4.9
Next 10 kstb/d 6.0 6.0 6.0 3.0 0
Above 20 kstb/d 5.0 7.5 2.5 0 0
Contractor Share ksbt/d 18.0 20.5 15.5 10.0 4.9
Contractor Share % 60% 58.6% 62.0% 66.7% 70.0% 66
Fiscal Arrangements

Production Sharing Agreement

Example: Revenue = $100 Royalty

Cost = $ 40 @10%
$10
Cost Recovery
Ceiling @50%
= $40 $40
Government
Govt. Take = $51
Contractor Profit
Take Share
= $9 $9 @70%
$35
Tax
$6
@40%

Cost = $40
*Net Govt. Take
Government Take = $51
= 85%
Contractor Take = $ 9

67
Fiscal Arrangements

Production Sharing Agreement

Project Contractor’s State/Government

Cash Flow Cash Flow Cash Flow

Revenue
(less)
Royalty

(less) Cost
Recovery
(equals)
Contr. State/Govt.
Profit Share
Profit Share Profit Share
(less) (less)
Opex

(less)
Tax
(less) (less)
Capex

(equals) (equals) (equals)

Net Cash Net Cash Net Cash

Flow Flow Flow
68
Fiscal Arrangements

Evolution of Malaysian PSC

• PETROLEUM DEVELOPMENT ACT (PDA) 1974:

– PETRONAS have the exclusive rights to explore for and produce

petroleum in the country

– PETRONAS is responsible for the management of the petroleum

operations while the Oil Company will be responsible to PETRONAS as
a "Contractor"

– Government or PETRONAS owns the production and shall pass to the

Oil Company only on the production that accrue to them

69
 Fiscal Arrangements

Evolution of Malaysian PSC 2012

2011 PROGRESSIVE
PROGRESSIVE
VOLUME
VOLUME
2008 RISK
RISK BASED
BASED
SERVICE
SERVICE
CONTRAC
CONTRAC
1997 To attract
T
T
HP/HT
HP/HT PSC
PSC development of
1994 To attract niche riskier potential
R/C
R/C PSC
PSC players and in brown fields
1985 To attract promote
DW/
DW/ Ultra
Ultra investments in innovation for Provide base
DW
DW PSC
PSC To attract new
1976 operational cost volume for
1985
1985 PSC
PSC
foreign exploration challenging optimization Contractor to
investments. conditions of
Pre-1976 accelerate cost
1976
1976 PSC
PSC Target for big extreme high Increase local
To promote use of recovery
players with pressure and high participation
Concession
Concession Primarily to cost-effective new
Agreement experience in temperature of and develop Progressively
Agreement attract foreign technology in the deep reservoirs
deepwater local capability better profit
Primarily to investment to exploration for
exploration, sharing to
convert the explore for oil higher risk subtle The terms offered
development & Some diversion contractor with
then existing and gas plays. are an
Concession production. in risk/reward development of
concession resources. improvement to
agreements sharing new resources
agreements Profitability-based the Standard R/C
between oil DW/UDW terms structure
into PSCs. Prod. tranche- sliding scale fiscal PSC to ensure
companies and based on water
based fiscal regime hooked onto a deep shelf
State depth
regime. profitability index projects are
Governments. production
with sliding scale commercially
tranches.
sharing of unused viable
cost.

Production Rate/Volume Based Profitability Based 70

Fiscal Arrangements
Production-Tranche and Profitability Based Comparison
Production-Tranche Based
• Gross Production is divided into 3 parts :
- Royalty : Fixed
- Cost Oil and Gas : Fixed
- Profit Oil and Gas : Fixed
• Profit Split : Variable
• Available Unused Cost is treated as Profit and
shared Accordingly.
• Profit splits are volume based and triggered by
production rates and fixed cumulative
production volume cap
Profitability Based
• Gross Production is divided into 3 parts:
- Royalty : Fixed
- Total Cost Tranche : Variable
- Total Profit Tranche : Variable
• Profit Split : Variable
• Better Profit Split in Unused Cost to Contractor
than in Available Profit.
• Profit splits are triggered by R/C Index and the
Threshold Volume, THV is variable (incremental)
to encourage development to subsequent fields.
71
Fiscal Arrangements

Production Sharing Agreement

Example: Malaysian Production Sharing Contract (R/C Terms)

• Royalty: 10.0%

• Cost Recovery & Profit Sharing:

where R/C = Revenue/Cost; TCT = Total

Cost Tranche , TPT = Total Profit Tranche,
P = PETRONAS/Govt., C =Contractor

• Petroleum Income Tax rate: 38% of taxable income

• Research Cess = 0.5% of Contractors’ Cost & Profit Oil

• Export Duty = 10% of Profit Oil

72
Fiscal Arrangements

Production Sharing Agreement

Example: Yemen Production Sharing Contract

• Royalty:
5% for production <= 50 MSTB/D
7% for production > 50 MSTB/D
10% for production > 100 MSTB/D

• Cost Oil Ceiling: 50%

• Profit Oil Sharing (Contractors’ Share)

37% for production <= 50 MSTB/D
30% for production > 50 MSTB/D
20% for production > 100 MSTB/D

• Petroleum Income Tax rate: 25% of taxable income

• Production Bonus (non-cost recoverable, non-tax deductable):

US$ 1.0 MM for production > 25 MSTB/D
US$ 2.0 MM for production > 50 MSTB/D
US$ 3.0 MM for production > 100 MSTB/D
73
TUTORIAL 5 : Fiscal Terms Computational Logic

Production Sharing Agreement

Provide the logic for Contractors’ Net Cash Flow calculations using the provided input
variables

Input Variable Computational Logic

Oil Production Revenue
Oil Price Royalty
Capex Cost Ceiling
Opex Cost Incurred
Royalty Rate Cost Bank
Cost Ceiling Rate Cost Recovered
Contr. Profit Rate Unrecovered Cost
Depreciation Rate Profit
Tax Rate Contr. Profit
Contr. Entitlment (Cash In)
Opex
Income Before Tax
Capital Allowance
Taxable Income
Tax Paid
Income After Tax
Capex
Cash Out
Net Cash Flow After Tax
74
TUTORIAL 6: Fiscal Terms Computational Logic

Production Sharing Agreement

Provide the logic for National Oil Company (NOC)’s Net Cash Flow calculations using the
provided input variables

Input Variable Computational Logic

Oil Production Revenue
Oil Price Royalty
Capex Cost Ceiling
Opex Cost Incurred
Royalty Rate Cost Bank
Cost Ceiling Rate Cost Recovered
NOC Profit Rate Unrecovered Cost
Depreciation Rate Profit
Tax Rate NOC Profit
NOC Entittlment (Cash In)
Income Before Tax
Taxable Income
Tax Paid
Income After Tax
Cash Out
Net Cash Flow After Tax

75
TUTORIAL 7 : Calculate Net Cash Flow under Production Sharing

Production Sharing Agreement

Calculate Contractors’ Net Cash Flow using the provided input

Year 1 Year 2 Year 3
Input Variable Annual Oil Production 2.0 6.0 5.0
Oil Price (US$/bbl) 20.0 Capex 30.0 20.0 -
Royalty Rate 10% Opex 10.0 10.0 10.0
Cost Ceiling Rate 50% Revenue
Contr. Profit Rate 30% Royalty
Depreciation Rate 20% Cost Ceiling
Tax Rate 38% Cost Incurred
Cost Bank
Cost Recovered
Unrecovered Cost
Profit
Contr. Profit
Contr. Entitlment (Cash In)
Opex
Income Before Tax
Capital Allowance
Taxable Income
Tax Paid
Income After Tax
Capex
Cash Out
Net Cash Flow After Tax 76
TUTORIAL 8 : Calculate Net Cash Flow under Production Sharing

Production Sharing Agreement

Calculate National Oil Company (NOC)’s Net Cash Flow using the provided input
Year 1 Year 2 Year 3
Input Variable Annual Oil Production 2.0 6.0 5.0
Oil Price (US$/bbl) 20.0 Capex 30.0 20.0 -
Royalty Rate 10% Opex 10.0 10.0 10.0
Cost Ceiling Rate 50% Revenue
NOC Profit Rate 70% Royalty
Depreciation Rate 20% Cost Ceiling
Tax Rate 38% Cost Incurred
Cost Bank
Cost Recovered
Unrecovered Cost
Profit
NOC Profit
NOC Entitlment (Cash In)
Income Before Tax
Taxable Income
Tax Paid
Income After Tax
Cash Out
Net Cash Flow After Tax

77
Fiscal Arrangements

Service Contract Agreement

Example: Revenue = $100

Cost = $ 40 Cost
Recovery
Ceiling $40
@50%
= $40 Tax
$6 $4 @40%
Contractor
Take Government
= $6 Take = $54

Govt.
$50 Profit
Share

Cost = $40
*Net Govt. Take
Government Take = $54
= 90%
Contractor Take = $ 6

77
78
Fiscal Arrangements

Service Contract Agreement

Project Contractor’s State/Government

Cash Flow Cash Flow Cash Flow

Revenue
(less) (equals)

Cost Recovery
Cost State/Govt.
Ceiling Profit Share
Remuneration

(less) (less)
Opex

(less)
Tax
(less) (less)
Capex

(equals) (equals) (equals)

Net Cash Net Cash Net Cash

Flow Flow Flow
79
Fiscal Arrangements

Service Contract Agreement

Example: Iran Service Contract

• Cost Oil Ceiling: 60%

Capital to be amortised over 6-year period for recovery

• Remuneration for contractors = remaining unused cost oil

• Petroleum Income Tax rate: 15% of taxable income

• Training bonus (non-cost recoverable, non-tax deductable):

$1.5 MM per year (from 1st production)

80
 Fiscal Arrangements

2012 Proved Oil Reserves,

Billion Barrels
1

100

10

Ireland
Mauritania
Philippines
Côte dIvoire
Ug
Turkmenistan
Indonesia
1
0 10 20 30 40 50 60 70 80 90 100
Government Take, %
Source: Proved Oil Reserves: BP Statistical Review of World Energy 2013
Government Take %: IHS PEPS, PEC internal assessment PETRONAS E&P Presence
Screening 81
 ECONOMIC ANALYSIS WORK-FLOW

Technical Inputs Economic Results

Reserves Time Value of Money
Production Economic Indicators
Capex eg. NPV, IRR
Opex
Economic Model
Net Cash Flow
Tax & Capital Allowance
Fiscal Arrangement

Economic
Assumptions
Risk &
Price
Cost Escalation
Sensitivity
Inflation Analysis
Exchange Rate

82
Economic Indicators

Examples of Profitability indicators • Economic indicators are yardsticks used to

quantify the relative attractiveness of an
investment :
Ultimate Cash Surplus 1. Establish the economic feasibility of an
Economic Life investment opportunity
Payback Period 2. Weight the RELATIVE merits on
investment opportunities
3. Determine the value for buying or selling
Maximum Cash Sink as asset
4. Assess the feasibility for project
Breakeven expansion or acceleration
Profit Investment Ratio
• Other than strategic considerations, we need
to apply APPROPRIATE profitability indicators
to support management decisions

83
Economic Indicators

A Sample of Cash Flow Profile

2500
Net Cash Flow
Cum Net Cash Flow
2000

1500 1st Prod in 2006

1000

500

0
0 0 0 0 0 0 0 1 1 1 1 1 1 1 1 1 1 2 2 2 2
20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20
-500

-1000
Development Production Abandonment

Project starts 2003 Project ends 2023

Total Investment = US$ 950 Million
84
Economic Indicators

A Sample of Cash Flow Profile

2500
Net Cash Flow
Cum Net Cash Flow
2000

1500

1000

500

0
0 0 0 0 0 0 0 1 1 1 1 1 1 1 1 1 1 2 2 2 2
20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20
-500
Maximum Cash Sink
= US$ 860 Million
-1000

• Definition: Maximum amount of cash outlay for a project

Maximum Cash Sink • Formula: MIN (Cumulative Net Cash Flow)
• Unit: Currency value
85
Economic Indicators

A Sample of Cash Flow Profile

2500
Net Cash Flow
Cum Net Cash Flow
2000

1500

1000

500

0
0 0 0 0 0 0 0 1 1 1 1 1 1 1 1 1 1 2 2 2 2
20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20
-500
Breakeven
= in year 2010
-1000

• Definition: The year when the sum of Cash Inflow equates to

Breakeven Cash Outflow, beyond which the project will fully fund itself
• Formula: Cumulative Net Cash Flow = 0
• Unit: -
86
Economic Indicators

A Sample of Cash Flow Profile

2500
Net Cash Flow
Cum Net Cash Flow
2000

1500 1st Development in 2003

1000
Payback period
500 = 7 years

0
0 0 0 0 0 0 0 1 1 1 1 1 1 1 1 1 1 2 2 2 2
20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20
-500
Breakeven in year 2010

-1000

• Definition: No of years from First Development

Payback Period Investment to achieve breakeven
• Formula: COUNT (Breakeven - 1st Development)
• Unit: Years
87
Economic Indicators

A Sample of Cash Flow Profile

2500
Net Cash Flow
Maximum Cumulative Cash
Cum Net Cash Flow
= US$ 1,911 Million
2000

1500

1000

500

0
0 0 0 0 0 0 0 1 1 1 1 1 1 1 1 01 01 02 02 02 02
20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 Economic
2 2 2 Limit2 2 2
-500 = in year 2021

-1000

• Definition: The year where Maximum Cumulative Cash realised

Economic Limit • Formula: MAX (Cumulative Net Cash Flow)
• Unit: -
88
Economic Indicators

A Sample of Cash Flow Profile

2500
Net Cash Flow
Cum Net Cash Flow
2000

1500 1st Prod in 2006

Economic Life
= 15 years
1000

500

0
0 0 0 0 0 0 0 1 1 1 1 1 1 1 1 1 1 2 2 2 2
20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20
-500
Economic Limit in 2021
-1000

• Definition: No. of years from 1st Production to achieve

Economic Life Economic Limit
• Formula: COUNT (from 1st Prod to Economic Limit)
• Unit: Years
89
Economic Indicators

A Sample of Cash Flow Profile

2500 Net Cash Flow
Cum Net Cash
Flow Ultimate Cash Surplus
2000 = US$ 1,801 Million

1500

1000

500

0
0 0 0 0 0 0 0 1 1 1 1 1 1 1 1 1 1 2 2 2 2
20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20
-500

-1000

• Definition: Cumulative Net Cash Flow at the end of project life

Ultimate Cash Surplus • Formula:S(Net Cash Flown) =Undiscounted Net Present Value
• Unit: Currency Value
90
Economic Indicators

A Sample of Cash Flow Profile

2500 Net Cash Flow
Cum Net Cash
Flow Ultimate Cash Surplus
2000 = US$ 1,801 Million

1500

1000
PIR = US$ 1,801 Million = 1.9
Total Investment US$ 950 Million
= US$ 950 Million
500

0
0 0 0 0 0 0 0 1 1 1 1 1 1 1 1 1 1 2 2 2 2
20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20
-500

-1000

Undiscounted • Definition: Amount earned for every dollar spent

Profit Investment Ratio • Formula: Undiscounted Net Present Value / Total Investment
(PIR) • Unit: Ratio
91
Valuation of these cash flow streams which are realized at different points in time
employs the time value money concept

oil and gas projects involve the investment of large sums

VA LUE
of money, often over a span of several years before any TIME NEY
O
revenue is obtained.
OF M
projects can last for twenty years or more.
a very long lead time between expenditure and resulting revenue
time has a critical bearing on the value of money.
30 years ago, 50 sen was sufficient for a primary school kid to buy a good lunch at
school
today, the same good lunch costs about RM 2.00
cater for potential opportunity loss and risk
opportunity cost - return foregone by investing in the project as opposed to alternative
opportunities available
present value analysis consistently values the money spent and received at different points
in time

92
Time Value of Money

• If you have a chance to collect $1 Million, which year do you prefer?

$1 MM $1 MM $1 MM
Now Future
1st year 6th year nth year
Uncertain More Uncertain

• What is the equivalent today’s value of the money in the future? Because of the
uncertainties, you discount the future value.

$1 MM $0.8 MM $0.5 MM
Now Future
1st year 6th year nth year
Uncertain More Uncertain

93
Time Value of Money

Future Value • “Value of $1 today is more valuable than the value of $1

in the future”.
Calculate
Profitability Discounting - opportunity loss
Indicators
- risk
Present Value
• In economic analysis, we should consistently value the
money spent and received at different time

• The discounting technique:

where; r = discount rate, n = number of years from

Future today
Value (MOD)
n : numbers of period
I : interest per period Present Value = Future Value
( 1+ r )n

Present
Value (RT) 94
Finding the Future Value - Compounding

Present Value Future Value

FV = PV x (1 + i)n

FV = Future Value
PV = Present Value
i = compound rate
n = time period
(1+i) = compounding factor
n

Example :
Cost of drilling a well in 2009 is $15 million. We expect cost to escalate at 5% p.a for the next 10
year period. If we plan to drill the well in 2013, what would be the expected cost ?

Well cost in 2013= 15 x (1 + 5%)4

= $18.2 million MOD (money of the day)

95
Through discounting, the money spent and received at different time are valued
consistently

NCF n

NPV   t

(1i)
i t
t 0

Year 2008 2009 2010 2011 2012 2013 2014 Total

Net Cash Flow (NCF) -250.0 50.0 100.0 100.0 70.0 60.0 50.0 180.0
Discount Factor @ 10%1.000 1.100 1.210 1.331 1.464 1.611 1.772

PV NCF t=0 -250.0

PV NCF t=1 45.5
PV NCF t=2 82.6
Disc
PV NCF t=3 75.1 oun
ted at 10
PV NCF t=4 47.8 %
PV NCF t=5 37.3
PV NCF t=6 28.2
Total NPV 66.5

• The project is anticipated to generate total MOD NCF of $180 million.

• However, in 2008 term it worth $67 million to the company (NPV @ 10%)
96
TUTORIAL 10 : Time Value Of Money

The forecasted Consumer Price Index is around 3% per year. Your company’s Cost
of Capital is at 10%. What is the Present Value of the following Net Cash Flow ?

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Total

Net Cash Flow -60 -92 10 163 177 117 20 336

Discount Rate @ 3%

Discounted NCF @3%

Discount Rate @ 10%

Discounted NCF @10%

98
Economic Indicators

A Sample of Net Present Value Profile

2000
NPV@0% = US$ 1,801 Million

1500
Net-Present-Value, US$ MM

1000 NPV@10% = US$ 566Million

NPV@15% = US$ 271 Million

500
NPV@23% = US$ 0 Million
NPV@40% = (US$ 197 Million)
0
0% 5% 10% 15% 20% 25% 30% 35% 40%

-500
Discount Rate, %

• Definition: Sum of discounted Net Cash Flow over project life

Net Present Value
• Formula: S (Net Cash Flown * discount factorn)
(NPV)
• Unit: Currency Value
99
Economic Indicators

A Sample of Net Present Value Profile

2000

1500
Net-Present-Value, US$ MM

1000 Internal Rate of Return

= 23%

500

NPV@23% = 0

0
0% 5% 10% 15% 20% 25% 30% 35% 40%

-500
Discount Rate, %

• Definition: Discount rate for which NPV=0

Internal Rate of Return • Formula: Discount rate where NPV=0 from NPV profile
(IRR) • Unit: Percentage

100
NPV and IRR

Both indicators apply time value money on the annual net cash flows forecast.
Net Present Value
describes the fair value of a project
indicates whether the project creates value (positive NPV) or erodes value (negative
NPV)
a project which gives NPV@10% of $50 million tells us that by investing in the project,
it will give us additional value of $50 million as compared to investing our money in
some alternative scheme which provide a return of 10%.
Internal Rate of Return
not a measure of value
a handy indicator for project screening against company hurdle rate; for example, if the
hurdle rate is 15%, any project with IRR < 15% should be excluded from the portfolio.
if the IRR of a particular project is greater than the rate of return which can be obtained
in comparable alternative investments, then the project theoretically should be
undertaken.

101
IRR and Hurdle Rate

Hurdle Rate is …
company specific
usually is a function of the company’s weighted average cost of capital (WACC)
plus the premium the company sets to cater for risks.
IRR for project should be greater than the company hurdle rate for the project to considered
economic.

‘Hurdle
Rate’ Project Value
Return Creation
f
‘Hurdle
Weighted ‘Risk Rate’
Average Cost of Premium’
Capital (WACC)
Risk
Premium
Cost of capital (funds) is a Management’s
function of prerogative to include risk
– cost of debt (interest on
premium from country and
loan)
– cost of equity (dividends
other perceived risks WACC
paid to shareholders)

102
Profit-to-Investment Ratio (PIR)

o A measure of investment efficiency i.e. amount
of present value profit per dollar of investment
i.e. Capex
o Normally, quoted on discounted basis at certain
rates, to reflect time value of money and the
pattern of Net Cash Flow
Investment opportunity may create value
for the company if it generates PIR
greater than company’s minimum
acceptable PIR

2008 2009 2010 2011 2012 2013 2014 Total

Net Cash Flow -100 -150 100 100 90 80 70 190.0
Discount Rate @ 10% 1.00 0.91 0.83 0.75 0.68 0.62 0.56
Discounted NCF @ 10% -100.0 -136.5 83.0 75.0 61.2 49.6 39.2 71.5

2008 2009 2010 2011 2012 2013 2014 Total

Capex 100 150           250.0
Discount Rate @ 10% 1.00 0.91 0.83 0.75 0.68 0.62 0.56
Discounted NCF @ 10% 100.0 136.5 0.0 0.0 0.0 0.0 0.0 236.5

PIR @ 0% = 0.76
PIR @ 10% = 0.30
103
Other indicators which could be derived from net cash flow

2500 PIR = US$ 1,801 Million = 1.9 Ultimate Cash Surplus

7 6 US$ 1,801 Million
US$ 950 Million

2000
1st Prod.
2006 4 Economic Life = 15 years
1500
Cash Flow (US$MM)

Payback
3 period
7 years
1000
1st Devt. Invest.
2003
500 5 Economic Limit in year 2021
Total Investment
US$ 950 Million

0
2003 2007 2011 2015 2019 2023

-500
Annual NCF
2 Breakeven in year 2010 Cum NCF
-1000
1 Maximum Cash Sink US$950 Million
103
TUTORIAL 11 : Calculate Economic Indicators

A project requires US$ 260 Million of total Investment, which excludes exploration Sunk
Cost of US$ 32 MM. First oil is expected to be in year 4. Below is the forecasted annual
Net cash Flow for your assessment. Calculate the economic indicators for the project life
at January Year 3.

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Total

Net Cash Flow (32) - (260) 90 80 80 70 58 86

Cum. Net Cash Flow

Discount Factor @ 10% 1.00 1.00 1.00 0.91

Discounted Net Cash Flow

Discount Factor @ 15% 1.00 1.00 1.00 0.87

Discounted Net Cash Flow

NPV NPV NPV Maximum Pay- Undisc.

IRR @0% @10% @15% Cash Sink back PIR

105
TUTORIAL 12 : Economic Indicators

Calculate the economic indicators for the previous project for look
forward Year 3. Sunk cost of US$ 32 Million in year 1 is now excluded.

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Total

Net Cash Flow - - (260) 90 80 80 70 58 118

Cum. Net Cash Flow - -

Discount Factor @ 10% 1.00 1.00 1.00 0.91

Discounted Net Cash Flow - -

Discount Factor @ 15% 1.00 1.00 1.00 0.87

Discounted Net Cash Flow - -

NPV NPV NPV Maximum Pay- Undisc.

IRR @0% @10% @15% Cash Sink back PIR

106
Economic Indicators

• Your management is considering the option to invest in Project A OR in Project

B. Which project would you recommend ? Note : Company’s WACC is 10%

Option Year 1 Year 2 Year 3 Year 4 Year 5

NCF A -100 - - - 200

NCF B -1000 350 350 350 350

107
Economic Indicators

• Your management is considering the option to invest in Project A OR in Project

B. Which project would you recommend ? Note : Company’s WACC is 10%

NPV Discounted at
IRR
Option Year 1 Year 2 Year 3 Year 4 Year 5 0% 10% 25%
NCF A -100 - - - 200 100 37 -18 20.0%
NCF B -1000 350 350 350 350 400 110 -173 15.0%

WACC of 10%
500
Option A
400 Option B
Option B
300
US$ 110 MM
Net-Present-Value

200
Option A
100 US$ 37 MM
0
-1000% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%
Observation !
-200
Option B
-300 15% IRR : Option A > Option B
But
-400
NPV@10% : Option A < Option B
-500 Option A
20%
Discount Rate, %

108
Economic Indicators

• Your management is considering the option to invest in Project A OR in Project

B. Which project would you recommend ? Note : Company’s WACC is 10%

NPV Discounted at
IRR
Option Year 1 Year 2 Year 3 Year 4 Year 5 0% 10% 25%
NCF A -100 - - - 200 100 37 -18 20.0%
NCF B -1000 350 350 350 350 400 110 -173 15.0%

( B –A) -900 350 350 350 150 300 73 -155 14.1%

WACC of 10%
500
Option A
400 Option B
Option B
300 Incr. (B -
US$ 110 MM
A)
Net-Present-Value

200
Option A
Conclusion !
100 US$ 37 MM
0 Select Option B since the
-1000% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%
incremental costs of US$
900 will result in IRR of
-200 14.1%
Option B
-300 15%

-400
-500 Option A
20%
Discount Rate, %

109
 Economic Analysis Work-flow

Technical Inputs Economic Results

Reserves Time Value of Money
Production Economic Indicators
Capex eg. NPV, IRR
Opex
Economic Model
Net Cash Flow
Tax & Capital Allowance
Fiscal Arrangement

Economic
Assumptions
Risk &
Price
Cost Escalation
Sensitivity
Inflation Analysis
Exchange Rate

110
 Risks and uncertainty in oil and gas investment

Level of Uncertainty Project Risks Technical/Operational Risks

• uncertainties in project execution • uncertainty in operating cash flow
• e.g. reservoir, facilities, schedule, budget • e.g. production, cost, price

1500
Exploration
1250

1000

750
N e t C a s h F lo w
Appraisal
500

250

Development -250
1 3 5 7 9 11 13 15 17 19 21 23 25

-500

Annua l NCF
-750
Cum NCF
-1000
Production
Ye a r

Source:
(1) EPSS, ‘Risk White Paper’, August 2001 Country Risk
• uncertainty in location
• E.g. political risk, economic risk, regulatory risk

Generally uncertainties tapers towards the production stage

111
Risk & Sensitivity Analysis

Methods of Risk Analysis

• Ad Hoc Methods
– Discount Rate Adjustment
– Capital at Risk
– Time Risk and Capital Recovery

• Sensitivity Analysis
– Analysis of One Variable
– Analysis of More than One
Variable
– Range Approach

• Probabilities (Monte Carlo)

112
Ad Hoc Methods

To increase the discount rate for capital “at risk”, or to favour a short payback period in risky
situations.
Three (3) types of commonly used are :
a. Discount Rate adjustment
 To increase the test discount rate for capital projects which are considered to be
risky. This suggest that capital invested in an uncertain project is required to yield a
higher margin of profit than capital invested safely.
b. Capital At Risk
 The amount of capital at risk (or the sunk cost) is that proportion of the initial
investment which would not be recovered in the event of the disposal of fixed
assets. Once the capital has been proportioned as “safe” or “at risk” the project can
be compared with company criteria. The decision can consequently be taken as to
whether the rate of return justifies the risk.
c. Time risk and Capital Recovery
 Certain types of risk are based on time criteria alone, namely those which lead to the
premature termination of a project i.e. political risk, the danger of nationalization or
revolution. Payback might therefore be useful criterion to include in the overall
assessment of investment projects.

113
Risk & Sensitivity Analysis

Sensitivity Analysis (Spider Plot)

• Investigates the relationships Spider Plot

IRR or NPV
between change in key project
variables and measure of value. 25

• Important variables are :

a) Production 20
Opex
b) Price
c) Capex
15
d) Opex Price Capex
Prod
• Start with “Base Case” and change
one variable at a time keeping all 10
other assumption at the Base Case 0.5 1 1.5 2 2.5 3 3.5 4 4.5
• The steeper the slope is, the more Variation ( % )

sensitive the parameter would be.

• The shaded region reflects our
confident range of variable
uncertainty that will impact the
project's IRR
114
Risk & Sensitivity Analysis

Sensitivity Analysis (Tornado Chart)

Tornado Chart
• Investigates the relationships
Oil Price 30 40
between change in key project
variables and measure of value.
Prodn 20 30
• Important variables are :
a) Production Capex 10 20
b) Price
c) Capex Opex 5 5

d) Opex 100 110 120 130 140 150 160 170 180 190 200
• Start with “Base Case” and change NPV@10%
one variable at a time keeping all
other assumption at the Base Case
• The longer the bar is, whether to the
left or right from the Base case, the
more sensitive the parameter would
be.

115
Decision Tree Analysis

• A technique to structure decision-making process.

• It consists of two (2) type of “nodes” :-
1. Decision nodes – indicated by rectangles (or diamond) branch into a
complete set of possible actions.
2. Chance nodes – indicated by circles (or rectangles) branch into all possible
results or situations.
• There are four (4) steps involved in the analysis :-
1. Draw the tree – starts with the first decision to be taken, begin at the
present, progresses in the future.
2. Assign values – normally NPV at certain discount rate, to all the “leaves”
3. Estimate the probabilities of the results.
4. Roll back the tree – evaluates at the “leaves” and works backward towards
the “trunk” of the tree.
• The value of the chance is the statistical (weighted) average of all its results
whereas the value of the decision is the optimum of the values of its action.

116
Decision Tree Analysis

Create tree from left to right according to sequence of event/decision

Solve from right to left OR

Create tree from top Solve from Bottom to Up

to bottom according
to sequence of
event/decision

117
Decision Tree Analysis

Expected Monetary Value (EMV)

• Weighs risk capital and chance of losing An Example of Decision Tree Analysis
it against potential rewards and the
EMV=10
probability of achieving that rewards discovery NPV @10% = 50
0.2
Drill
EMV=2 prospect
( Probability of Success * Net Value Gain )
0.8
EMV = Less dry NPV @10% = (10)
( Probability of Failure * Net Value Loss ) EMV=(8)

• The rule is if EMV is positive, then the Don’t drill

EMV=0
risk-weighted reward outweighs the risk-
weighted cost of failure

118
Decision Tree Analysis

Flip Point Analysis

• Indicates the breakeven probability An Example of Flip-Point Analysis

of success in order to achieve 60
positive EMV 50
EMV +ve
40
• Explains changes in probability 30
assessment would results in a

EMV
20
different recommendation
10
0
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
-10
-20
Probability of Success

119
 PART 3 & 4

• Basic Economic Modeling

• Case Study Preparation

120
 Economic Modeling – A Few Tips!
Before .. While …
• Understand business • Use headings for different
model calculation blocks.
• Summarize salient terms. • Keep formula simple, if
• Create revenue flow necessary break down to a
diagram few rows/columns
• Insert comments for cells as
• List down
required
• basis & assumptions
• Avoid
• evaluation scenario
• “cut and paste” within
• project parameters
formula range.
• using > 2 decimal places
(unless required)
After …
• “What else is missing ?”
• Cross check
• the flow diagram
• basis & assumptions
• project parameters
• Calibrate with manual
calculation.
• Rationalize output.
• Prior running new cases or
sensitivity, start with the
reference case to ensure
input and model are intact.
121
Getting Started : Information Required

Volumetrics
• SR for prospects and
corresponding probability of
exploration success
• Reserves for fields
Project Parameters
• First year of production
• Oil production profile, gas
demand forecast and matching
gas delivery rates from fields Fiscal & Economic Model
Economic Analysis & Results

Exploration Costs
• G&G costs Assumptions
• Number of wells, well cost,
and timing of exploration and
appraisal costs

Development Costs
• Development scenarios
• Development cost detailed by
fixed structure, facilities,
pipeline, etc.
• Development drilling cost
• Typical operating cost
• Phasing of each type of
development capex
General Assumptions
• Oil price, gas price,
• Cost and price escalations,
• Currency exchange rate,
• Required hurdle rate
Fiscal & Economic Modeling
• Fiscal Contract (PSC, Concession,
Service Agreement)
• Tax law
• Joint Operating Agreement
• Farm-out offer
• PCSB equity share
• Funding arrangement

122
Three (3) - Fundamental Rules !

1. “The input data must reflect the project parameters of the respective
scenario”
2. “The calculation must reflect what stated in the contract”
3. “The input and the calculation must be correctly linked”

122
 CASE STUDY
BENIN BLOCK 4
ECONOMICS MODELING

123
 Economics Basis and Results Snapshot
5 6
3

124
1 Conversion of Real Terms (RT) to Money-of-Day (MOD)

Costs (MOD) =Costs (RT) x ( 1 + esc. ) n

125
2 Profit Calculation

126
3 Cost Recovery Calculation

127
4 Costs Allocation for Carry provisions

128
5 Contractor and Government NCF Calculation

NET CASHFLOW = CASH INFLOW - CASH OUTFLOW

129
6 Profitability Indicators Calculation

2000
7 PIR 6 Ultimate Cash Surplus

Net-Present-Value, US$ MM
1500
1st Production
4Economic Life
Cash Flow (US$MM)

3 Payback period 1000 Internal Rate of Return

= 23%
5 Economic Limit 500
Total Investment

0 0 NPV@23% = 0
0% 5% 10% 15% 20% 25% 30% 35% 40%
An nu
2 Breakeven in year al NC F -500
-
1 Maximum Cash Sink Discount Rate, %

130
Thank You for
Your Attention

© 2015 PETROLIAM NASIONAL BERHAD (PETRONAS) 138