All my economists say, ‘on the one hand……..on the other’. Give me a one-handed economist.
Attributed to U.S. President, Harry Truman
Generally, in an OU, different economic computer models will be available with varying degrees of sophistication depending on the application required. Simple tools (e.g. spreadsheets) may be used for early screening and ranking evaluations. Full economic evaluations for budget proposals require more comprehensive models which
fully reflect the fiscal and contractual terms applicable to the project and allow a more elaborate sensitivity analysis to be made.
Principal Steps for Economic Analysis of Projects
The principal steps for assessing the economic attractiveness of a project in EP are to determine:
1 Production Profile for Field/Reservoir
2 Capital Expenditure for Field Development
3 Operating Expenditure for Operating Field
4 Annual Net Cash Flow
5 Discounted Cash Flow
6 Cumulative Cash Flow
7 Profitability Indicators
8 Sensitivities
Step 1 – Production profile
The first step is to define an outline Field Development Plan (FDP) with the most likely production profile for the field, taking the schematic field development plan as a basis. This assessment should take into account the expected reservoir conditions, the optimum ultimate recovery from the reservoir, and the likely oil and gas conservation requirements. Also any immediate or future need for reservoir pressure maintenance, secondary recovery, or for stricter environmental requirements need to be considered.
When selecting the plateau production level, allowance should be made for any national depletion policy of the host government concerned. The production profile in our example case is shown in Figure 4.3.1
Step 2 – Capex
The outline FDP and its production profile also provides an estimate of the total capital expenditure required for the development of the field, and its phasing. The capital expenditure peak usually precedes the production peak although the two profiles may well overlap. At the earliest stage, (the first economic assessment of a venture), the
profiles will not be perfect, but attempts should be made to make them as accurate as possible. During later economic assessments, the profiles for capital expenditure and production should, of course, be refined in the light of the latest available information. The capital cost profile selected as an example is shown in Figure 4.3.2.
Step 3 – Operating expenditures
Once the capital expenditure profile has been established, the future operating costs of the project can be estimated. This is based on the Asset Reference Plan (ARP) for the development. Potential Capex/Opex trade-offs should be considered at this stage. The location, complexity, capital cost and phasing of the facilities to be installed,
together with safety and environmental factors have to be taken into consideration.
Other important aspects of operating costs in case of a field development, are, for example, the total foreseeable number and locations of producing wells (and gas or water injection wells), estimates of the future cost of lifting oil from the bottom of the wells to the surface, and of the future costs for stricter environmental requirements.
The estimate of operating costs should be refined at each subsequent economic assessment, taking account of the latest available information, in the same way as for production and capital expenditure.
Step 4 – Annual net cash flow
Using this basic information together with the fiscal and contractual terms and general economic parameters (price, inflation, exchange rates), the annual net cash flow for the project can now be calculated. This is the total net amount of cash accruing to the Company each year, after allowing for all cash outlays for the project, and payments to the government in the form of taxes and/or special contractual payments such as profit share, or profit participation, etc.
It is in essence the difference between the gross annual income from the venture and the sum of all annual expenditure.
Income
The gross income is obtained from the expected volumes of oil, natural gas and natural gas liquids production and the estimates of the respective future selling prices. A set of up-to-date Project Screening Values (reference selling prices) to be used in economic evaluations are advised by SIEP each year.
Expenditure
The expenditure takes into account the exploration and appraisal expenditure, the capital
expenditure (Capex) and future operating costs (Opex) as described above.
Note that for base case analysis, costs and expenditure are always based on a 50/50,
not a 90/10 estimate. The amount of any taxes and royalties payable to a government
must also be deducted. If royalties are taken in kind they are deducted directly from
gross production, in which case the gross income is calculated ‘net of royalty’. If royalties
are paid in cash they are included as expenditure.
Taxation payments are subject to the provisions of the tax legislation applicable to the
project and to any further agreements between the project company and the government.
Cash flow
The net cash flow is obtained by deducting all expenses, taxes and contributions due
to the government (giving due regard to the timing of such payments) from the gross
income estimated for the venture. The total net cash flow calculated in this manner
forms the basis for further economic analysis of the project. A graphic presentation of
a cash flow is given in Figure 4.3.3.
Step 5 – Discounted cash flows
The net annual cash flow in Money-of-the-Day (MOD) terms is discounted in two phases.
First, the MOD cash flow is converted into a cash flow expressed in money with a
constant value, that is, a ‘real terms’ cash flow, by using an assumed inflation factor.
Secondly, the annual real terms cash flow is discounted further using a discount factor
advised in the SIEP Project Screening Criteria to test the economic acceptability of the
project. The discount rate should be sufficiently high to recover the basic cost of funds,
plus a premium to provide a buffer profitability erosion (represented by the gap between
the aggregate cash flow of investment proposals and the actual total upstream cash flow.
The economic evaluation should give the net present value of the project cash flow at the
0, 8, 12 and 15% screening rates, and a range of Project Screening Values (PSVs) as
periodically advised by SIEP.
Step 6 – Cumulative cash flows
The discounted real terms annual cash flow, (as shown in figure 4.3.4), summarises the economic impact of a project on the Company on a year by year basis. Another useful tool for comparison purposes is the cumulative cash flow, which is the progressive sum of the annual cash flows.
The discount rate at which the present value cash surplus of a project equals zero is called the projects earning power (or internal rate of return). Figure 4.3.5 shows cumulative cash flow curves where the annual real terms net cash flow has been discounted at zero (undiscounted), at the cost of funds and at the screening rate.
Step 7 – Profitability yardsticks
The profitability yardsticks derived from the cumulative cash flows and most frequently used in practice are:
• discounted ultimate cash surplus (= net present value) at different PSVs and discount rates
• pay-out time
• exposure, or cash-sink level
• ultimate cash surplus in real terms
• earning power
• Value Investment Ratio (VIR, or Profitability Index PI) =NPV/PV Capex discounted at the cost of capital
• exposure (depth of the cash sink) the cash sink)
• break-even price (the oil price required to yield x% real terms earning power after tax to the investor is called the break-even price at x%)
• present value unit technical costs (at x%) = Capex + Opex discounted at x% ÷ production discounted at x%
For a project to be economically acceptable, the earning power should equal or exceed the project screening rate and a certain Value/Investment Ratio (VIR) is needed, dependent on project type.
Step 8 – Sensitivities
In a sensitivity analysis, each input parameter of the cash flow is varied in turn around its base case value in order to judge the impact of the variations resulting from ‘what if ’? questions. Examples of sensitivity analyses are to calculate for a 90/10 Capex estimate or for Opex +25%. Others might be to calculate for the effect of delaying production by a year, or for a ±20% variation in production rates and recovery.
The results of the sensitivity analysis can be graphically represented in a ‘spider diagram. In such diagrams, the required profitability indicator is plotted against the percentage change for each input parameter in turn. A spider diagram can be enhanced by marking the range within which the various input parameters are expected to vary, and then joining these points to give an envelope.
