Petroleum Economics

PETROLEUM ECONOMICS

Sunday Isehunwa (Ph. D)

SPECIAL FEATURES OF MINERAL ECONOMICS

• Minerals are found only in certain favoured places. There is no question of locating a mine anywhere else except where it is found in commercial quantities.

• The minerals are exhaustible

• The minerals are found in places where they may not be needed and used.

SPECIAL FEATURES OF MINERAL ECONOMICS

• There is always a very large excess capacity built into the system. Therefore the normal laws of supply and demand, marginal costs, etc are not often readily applicable in the case of minerals.

• Very long term forecasts have to be made

SPECIAL FEATURES OF MINERAL ECONOMICS

• Mineral economics is bound up with politics very intimately.

• Mineral industries are extremely well organized in the hands of a small number of integrated firms who have considerable power in regulating supply, demand and prices. Thus normal economic mechanisms are simply not operative under these conditions in their classical forms.

ECONOMIC CHALLENGES

• Petroleum getting more difficult to find• Smaller fields• Aging facilities and staff• Harsher terrains of discovery• Environmental challenge• Unstable prices• Community issues (in developing countries)• Technology and higher business costs• Depleting reserves

ECONOMIC CHALLENGES

• Companies have tried to meet these challenges through:

• Cost reduction measures• Staff rationalization • Vertical integration• Strategic business units• Portfolio diversification

• Other measures

OIL AND GAS PRICES

• There are 5 factors that determine the price of crude oil:

• Market (Supply and Demand)• Reliability (Production rate)• Location (Transportation)• Quality (Refining cost and Yield)• Availability (Reserves)

Oil Pricing Model

• Oil Price /bbl

• = Base Price/bbl + A (API) - B (% S)

• Base price = current price for 0 API oil• A= Scale factor for API gravity• B = Markdown Factor for presence of sulphur

Marker Crudes

• A marker crude is an oil from a specified field or region which is traded in spot markets and considered a standard

Characteristics of Marker Crudes

• Perceived to represent ‘fair value’• Traded in liquid and transparent markets• Wide range of buyers and sellers• Supply is freely tradable• Adequate reserves• Production is strategically situated• Politically acceptable to producers and end users• Spot price is widely reported• Reasonably immune to manipulation

CRUDE OIL MARKETS

• There are 2 basic types of markets in crude oil:

• The ‘Wet’ or cash Market, and

• Futures market where trades are made through a formal commodities exchange for some specified future delivery date.

CRUDE OIL MARKETS

• The bulk of the world’s crude oil traded internationally never reaches an open market in the literal sense.

• They are handled within the integrated operations of the majors and in direct deals or contarct arrangements between producers and consuming governments as well as other players.

THE SPOT MARKET

• Little happens in the industry without the Spot Market, particularly the Rotterdam spot market.

• The spot Market refers to one-off or spot sales of crude oil in tanker loads. This is usually crude oil that is surplus to the requirements of direct purchasers. Companies that are short of crude also resort to the spot market to make up the balance.

THE SPOT MARKET

• However, price movements in the spot market do not necessarily reflect real market conditions as can fluctuate widely and involve relatively small amounts of crude oil on a global scale.

• During surplus, spot prices tend to fall below official prices, while they can rise steeply during peiods of shortages.

THE SPOT MARKET

• Major Players

• The major international oil companies

• Traders

• Brokers

• Independent oil companies

NET BACK PRICING

• In a netback transaction, crude oil is sold on the basis of the price that the buyers expect to receive for his final products, rather than the price set by the producer at the time of sale.

COMPONENTS OF NETBACK DEALS

• Refinery Yields

• Products Prices

• Timing

• Transportation

• Other fees and Profit Margin

MAJOR INTERNATIONAL PETROLEUM COMMODITY

MARKETS

• NYMEX (New York Mercantile Exchange)

• IPE (International Petroleum Exchange London)

• SIMEX (Singapore Mercantile Exchange)

PETROLEUM PROJECT ECONOMICS

• In any decision making process, one must account for the benefits and costs of a project

• In a typical project, the costs occur at the beginning of the project and the benefits occur over a period of time.

TASKS IN PETROLEUM PROJECT ECONOMIC ANALYSIS

• Setting an economic objective based on corporate economic criteria

• Formulate scenario for the projects• Collecting all relevant Technical and

economic data• Making Economic calculations• Making Risk Analysis• Selection of optimum development plan

COST ESTIMATING AND ECONOMIC EVALUATION

• Predicting future operating costs• Economic limits of producing wells (or plants in

downstream projects)• Field life (or project life)• Failure Analysis• Price-effect cost escalation• Risks• Funding

TIME VALUE OF MONEY

Theory of Equivalence

• When cash flows can be traded for one another in a financial world, those cash flows are considered equivalent to each other.

Economic equivalence depends upon• Interest rate• Time

PROJECT ECONOMICS

• When conducting a cost benefit analysis of any project, if the benefits are received in the future, we cannot directly compare the front cost to the future benefits unless we:

• Convert the future benefit to equivalent present benefit, or

• Convert the present cost to equivalent future cost

ECONOMIC INDICATORS

• They reduce net cash flow projection to single numbers

• Measures the relative economic attractiveness of the cash flow

• Tells us whether one investment gives a greater economic benefit than other investments

COMMON ECONOMIC INDICATORS

• Net present value (NPV)

• Internal rate of return (IRR)

• Pay back time (PB)

• Discounted profit – to investment ratio (DPIR)

• Unit technical cost (UTC)

ECONOMIC INDICATORS

NPV• Consistently the most reliable and most frequently

used in practice• Takes into account timing of future cash flow• Tells us how much an investment is better or

worse than putting money into the bank or some alternative investment

• Makes large projects more attractive than smaller ones, no indication of investment efficiency.

• Highly dependent on discount rate

ECONOMIC INDICATORS

IRR• It is the after tax return equivalent to putting an

investment in an interest bearing account.• Frequently used as an initial screening device• Tends to favour high initial earnings projects over

long-lived projects• Can produce multiple values, and ambiguous.• Could be difficult to calculate (trial and error)

ECONOMIC INDICATORS

PAYBACK (PB)• Indicates length of investment “exposure”,

or break-down point of a project.• Easy to calculate and understand• It ignores the timing or variations of cash

flow before payback• Useful as an initial indicator of the merits of

a project

ECONOMIC INDICATORS

DPIR• defined as the net cash flow of the project

per dollar of capital investment• used as quick “first look” investment

criteria• excellent for ranking projects• highly dependent on discount rate• measures investment efficiency

ECONOMIC INDICATORS

COMPARISON OF ECONOMIC INDICATORS

Desirable Criteria NPV IRR PB PIR DPIR

Takes time into account

Gives unique value

Can add or subtract

Measure money value

Depends on when project starts

Indicates size of investment

YES

YES

YES

YES

YES

NO

YES

YES

NO

NO

NO

NO

YES

YES

NO

NO

NO

NO

YES

YES

NO

NO

NO

NO

YES

YES

NO

NO

NO

NO

CASH FLOW ANALYSIS

• Cash flow is defined as cash received and the cash expanded over a defined period of time.

• Forecasts of cash flow are the foundation of almost all economic analysis carried out for investment decision-making.

BASIC PRINCIPLES OF CASH FLOW ANALYSIS

• Basic principles of cash flow analysis that are vital to the correct analysis of investment alternatives include:

• Difference between cash flow and profit• Treatment of depreciation• Way in which inflation can be incorporated• Concepts of nominal and real cash flow• Treatment of loans• Interest on loans• Loan repayments

BASIC DEFINITIONS

Capital Costs• One-time costs usually incurred at the beginning of a

project. They are usually large expenditures incurred several years before any revenue is obtained.

• Examples• Tankers• Pipelines Construction• Process facilities• Camps and Accommodations• Storage vessels

BASIC DEFINITIONS

Operating Costs

Occurs regularly and are necessary to maintain operations.

Usually expended in terms of expenditure per year or per unit production.

Examples• Field labour cost• Maintenance cost• Office overhead• It can be fixed periodic/annual amount or can be variable and

determined as a function of production rate.

Petroleum Fiscal Terms

Government Take

• In many projects worldwide, government take is over 50% of net pre-tax cash flow. It includes:

• Royalties

• Profit Sharing

• Taxes

• JV S vs PSC

CASH FLOW ANALYSIS

• Net Cash Flow

• Net cash flow = cash received – capital expenditure – operating expenditure – royalties, taxes, profit sharing.

PROFIT

• Accounting concept used in reporting company accounts or in assessing tax liability.

• Does not refer to total money flow but usually incorporates depreciation of capital costs.

• Profit = cash received – depreciated capex – opex – royalties, taxes, profit sharing, etc

CASH FLOW VS PROFIT Illustration of Difference between cash flow and profit

Description Year 1 Year 2 Year 3 Year 4 Year 5

Income ($mm)

- CAPEX ($mm)

- OPEX ($mm)

0

100

0

40

10

40

10

40

10

40

10

= Net Cash flow ($mm) -100 30 30 30 30

Description Year 1 Year 2 Year 3 Year 4 Year 5

Income ($mm)

- Depreciated CAPEX ($mm) - OPEX ($mm)

0

0

0

40

25

10

40

25

10

40

25

10

40

25

10

Profit 0 5 5 5 5

CASH FLOW VS PROFIT

Conclusion• Net cash flow gives the forecasted actual money spent and

received. It correctly represents the size and timing of cash flow.

• Profit is an Artificial Construction

• It is inappropriate for making investment decisions because it does not represent actual money flow.

• Used for annual reporting to stockbrokers and assessing tax liability.

EXAMPLE ECONOMIC CALCULATION

Capital Investment = $110,000Net Operating Income:Year Income1 $40,0002 $40,0003 $40,0004 $40,0005 $40,0006 $30,0007 $20,0008 $10,0009 $4,000

EXAMPLE ECONOMIC CALCULATION

Net Cash Recovery = ∑ Ix - P

= $264,000 - $110,000

= $154,000

EXAMPLE ECONOMIC CALCULATION

Payback Time = P/ ∑ Ix/N

= 110,000/ 264,000/9

= 3.75 Years

EXAMPLE ECONOMIC CALCULATION

Discounted Profit = NPV(I) – NPV(P)

Assuming i=9%

1ST 5 Yrs: $200,000(Fc, 9%, 5 yrs)

=$162,400

6th Yr : $30,000* Fc (1 yr)* Fsp (5 yrs)

= $30000* 0.958*0.6

= $18,281

EXAMPLE ECONOMIC CALCULATION

7th Yr : $20000* 0.958*0.596= $11,419.36

8th Yr : $10000* 0.958*0.547= $5240.26

9th Yr : $4000* 0.958*0.502= $1923.37

EXAMPLE ECONOMIC CALCULATION

NPV (I) = $199,664.29 (@9 %)

Discounted Profit = $199664.29-110000 = 89,664.29 (@ 9%)

NPV(I) @ 25% = 136,595.4 Profit =$26595.4NPV(I) @40% = 104833.2 Profit = -$5166.77IRR = 37%

ECONOMIC EVALUATION

PROJECT RISK MANAGEMENT

Why is Project Risk Management Important?

• Dilemma of a project manager:• Project costs are uncertain• Schedules are uncertain• Scope of work is often uncertain• External factors are uncertain• But the project manager must never be uncertain.

RISK AND UNCERTAINTY

• Derivation of cash flow and the measurement of economic worth are based on the assumption that investments are risk-free.

• Assessment of risk and uncertainty is important to decision making

• Analysis allows one to select the appropriate discount rates which account for risk and uncertainty.

DEFINITION OF RISK

RiskThe probability that a certain undesirable outcome will occur

UncertaintyThe range of values within which the actual value is

expected to fall

Contingency• Provision for variations to the basis of a plan or cost

estimate which are likely to occur and which cannot be specifically identified at the time the plan or estimate was prepared.

• It provides an equal chance of over run or under run.

ELEMENTS OF PROJECT RISK MANAGEMENT

• Risk Identification

• Risk Quantification

• Risk Response Development

• Risk Response Control

PROJECT RISK MANAGEMENT

How is Project Risk Management undertaken?

• Identifying risks and uncertainties• Calculating the cost of contingency• Calculating the schedule contingency• Calculating the estimate accuracy• Calculating the sensitivity of cost, schedule, or

profitability to specific risk factors• Identifying the elements of risk that contribute most to

current inconsistency • Defining a program to reduce and manage risk