Petroleum Economics Part2

8/2/2019 Petroleum Economics Part2

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Petroleum EconomicsElias Abllah

Course Outcome• Describe the underlying concept of key economic indicators

such as maximum cash sink, payout time, Net Present Value(NPV), Internal Rate of Return (IRR)

• Identify the various types of Fiscal Arrangements and itscomputational logic

• Develop basic economic models for E&P project economicevaluations.• Identify risk factor and impact on the project economics.

Basic Economic

Learning Outcome• Basic Economic• Time Value of Money• Inflow, Outflow and Net Cash Flow• Inflation & Cost Escalation

• Tax & Capital Allowance

What Does Economics Mean?

A social science that studies how individuals,governments, firms and nations make choices

on allocating scarce resources to satisfy theirunlimited wants .Economics can generally be broken down into:

macroeconomics, which concentrates on thebehavior of the aggregate economy;microeconomics, which focuses on individualconsumers

investopedia

Quiz• Question 1

Who is considered to be the "father of modern economics"?

A) Karl Marx

C) Adam SmithD) Barack Obama



Answer• "Adam Smith (1723 - 1790), the "father of modern economics" and author of the famousbook "An Inquiry into the Nature and Causes of the Wealth of Nations", spawned the discipline

of economics by trying to understand whysome nations prospered while others laggedbehind in poverty"

Question 2• The tension between limited resources and

unlimited wants and needs, is referred to as?

A) ElasticityB) Market Economy

D) ScarcityE) None of the above

Answer• "Scarcity refers to the tension between ourlimited resources and our unlimited wants andneeds. For an individual, resources includetime, money and skill. For a country, limitedresources include natural resources, capital,labor force and technology

Question 3• What are the two primary branches of study

within economics?

A) Macroeconomics and NanoeconomicsB) Nanoeconomics and Intra-economics

D) Macroeconomics and MicroeconomicsE) Intra-economics and Microeconomics

Answer"Macroeconomics looks at the total output of a nationand the way the nation allocates its limited resourcesof land, labor and capital in an attempt to maximizeproduction levels and promote trade and growth for

future generationsï

Microeconomics looks into similar issues but on thelevel of the individual people and firms within theeconomy. It tends to be more scientific in its approach,and studies the parts that make up the wholeeconomy. Analyzing certain aspects of humanbehavior, microeconomics shows us how individualsand firms respond to changes in price and why theydemand what they do at particular price levels."

Question 6

• The value of the next best alternativeforegone by making another decision isknown as?

A Sto loss B) Opportunity costC) UtilityD) ElasticityE) Comparative Advantage



AnswerOpportunity cost is the value of what is foregonein order to have something else. This value isunique for each individual. You may, for instance,forgo ice cream in order to have an extra helpingof mashed potatoes. For you, the mashed

otatoes have a reater value than dessert. Butyou can always change your mind in the futurebecause there may be some instances when themashed potatoes are just not as attractive as theice cream. The opportunity cost of an individual'sdecisions, therefore, is determined by his or herneeds, wants, time and resources (income)."

Question 9• Marginal utility will usually __________ with

each additional increase in consumption of agood.

A) Increase

C) Remain unchangedD) Move inversely to the invisible handE) None of the above

Answer"Although total utility usually increases as moreof a good is consumed, marginal utility usuallydecreases with each additional increase in theconsumption of a good. This decreasedemonstrates the law of diminishing marginalutility.

Because there is a certain threshold of satisfaction, the consumer will no longer receivethe same pleasure from consumption once thatthreshold is crossed. In other words, total utility

will increase at a slower pace as an individualincreases the quantity consumed."

What Does Time Value of Money (TVM) Mean?

The idea that money available at the presenttime is worth more than the same amount inthe future due to its potential earningcapacity. This core principle of finance holdsthat, provided money can earn interest, anyamount of money is worth more the sooner itis received.

Also referred to as "present discountedvalue".

What Does Inflation Mean?

The rate at which the general level of prices for goodsand services is rising, and, subsequently, purchasing

power is falling. Central banks attempt to stop severeinflation, along with severe deflation, in an attempt tokeep the excessive growth of prices to a minimum

As inflation rises, every dollar will buy a smallerpercentage of a good. For example, if the inflation rateis 2%, then a $1 pack of gum will cost $1.02 in a year.

Most countries' central banks will try to sustain aninflation rate of 2-3%

What Does Deflation Mean?A general decline in prices, often caused by areduction in the supply of money or credit. Deflationcan be caused also by a decrease in government,personal or investment spending.

The opposite of inflation, deflation has the side effectof increased unemployment since there is a lowerlevel of demand in the economy, which can lead to aneconomic depression. Central banks attempt to stopsevere deflation, along with severe inflation, in anattempt to keep the excessive drop in prices to aminimum.

The decline in prices of assets, is often known as AssetDeflation



What Does Consumer Price Index - CPI Mean?A measure that examines the weighted averageof prices of a basket of consumer goods andservices, such as transportation, foodand medical care.The CPI is calculated by taking price changes for

and averaging them; the goods are weightedaccording to their importance. Changes in CPI areused to assess price changes associated with thecost of living.Sometimes referred to as "headline inflation

MOD vs RT• Money of the Day (MOD), also known as "Current Dollar", "As Spent

Dollar", "Escalated Dollar". MOD Dollar is also used in budgeting purposes.The actual economic calculation is carried out in MOD Dollars.

• Real Term Dollar (RT), is the "Constant Dollar” in discussing about income.Reference year must be specified such as RT 2002, RT 2003, etc. In

economic analysis, RT Dollars is used to report profitability.

• Converting RT to MOD:

where; i = escalation rate, n = number of years from today

Value (MOD) t+ n = Value (RT) t * ( 1+ i )n

Value (RT)

Value (MOD)

n: numbersofperiodI : interestper perriod

INFLATION & ESCALATIONS

Your engineering department provided the cost estimate for acompressor at US$ 20.0 Million (RT 2006) and it will be requiredin year 2012. The cost is expected to escalate at 3% per year.

What will be the compressor costs by then?

Exercise


Cost (RT)2006= US$ 20.0 Milliont = 2006,

Your engineering department provided the cost estimate for acompressor at US$ 20.0 Million (RT 2006) and it will be required in year2012. The cost is expected to escalate at 3% per year. What will be thecompressor costs by then?

SUGGEANSWE

Value (MOD)

n = - = ,i = 3%,

Cost (MOD)2012 = ?

Cost (MOD) t+n = Cost (RT)t * ( 1+ i )n

Cost (MOD)2011 = US$ 20.0 Million * ( 1+3%)6

= US$ 20.0 Million * 1.194= US$ 23.9 Million

Value (RT)



INFLATION & ESCALATIONSFor the following data input;1) Escalate the projected costs at 3% pa2) Calculate the Unit Operating Cost, Unit Development Cost and

the Unit Technical Cost, both in RT and MOD units

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

Annual Product’n 15.0 12.8 10.8 9.2 7.8 6.7 62.3

RT Capex 25.0 100.0 75.0 200.0

RT Opex 10.0 10.0 10.0 10.0 10.0 10.0 60.0

Escalation factor

MOD Capex

MOD Opex

• RT U ni t D ev el op me nt C os t ( UD C) = U S$ / BB L

• RT Unit Operating Cost (UOC) = US$ /BBL

• R T Unit Technical C ost (UTC) = U S$ /BBL

• MOD Uni t Development Cost (UDC) = US$ /BBL

• MOD Unit Operating Cost (UOC) = US$ /BBL

• M OD U ni t Tec hn ic al C os t ( UT C) = U S$ /B BL


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

Annual Product’n 15.0 12.8 10.8 9.2 7.8 6.7 62.3

RT Capex 25.0 100.0 75.0 200.0

For the following data input;1) Escalate the projected costs at 3% pa2) Calculate the Unit Operating Cost, Unit Development Cost and

the Unit Technical Cost, both in RT and MOD units

SUGGESTANSWER

. . . . . . .

Escalation factor 1.00 1.03 1.06 1.09 1.13 1.16 1.19 1.23

MOD Capex 25.0 103.0 79.6 207. 6

MOD Opex 10.6 10.9 11.3 11.6 11.9 12.3 68.6

• RT Uni t Development Cost (UDC) = US$ 3 .21 /BBL

• RT Unit Operating Cost (UOC) = US$ 0.96 /BBL

• RT Un it Te chn ic al Co st (U TC ) = US $ 4 .1 7 / BB L

• MOD Unit Development Cost (UDC) = US$ 3.33 /BBL

• MOD Unit Operating Cost (UOC) = US$ 1.10 /BBL

• M O D U ni t Te chn ic al C os t ( UT C) = U S$ 4 .4 3 / BBL

CONCEPTS OF CASH FLOW

NET CASHFLOW = CASH INFLOW - CASH OUTFLOW

• Capital expenditure (Capex):

–eg. p latforms, facilities, wells

• Fiscal income:

–eg. sale of oil and gas(+) (-)

Examples of Cash Inflow Examples of Cash Outflow

–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

• Operating income:

–eg. tariff received

• Other income:

–eg. premium received

NET CASH FLOW(1) = C AS H I NF LO W - C AS H O UT FL OW

= R ev en ue - ( Ro ya lt y + Ta x + Ca pe x + Op ex )

= Rev en ue - Roy alt y - O pe x - Tax - C ap ex

= I nc om e B ef or e Tax - Tax - C ap ex

= I nc om e A ft er Ta x - Ca pe x


Note:(1)Examplefrom aRoyalty-Tax fiscalregime

Cash In

Royalty

Opex

Tax

Capex

Cash Out

Net Cash Flow After Tax

Cash Flow Model versus Financial (Accounting) Model


TOTAL CAPEX4

$10,000$10,000$10,000$10,000 $10,000• Net Cash Flow Model simulates

actual flow of cash for each year.

,

1/5Cost$8,000

$10,000$10,000$10,000$10,000 $10,000

1/5Cost$8,000

1/5Cost$8,000

1/5Cost$8,000

1/5Cost$8,000

• Financial Model depreciates theasset over the assumed life of theasset.

• This result in a different profitpicture.

s h F l o w


Net CashSurplus

Net CashDeficit

Sample of A Field Life Cycle Project

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 C a

Royalty & TaxesSurplusOpexDevelopment CapexExploration Capex

(-) Detailed Design(-) Construction/Fabrication(-) Hook-up/Commissioning(-) Development Drilling

DEVELOPMENT PERIOD

(+) PSC revenues (cost oil, profit oil)(-) Opex(-) Development Drilling(-) PSC costs

PRODUCTION PERIOD

(-) G&G studies(-) Seismic(-) Exploration Drilling

EXPLORATION PERIOD



• Tax Payable

= Tax Rate * Taxable Income

• Taxable Income

= Income -Expenses – Capital Allowance

(less)

TAX & CAPITAL ALLOWANCE

Income

Expenses

(less)

IncomeBefore Tax

(equals)

• Capital Allowance:

– r i i n l l i n in fr m 1 st r i n RCapital Allowance

(less)

Income

Expenses

(less)

Income

Before Tax

(equals)

Capital Allowance

Tax Paid

(less)

Taxable Income

(equals)

IncomeAfter Tax

(equals)

– i i i i i

1st year of investment incurred (whichever later)

– rate varies with types of capital; investment in high risk

areas or in Secondary/Tertiary recovery will entitle for

higher depreciation rate (government incentive)

– Intangible Capex, such as portion of development

drilling (circa 80%), can be expensed off

Tax Paid

(less)

Taxable Income

(equals)

IncomeAfter Tax

(equals)


• 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




Example : Capexto 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

Straight Line Method

Capex to be Depreciated 100

Capital Allowance 25 25 25 25 100


Example : Capex to be depreciated based on 25% of the non-depreciated balance, First Productionin Year 2



Capex 100

Declining Balance Method

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.


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



Reserves @ 1 st January 40 36 26 16 7

Depletion/Unit of Production Method

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


25 25 25 2525

31

25 2530

40

n c e

Straight Line Declining Balance Depletion

• Straight Line method allow constant CCA claim compared to Declining Balance

and Depletion/Unit of Production methods

19

14

1110

22

18

0

10

20

Year 1 Year 2 Year 3 Year 4 Year 5

C a p

i t a l A l l o w a

TAX & CAPITAL ALLOWANCE• CAPEX and OPEX are treated differently• OPEX is treated more favorably that can be claim as an expense

immediately• CAPEX is claimed over the life of the asset or depending on

declining method used• The benefit of capital allowance is diminishes as of results of

delay


Capital Allowance: Straight Line Method

Exercise : Capex to be depreciated at 25% p.a. using STRAIGHT LINE method,First Production in Year 2



Capex 20 100 80


Capital Allowance (Year 1)






Total Capital Allowance




Capital Allowance: Straight Line Method

Exercise : Capex to be depreciated at 25% p.a. using STRAIGHT LINE method,First Production in Year 2



Capex 20 100 80

SUGGESTEDANSWER


Capital Allowance (Year 1) 5 5 5 5 20






Total Capital Allowance 30 50 50 50 20 200


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)

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


Tax Deductible

Revenue –Cash In 100.0 US$ MM

(less) Royalty (30.0) US$ MM

(less) Bonus (10.0) US$ MM

Revenue – Cash In 100.0 US$ MM

(less) Royalty (30.0) US$ MM

Income Before Tax 70.0 US$ MM

Tax Creditable

Income Before Tax 60.0 US$ MM

(less) Capital Allowance (10.0) US$ MM

Taxable Income 50.0 US$ MM

Tax Payable @ 38% (19.0) US$ MM

(less) Tax Paid (19.0) US$ MM

Income After Tax 41.0 US$ MM

(less) Capital Allowance (10.0) US$ MM

Taxable Income 60.0 US$ MM

Tax Payable @ 38% (22.8) US$ MM

(less) Bonus (10.0) US$ MM

(less) Tax Paid (12.8) US$ MM

Income After Tax 57.2 US$ MM

Petroleum Economics Part2

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