12.

Economic analysis
and decision criteria
what engineers must know!

Cash flow analysis Decision criteria

Inflation and deflation Uncertainty and risk

Income and commercial Stochastic analysis and

framework decision trees

Time value of money

 Commercial - Economic Analysis

Investment analysis is used to evaluate the

profitability of different projects:
Is it profitable to drill exploration well X?
Is it profitable to develop field Y?
How much is asset Z worth?
Is it cheaper to own or to lease?

The main decision criterion is usually maximize

net present value (NPV) after tax
Acquisition
Exploration and appraisal
Cost categories
Planning
Project development phases
Execution - CAPEX

Production - OPEX

Abandonment
Final investment decision

Acquisition can take place at

any time, but at different cost

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

Aquisition cost Exploration cost CAPEX Operational CAPEX OPEX Abandonment Production Extensions, revisions, IOR
 Capital expenditure - CAPEX
This category includes all costs related to execution of the field
development project; from final investment decision.

The costs are related to engineering, procurement, construction,

installation and completion of production facilities (Facilities
Capex), and drilling and completion of wells (Well Capex).

Most of the costs occur before start of production, but some

costs, such as drilling of some of the wells may occur after start
of production.

Investments that occur in the production phase (de-

bottlenecking, modifications, IOR wells, other IOR initiatives etc)
are referred to as Operational Capex.
 Operating expenditure - OPEX
This category includes all costs related to production and
maintenance operation; from start of production to end of production.
Some costs related to preparation for operation occur in the period
just before the final investment decision.

The costs are related to operation and maintenance of facilities and

wells, materials, logistics, on-shore support and administration and
tariffs related to transport of products and other services.

Tariffs
Some operating costs like transportation of oil and/or gas through
facilities owned by others are proportional to the through-put. Such
costs are called tariffs.

A tariff is defined in the same units as product price (i.e. USD/bbl or

NOK/Sm3) and can therefore be seen as a reduction in price obtained
at the field. Tariffs are also paid for processing and treatment of oil
and gas in facilities with other owners.
 Cash Flow
Definition

Every project comprises cash coming in and cash being

paid out Cash Flow

Cash flow in an oil project consists of:

Cash flow analysis

Income (production * price) 3000

2500

- Capital Expenditure (CAPEX)

2000

1500

1000

- Operating Expenditure (OPEX) 500

-500

- Tax paid -1000

-1500

= Cash flow after tax (Profit) -2000

1 2 3 4 5 6 7 8

Revenue
9 10 11 12 13 14 15 16 17 18 19 20 21 22

CAPEX OPEX TAX

 Cash flow analyses
Revenue Opex Capex Tax = Cash flow after tax

Cash flow analysis

3000

2500

2000

1500

1000

500

-500

-1000

-1500

-2000
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22

Revenue CAPEX OPEX TAX

 Cash flows
1 3
Cash flows Net cash flow after tax

40000 40000

30000 30000

20000 20000
10000 10000
0 0
-10000 -10000
-20000 -20000
-30000 -30000

Revenue CAPEX OPEX TAX Net cash flow after tax

2 4
Net cash flow before tax Accumulated net cash flow after tax

40000 50000
30000 40000
20000 30000
10000 20000
0 10000
-10000 0
-20000 -10000
-30000 -20000

Net cash flow before tax Accumulated

 12. Economic analysis
and decision criteria

Cash flow analysis Decision criteria

Inflation and deflation Uncertainty and risk

Income and commercial Stochastic analysis and

framework decision trees

Time value of money

 Inflation/deflation
This is about how much services and goods you get for a given
amount of money from one year to another.

We have inflation when the amount of goods you get for a given
amount of money is reduced as times goes by. This is the normal
situation.

Deflation is the opposite and seldom happens, and do not continue for
along time.
Inflation rates around the world in
2013
Nominal versus Real values

Nominal value: "the observed price/value

The actual amount received at the time of receipt

Real value: "purchasing power" of money

The value in todays terms of the amount received

2014: Today: 2016 2018:

3.5 mill. NOK nominal 4 mill. NOK nominal 4.4 mill. NOK nominal
4 mill.NOK2015 real 4 mill.NOK2015 real 4 mill.NOK2015 real
 Real and Nominal value
Real $: real value (buying power)
Nominal $: facial value

Net Cash Flow

1500

1000

500

-500

-1000
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19

real nominal

Real $ = Nominal $ / Price index

 Real and Nominal value
what do we use?

Real Nominal Real

Planning Execution History

Sanction

According to common practice cost estimates in the planning phase are

prepared in real money

After project sanction the cost estimate is converted to nominal money for cost
control purposes

For later comparison with other projects, for bench-marking and other
analyses, the experienced costs are converted to real money
 12. Economic analysis
and decision criteria

Cash flow analysis Decision criteria

Inflation and deflation Uncertainty and risk

Income and commercial Stochastic analysis and

framework decision trees

Time value of money

 Commercial framework
Petroleum Agreements
Government grants - exclusive
rights to explore.

Operations financed by licence

holder.

Total production disposed of by

Leases, permits, licence holder.
Licences concessions Royalty and tax paid to government.

State participation sometimes

obligatory.

Legislated Fiscal Systems

Petroleum agreements

Negotiated Fiscal Systems Production Rights obtained through contract with

sharing government or national oil company
contracts / (NOC).
agreements
Operations financed by contractor.

Contracts Production shared with government

and NOC (share may include tax)
in PSC/PSA. Fee in cash in Service
Service Contract (pure = flat fee; profit= risk)
Contracts Cost recovery out of cost oil.
 Example
Tax calculation principles Norwegian system

Volumes

Operating income
- Operating expenses Prices
- Linear depreciation for investments (6 years)
- Exploration expenses
OPEX
- CO2 tax and area fee
- Net financial costs
= Corporation tax base (tax rate: 28%) CAPEX
- Uplift
=Special tax base (tax rate: 50%)
Taxes

Risk
Contractor PSA Government
$ 100/bbl

Royalty 10% $ 10,00

$ 90 remaining

$ 30 Cost recovery
33,3%

$ 60 remaining

Profit oil split $ 36

$ 24
40% / 60%

-$ 6 Tax $6
25%

$ 48 Gross revenue $ 52

$ 18 Net cash flow $ 52

26% Take 74%

 12. Economic analysis
and decision criteria

Cash flow analysis Decision criteria

Inflation and deflation Uncertainty and risk

Income and commercial Stochastic analysis and

framework decision trees

Time value of money

 What is time value?
You have just finished a project and are to be paid. You get two payment
options:
$1.0 mill now, or $1.2 mill in one year from now.
What will you choose?

Some considerations:
How much interest can I obtain from $1.0 mill in one year?
How much do I really need the money now?
Will I really get the money in one year from now?

Where is the breaking point? What is the critical interest rate for you?

Now In one year

$1.0 mill $1.0 mill
$1.0 mill $1.03 mill
$1.0 mill $1.05 mill
$1.0 mill $1.10 mill ?
$1.0 mill $1.50 mill
Present value (Fo) and future value (Fn)
1) The value in year 0 is F0. What is then the value in year n?
2) The value in year n is Fn. What is then the value in year 0?

2,0
1,8
1,6
1,4
1,2
F(n)

1,0
0,8
0,6
0,4
0,2
0,0
0 1 2 3 4 5 6 7 8 9
Year (n)
r (n)

F1 = (1+r) F0 , F2 = (1+r)2 F0 , Fn = (1+r)n F0

Present value: PV = F0 = Fn / (1+r)n

r = discount rate
 Cash flows
1 3
Cash flows Net cash flow after tax

40000 40000

30000 30000

20000 20000
10000 10000
0 0
-10000 -10000
-20000 -20000
-30000 -30000

Revenue CAPEX OPEX TAX Net cash flow after tax

2 4
Net cash flow before tax Accumulated net cash flow after tax

40000 50000
30000 40000
20000 30000
10000 20000
0 10000
-10000 0
-20000 -10000
-30000 -20000

Net cash flow before tax Accumulated

 Discounted Cash flows 10%
Cash flows Net cash flow after tax

25000 40000
20000 30000
15000
20000
10000
5000 10000
0 0
-5000
-10000
-10000
-15000 -20000
-20000 -30000

Revenue CAPEX OPEX TAX Net cash flow after tax

Net cash flow before tax Accumulated net cash flow after tax

40000 50000

30000 40000

20000 30000

10000 20000

0 10000
-10000 0

-20000 -10000

-30000 -20000

Net cash flow before tax Accumulated

 50000
100000
150000
200000
250000
300000

0
Undiscounted

Discounted
Revenue

Undiscounted

Discounted
Capex

Undiscounted
Opex

Discounted

Undiscounted
Tax

Discounted
Accumulated Cash flows
 Discounting and Present Value
Net Cash Flow

1500

Cash flow Fn
1000

=
500
(1 + rate) years (1 + r)n
0

-500

-1000
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19

undiscounted discounted (10%) Net Present value

4000
3500

N Fn

3000

PV = 2500

n=0 (1 + r)n 2000

1500
1000
500
0

-500
0 5 10 15 20 25 30 35
Discount rate
 Nominal, real and discounted NOK
600

400

200

-200

-400

-600 Assumed inflation: 2,5 % per year

-800 Discount rate: 7 % per year
-1000

-1200
0 1 2 3 4 5 6 7 8 9 10

NOK - nominal NOK - real NOK - discounted/real

Example: We invest 1000 NOK each year for 3 years and get back 500
NOK (nominal) in each of the following 8 years

The sum of the cash flow is then: Antatt inflasjon: 2,5 % pr r

1000 NOK (nominal) Diskonteringsrente: 7 % pr r
or 485 NOK (real with year 0 as reference)
or -499 NOK (discounted real with year 0 as reference) = NPV
 EXAMPLE: NET PRESENT VALUE
Oil price 100 USD/bbl Tariff 5 USD/bbl
Discount rate 10 percent NPV 8245 mill.USD

Capex Capex Opex Tariff Income Net Present Accum Production

facilities wells cash flow Discount value PV oil
year mill.USD mill.USD mill.USD mill.USD mill.USD mill.USD factor mill.USD mill.USD mill.bbl
1 2000 0 0 0 0 -2000 0,909 -1818 -1818 0
2 3000 0 0 0 0 -3000 0,826 -2479 -4298 0
3 2500 500 0 0 0 -3000 0,751 -2254 -6551 0
4 500 200 100 2008 1207 0,683 824 -5727 20
5 500 200 201 4015 3114 0,621 1934 -3793 40
6 500 200 258 5163 4204 0,564 2373 -1420 52
7 200 258 5163 4704 0,513 2414 994 52
8 200 250 4991 4541 0,467 2118 3112 50
9 200 200 3992 3593 0,424 1524 4636 40
10 200 160 3194 2834 0,386 1093 5729 32
11 200 128 2555 2227 0,350 781 6510 26
12 200 102 2044 1742 0,319 555 7065 20
13 200 82 1635 1354 0,290 392 7457 16
14 200 65 1308 1043 0,263 275 7731 13
15 200 52 1047 794 0,239 190 7921 10
16 200 42 837 595 0,218 130 8051 8
17 200 33 670 436 0,198 86 8137 7
18 200 27 536 309 0,180 56 8193 5
19 200 21 429 207 0,164 34 8227 4
20 200 17 343 126 0,149 19 8245 3
SUM 7500 2000 3400 1996 39928 25032 8245 399
PV 6176 1310 1205 891 17828 8245 178
 Comparison of two loans
120000 Serial loan
100000 Loan NOK 1000000
80000 Interest 5%
60000 Pay-back time 20 years
40000 Sum installment NOK 1000000
20000 Sum interest NOK 525000
0 Sum payments NOK 1525000
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Present value NOK 1000000
instalment interest

120000
Annuity loan
100000
Loan NOK 1000000
80000
Interest 5%
60000
Pay-back time 20 years
40000
Sum installment NOK 1000000
20000
Sum interest NOK 604852
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Sum payments NOK 1604852
Present value NOK 1000000
instalment interest
 Annuities and day-rates
An annuity is a series of equal payments or receipts that occur
at evenly spaced intervals. Leases and rental payments are
examples. The payments or receipts occur at the end of each
period for an ordinary annuity.

The Present Value of an ordinary annuity is the value of a

stream of expected or promised future payments that have been
discounted to a single equivalent value today. It is extremely
useful for comparing two separate cash flows that differ in some
way.

An annuity can be seen as the lease payment for, equipment,

vessels etc.
 Annuities and day-rates
If the initial cost of a mobile offshore drilling unit (MODU) is C, it may be
leased for an annual cost equal to A. The present value of all annual
payments (A) is equal to the initial cost (C).

The annuity can be calculated from the following relation:

C = A[1-(1+r)-n]/r , or A = k C, where k is the annuity factor

Where n is the number of payments and r is the corresponding discount

rate.

Example: Cost of MODU, C = 600 mill.USD;

n = 20 years and r = 8%.

Then A = 61.11 mill. USD/year,

corresponding to 167 428 USD/day (day-rate)
 Annuity factor and day-rate
0,35 90000
Capex = 100 mill.USD
80000
0,30
70000
0,25
60000

Day rate (USD/day)

0,20 50000

0,15 40000

30000
0,10
20000
0,05
10000

0,00 0
0 5 10 15 0 5 10 15
Interest rate, percent Interest rate, percent

n- years 5 10 15 20 25 n- years 5 10 15 20 25
 12. Economic analysis
and decision criteria

Cash flow analysis Decision criteria

Inflation and deflation Uncertainty and risk

Income and commercial Stochastic analysis and

framework decision trees

Time value of money

 Decision criteria
Investment decisions are very important to a business. They tend to involve large sums of
money and their impact on the survival and prosperity of the business can be profound.

Once an investment decision has been made, and the funds committed, it is often difficult to
abandon the project without significant losses being incurred.

It is important that investment proposals are properly evaluated before a final decision is made.
Some methods for evaluating investment proposals are:

Net Present Value (NPV)

Internal Rate of Return (IRR)
Profitability Index (PI)
Break-Even-Price (BEP)
Payback Time (PT)

The NPV method discounts the future cash flows associated with the investment project using
an appropriate discount rate:
NPV is an important decision criteria and the project can be accepted if NPV is positive
The other evaluations criteria will also be used for evaluation of robustness and ranking
between projects
 NPV = Net Present Value of a project

NPV = PV(price x volume) - PV(Capex) PV(Opex) PV(tax)

PV means Present Value of.

Net Present Value = Expected future income and costs in todays value
 The implication of NPV
NPV is an indicator of how much value an investment or project adds to
the company

NPV gives a consistent calculation method for different projects

Use the same economic assumptions, e.g. prices for oil and gas
Different projects can be assessed on a comparable basis

With a particular project, if the net cash flow is a positive value, the project
is in the status of discounted cash inflow in the time of t

If the net cash flow is a negative value, the project is in the status of
discounted cash outflow in the time of t

Appropriately risked projects with a positive NPV could be accepted

This does not necessarily mean that they should be undertaken since
NPV at the cost of capital may not account for opportunity cost, i.e.
comparison with other available investments
 Life Cycle Costs - LCC

CAPEX

Operation

Production OPEX LCC

Facilities

Maintenance

Down - time Cost of deferred

production

Capital Costs (CAPEX)

Operating Cost (OPEX)
Cost of Deferred Production
Production profiles versus regularity

Production profiles (total production: 60 mill.Sm3)

10

8
Production (mill. Sm3)

7
regularity

6 100 %
95 %
5
90 %
4 85 %
3

0
1

11
2

10

12

13

14

15

16

17
Year
Value of production versus regularity
Example with different discount rates

Discounte d Value of Production versus Re gula rity

Discounted Value of Production (mrd.NOK)

27
26
rate
25
10 %
24
23 8 %

22 6 %
21
20
19
10 0 95 90 85
Regularity (availability) in percent
 NPV and Internal Rate of Return (IRR)
Net Cash Flow

1500

Cash flow Fn
1000

=
500
(1 + rate) years (1 + r)n
0

-500

-1000
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19

undiscounted discounted (10%) Net Present value

4000
3500
T
Fn
NPV =
3000

2500
Internal Rate of Return
n=0 (1 + r)n 2000
1500
1000
500
The IRR of a project is the discount rate that 0
results in NPV=0 -500
IRR gives an indication of the return achieved 0 5 10 15 20 25 30 35
over the life of the project Discount rate
Internal rate of return (IRR)
Real Rate of Return (RRoR)
(internrente)

p = 16USD/bbl

RRoR
NPV
Profitability Index (PI)
(nverdiindeks)

PI = NPV / PV(Capex)

NPV = net present value of project

PV(Capex) = present value of Capex
Break even price B-E-P
(nullpunktspris)

i = 8%

B-E-P
NPV
Maximum exposure and pay-back time
Cash flow

8000
6000
4000
2000
0
-2000
-4000
-6000
0 2 4 6 8 10 12 14 16 18 20 22

Pay-back time Accumulated NPV

6000

3000

-3000

-6000

-9000

-12000
0 2 4 6 8 10 12 14 16 18 20 22

Maximum exposure
 12. Economic analysis
and decision criteria

Cash flow analysis Decision criteria

Inflation and deflation Uncertainty and risk

Income and commercial Stochastic analysis and

framework decision trees

Time value of money

 Uncertainty
A cost or NPV estimate is a
prediction of future investment and
operating cost

A prediction is always associated

with uncertainty!

The evaluation of risk is an

important part of the job;
Be aware of the most important
types of risks in the oil and gas
industry
Understand the basic nature of risks
Understand how to manage and
reduce risk
 Systematic and unsystematic risk
Systematic Unsystematic
Effect a large number of assets Effect a limited number of assets
Diversification will not decrease Diversification will
risk eliminate/reduce risk

Added risk
60
50
40
Unsystematic
Risk

30
20
10 Systematic
0
1 3 5 7 9 11 13 15 17 19 21 23 25 27
Number of projects

Diversification strives to smooth out unsystematic risk events in a portfolio so that the
positive performance of some projects will neutralize the negative performance of others
 Risk categories in oil & gas

Systematic risk: Unsystematic risk:

Cost level/inflation Exploration success
Interest rate Reservoir quality
Marked situation Production profile
Currency Oil recovery
Political issues Project cost
Global crisis Technology
Changed tax level uncertainties
New regulation Project schedules
and laws Operation regularity
Oil/gas price and cost
Not diversifiable Diversifiable

The projects overall risk can be divided into systematic and unsystematic risk
Risk is a positive or negative deviation in relation to the expected values
Unsystematic risk can be diversified and managed through detailed risk
evaluations and defined compensating measures
Portfolio effects on risk
 Tornado chart

Tornado Chart should

give decision-makers
an indication of the
impact of changes in Oil price; +/- 20%
the key variables
Volume; +/- 20%
Project should decide
which sensitivities are
relevant Capex; +/- 20%

The value impact Opex; +/- 20%

should be compared
with the Base Case
value
Ranked in
decreasing order
of value effect
0 base case NPV
 12. Economic analysis
and decision criteria

Cash flow analysis Decision criteria

Inflation and deflation Uncertainty and risk

Income and commercial Stochastic analysis and

framework decision trees

Time value of money

Stochastic processes:
Processes depending on one
or more stochastic variables

Probability density function

Cumulative distribution
 Product prices

Effective plateau
Schedule Reserves Decline rate

OPEX
CAPEX Taxes

Stochastic process
 Reserves

Low 544 mill.bbl

Mean 894 mill,bbl
High 1429 mill.bbl

What is low and high?

Log-normal distribution
with +/-26,5% accuracy

P99 j 544 mill.bbl

P01 j 1429 mill.bbl
P90 = 670 mill.bbl
P10 = 1135 mill.bbl
 Production profiles

15
Base case sensitivities
12,5

10
Technical Unit Cost
7,5
1,0
5 0,9
0,8
2,5
0,7
0,6
0
1 3 5 7 9 11 13 15 17 19 21 23 250,5
0,4
0,3
0,2
0,1
0,0
5,00 7,50 10,00 12,50 15,00

NPV
Oil price +/-20% 1,0
0,9
Reserves +/-25% 0,8
CAPEX +/-20% 0,7
0,6
OPEX +/-20% 0,5
Schedule +/-20% 0,4
0,3
Plateau length* +/-10% 0,2

Plateau level +/- 5% 0,1

0,0
-200 -100 0 100 200 300 400
*Reserves produced at plateau
Decision trees
A decision tree is a decision support
tool that model the decisions and their
possible consequences

A decision tree further shows the actual

economic calculations and value of the
actual business case

Decision trees are commonly used in

exploration to help identify a drilling
strategy and to estimate value of
prospects

A decision tree is used as a visual and

analytical decision support tool, where
the expected values of competing
alternatives are calculated
 Decision trees

A decision tree integrates uncertainties and decisions

Uncertainties are represented by chance nodes
And decisions are represented by decision nodes
A tree starts to the left with a decision node
Normally the tree grows along the time line
Each branch can be assigned a value (+/-)
A branch from a chance node can be assigned a probability
The tree visualises the decision process
The mathematics in the tree is very simple
Decision tree analysis should always be done!
 Decision tree example
Exploration cost: 50 million NOK
Appraisal cost: 100 million NOK
Probability for finding oil = 30%
Value estimates (from modelling including uncertainty in reserves
and cost. Excluding exploration and appraisal costs):
P10= 750 million NOK net present value
P50= 250 million NOK net present value
P90= 100 million NOK net present value
Assumption: No appraisal means project stop

Goal: Value of project?

 Example: Exploration drilling

P10 9%
30% 750

Decision node -100 P50

Drill 40% 12%
True 250
Chance node
30% P90
End node 100
9%
Discovery Drill appraisal well?
30%
0
Stop 0%
False
-50
Drill
True
70%
Dry well 70%

Exploration Drill exploration well?

0
Stop 0%
False

Total value of the project following the optimum path (TRUE) =

[(100*0.3 + 250*0.4 + 750*0.3) 100 50] * 0.3 + [0.7*(-50)] =
205 * 0.3 - 50 * 0,7 = 27 MNOK
 Risk picture
oil/gas company perspective

Uncertainty regarding energy politics

Access to new oil and gas resources
Cost management development projects
Fiscal regime and regulations (tax)
Environmental and climate issues/requirements
Oil and gas price
Human resources and industry capacity
Supply shocks
Role uncertainties and competition (oil company versus oil service
company)
Technical risk related to new challenging areas (deep water, arctic)
Project evaluation and ranking/selection
x
Planning assumptions
Strategic exchange rates, crude oil prices, inflation Risk
Criteria Profile

Value
Profitability
Profitability Creation
technical
IRR $ NPV
PV(CAPEX)
commercial
execution
strategic fit NPV local conditions
HSE human resources
robustness HSE
materiality governance
technical cost quality of work
CAPEX/boe uncertainty
OPEX/boe management
plan

Project ranking/selection
10 Questions
1. What are the main cash flow elements?
2. What is the discount rate?
3. What is the discount factor?
4. What is the price index?
5. Explain the difference between real and nominal value of money.
6. What is pay-back time?
7. What is a tornado chart?
8. What is systematic and unsystematic risk?
9. What is meant by stochastic analysis?
10. What can a decision tree be used for?