CGE 660

ENGINEERING ECONOMICS OF OIL

& GAS OPERATIONS

Chapter 4 – PROJECT CASH FLOWS

BY: H U S N A H AYAT I & D R N O R R O S L I N A
D E PA R T M E N T O F O I L A N D G A S E N G I N E E R I N G
FA C U LT Y O F C H E M I C A L E N G I N E E R I N G
UITM SHAH ALAM
COURSE LEARNING OUTCOMES
By the end of this chapter, the students will be able to:
1. Explain and describe the concept of cash flow.
2. Generate the cash flows for E&P projects.
3. Apply the time value of money concept into cash flow
analysis.
4. Perform the economic analysis on the generated cash
flow based on key economic indicators; NPV, IRR, ROI.
INTRODUCTION
• Cash flow is the most appropriate methodology
for evaluating long terms investment such as in
an E&P projects.
• For a long term project, time is an important
factor in determining the value of individual
cash flows.
• The measures of profitability in a cash flow can
either be discounted or undiscounted. The
discounted measures take into account the
time value of money concept.
PROJECT CASH FLOWS
• Cash Flows involve the physical (or electronic) transfer of funds from one
account to another. Typical cash flow inputs :
• Revenue – Income from sales and services
• CAPEX – Project development
• OPEX – Project running cost
• Taxes – Payments to governments
• Net Cash Flow (NCF) is the aggregate cash flow for a specified time period. The
currency units for NCF is the same as for the cash flows from which it is
derived.
PROJECT CASH FLOWS
• For a project, which has been divided into calendar years, the aggregation time is normally modeled
as the mid point of the period.
• The cumulative NCF over time forms a measure of performance or value and give rise to a number
of useful parameters.
• Net Cash Flow = Net Annual Revenue – Net Annual Expenditure

• Net Annual Expenditure include costs of:

• Capital Expenditure (CAPEX)
• Operating Expenditure (OPEX)
• Abandonment Costs
• Sunk Costs : a cost that has already been incurred and cannot be recovered
• Opportunity Costs : the cost of a missed opportunity.
Sunk Cost Example
You're a homebuilder and you've started work on 20
spec homes in a small development. You've cleared the
land, prepped the home sites and brought in power,
water and sewer. Halfway through construction of the
homes, the real estate market starts to crash. Do you
keep working and finish the construction, hoping that
the market will soon improve? Or, do you stop work
and save the money you would have spent finishing all
the homes?
At the point in time where you make this decision,
everything you've spent so far is sunk cost. In this case
it's a considerable amount of money, and it may be
painfully difficult to walk away. If you do, that money is
lost forever. If you don't, you run the risk of spending
even more money that you'll never recover if economic
conditions don't improve fast enough. The dilemma
can be framed as one of certain loss versus uncertain
success.
Sunk Cost Analogy
If you bought an advance ticket to a movie and then
heard from several moviegoers that it was terrible,
would you still go see it if you couldn't get a refund or
resell the ticket? Made on a purely economic basis, you
wouldn't go because the ticket is a sunk cost. On a
psychological level though, you might believe if you don't
go you won't get your money's worth. Plus, there's
always the chance that you might like it. But if you go
and don't like it, you've not only wasted the cost of the
ticket but a few hours of your time. You've compounded
the financial loss with an opportunity loss.
Back to Project Cash Flow
Opportunity Cost: Example
One way to demonstrate the concept of opportunity costs is through an example of investment
capital.
A private investor purchases $10,000 in a certain security, such as shares in a corporation, and
after one year the investment has appreciated in value to $10,500. The investor's return is 5
percent. The investor considers other ways the $10,000 could have been invested, and discovers
a bank certificate with an annual yield of 6 percent and a government bond that carries an
annual yield of 7.5 percent. After a year, the bank certificate would have appreciated in value to
$10,600, and the government bond would have appreciated to $10,750. The opportunity cost of
purchasing shares is $100 relative to the bank certificate, and $250 relative to the government
bond. The investor's decision to purchase shares with a 5 percent return comes at the cost of a
lost opportunity to earn 6 or 7.5 percent.
Opportunity Cost Analogy
Expressed in terms of time:
Consider a commuter who chooses to drive to
work, rather than using public transportation.
Because of heavy traffic and a lack of parking, it
takes the commuter 90 minutes to get to work.
If the same commute on public transportation
would have taken only 40 minutes, the
opportunity cost of driving would be 50
minutes.
PROJECT REVENUES
• Petroleum Production is the main revenue generated from O&G Project. Rate
of production determines revenue received.
• Rate of production is constrained by:
• Volumetric reserves
• Drive mechanism
• Reservoir Geometry
• Capacity of installed facilities
• Regulatory requirements
• Reservoir management optimization
 CONCEPT OF CASH FLOW
Net Cash Flow = Cash inflow – Cash outflow
(+) (-)
• Example of Cash Inflow:
o Fiscal income (e.g. sale of oil and gas)
o Operating income (e.g. tariff received)
o Other incomes (e.g. premium received)
• Example of Cash Outflow:
o Capital expenditure (CAPEX) – platform, facilities, wells, other expenditures
o Operating expenditure (OPEX) – maintenance, chemical, fuel, tariff paid, recurring
expenditures
o Fiscal costs – royalty, taxes, duties, bonuses, premium payments
CAPITAL EXPENDITURES (CAPEX)
• CAPEX is a one-time costs which occurs at the beginning of projects
• Classification of CAPEX by purpose:
◦ Exploration costs
◦ Appraisal costs
◦ Development costs
◦ Running Business costs
◦ Abandonment costs
◦ Acquisition cost
• Classification by purchased items:
◦ Facility costs
◦ Wells/ Drilling costs
◦ Pipeline costs
◦ G&G costs (mainly seismic)
OPERATIONAL EXPENDITURES (OPEX)
• OPEX are costs that occur periodically and necessary for day to day
operations:

Feedstocks Treatment Costs/Workover

Utilities Secondary recovery costs
Maintenance of facilities Water disposal costs
Overheads Evacuation costs
Production costs (Lifting costs) Insurance cost
 G&G Studies Planning & Data Integrated Development Production

ABANDONMENT
Play Concepts Acquisition Studies & Modelling
Basin modelling Field & Reservoir
Appraisal Drilling & Development Plan Management
Etc. Seismic Detailing
E&P ACTIVITIES
New Seismic Development Seismic and Field Master Plan
Early Development Drilling
Leads & Prospect Workover/
Production Scheme Facilities Design, Construction &
Evaluation Re-completion
(where applicable) Commissioning
Wildcat Drilling
Integrated Work Additional “brown” Field Development (based on new data)
Integrated Work

Life of Reservoir Management

Integrated 3D Static Well Technology/ Model Production System Model

Earth Model
Reservoir Analytical and/or Numerical Simulation

Economic Models
 REVIEW: PROJECT COST ESTIMATION
• Unit Finding Cost (UFC) = Exploration CAPEX/Total Production
• Unit Development Cost (UDC) = Development CAPEX/Total Production
• Unit Operating Cost (UOC) = Total OPEX/Total Production
• Unit Technical Cost (UTC) = Exploration CAPEX + Development CAPEX + OPEX
Total Production
= UFC + UDC + UOC
PROJECT COST ESTIMATION
CASH FLOW
• Revenue
◦ All income from product sales and services

• CAPEX : Project Development Cost

◦ Expenditures which contributes to creation or construction of something productive.
Normally a once off payment

• OPEX : Project Running Cost

◦ Expenditures which enables the running of something productive. Usually a periodically
occurrence expense

• Taxation
◦ Payments made to the government for an assigned project/development
CASH FLOW
• Both CAPEX & OPEX are expenditures, i.e. negative cash flows.
• Distinction is made between these two because :
◦ Taxation OPEX can immediately be written off on the purchased year but
CAPEX is depreciated over the life of the asset through capital allowance. The
less depreciation allowed means that more taxes need to be paid.
◦ For assets in corporate accounts, CAPEX creates assets and reflect greater
profitability for the company
 CUMULATIVE NET CASH FLOWS & ITS PARAMETERS
Payback period – Payback is the point where
the cumulative NCF returns to zero. The
payback period is the time taken to get to this
point. TCS UCS
PIR  
Terminal Cash Surplus (TCS) or Ultimate Cash MCO MCS
Surplus is the end point on the cumulative NCF
curve. It is the sum of all revenues minus total
CAPEX and OPEX and Taxes.
Profit to Investment Ratio (PIR) is the profit
earned for each Ringgit invested. It is the
measure of project/investment efficiency.
Maximum Capital Outlay/Maximum Cash Sink
is the minimum value on the Cumulative NCF
curve.
DISCOUNTED CASH FLOW
• Parameters for Discounted Cash Flow includes;
◦ Net Present Value (NPV)
◦ Net Present Value Index (NPVI)
◦ Annual Capital Charge

NPV is the sum of all project cash flows, discounted back to a common point in
time.

A0 A1 A2 An
NPV     ....... 
(1  i) (1  i) (1  i)
0 1 2
(1  i) n

Note: A is NOT Annuity! It represents cash flow on that specific year!

 DISCOUNTED CASH FLOW Discounted Cash Flow

n NCF DF [0.10] = [1.1]^-n DCF [0.10] = NCF*DF

0 1994 -23.60 1.00 -23.60
1 1995 -102.50 0.91 -93.18
2 1996 -315.80 0.83 -260.99
3 1997 -320.80 0.75 -241.02
4 1998 10.40 0.68 7.10
5 1999 244.90 0.62 152.06
6 2000 447.70 0.56 252.71
7 2001 113.00 0.51 57.99
8 2002 222.50 0.47 103.80
9 2003 197.30 0.42 83.67
10 2004 151.60 0.39 58.45
11 2005 146.20 0.35 51.24
n at 1st year must 12 2006 126.40 0.32 40.27
always be 0 13 2007 113.90 0.29 32.99
14 2008 101.40 0.26 26.70
15 2009 93.60 0.24 22.41
16 2010 84.50 0.22 18.39
17 2011 76.70 0.20 15.17
18 2012 68.90 0.18 12.39
NPV: Summation of all 19 2013 71.80 0.16 11.74
PV for each year 20 2014 -56.30 0.15 -8.37
21 2015 8.70 0.14 1.18
UCS 1460.50 NPV 321.12
DISCOUNTED CASH FLOW
• NPV can be considered as a measure of profit.

• If the NPV of project is

negative DO NOT PROCEED
WITH THE PROJECT
• What if there are several
projects to be selected,
which project should you
choose?
DISCOUNTED CASH FLOW
• Internal Rate of Return (IRR) is the discount rate, which reduces the project NPV to
zero.
A0 A1 A2 An
   .......  0
(1  i) (1  i) (1  i)
0 1 2
(1  i) n

• Methods to solve for IRR

◦ Compute NPV and check for zero
◦ Plot NPV Profile and find intercept on x axis
◦ Iterative calculations to find NPV zero.
• IRR is an interest or growth rate and is assumed to be a measure of investment
efficiency
EXAMPLE: IRR
Cash flow:
Year 0 : -100
Year 1: 130

Let the NPV = 0

 ECONOMIC INDICATORS
Example of Economic Indicators
• Economic indicators are yardsticks used to
quantify the relative attractiveness of an • Maximum Cash Sink
investment:
1. Establish the economic feasibility of an • Payback Period
investment opportunity • Ultimate Cash Surplus
2. Weight the relative merits on investment
opportunities • Profit Investment Ratio (PIR)
3. Determine the value for buying or selling as • Net Present Value (NPV)
asset
• Internal Rate of Return (IRR)
4. Assess the feasibility for project expansion
or acceleration • Breakeven
• Other than strategic considerations, we need to • Economic Limit
apply appropriate profitability indicators to
support management decisions • Economic Life
 ECONOMIC INDICATORS

Example of Cash Flow Profile

+ve
Net Cash Flow
Cum Net Cash Flow

First Production
Cash Flow (USDMM)

Economic
limit year

18 Years
07 10

Abandonment
03
04
05 06

Development Production
-ve
Project ends
1 - 27
 ECONOMIC INDICATORS

Maximum Cash Sink:

 Definition: Maximum amount of cash outlay for a project
 Formula: MIN (Cumulative Net Cash Flow)
 Unit: Currency value

Cash Flow (USDMM)

Years
07 10 18
03
04
05 06
Maximum
Cash Sink

1 - 28
 ECONOMIC INDICATORS
Breakeven:
 Definition: The year when the sum of cash inflow equal to the sum of
cash outflow, beyond which the project will fully fund itself
 Formula: Cumulative Net Cash Flow = 0
 Unit: -
Cash Flow (USDMM)

Years
07 10 18
03
04
05 06

Breakeven year

1 - 29
 ECONOMIC INDICATORS
Payback Period:
 Definition: Number of years from first production to achieve
breakeven
 Formula: COUNT (Breakeven – 1st Production))
 Unit: Years

Payback
period
Cash Flow (USDMM)

Years
07 10 18
03
04
05 06

1 - 30
 ECONOMIC INDICATORS

Economic Limit:
 Definition: The year where maximum cumulative cash is realized
 Formula: MAX (Cumulative Net Cash Flow)
 Unit: -

Cash Flow (USDMM)

Years
07 10 18
03
04
05 06 Economic
limit year

1 - 31
 ECONOMIC INDICATORS

• Economic Life:
 Definition: Number of years from first production to achieve
economic limit
 Formula: COUNT (from 1st production to economic limit)
 Unit: Years
Economic life
Cash Flow (USDMM)

Years
07 10 18
03
04 Economic
05 06 limit year

1 - 32
 ECONOMIC INDICATORS

Ultimate Cash Surplus:

 Definition: Cumulative net cash flow at the end of project life
 Formula:  (Net Cash Flow) = undiscounted Net Present Value
 Unit: Currency value
Ultimate
Cash Surplus

Cash Flow (USDMM)

Years
07 10 18
03
04
05 06

1 - 33
 ECONOMIC INDICATORS

Profit Investment Ratio:

 Definition: Amount earned for every dollar spent
 Formula: Undiscounted Net Present Value / Total Investment
 Unit: Ratio
Ultimate
Cash Flow (USDMM) Cash Surplus

Years
07 10 18
03
04
05 06
Maximum
Cash Sink

1 - 34
 ECONOMIC INDICATORS

Net Present Value (NPV):

 Definition: Sum of discounted cash flow over project life
 Formula:  (Net Cash Flown * Discount Factorn)
 Unit: Currency value


NPV@10%=$566 MM
NPV@40%=($197 MM)
Net Present Value (USDMM)

NPV@15%=$271 MM

NPV@23%=$0 MM

Discount
5% 10% 15% 20% 25% 40% Rates

1 - 35
 ECONOMIC INDICATORS

Internal Rate of Return (IRR):

 Definition: Discount rate for which NPV = 0
 Formula: Discount rate where NPV=0 from NVP profile
 Unit: %

Internal rate of return

Net Present Value (USDMM)

= 23%


NPV@23%=$0 MM

Discount


5% 10% 15% 20% 25% 40% Rates

1 - 36
 ECONOMIC INDICATORS
SUMMARY

+ve Economic
life Ultimate
Cash Surplus
Payback
Cash Flow (USDMM) period

Economic
limit year

Years
07 10 18
03
04
05 06
Ultimate Cash Surplus
Breakeven year PIR =
Maximum Cash Sink
Maximum
-ve Cash Sink

1 - 37
CUMULATIVE NET CASH FLOWS IN REAL TERMS
• It is inappropriate to add together net cash flows over a long period of time in
MOD terms since the value of money (purchasing power) varies with time.
• The value of money changes with inflation and CPI (Customer Price Index).

Year Inflation rate, % NCF £ MOD n Discount Factor NCF £ 2000

1997 2.5 -297.63 -3 1.08 -320.51
1998 3.4 9.93 -2 1.07 10.62
1999 2.5 238.94 -1 1.03 244.91
2000 3.1 447.75 0 1.00 447.75
2001 3.5 115.87 1 0.97 111.95
2002 1.7 233.77 2 0.97 226.02
2003 2.5 212.49 3 0.93 197.32
 Calculated
Inflation Discount
Year RPI Index Rate % n Factor NCF £ MOD NCF £ 2000
EXAMPLE 1994
1995
84.9
87.8 3.42
-6
-5
1.16
1.19
-20
-90
-23.56
-102.42
1996 90.0 2.51 -4 1.10 -284.1 -315.9192
1997 92.8 3.11 -3 1.10 -297.63 -320.84514
1998 96.0 3.45 -2 1.07 9.93 10.34706
1999 97.6 1.67 -1 1.02 238.94 244.9135
2000 100.0 2.46 0 1.00 447.75 447.75
2001 102.5 2.50 1 0.98 115.87 113.08912
2002 105.1 2.54 2 0.95 233.77 222.54904
• Note: Retail Price Index (RPI) in this 2003 107.7 2.47 3 0.93 212.49 197.40321
2004 110.0 2.14 4 0.91 167.37 151.63722
example is a term previously used in
2005 113.1 2.82 5 0.88 165.37 146.18708
the UK. 2006 116.0 2.56 6 0.86 146.61 126.37782
2007 118.9 2.50 7 0.84 135.4 113.8714
2008 121.8 2.44 8 0.82 123.6 101.4756
2009 124.9 2.55 9 0.80 116.92 93.65292
2010 128.0 2.48 10 0.78 108.12 84.44172
2011 131.2 2.50 11 0.76 100.59 76.64958
2012 134.5 2.52 12 0.74 92.7 68.9688
2013 137.9 2.53 13 0.73 98.86 71.6735
2014 141.3 2.47 14 0.71 -79.61 -56.36388
2015 144.8 2.48 15 0.69 12.54 8.6526
500
400
300
200
100 NCF £ MOD
NCF £ 2000
0
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016
-100
-200
-300
-400
EXERCISE 1
EZZRA Petroleum has various ongoing E&P projects worldwide. These projects life cycle begins and ends at
different time. As the Finance Director, you need to evaluate these various projects at a single point at
2012. Assuming 5% Inflation rate per annum, determine the Real Term 2012 cash flow for these projects.
YEAR 2009 2010 2011 2012 2013 2014
MOD 100 150 165 175 220 200
RACIK # of years from today, n -3 -2 -1 0 1 2
FIELD RT 2012 115.76 165.38 173.25 175.00 209.52 181.41
YEAR 2010 2011 2012 2013 2014 2015
MOD 200 250 250 200 170 100
SERZIP # of years from today, n -2 -1 0 1 2 3
FIELD RT 2012 220.50 262.50 250.00 190.48 154.20 86.38
YEAR 2012 2013 2014 2015 2016 2017
MOD 115 165 157 200 250 260
XINHUA # of years from today, n 0 1 2 3 4 5
FIELD RT 2012 115.00 157.14 142.40 172.77 205.68 203.72
EXERCISE 2: No Tax Payable . Determine the NCF & Present value.
Complete the table (the orange spaces)

Year Unit 1 2 3 4 5 6 Total

Production MM bbls 1 4 3 2 10
Price $/bbl 25 25 25 25
Revenue $ MM
CAPEX $ MM 50 50 100
OPEX $ MM 15 15 15 15 60
NCF $ MM
Discount Rate % 10 10 10 10 10 10
Discount Factor
Discounted NCF $ MM
EXERCISE 3
Bayu is a medium size prospect with recoverable reserves of 400 million barrels of oil and 200 trillion scf of
gas. The estimated development cost is RM750 million, with an annual OPEX of RM45 million. Fabrication
could start in 2003 with first oil in 2007.
Assumptions:
◦ Oil price is RM110 /bbl
◦ Gas price is RM20/Mscf.
◦ Inflation 3% per year.
Construct Cash Flow matrix for this project in MOD terms.
Calculate Net Cash Flow
Convert to RT2002
Plot cumulative Net Cash Flow versus Time for MOD and RT2002
Determine Payback, Maximum Cash Sink, Ultimate Cash Surplus and PIR for MOD terms.
Year Unit 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2018
Exploration &
Appraisal MM MYR 5 10
Development MM MYR 8 16 0 8 34 16
Facilities MM MYR 1 20 211 356 46 23
Abandonment MM MYR 110

Year Unit 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Oil production MBbl/d 86 170 170 170 148 104 80 58 42 32 24 8
Gas Production MMscf/d 44 86 86 86 74 54 40 30 22 16 12 4

Year Unit 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Tax MM MYR 3.9 95.67 106.42 114.18 99.18 62.65 43.13 24.99 11.66 3.26 -3.56 -80.53