30110742 Petroleum Economics

8/8/2019 30110742 Petroleum Economics

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PETROLEUM

ECONOMICS

Sunday Isehunwa (Ph. D)


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SPECIAL FEATURES OF

MINERAL ECONOMICS

Minerals are found only in certain favouredplaces. There is no question of locating a mine

anywhere else except where it is found incommercial quantities.

The minerals are exhaustible

The minerals are found in places where they maynot be needed and used.


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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


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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.


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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


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ECONOMIC CHALLENGES

Companies have tried to meet thesechallenges through:

Cost reduction measures Staff rationalization

Vertical integration

Strategic business units

Portfolio diversification

Other measures


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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)


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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


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Marker Crudes

A marker crude is an oil from a specified

field or region which is traded in spot

markets and considered a standard


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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


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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 aformal commodities exchange for some specified

future delivery date.


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CRUDE OIL MARKETS

The bulk of the worlds 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 contarctarrangements between producers and consuming

governments as well as other players.


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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.


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THE SPOT MARKET

However, price movements in the spot market do

not necessarily reflect real market conditions as

can fluctuate widely and involve relatively smallamounts 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.


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THE SPOT MARKET

Major Players

The major international oil companies

Traders

Brokers Independent oil companies


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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 thanthe price set by the producer at the time of

sale.


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COMPONENTS OF NETBACK

DEALS

Refinery Yields

Products Prices

Timing

Transportation

Other fees and Profit Margin


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MAJOR INTERNATIONAL

PETROLEUM COMMODITY

MARKETS

NYMEX (New York Mercantile Exchange)

IPE (International Petroleum Exchange

London)

SIMEX (Singapore Mercantile Exchange)


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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 benefitsoccur over a period of time.


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TASKS IN PETROLEUM PROJECT

ECONOMIC ANALYSIS

Setting an economic objective based oncorporate 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


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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


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TIME VALUE OF MONEY

Theory of Equivalence

When cash flows can be traded for one another ina financial world, those cash flows are consideredequivalent to each other.

Economic equivalence depends upon Interest rate

Time


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PROJECT ECONOMICS

When conducting a cost benefit analysis ofany project, if the benefits are received in

the future, we cannot directly compare thefront cost to the future benefits unless we:

Convert the future benefit to equivalentpresent benefit, or

Convert the present cost to equivalent futurecost


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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


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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)


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ECONOMIC INDICATORS

NPV

Consistently the most reliable and most frequentlyused in practice

Takes into account timing of future cash flow

Tells us how much an investment is better orworse than putting money into the bank or somealternative investment

Makes large projects more attractive than smallerones, no indication of investment efficiency.

Highly dependent on discount rate


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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)


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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


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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


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ECONOMIC INDICATORS


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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 outfor investment decision-making.


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BASIC PRINCIPLES OF CASH

FLOW ANALYSIS

Basic principles of cash flow analysis that are vital tothe 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


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BASIC DEFINITIONS

Capital Costs

One-time costs usually incurred at the beginning of aproject. They are usually large expenditures incurred

several years before any revenue is obtained.

Examples

Tankers

Pipelines Construction

Process facilities Camps and Accommodations

Storage vessels


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BASIC DEFINITIONS

Operating Costs

Occurs regularly and are necessary to maintainoperations.

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

Examples

Field labour cost

Maintenance cost

Office overhead

It can be fixed periodic/annual amount or can be variable anddetermined as a function of production rate.


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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


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CASH FLOW ANALYSIS

Net Cash Flow

Net cash flow = cash received capital

expenditure operating expenditure

royalties, taxes, profit sharing.


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PROFIT

Accounting concept used in reporting company

accounts or in assessing tax liability.

Does not refer to total money flow but usuallyincorporates depreciation of capital costs.

Profit = cash received depreciated capex

opex royalties, taxes, profit sharing, etc


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CASH FLOW VS PROFIT

I1 2 3 4 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)00

0

4025

10

4025

10

4025

10

4025

10

Profit 0 5 5 5 5


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CASH FLOW VS PROFIT

Conclusion

Net cash flow gives the forecasted actual moneyspent and received. It correctly represents the sizeand 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.


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EXAMPLE ECONOMIC

CALCULATION

Capital Investment = $110,000

Net Operating Income:

Year Income

1 $40,0002 $40,000

3 $40,000

4 $40,000

5 $40,0006 $30,000

7 $20,000

8 $10,000

9 $4,000


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EXAMPLE ECONOMIC

CALCULATION

Net Cash Recovery = Ix - P

= $264,000 - $110,000

= $154,000


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EXAMPLE ECONOMIC

CALCULATION

Payback Time = P/ Ix/N

= 110,000/ 264,000/9

= 3.75 Years


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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


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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


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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 = -$5166.77

IRR = 37%


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ECONOMIC EVALUATION


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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.


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RISK AND UNCERTAINTY

Derivation of cash flow and the measurement ofeconomic worth are based on the assumption thatinvestments are risk-free.

Assessment of risk and uncertainty is important todecision making

Analysis allows one to select the appropriatediscount rates which account for risk anduncertainty.


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DEFINITION OF RISK

RiskThe probability that a certain undesirable outcome will occur

Uncertainty

The range of values within which the actual value isexpected to fall

Contingency

Provision for variations to the basis of a plan or costestimate which are likely to occur and which cannot bespecifically identified at the time the plan or estimate wasprepared.

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

ELEMENTS OF PROJECT RISK


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ELEMENTS OF PROJECT RISK

MANAGEMENT

Risk Identification

Risk Quantification

Risk Response Development

Risk Response Control


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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 profitabilityto specific risk factors

Identifying the elements of risk that contribute most tocurrent inconsistency

Defining a program to reduce and manage risk

30110742 Petroleum Economics

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