Petroleum Economics

By Moez SAKKA (Certified Public Accountant)

February 2016
Objectives of the module
Acquire basic knowledge regarding economic analysis and economic modelling in the
petroleum industry.

Understand the main concepts, tools and techniques used in the economic evaluation of
a development project. Understand how they are used in practice.

Be able to do the economic calculations needed for different development projects.

Plan of the module
Session 1: Fiscal and license terms : determining aspects for economic evaluation
Session 2: Economic Assessment techniques used in oil & gas industry (1/2)
Session 3: Economic Assessment techniques used in oil & gas industry (2/2)
Session 4: Case study
Session 5: : Case study
Session 6: : Case study
Session 1 : Fiscal and license terms: determining
aspects for economic evaluation
Main forms of agreements (1/2)
The state has monopoly ownership of what is beneath the soil (art 4 Hydrocarbon law)

The concessions and exploration permits in Tunisia are governed by different legal regimes depending
on the date of the attribution of concession or of the exploration permit. Actually three regimes coexist:
the permit agreement, the law 85/09 modified by laws 87/09 and law 90/56 and the hydrocarbon code.

States grant licenses over designated areas for extraction of minerals for companies which has
technical and financial abilities (commitments to work program minima) (art 7 HL)

No Work without hydrocarbon licenses: Prospection, Exploration, concessions (Discovery, POD)

(art 6 HL)
Main forms of agreements (2/2)

Legal document approved by decree : Convention + Cahier de charges between the state, ETAP and
the company

Contractual documents approved by the granting authority : depending on the forms of agreements:
Tax and Royalty Concessions : JOA between the co-holder of the permit : ETAP/Company

Production Sharing Agreements : between the holder of the permit (ETAP) and the contractor (the company)

L'Autorisation de Permis de Prospection Permis de Recherche Dveloppement

Prospection (1 an) (2 ans+ 1an) (5 ans+ 4ans +4 ans)
Taxes
The tax-regime in a particular year is determined

Tax and Royalty Concessions (1/6)

Creation of Association without legal entity : ETAP participation rate %; Company participation rate %

Art 91 + Art 93.1 HL

Each partner bears the risks and profit from benefits proportionally to its participation (Exploration risks
are assumed by the company) Art 92 HL

NOC-participation
Prior to approval of the development plan and granting the production license the participation of the
NOC (ETAP) will be determined

ETAP has a participation-right up to maximum % determined in the convention (Art 94 HL)

In case of participation, ETAP reimburses its share in exploration costs (from its share in production)
and finances its share in development and exploitation costs (Art 96, Art 95)
Taxes
The tax-regime in a particular year is determined

Tax and Royalty Concessions (2/6)

Royalty

Under the JVA part of future production will fall directly to the Government (or its representative), which
is called royalty. The royalty is a function of the exploitation success, expressed as the R-factor
function, set by Law (Art 101.2.1 HL)

In case on Non participation of ETAP, Minimum royalties of 10% for oil and 8% for Gas (Art 101.2.4 HL)

Domestic Market Obligation (DMO)

The JVA imposes a domestic market obligation to sell part of the produced hydrocarbons to the
domestic market at discounted prices. The Government (or an intermediate) is the buyer. DMO-related
revenue is taxable.
Tax and Royalty Concessions (3/6)
Income Tax
The tax-rate in a particular year is determined by the R-factor, which is a function of the cumulative net-
revenue to the Contractor and his expenditure. The taxable income is determined as follows: the net
revenues OPEX - Amortization of CAPEX - The financing costs of the Contractor

In case of ETAP participation % above 40% : Tax rate is fixed at 50%.(Art 101.3 HL)

Cost-recovery, Depreciation and Amortization

The investment-partners and contractor are annually compensated for their share of the (past) capital
investments made and annual production expenditure (i.e. operating cost) by part of the generated
revenue-stream. Under the JVA the amortization-scheme is determined as follows:

Eligible operating costs are compensated on an annual basis, provided sufficient revenue;

Capitalized expenditures are amortized over a number of subsequent production years;

Past exploration and appraisal costs ( ) are capitalized and included as intangible development costs;

Non-compensated costs in one year are transferred to the next for amortization;
Tax and Royalty Concessions (4/6)
Tax Free Provisions

Provision for abandonment and site restoration for the last 5 years of the field life (Art 118 HL)

Provision for exploration expenditure in the limit of 20% of taxable income without exceeding 30% of
the total of expenditure projected (Art 113.3 HL)

The R-factor rule for royalty and tax rates

Under the JVA, the so-called R-factor, which is roughly defined as the ratio of the Contractors cumulative
net revenue, derived from the project, to cumulative expenditure, made for the project by the Contractor,
determines the royalty and tax-rate to be applied in a given year. The cumulative net revenue in one
particular year is the cumulative gross revenue for that year minus cumulative tax-payments over the
previous years; i.e.
Tax and Royalty Concessions (5/6)
The R-factor rule for royalty and tax rates

n n 1

val. de la prod. Redev. impt sur bn. autres impotset taxes

R i 1
n
i 1

cots d' explo. cots de dvelop. cots oper. charges d' intrts
i 1
Tax and Royalty Concessions (6/6)

Company Host

Royalty

Costs

Tax

Profit
Production Sharing Agreements (1/5)
ETAP is the Title Holder of the permit and any concession thereof (Art 98 HL)

Contractor carry out exploration, appraisal, development and exploitation work at his sole risk and at
his expense

In case of the development of a field a concession is granted to ETAP with the contractor as operator

Contractor will receive on a yearly basis a portion of the production: Cost-oil/Cost-gas to recover his
expenditures (exploration, appraisal, development and exploitation costs)

The remaining portion (after deduction of Cost-oil/Cost-gas portion from total production) is shared
between ETAP an Contractor as Profit-oil/Profit-gas.
Production Sharing Agreements (2/5)
From its share of Profit-oil, ETAP shall:

deliver 20% of total oil production to Domestic market with a price discount of 10%

pay royalties on hydrocarbon produced from the field (royalties rates are determined by R factor)

pay to the State, on behalf of Contractor, tax on profits of the Contractor which is fixed to the
amount of Contractors share of profit-oil of the year

pay its tax on profits as Title Holder (tax rates are determined by R factor)

Contractor is exempted from delivering oil for Domestic market and from paying royalties on
production.

Royalties and tax due by ETAP are determined as for JVA with ETAP holding 100% stake.
Production Sharing Agreements (3/5)
The law doesnt fix the modality of production sharing
Examples of Production sharing:

Cost oil/Cost gas :

Example 1 : Cost oil Fix at 40%

Example 2 : Cost oil depends on production

Monthly Production
bbl/Day Contactors
0-5000 X%
5000-10000 Y%
> 10000 Z%
 Production Sharing Agreements (4/5)

Profit oil/Profit Gas:

Example 1: depending on R Factor
Example 2 : depending on daily production rates:

Example 1 : Example 2 :

Monthly Production Entrepreneur Titulaire

Rapport R ENTREPRENEUR(%) TITULAIRE (%)
bbl/Day (%) (%)

R 1 30 70 0-5000 X% 1-X%

1<R1,5 25 75
5000-10000 Y% 1-X%
1,5<R2 22,5 78,5
2<R2,5 20 80 > 10000 Z% 1-X%
R>2,5 15 85
Production Sharing Agreements (5/5)

Contractor Host

Royalties

Costs

Take

Profit
Session 2 : Economic Assessment techniques (1/2)
Economic Evaluation : When ?

Investment decision
- Exploration;
- Development;
- Purchase or Sale transactions (Farm in, Farm out, shares acquisition, company acquisition).
Need to know to economic value of a project
Comparison between independent projects
Negotiation of petroleum agreements
Choice between development options.
Economic Calculation ?

CONFRONTATION

BETWEEN

IMMEDIATE DECISION TO INVEST

AND

ESTIMATED FUTURE CASH FLOWS

Intervenients?

Cost
Estimation
Drilling
Contract
Program

Economic Evaluation
Reservoir
G&G studies
Studies

Decision
Key characteristics of petroleum projects
Oil & Gas Exploration and Development Projects are characterized by very large capital costs and very
long lead times before revenue is seen.
The scale of the costs involved, and the exposure of the company to cost and timing over-runs is a
major issue to Oil & Gas Companies
Aside for the obvious Exploration Risk, the development of oil and gas projects carries significant risks
for all Parties. Often with incomplete information and unreliable forecasts
Volatility of oil prices
Abandonment and site restoration costs
In essence, the value from Upstream Oil & Gas activity is only captured at the point of sale. For an oil
project this usually means at the moment of production into a pipeline or ship
Investment decision

Investment decision is the most important decision that a company/government can make:
- Huge capital need;
- irreversible;
- high risk/uncertainty.

Exploration
Even with modern seismic data and geoscience, the chances of a successful Exploratory Well are low

Development
A successful discovery leads to a Field Development that exposes an Oil & Gas company to a wide
range of large risks. For example, the risk of construction costs exceeding estimates, of oil prices not
being as foreseen when production comes on stream in five years time, etc
In light of the risks being taken, shareholder expectations in an Oil & Gas Company are for high rates
of return on capital in light of the high risks being taken
Life-cycle of a petroleum project

Develop

Drill
appraisal
wells
Drill
exploration
wells Drop
3D
seismic
Drop
Accept
work
program Drop
Apply
for license
Drop

In all these phases, you have to make decisions.

Investment analysis is used as a management tool when making such decisions.
From Reservoirs to Economics
Translate technical and business data into MONEY
Enables meaningful comparisons among assets & opportunities
Methodology combines :
Resource volumes
Production forecasts
Prices, opex , capex
Ownership and taxes
Compute values for :
Economic reserves
Revenue and profit Production
Net present value, ROI Forecast
Recoverable
Resources
Hydrocarbons Economics
In place
Reservoir Fluids
Reservoir Pore
Reservoir Rock
Volume $
Volume
Gross Rock
Volume
The role of corporate Management

Invest $$ Raise funds $$

Company Capital
Assets
Markets

Reinvest ?

Good investment ? Repay + return $$

Decision process

Establish a cash flow forecast

Nominal/real values
Consider the uncertainties
Idea Discount the cash flow
Net Present Value

Analysis

Make a decision

Invest Drop Wait

Decision process

Initiative / Idea Strategy

Knowledge Contractual
Project definition Choice

Economical
Fiscal environment Technical evaluation
environment

Economic results
Political
Company strategy
environment

uncertainty DECISION Social environment

Hypothesis for economic calculation

Technical Contractual Economical

Production
profiles Contract type
Oil/Gas price
Investments Cost-Oil
Capital Expenditure Inflation
(CAPEX) Profit-Oil
Cost rise
Exploitation Cost Royalty
Operating Expenditure Exchange ratio
(OPEX) Taxes
financing
Abandonment Cost Amortization
Hypothesis for economic calculation

bank

interest revenue

exploration repayment

loan

appreciation exploitation cost

development Project taxes

abandonment royalty
Hypothesis for economic calculation
Financing sources of the company

Share purchase

Shareholder Dividend
Increase of participation in the
company

Company
Loan

Bank Repayment

Interest
Economic Value
Present Value Combines:
Cash Flow.
Timing Preferences.
Risk Preferences.
Opportunity Cost
Economic decision-making is not in a vacuum.
Rate of return on the next best, available, investment option
Cash flow
Cash flow is the cash received (inflow) and the cash expanded (outflow) over a defined period of time
by a company, project or asset.
Net cash flow is the cash received less the cash expanded during a period.
Why concerned about the cash flow? : Investor invests $ today (outflow) hoping to harvest more $ in
the future (inflow).
Cash flow is not net income
Cash flow
Cash in
Sales from Production
Cash out
Exploration Expenses
Development Expenses
Operating Expenses (Variables+Fixes)
Tax & Royalties
Financial expenses
Income Tax
Net Revenues
Sales from Production
- Expenses
OPEX & GA
Overheads
Financial Expenses
Amortizations and Provisions

Taxable Income
* Tax Rate

= Income Tax
Cash flow
Economic Value : Timing Preferences
Always prefer consumption / money today.
First Fundamental Principle of Finance: A dollar / euro / dinar today is worth more than a dollar / euro /
dinar tomorrow.
Must be paid to wait.

Time Value of Money;:

Inflation
General increase in prices
Depreciation of the Money
Measurable phenomena
It depends on the money units

Future Value (after one year):

PV + PV x if = FV
Discounted Cash flows
Even after you have adjusted for inflation, it is not correct to simply add up inflow and outflow of the
project.
Measure of Future depreciation compared to Present
It depends on the operator and the nature of the operation but not on the money.
Money received today is worth more than money received in the future.

Present Value (of next year)

PV = FV/(1+i)
Economic Value: Risk preferences

Investors avoid risk.

Must be paid to take additional risk.

Risk preferences : Implication

Components are expected values.

Expected cash flow.

Expected or required rate of return.

Expectations may not be fulfilled.

Risk is the variability of returns from an investment.

Risk includes both good and bad outcomes.

Risk exists whenever the actual outcome can differ from the expected
outcome positively or negatively!

Risk has two components :

Unique, unsystematic. Diversification eliminates

Market, systematic. unique risk.
Understanding Risk and the Discount Rate

Opportunity Cost of Capital

Economic standard for investment decision-making.

Rate of return on the next best, available, investment option.
Implicitly considers risk class.
Understanding Risk and the Discount Rate

Required discount rate ?

From shareholders Perspective : Cost of equity (Divended Growth

Model, Capital Asset Pricing Model)

From Bank Perspective : Cost of Debt (Actual on the Balance sheet,

Replacement from the market)
 Understanding Risk and the Discount Rate

Weighted Average Cost of Capital

Debt Equity
WACC = id(1-t) + ie
Debt+ Equity Debt+ Equity

The companys cost of funding its set of assets.

Appropriate only when the risk of the project replicates the risk of the firm.
Net Present Value

Ct
NPV
t

(1 i)

Always Applicable NPV> 0; Value above the min required

NPV< 0; Value under the min required
Session 3 : Economic Assessment techniques Used
in Oil & Gas industry (2/2)
Net Present Value

The sum of all cash flows of a project valued at a single point in time.

Ct
NPV
t t

(1 i)
Forward-looking NPV uses cash flows from today forward in time.

Net Present Value (NPV) concept says:

Ct - Accept projects with NPV > 0

NPV - Reject all projects with NPV < 0

- If NPV = 0, we are indifferent between
t=0 t
accepting or rejecting the project
(1 i)
Considerations in computation of NPV

Incremental Cash Flow.

Inflation.

Financing.
Incremental Cash flow

Definition : Those benefits and costs that a company would not have but
for the existence of the project.

Implications:
Include Opportunity Costs.
Handling of Overhead.
Handling of Taxes.
Sunk Costs.
Inflation

Interest rates are nominal; cash flows should be.

Match cash flows and discount rate.

Financing

The financing decision is not part of the investment decision.

Presume general equity financing.

Modigliani and Miller Separation (1958) :

The value of a company / project / is independent of the capital structure.

It is given by capitalizing the expected return at the rate appropriate for the risk
class.
Decision-making Rules
Net Present Value Rule.

Accept all projects that have a net present value greater than zero.
Invest so as to maximize the value of the project / company.
Special Situations: Optimal Timing

Positive NPV is not the same as maximal NPV.

Negative NPV now does not mean negative forever.
Decision-making requires optimal timing.
Special Situations: Different Project Lives

Cash Flow Year 0 Year 1 Year 2 Year 3 Present Value

Project Gamma -15 6 6 6 1,04

Project Omega -11 6,5 6,5 0 0,92

Choosing between the projects.

Need a mechanism to make the decision equivalent.
NPV and Decision-making Rules: Summary

Net present value is the optimal decision-making rule.

Form of NPV depends on the decision.

General Approach:

Forecast cash flow over the life of the project.

Discount at the correct cost of capital.
Considerations in Computation.
Account for project interaction.
Other Measures of Value

Payback.
Return on Capital Employed.
Net Income.
Profitability Index.
Internal Rate of Return.
Other Measures of Value : Payback

Definition: The point in time at which the (usually) undiscounted

cash flow is equal to zero. (Pay-back: the time required for an investment to
generate sufficient cash flow to recover the initial capital investment)

Acceptance Criteria: Company standard.

Attraction:

Example :
Cash Flow Year 0 Year 1 Year 2 Year 3

Project Gamma -2 2 0 0

Project Omega -2 1 1 5

o Does not use all cash flows.

Easy to compute and use.
o Biases toward short-lived projects.
Relevant in cash tightness
o Weights all cash flows equally.
Related to the planning horizon.
o Can cause acceptance of projects with negative economic
value.
Other Measures of Value : Net Income

Definition: Revenues less expenses of the company.

Acceptance Criteria: ???
Attraction: Ease of computation.

Ignores time value of money.

Is accounting data.
No consideration of the opportunity cost of capital.
No basis for comparison of projects.
Other Measures of Value : Profitability Index

Definition: Future cash flows divided by the investment.

Acceptance Criteria: Greater than 1 or a company standard.

Attraction: If discount and single investment period: same as NPV.

Other Measures of Value : Internal Rate of Return

Definition: The discount rate at which the NPV is exactly zero.

Acceptance Criteria: Accept all projects for which the IRR exceeds the
opportunity cost of capital.

Attraction:
Relatively easy to compute.
Decision-makers seem more comfortable with
rates.

Rate of Return Rule.

Accept all projects that provide a rate of return greater than their opportunity cost
of capital.
Invest to the point at which the marginal return is equal to that of the next best
option.
 The Nexus between IRR and NPV

NPV

IRR = 20 percent
NPV(10) = Negative
Discount Rate

IRR = 25 and 400 percent

IRR = ???
NPV(10) = Negative
NPV(10) = Positive

IRR and NPV give the same result if and only if NPV is a smooth, declining
function of the discount rate.
Other Concerns about Internal Rate of Return

Mutual Exclusive Projects :

Requires computation of the incremental IRR.
Increases the chances of multiple rates of return.
Computationally challenging.
Unreliable for ranking

Capital Budgeting is concerned with finding the optimal set of projects . IRR
cannot identify that set.

Which OCOC must the IRR exceed?

Reinvestment Rate Assumptions

 Exploration Phase and Expected Monetary Value

EMV is a balance of probability and its impact over the range of possible
scenarios.

EMV = P * Value
Expected Monetary Value : Example

Decision between two prospects, which one will provide the greater potential payoff?

P% NPV ($M) EMV ($M)

Prospect A

Dry hole 90 -12 - 10.8

400 mmbbl field 10 250 25.0
14.2
Prospect B

Dry hole 80 - 9.6

-12
100 mmbbl field 20 8.0
40
-1.6
Project Economic Evaluation : Data Collection

Field data

Fiscal data

Economic data

Product data

Cash flow

Economic Indicators
Project Economic Evaluation : Inputs : Field Data

Project Start date, Evaluation date

Reservoir Production Profile, Hydrocarbon quality data

Costs Exploration, Appraisal, Capital, Operating, Abandonment

Technical cost

1) Exploratio n cost
exploration investment
Production
2) Development cost
development investment
Production
3) Exploitation cost
exploitation expenses
Production
Technical cost (1) (2) (3)
Project Economic Evaluation : Inputs : Fiscal Data

Royalty Rate, Allowances, Depreciation

Petroleum Tax B/F position, Rate, Allowances,

Depreciation, Ring Fence

B/F position, Rate, Allowable costs,

Cost Recovery Depreciation

Profit Share B/F position, Rate, Ring Fence

B/F position, Rate, Allowances,

Petroleum Tax Depreciation, Ring Fence, Dual tax
position

Domestic Market, State participation,

Others
other taxes
Project Economic Evaluation : Inputs : Economic Data

Gas prices Gas/LNG contract terms, indexation, base

prices

Oil prices Differentials to marker crude, oil price forecast

Inflation General, Capex / opex / abandonment costs

escalation

Discounting Rates, Date, Method

Others Exchange rates, Interest rates,

Project Economic Evaluation : Outputs

Cash flow

Economic Indicators

Net cash flow: Nominal, Deflated (Real)

DCF : NPV, PI, IRR, NPV/bbl

Indicators : Pay back, Maximum Exposure,

Economic reserves,
Min economic oil price
Sensitivity analysis

Starting from a Base Case, we change one parameter

and measure the impact on economic result
Cash flow

Identify relevant parameters

Economic Indicators

Help to measure how solid is the business case

Help to measure the risk

Project Time line and execution

Concept

Pre-
Feasibility FEED Project FID Project
Feasibility

Abandon

Site specific Engineering +

Generic data Price data
data

Steps in the evaluation process are linked to the corporate approvals process
and release of funds & human / technical resources for the next stage
Project Time line and execution

Economic Evaluation conceptual, pre-feasibility and feasibility

Input data and output results in generic terms

Returns as expressed in unit profits, costs
Decision making tool for taking next steps
The Economic Model
Data input closely resembles the expected project
Decision making tool for making a firm investment
Project versus consolidated models
Consider equity and financial returns to project developer
Data collection : Scoping Study
Scoping Study
Generic data
Basin studies
Unit indicators
Arrive at general indication of whether there is merit in pursuing
opportunities in this area

Feasibility study

Generic data applied to a specific situation / project

Sensitivities of prices and costs to test the range of feasibility
Basis for committing to further commercial work and basic
engineering
Additional sources of Information and data

Sources of fiscal information

Supply demand information
Government agencies
Benchmarking
Web: Subscription service that provides comprehensive data
comparisons for oil & gas companies worldwide, including
financial and operating performance
Sessions 4-5-6 : Cases studies