12/7/2015

PETROLEUM ECONOMICS
Dr. Syahrir Ridha

ECONOMIC
INDICATORS
(E&P Project Economic Evaluation)
PETROLEUM ECONOMICS

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Course Outcomes
Having worked through this chapter the Student will be able to:

 Describe two methods of economic indicators

 Describe the underlying concept of key economic indicators for

undiscounted method, such as payback period, maximum capital
outlay, terminal cash surplus, and profit to investment ratio.

 Describe the underlying concept of key economic indicators for

discounted method, such as net present value, internal rate of
return, discounted payback, and profitability index.

 Describe the significant of net present value and internal rate of

return for investment decision making.

 Describe the application of economic indicators for ranking and

screening of the project

Economic indicators
are devices which
reduce a net cash flow
projection to single
numbers in time.

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NET CASH FLOWS Profit

Cost

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Economic Indicators Application

Economic indicators tell us whether one investment gives a greater economic
benefit than other investments

a. Project Screening
Comparing all projects with a set of company investment criteria to
identify suitable candidates for investment

b. Project Ranking

Comparing all acceptable projects and placing in rank order for

investment purposes

Economic Indicators Methods

1. Undiscounted method
 Payback Period
 Maximum Capital Outlay
 Terminal Cash Surplus
 Profit to Investment Ratio
2. Discounted method
 Net Present Value (NPV)
Note:
All the measures are “no-risk”
profitability criteria. It is assumed
that all of the projected cash flows
and expenditures are guaranteed
to occur at the exact time specified

 Internal Rate of Return (IRR)

 Discounted Payback
 Profitability Index (PI)

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1. Undiscounted method

(c)

(d)

(a)

(b)

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Maximum Capital Outlay

Terminal Cash Surplus

• The simplest measure of a profit

relates to the concept of a surplus.
• TCS is the cumulative value at the end of the
project’s life, not the highest value achieved.
• It is the sum of all project Revenue,
minus the sum of all Capex, Opex • TCS is usually called Net Cash,
and Taxes. Profit and Terminal Value of the
project.

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Profit to Investment Ratio

TCS

MCO

Short Exercise:

No Year Cash flow

1 1994 -24
2 1995 -102
From the Cash Flow profile, define the
3 1996 -316 values of:
4 1997 -321
5 1998 10
6 1999 245 1. Payback period?
Cash flow 7 2000 448 2. Maximum capital outlay?
8 2001 113
Performance 9 2002 223 3. Terminal cash surplus?
10 2003 197 4. Profit to investment ratio?
11 2004 152
12 2005 146
13 2006 126
14 2007 114 Note: First, Develop the Net Cash Flow….
15 2008 101
16 2009 94
17 2010 84
18 2011 77
19 2012 69
20 2013 72
21 2014 -56
22 2015 9
Total 1461

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Solution….

2000
Year Year
Duration Project Cash flow Net cash flow
1 1994 -24 -24 1500
2 1995 -102 -126
3 1996 -316 -442 1000

Net Cash Flow

4 1997 -321 -763
5 1998 10 -753
500
6 1999 245 -508
7 2000 448 -60
8 2001 113 53 0
1 2 3 4 5 6 7 8 9 1011 12 1314 15 16 1718 19 2021 22 23 24
9 2002 223 276
Project Durations (years)
10 2003 197 473 -500
11 2004 152 625
12 2005 146 771 -1000
13 2006 126 897
14 2007 114 1011
15 2008 101 1112
16 2009 94 1206
17 2010 84 1290
18 2011 77 1367 1. Payback period = 7.6 years of project duration
19 2012 69 1436 2. Maximum capital outlay = 763
20 2013 72 1508 3. Terminal cash surplus = 1461
21 2014 -56 1452 4. Profit to investment ratio = 1.91
22 2015 9 1461
Total 1461

2. Discounted method
 Net Present Value (NPV)
 Internal Rate of Return (IRR)
 Discounted Payback
 Profitability Index (PI)

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1. Net Present Value (NPV)

• It is a measure of how much more we gain by putting our money

into the project by comparison with putting it into the bank or
some alternative investment.
or,
• NPV measures how much more we would have to put in the bank
today ( or an alternative investment) to give the same net cash
flow as the project.

Features of NPV

• Assuming a risk-free investment opportunity of $100 with the

promise of $120 after exactly 1 year

• Compare the investment project against putting the money in

the bank (Assuming the bank is risk-free too) @ the bank rate of
10%

• Cash flow of the investment and the present value of our cash
flow using a discount rate of 10% ?

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Features of NPV

At discount rate of 10%, the investment is $10

better than putting the money in the bank

We would have to put $109 in the bank to get the

same return as the investment!

DIFFERENT INPUTS

Bank $109
$120
Alternative Investment $100

The alternative investment

In previous sections, we established that the NPV of a project

told us how much better (or worst) the project is than
investing our money in the bank

Must we make reference to the bank as the only investment?

NO, we can use other kinds of investments

We can make reference to investing in oil industry shares on

the stock market, for instance.

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The NPV is a single indicator

The NPV combines into one number all the physical and
financial attributes of a project-:
• the production profile,
• the capital and operating costs,
• the fiscal terms,
• the timing,
• and the discount rate

The NPV fulfills our first requirement of an economic

indicator, which is - To represent the project by a single
number

…..as a Measure of Profit

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Caution, It is not valid to add cash flows

• The NPV takes time into account

• It is therefore invalid to add up the individual net cash

flows of a project unless we first discount them to bring
them back to the present day

• We can only add net cash flows after we have discounted

them and translated them into equivalents units.

The NPV aids decision making

• The NPV is a useful tool in making decision whether or not to
go ahead with a project

• A positive NPV suggests that we should go ahead with the

project

• A negative NPV tells us we should not go ahead with the

project

• In summary, the NPV is an important part of the go/no-go

decision.

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The NPV and asset acquisition

Since the NPV is a measure of value, it helps to determine the

price the seller would seek in a sale of a petroleum asset.

The NPV is based on the sellers views of the asset’s attributes

(reserves, production potential, capital and operating costs
and so on) and its economic circumstances (future oil prices,
escalation rates and so on)

Similarly, the NPV helps to determine the price the buyer would
be prepared to pay

Short exercise:

A company is expected to have RM 2500, RM

4500, and RM 5000 in years 3, 4 and 5. With the
initial investment of RM 7500, does the project
benefits with the assumed interest return of 12%?

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Solution

12%
0 1 2 3 4 5

-RM7500 +RM2500 +RM4500 +RM5000

NPV 3yrs = 2500 (1.12)-3 = 2500 x 0.7118 = RM 1779.5

NPV 4yrs = 4500 (1.12)-4 = 4500 x 0.6355 = RM 2859.8
NPV 5yrs = 5000 (1.12)-5 = 5000 x 0.5674 = RM 2837.2
NPV = RM 7476.5
Total NPV = RM 7476.5 – RM 7500 = - RM 23.5

The investment is not recommended since the NPV < 0.

2. Internal Rate of Return (IRR)

IRR is the discount rate, which reduce the project NPV to zero.

IRR follow the equation: + + +…+ =0

Unlike NPV calculation, there is no analytical solution to this IRR equation.

Therefore, numerical methods may be applied:

• Trial and error : Compute NPV index and check for zero
• Graphical : Plot NPV profile and find intercept on x axis
• Extrapolation : Iterative calculations to find zero NPV

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Trial and error  By computing NPV index and check for zero NPV

• The calculation of NPV’s

for the Foinaven project at
0, 10, and 20 % discount
rate.

• This constitute a “trial and

error” sequence, with
NPV reducing from 1460
to 321 and minus 44.

• Since IRR locate when NPV

= 0, it must between 321
and -44.

• At this case, the IRR = 18%

that produce NPV slightly
equals zero.

Graphical  By plotting NPV profile and find intercept on x axis

Example of NPV profile of Foinaven project

±18%

- 44

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Extrapolation  Iterative calculations to find zero NPV

IRR  efficiency, quality and yield of

Significant of IRR an investment
NPV  value or magnitude of an
 A measure of growth rate investment
 A measure of investment efficiency

It is arithmetically analogous to the interest earned

on a bank account, which is:
Negative NCF is equivalent to Deposit
Positive NCF is equivalent to a Withdrawal
IRR is equivalent to the Interest rate

 IRR calculations are commonly used to evaluate the desirability of

investments or projects.
 The higher a project's IRR, the more desirable it is to undertake the
project.
 Assuming all projects require the same amount of up-front
investment, the project with the highest IRR would be considered
the best and undertaken first.

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Short Exercise:

The BIG Fish company decided to choose an investment

with has a return of RM 5000 after 15 years with initial
investment RM 800. What is the IRR if interest rate is 12%
per annum. What is your recommendation for the
investment? (hint: use Graphical method)

Solution:
IRR calculation using graphical method, we should define another 2 NPV values.
Assume we use 13% and 15% interest rate,

PV of RM 5000 for 15 years = 5000*(1+0.12)-15 = 5000 * 0.1827 = RM 913.48

12%
NPV = 913.48 + (- 800) = RM 113.48

PV of RM 5000 for 15 years = 5000*(1+0.13)-15 = 5000 * 0.1599 = RM 799.45

13%
NPV = 799.45 + (- 800) = RM – 0.55

15% PV of RM 5000 for 15 years = 5000*(1+0.15)-15 = 5000 * 0.1229 = RM 614.47

NPV = 614.47 + (- 800) = RM –185.53

Interest rate 12% 13% 15%

NPV RM 113.48 RM – 0.55 RM – 185.53

150
100
50
Using graphical solution below,
0 the IRR is when NPV= 0) and is
NPV

-50 0.1 0.11 0.12 0.13 0.14 0.15 0.16

about 13%.
-100 Interest rate

-150
-200
-250

Since IRR > i, the investment is preferable.

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Discounted Payback Period

 A capital budgeting procedure used to determine

the profitability of a project.

 In contrast to an NPV analysis, which provides the

overall value of an project, a discounted payback
period gives the number of years it takes to break
even from undertaking the initial expenditure.

 This procedure is similar to a payback period; with

ignoring the time value of money.

Comparison of Undiscounted and Discounted payback period

5%
0% 10%

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Profitability Index (PI)  also known as profit investment ratio (PIR)

 is the ratio of present value of future cash
flow to investment of a proposed project.
It is a useful tool for ranking projects because it allows you to
quantify the amount of value created per unit of investment.

PV of future cash flow

Profitability Index =
Initial investment

PI > 1, the project accepted (attractive)

PI < 1, the project rejected (PV less that investment)
PI = 1, breakeven

NPV = PV of future cash flow - Investment

Short Exercise:

Calculate the net present value and profitability index of

a project with a investment of $20,000 and expected net
cash flows of $3,000 a year for 10 years. The project's
required return is 12%. Is the project acceptable using
NPV and PI?

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Solution:

Present Value of Future cash flows= 3000/year for 10

years @12%= $16951.

Time Cash flow Discounted Cash flow @12% NPV= Present value of Future cash flows-
1 3000 2678.571429 Investment
2 3000 2391.581633 =16951-20000
3 3000 2135.340743 = minus $3049
4 3000 1906.554235
5 3000 1702.280567 PI= Present value of Future cash flows/
6 3000 1519.893364 Net Investment
7 3000 1357.047646
=16951/20000
8 3000 1211.649684
9 3000 1081.830075 =0.85
10 3000 965.9197098
PV of future cash flow: 16950.66909 The project is not acceptable as NPV is
negative and PI is less than 1.

Application of Economic Indicators

Economic indicators, which are derived from project cash flow, have a
number of important applications:
1. Project screening
Comparing projects with a set of company criteria
to identify suitable candidates for investment

2. Project ranking
Comparing acceptable projects and placing them
in suitable rank order for investment purposes

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1. Project Screening

THREE most important economic parameters for screening criteria:

NPV ≥0

IRR ≥0

PI ≥1

In screening evaluation, secondary criteria might be considered, for example,

maximum Discounted Payback Period.
The big issue is the choice of an appropriate discount rate  it should
reflect the company’s perception of investment opportunity and risk.

 Screening process generates a list of projects  marked as ‘”good” or

“no-good” projects.
 However, passing the screen test does not necessarily lead to investment.
 They need to rank one against another.

2. Project Ranking
Ranking decision is taken by several consideration:
a. Resources Limitation
• All organizations have finite resources  might constrain investment
• The most important are specialist manpower and finance

b. Mutual Exclusive
• Project A & B may be alternative development plan for the same reservoir
• Take over of Company X may be seen as alternative to initiating
exploration in Country Y
c. Best First
• Company performance is optimized by making the best possible
investments.
• Lesser projects may be enhanced by new technology or replaced by new
opportunities.
• Earning profit early will contribute to corporate growth.
b. Risk
• Company may have a specific attitude to risk or prefer a mix of high
and low risk

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Projects comparison

 The dilemma is whether to rank by NPV, IRR or PI?

 Project A has undiscounted profit of 50 and an IRR of 50%.
 Project B has an undiscounted profit of 80 and an IRR of 36%.
 Below a discount rate of about 21%, B has a higher NPV, but A has a higher IRR.
 So which his the better project when there parameters rank differently?

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Ranking Parameters

1. NPV as Ranking Criterion

• NPV is a measure of profit  prefer largest profit. With
12% discount rate, Project B produce profit £44 million
and Project A £34 million.

• NPV reveal nothing about the investment size. It is

imply the surplus. Investment could be £50 million or
£500 million.

• Larger projects produce larger NPV.

• If investment requirements are similar, NPV is prefer.

• If projects are mutually exclusive, NPV optimize profit

generation.

• Government tends to use NPV as a basis for definition

of economic reserves.

2. IRR as Ranking Criterion

• IRR indicates the return per unit investment and a measure of

investment efficiency.

• As a ranking parameter, it indicates where investment will grow

faster. Project A: 50%, B: 36% per annum.

• IRR is very sensitive to the timing of cash flows. High IRR is often
associated with small projects and early production.

• IRR must not be used to rank mutually exclusive projects.

• Importantly, IRR is appropriate in a small company  where

individual investment is likely to represent a larger proportion on
investment opportunity.

• IRR is useful indicator for investment sequences amongst

opportunity.

Project with high IRR may generate income very quickly

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3. PI as Ranking Criterion
• PI is very useful to rank investment efficiency.

• PI is very recommended, if a company try to maximize profit and

has limited funds to invest.

In this case:
 NPV and PI produce the
same result in about
22%.
 Below 22%, Project B is
better investment

Conflicts Between NPV and IRR

 NPV directly measures the increase in value to the company

 Whenever there is a conflict between NPV and another decision

rule, you should always use NPV

 IRR is unreliable in the following situations:

 Non-conventional cash flows
Cash flow signs change more than once

 Mutually exclusive projects

Initial investments are substantially different
Timing of cash flows is substantially different

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Example:

Suppose an investment will cost $ 90,000 initially and will

generate the following cash flows:
Year 1: 132,000
Year 2: 100,000
Year 3: -150,000
The require return is 15%. Should we accept or reject the
project?
As a petroleum economist you are asking to use NPV and IRR
for answering this.

Solution:

i = 15%,
NPV NPV = -90,000 + 114783 + 75,614 – 98,627
= $ 1,770

If i = 10%,
NPV = -90,000 + 120,000 + 82,645 – 112,697
= $ -52
IRR
If i = 25%,
NPV = -90,000 + 105,600 + 64,000 – 76,800
= $ 2,800

If i = 45%,
NPV = -90,000 + 91,034 + 47,562 – 49,202
= $ -606

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By Graphical method:

THE END
&
THANK YOU

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