Petroleum Economics FOR GEOLOGISTS
– Introduction
| By Colin Yeo, P.Geol. and Lionel Derochie, P.Eng.
Introduction
As technical earth science professionals,
we focus almost exclusively on petroleum
exploration and development. We are
concerned with the key elements of the
petroleum system – source, migration,
reservoir, trap and seal. Once we have
identified a play and a prospect, it is often
turned over to the engineers (reservoir,
exploitation, development or operations) to
be evaluated from an economic perspective.
We are then given the news: the prospect is
good or it is uneconomic. If it is bad news, we
are disappointed and we go back and try to
find something better. We assume that means
bigger reserves and higher flow rates but that
is a tall order to fill in a mature basin that is
in decline.
Rather than looking for bigger prospects, what
if we challenged our engineering colleagues
to reduce operating costs? What kind of
royalty credits might be available? What if
we suggested that we drill more wells faster
and at a reduced cost? What kind of rates
and reserves will a horizontal well find?
Will our prospect suddenly meet or exceed
corporate hurdle rates? And by the way, why
is the corporate discount rate higher than the
company’s cost of capital?
These are just some of the questions we
will investigate in this new series “Petroleum
Economics for Geologists.” We will examine
the purpose, mechanics and utility of the
ubiquitous discounted cash flow (DCF) model
that is a cornerstone of our industry. We
intend to present an overview of this evaluation
methodology, keeping it simple yet accurate.
Our intention is to provide the geological
practitioner with the knowledge and language
necessary to conduct meaningful discussions
with those who “crunch the numbers”
and pass judgment on our exploration and
development efforts.
The purpose of this introductory article is
to review the underlying cornerstone of
corporate profitability, cash flow, and how it
is normalized for time. The article will also
consider how cash flow is estimated and how
it, and its derivatives, can be used to rate and
rank projects.
A Basic Principle of Petroleum
Economics: the Need to Ensure
Profitability
All companies exist to maximize the wealth
of their share or unit holders and they
invest money in projects in order to provide
their shareholders with a reasonable and
steady rate of return on their investment. returns to shareholders in the form of
The primary corporate objective of all dividends or unit distributions.
companies is to enhance the investment of
shareholders in the company through the Future Cash Flow
simultaneous goals of profitability, growth, A company invests in a project with the
and performance stability. Companies are expectation that the project will generate a
expected to grow; growth is defined as an return on that investment that is acceptable
annual increase in net income, total assets, to the investor. The return on this investment
and shareholder equity. Companies are also is generally in the form of an income stream
expected to provide stability of performance over a period of time after the investment
with a long record of continuous dividend is made. This income stream is the “Future
payments and steady year-over-year Cash Flow” that will provide a rate of return
increases in financial performance. This on the investment. In the petroleum industry,
unrelenting focus on financial performance producing and selling crude oil and natural gas
and growth leads to the concept of cash provides future cash-flow streams. The sale
flow because all profitability measurements of these commodities generates revenue for
are in some way tied to cash flow and the the company from which royalties, operating
performance of the corporation is directly costs, general and administrative overhead, and
linked to the performance of its assets and income taxes are paid. The residual amount is
projects. Assets (any property, plant, or considered to be “Net Cash Flow” and since
equipment that generates income) generate it will come back to the investor over time, it
cash flow that is used by a company to grow is defined as “Future Cash Flow”.
by increasing production and/or providing (Continued on page 32...)
Corporate Performance Project Performance
Financial Book Profit from growth in: Expected Cash Flow and indices:
Sales Internal Rate of Return
Earnings Net Present Value
Dividends Return on Investment
Rate of Return Discounted Return on Investment
Market Share Payout
Consistency of Dividend Payments
Table 1. Corporate performance is based on the aggregate performance of all projects both past and current
while project performance is determined solely by expected cash flow.
Discount Factor as a Function of Discount Rate
1.00
0.90
Discount Factor Applied to Cash Flow Stream
0.80
0.70
Discount Rate
0.60
0%
0.50 5%
10%
0.40
15%
0.30
0.20
0.10
0.00
0 2 4 6 8 10 12 14
Time Period, years
Figure 1. As discount rates increase, the discount factor becomes smaller and this reduces the present value of a
future amount. For example, at 5 years out, at a discount rate of 5%, the present value of the cash flow in that year
is reduced by 22% and at a discount rate of 10%, it is reduced by 38%. This explains why the present value of a
given cash flow stream is lower for a higher discount rate.
RESERVOIR ISSUE 9 • OCTOBER 2009 31
 be the discount rate and the term 1/(1+i) n is
Discounted Cash Flow as a Function of Discount Rate
called the “Discount Factor.”
100

90
In the example above, each of the amounts
to be invested today are considered to be
80 the present values of the future payments
Present Value of Cash Flow, $

70 Discount Rate of $400 for each of the next five years. The
$400 payments are considered to be the
60
0% future values for the amounts being invested
50
5%
today. Each of the invested amounts were
40 10%
calculated by applying a discount factor that
is appropriate for a 5% per annum investment
30 15%
rate. A total of $1,732 would have to be
20 invested today in order to generate the cash-
10
flow stream described and therefore, the
present value of the entire cash flow stream
0
is $1,732 at a 5% discount rate. If we were to
0 2 4 6 8 10 12 14
go through the same exercise using a 10% per
Time period, years annum investment rate, we would find that
Figure 2. The effect of increasing discount rates on an already declining cash flow stream. $364, $331, $301, $273, and $248 would have
to be invested today to generate the same
Discounted Cash Flow Summation vs Discount Rate cash-flow stream of $400 per year for the
450 next five years. It follows that the amounts
$393 to be invested are lower at higher interest
400 rates and therefore, the present value of this
Discounted Cash Flow Summation, $

$347
350 same cash-flow stream at a 10% Discount
$313
$287 Rate is $1,517. Whether you use a 5% or 10%
300
discount rate, you can see that the present
250 value of the cash-flow stream is greater than
200
the actual $1,000 original investment, which
indicates that the actual rate of return in this
150 example is greater than 10%. It should be
100 noted that the present values of the cash-flow
stream that Investor #2 receives are $1,544
50
and $1,229 for discount rates of 5% and 10%
0 respectively. This shows that getting money
0% 5% 10% 15%
back faster enhances the present value of the
Discount Rate investment.
Figure 3. Summing discounted future cash flows at various discount rates shows the diminishing effect on present
values with increasing discount rates.
In Figure 1 (page 31), the discount factor
is plotted as a function of time for various
(...Continued from page 31) In this example, Investor #1 made a $1,000 discount rates. For a given discount rate,
“Time Value of Money”: investment to generate a future cash flow the discount factor starts at 1 at time 0 and
Measuring the Present Value of stream of $400 per year for the next five decreases over time for each subsequent time
Future Cash Flows years. Another way to look at the concept of period. For a given time period, the discount
Petroleum projects are evaluated using Present time value of money would be to determine factor is lower the higher the discount rates.
Value Theory that says a dollar received today how much money would have to be invested
is worth more than a dollar received anytime today at a given interest rate in order to Oil and gas production usually declines over
in the future. This is true because as soon as receive each of the $400 payments over the the life of a well. A discounted cash flow
a given sum of money is received, it can be next five years. For example, at an interest (DCF) model basically multiplies a production
reinvested to earn even more money and, rate of 5% per annum, $381 would have to forecast on a year-by-year basis by a forecasted
therefore, the earlier in time it is received, be invested today in order to yield the first future price and then subtracts operating
the more valuable it is. The time value of payment of $400 whereas $363 would have costs, royalties, and taxes to get a future net
money is critical in assessing whether a given to be invested today to yield the second cash flow.
investment is going to meet the investor’s payment of $400. Similarly, amounts of $346,
expectation. $329, and $313 invested today would yield Figure 2 shows a typical cash-flow profile for
the third, fourth, and fifth years of payments. an oil well. The 0% discount rate shows the
Suppose two investors were both going This is where the concepts of “Present actual cash-flow profile assuming that the cash
to invest $1,000 at the same point in time Value,” “Future Value,” and “Discount Rate” flow per barrel is a constant $1. The lines
and they were going to double their money. can be introduced. We know that the future corresponding to the 5, 10, and 15% discount
Investor #1 is going to receive $400 each value of an investment can be calculated rates show the effect of discounting on the
year for the next five years and Investor #2 by the equation FV=PV(1+i) n, where FV cash-flow stream. By summing the yearly
is going to receive $200 each year for the is future value, PV is present value, i is the discounted cash flows, you can calculate the
next ten years. In both cases, the investors interest rate and n is the number of time present value of the cash-flow stream. These
are going to earn $2,000 from their initial increments. By rearranging this equation, are shown in Figure 3 for each discount rate.
$1,000 investment but Investor #1 is further the present-day value of a future value (like
ahead because the money is received sooner a future cash flow) can be calculated by PV= When these discounted cash-flow streams
in time. FV/(1+i) n. In this equation, i is considered to are summed to calculate a present value,

32 RESERVOIR ISSUE 9 • OCTOBER 2009

the effect can be significant. In Figure 3, the
present value of the cash-flow stream at
a discount rate of 15% is only worth 73%
of the undiscounted (0%) cash-flow stream.
The greater the discount rate is, the less the
present value of the project for a given cash-
flow stream.
Reasonable Accuracy and
Assumptions Lead to Better
Decision Making
Preparing a proper DCF model requires a fairly
detailed knowledge of an existing operation or
accurate estimates and forecasts on undrilled
prospects. Price forecasts, a very important
driver of profitability, are notoriously
inaccurate. Production forecasting is uncertain
and there is always the risk of drilling a dry
hole. Capital costs for land, seismic, wells, and
facilities can be estimated with some degree
of accuracy and operating costs are often
well understood and predictable but are still
only a forecast. While royalties and taxes
are well known at any point in time, we all
know they can be arbitrarily changed without
notice during the life of a project. When
conducting any analytical process, the better
the information, the better the result. At the
same time, it is important to remember that it
is better to be approximately correct than to
be precisely wrong. Ranges of estimates and
sensitivities provide investors and management
with a sense of risk and uncertainty in their
investments.
Corporate management carefully selects
projects from an inventory that will maximize
expected cash flow at a rolled-up, company
level by balancing risk, size, and financial
return. To aid management in this selection
process, analysis and assessment of investment
opportunities needs to follow an orderly,
methodical, and standardized process so that
all critical attributes can be easily compared
and projects can be rated and ranked.
Management invests its cash flow from existing
properties into projects that will continue to
meet its corporate objectives of profitability,
growth and sustainability. Remember that
investors are most happy when they are
receiving appropriate and growing dividends
or distributions, year over year.
Carefully estimating parameters to be used
in an economic evaluation pays off when
conducting post investment appraisals on a
property. Preparing a cash-flow statement
provides a forecast record that can be
compared to actual performance. This can be
done in either a formal or cursory fashion by
management to ensure that future projects
continue to deliver expected cash flow. Those
projects that are not meeting expectations will
likely be unfunded in the future, with money
being diverted to more profitable operations.
The Great Equalizer
DCF models can be built for any asset that is
Asset Based Approach
focuses on the individual
assets and liabilities
assumes the company will be
liquidated
Book Value
Book Value Multiple
Adjusted Book Value
Replacement Value
Comparable Sales
Discounted Cash Flow
Table 2: Difference between an asset based and income based approach in estimating share price. (after Johnston
and Johnston, 2006)
producing or will produce a cash-flow stream.
It can be an existing producing property;
facilities such as pipelines, gas plants, or
oil batteries; marketing arrangements; or
undeveloped acreage. Using DCF models
allows diverse and unrelated assets to be
compared for investment purposes by
focusing on financial value alone. In this
way, management may elect to diversify
their income stream and avoid concentration
in any one commodity or segment of the
petroleum industry. There are many examples
of companies that have a balanced oil and
natural gas portfolio with both upstream and
downstream activities. Such diversification
reduces cyclical volatility that is common for
the oil and gas industry. However, product
or operational diversification beyond the
knowledge and capability of management is
not recommended as history has shown that
these strategies can be disastrous.
Corporate Valuations
While company management is using the DCF
model to carefully select projects in which to
invest, independent financial analysts are using
the same technique to determine the fair
market value of company shares relative to
their trading price (market price) and relative
to their competitors. They are looking to spot
corporations that are trading far below fair
market value with the expectation that the
marketplace will eventually recognize the true
value of the company and bid up share price.
Table 2 shows the two different approaches
used to evaluate a company using fundamental
analysis techniques.
Because the value of oil and gas reserves
in the ground does not always show up
on a company’s balance sheet, book value
and replacement value are not appropriate
for evaluation purposes. Cash flow, and
its derivatives, used both in the asset-and
income-based approach provide a better proxy
for value. There really is no better evaluation
technique for petroleum companies than a
discounted cash flow model and it explains
why a company’s fair market value is usually
higher than its market value.
Income Based Approach
considers the income or cash
generating capability
assumes the company remains
as a going concern
Dividend Discount
Capitalized Earnings
Discounted Cash Flow
Capitalized Cash Flow or Operating Profit
Comparable Sales
Next Steps
This series on Petroleum Economics for
Geologists will examine how a discounted
cash flow model is built, what factors need
to be considered, what kinds of outputs are
useful, and how this information can be used
to ensure a company is on track to achieve
its goals. Over the next several months, we
will look at:
• Price forecasts and hedging,
• Production forecasts and reserves,
• Capital and operating costs,
• Royalties,
• Income tax,
• Discount rates,
• Risk and probability,
• Ratios and metrics, and
• Strategic planning and portfolio
management.
We hope to provide readers with an
understanding of the importance and impact
economics have on their prospects, plays,
and companies and the role finance has in
shaping exploration and development.
If as geoscientists we can understand the
financial imperatives of our companies, we
can better deliver the type of exploration
and development needed to meet and exceed
investor expectations.
References
Johnston, D. and Johnston, D. 2006.
Introduction to Oil Company Financial
Analysis. Pennwell. p. 21-25.
Please note that this article is part of the
Petroleum Economics for Geologists series. The
series’ second installment will be in the November
Reservoir.
Support for this series is provided by Energy
Navigator who have reviewed articles, supplied
technical consultation, and critiqued manuscripts.
CSPG thanks them for their help.
RESERVOIR ISSUE 9 • OCTOBER 2009 33