PETROLEUM

ECONOMICS

Sunday Isehunwa (Ph. D)

 SPECIAL FEATURES OF
MINERAL ECONOMICS

• Minerals are found only in certain favoured

places. There is no question of locating a mine
anywhere else except where it is found in
commercial quantities.

• The minerals are exhaustible

• The minerals are found in places where they may

not be needed and used.
 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

 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.
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
ECONOMIC CHALLENGES

• Companies have tried to meet these

challenges through:
• Cost reduction measures
• Staff rationalization
• Vertical integration
• Strategic business units
• Portfolio diversification

• Other measures
 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)
 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
 Marker Crudes

• A marker crude is an oil from a specified

field or region which is traded in spot
markets and considered a standard
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
 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 a

formal commodities exchange for some specified
future delivery date.
 CRUDE OIL MARKETS

• The bulk of the world’s 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 contarct
arrangements between producers and consuming
governments as well as other players.
 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.
 THE SPOT MARKET

• However, price movements in the spot market do

not necessarily reflect real market conditions as
can fluctuate widely and involve relatively small
amounts 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.
 THE SPOT MARKET

• Major Players

• The major international oil companies

• Traders
• Brokers
• Independent oil companies
 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 than
the price set by the producer at the time of
sale.
 COMPONENTS OF NETBACK
DEALS

• Refinery Yields
• Products Prices
• Timing
• Transportation
• Other fees and Profit Margin
 MAJOR INTERNATIONAL
PETROLEUM COMMODITY
MARKETS
• NYMEX (New York Mercantile Exchange)

• IPE (International Petroleum Exchange

London)

• SIMEX (Singapore Mercantile Exchange)

 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 benefits
occur over a period of time.
TASKS IN PETROLEUM PROJECT
ECONOMIC ANALYSIS

• Setting an economic objective based on

corporate 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
 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
 TIME VALUE OF MONEY

Theory of Equivalence

• When cash flows can be traded for one another in

a financial world, those cash flows are considered
equivalent to each other.

Economic equivalence depends upon

• Interest rate
• Time
 PROJECT ECONOMICS

• When conducting a cost benefit analysis of

any project, if the benefits are received in
the future, we cannot directly compare the
front cost to the future benefits unless we:
• Convert the future benefit to equivalent
present benefit, or
• Convert the present cost to equivalent future
cost
 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
 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)
 ECONOMIC INDICATORS

NPV
• Consistently the most reliable and most frequently
used in practice
• Takes into account timing of future cash flow
• Tells us how much an investment is better or
worse than putting money into the bank or some
alternative investment
• Makes large projects more attractive than smaller
ones, no indication of investment efficiency.
• Highly dependent on discount rate
 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)
 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
 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
ECONOMIC INDICATORS
 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 out
for investment decision-making.
BASIC PRINCIPLES OF CASH
FLOW ANALYSIS

• Basic principles of cash flow analysis that are vital to

the 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
 BASIC DEFINITIONS

Capital Costs
• One-time costs usually incurred at the beginning of a
project. They are usually large expenditures incurred
several years before any revenue is obtained.

• Examples
• Tankers
• Pipelines Construction
• Process facilities
• Camps and Accommodations
• Storage vessels
 BASIC DEFINITIONS

Operating Costs
Occurs regularly and are necessary to maintain
operations.
Usually expended in terms of expenditure per year or per
unit production.

Examples
• Field labour cost
• Maintenance cost
• Office overhead
• It can be fixed periodic/annual amount or can be variable and
determined as a function of production rate.
 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
 CASH FLOW ANALYSIS

• Net Cash Flow

• Net cash flow = cash received – capital

expenditure – operating expenditure –
royalties, taxes, profit sharing.
 PROFIT

• Accounting concept used in reporting company

accounts or in assessing tax liability.
• Does not refer to total money flow but usually
incorporates depreciation of capital costs.

• Profit = cash received – depreciated capex –

opex – royalties, taxes, profit sharing, etc
 CASH FLOW VS PROFIT
Illustration of Difference between cash flow and profit
Description Year 1 Year 2 Year 3 Year 4 Year 5
Income ($mm) 0 40 40 40 40
- CAPEX ($mm) 100
- OPEX ($mm) 0 10 10 10 10
= Net Cash flow ($mm) -100 30 30 30 30

Description Year 1 Year 2 Year 3 Year 4 Year 5

Income ($mm) 0 40 40 40 40
- Depreciated CAPEX ($mm) 0 25 25 25 25
- OPEX ($mm)
0 10 10 10 10
Profit 0 5 5 5 5
 CASH FLOW VS PROFIT

Conclusion
• Net cash flow gives the forecasted actual money
spent and received. It correctly represents the size
and 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.
 EXAMPLE ECONOMIC
CALCULATION

Capital Investment = $110,000

Net Operating Income:
Year Income
1 $40,000
2 $40,000
3 $40,000
4 $40,000
5 $40,000
6 $30,000
7 $20,000
8 $10,000
9 $4,000
 EXAMPLE ECONOMIC
CALCULATION

Net Cash Recovery = ∑ Ix - P

= $264,000 - $110,000
= $154,000
 EXAMPLE ECONOMIC
CALCULATION

Payback Time = P/ ∑ Ix/N

= 110,000/ 264,000/9
= 3.75 Years
 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
 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
 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 =$26595.4

NPV(I) @40% = 104833.2 Profit = -$5166.77
IRR = 37%
ECONOMIC EVALUATION
 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.
 RISK AND UNCERTAINTY

• Derivation of cash flow and the measurement of

economic worth are based on the assumption that
investments are risk-free.

• Assessment of risk and uncertainty is important to

decision making

• Analysis allows one to select the appropriate

discount rates which account for risk and
uncertainty.
 DEFINITION OF RISK
Risk
The probability that a certain undesirable outcome will occur

Uncertainty
The range of values within which the actual value is
expected to fall

Contingency
• Provision for variations to the basis of a plan or cost
estimate which are likely to occur and which cannot be
specifically identified at the time the plan or estimate was
prepared.
• It provides an equal chance of over run or under run.
 ELEMENTS OF PROJECT RISK
MANAGEMENT

• Risk Identification
• Risk Quantification
• Risk Response Development
• Risk Response Control
 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 profitability
to specific risk factors
• Identifying the elements of risk that contribute most to
current inconsistency
• Defining a program to reduce and manage risk