petroleum economics part2
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8/2/2019 Petroleum Economics Part2
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Petroleum EconomicsElias Abllah
Course Outcome• Describe the underlying concept of key economic indicators
such as maximum cash sink, payout time, Net Present Value(NPV), Internal Rate of Return (IRR)
• Identify the various types of Fiscal Arrangements and itscomputational logic
• Develop basic economic models for E&P project economicevaluations.• Identify risk factor and impact on the project economics.
Basic Economic
Learning Outcome• Basic Economic• Time Value of Money• Inflow, Outflow and Net Cash Flow• Inflation & Cost Escalation
• Tax & Capital Allowance
What Does Economics Mean?
A social science that studies how individuals,governments, firms and nations make choices
on allocating scarce resources to satisfy theirunlimited wants .Economics can generally be broken down into:
macroeconomics, which concentrates on thebehavior of the aggregate economy;microeconomics, which focuses on individualconsumers
investopedia
Quiz• Question 1
Who is considered to be the "father of modern economics"?
A) Karl Marx
C) Adam SmithD) Barack Obama
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Answer• "Adam Smith (1723 - 1790), the "father of modern economics" and author of the famousbook "An Inquiry into the Nature and Causes of the Wealth of Nations", spawned the discipline
of economics by trying to understand whysome nations prospered while others laggedbehind in poverty"
Question 2• The tension between limited resources and
unlimited wants and needs, is referred to as?
A) ElasticityB) Market Economy
D) ScarcityE) None of the above
Answer• "Scarcity refers to the tension between ourlimited resources and our unlimited wants andneeds. For an individual, resources includetime, money and skill. For a country, limitedresources include natural resources, capital,labor force and technology
Question 3• What are the two primary branches of study
within economics?
A) Macroeconomics and NanoeconomicsB) Nanoeconomics and Intra-economics
D) Macroeconomics and MicroeconomicsE) Intra-economics and Microeconomics
Answer"Macroeconomics looks at the total output of a nationand the way the nation allocates its limited resourcesof land, labor and capital in an attempt to maximizeproduction levels and promote trade and growth for
future generationsï
Microeconomics looks into similar issues but on thelevel of the individual people and firms within theeconomy. It tends to be more scientific in its approach,and studies the parts that make up the wholeeconomy. Analyzing certain aspects of humanbehavior, microeconomics shows us how individualsand firms respond to changes in price and why theydemand what they do at particular price levels."
Question 6
• The value of the next best alternativeforegone by making another decision isknown as?
A Sto loss B) Opportunity costC) UtilityD) ElasticityE) Comparative Advantage
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AnswerOpportunity cost is the value of what is foregonein order to have something else. This value isunique for each individual. You may, for instance,forgo ice cream in order to have an extra helpingof mashed potatoes. For you, the mashed
otatoes have a reater value than dessert. Butyou can always change your mind in the futurebecause there may be some instances when themashed potatoes are just not as attractive as theice cream. The opportunity cost of an individual'sdecisions, therefore, is determined by his or herneeds, wants, time and resources (income)."
Question 9• Marginal utility will usually __________ with
each additional increase in consumption of agood.
A) Increase
C) Remain unchangedD) Move inversely to the invisible handE) None of the above
Answer"Although total utility usually increases as moreof a good is consumed, marginal utility usuallydecreases with each additional increase in theconsumption of a good. This decreasedemonstrates the law of diminishing marginalutility.
Because there is a certain threshold of satisfaction, the consumer will no longer receivethe same pleasure from consumption once thatthreshold is crossed. In other words, total utility
will increase at a slower pace as an individualincreases the quantity consumed."
What Does Time Value of Money (TVM) Mean?
The idea that money available at the presenttime is worth more than the same amount inthe future due to its potential earningcapacity. This core principle of finance holdsthat, provided money can earn interest, anyamount of money is worth more the sooner itis received.
Also referred to as "present discountedvalue".
What Does Inflation Mean?
The rate at which the general level of prices for goodsand services is rising, and, subsequently, purchasing
power is falling. Central banks attempt to stop severeinflation, along with severe deflation, in an attempt tokeep the excessive growth of prices to a minimum
As inflation rises, every dollar will buy a smallerpercentage of a good. For example, if the inflation rateis 2%, then a $1 pack of gum will cost $1.02 in a year.
Most countries' central banks will try to sustain aninflation rate of 2-3%
What Does Deflation Mean?A general decline in prices, often caused by areduction in the supply of money or credit. Deflationcan be caused also by a decrease in government,personal or investment spending.
The opposite of inflation, deflation has the side effectof increased unemployment since there is a lowerlevel of demand in the economy, which can lead to aneconomic depression. Central banks attempt to stopsevere deflation, along with severe inflation, in anattempt to keep the excessive drop in prices to aminimum.
The decline in prices of assets, is often known as AssetDeflation
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What Does Consumer Price Index - CPI Mean?A measure that examines the weighted averageof prices of a basket of consumer goods andservices, such as transportation, foodand medical care.The CPI is calculated by taking price changes for
and averaging them; the goods are weightedaccording to their importance. Changes in CPI areused to assess price changes associated with thecost of living.Sometimes referred to as "headline inflation
MOD vs RT• Money of the Day (MOD), also known as "Current Dollar", "As Spent
Dollar", "Escalated Dollar". MOD Dollar is also used in budgeting purposes.The actual economic calculation is carried out in MOD Dollars.
• Real Term Dollar (RT), is the "Constant Dollar” in discussing about income.Reference year must be specified such as RT 2002, RT 2003, etc. In
economic analysis, RT Dollars is used to report profitability.
• Converting RT to MOD:
where; i = escalation rate, n = number of years from today
Value (MOD) t+ n = Value (RT) t * ( 1+ i )n
Value (RT)
Value (MOD)
n: numbersofperiodI : interestper perriod
INFLATION & ESCALATIONS
Your engineering department provided the cost estimate for acompressor at US$ 20.0 Million (RT 2006) and it will be requiredin year 2012. The cost is expected to escalate at 3% per year.
What will be the compressor costs by then?
Exercise
INFLATION & ESCALATIONS
Cost (RT)2006= US$ 20.0 Milliont = 2006,
Your engineering department provided the cost estimate for acompressor at US$ 20.0 Million (RT 2006) and it will be required in year2012. The cost is expected to escalate at 3% per year. What will be thecompressor costs by then?
SUGGEANSWE
Value (MOD)
n = - = ,i = 3%,
Cost (MOD)2012 = ?
Cost (MOD) t+n = Cost (RT)t * ( 1+ i )n
Cost (MOD)2011 = US$ 20.0 Million * ( 1+3%)6
= US$ 20.0 Million * 1.194= US$ 23.9 Million
Value (RT)
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INFLATION & ESCALATIONSFor the following data input;1) Escalate the projected costs at 3% pa2) Calculate the Unit Operating Cost, Unit Development Cost and
the Unit Technical Cost, both in RT and MOD units
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Total
Annual Product’n 15.0 12.8 10.8 9.2 7.8 6.7 62.3
RT Capex 25.0 100.0 75.0 200.0
RT Opex 10.0 10.0 10.0 10.0 10.0 10.0 60.0
Escalation factor
MOD Capex
MOD Opex
• RT U ni t D ev el op me nt C os t ( UD C) = U S$ / BB L
• RT Unit Operating Cost (UOC) = US$ /BBL
• R T Unit Technical C ost (UTC) = U S$ /BBL
• MOD Uni t Development Cost (UDC) = US$ /BBL
• MOD Unit Operating Cost (UOC) = US$ /BBL
• M OD U ni t Tec hn ic al C os t ( UT C) = U S$ /B BL
INFLATION & ESCALATIONS
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Total
Annual Product’n 15.0 12.8 10.8 9.2 7.8 6.7 62.3
RT Capex 25.0 100.0 75.0 200.0
For the following data input;1) Escalate the projected costs at 3% pa2) Calculate the Unit Operating Cost, Unit Development Cost and
the Unit Technical Cost, both in RT and MOD units
SUGGESTANSWER
. . . . . . .
Escalation factor 1.00 1.03 1.06 1.09 1.13 1.16 1.19 1.23
MOD Capex 25.0 103.0 79.6 207. 6
MOD Opex 10.6 10.9 11.3 11.6 11.9 12.3 68.6
• RT Uni t Development Cost (UDC) = US$ 3 .21 /BBL
• RT Unit Operating Cost (UOC) = US$ 0.96 /BBL
• RT Un it Te chn ic al Co st (U TC ) = US $ 4 .1 7 / BB L
• MOD Unit Development Cost (UDC) = US$ 3.33 /BBL
• MOD Unit Operating Cost (UOC) = US$ 1.10 /BBL
• M O D U ni t Te chn ic al C os t ( UT C) = U S$ 4 .4 3 / BBL
CONCEPTS OF CASH FLOW
NET CASHFLOW = CASH INFLOW - CASH OUTFLOW
• Capital expenditure (Capex):
–eg. p latforms, facilities, wells
• Fiscal income:
–eg. sale of oil and gas(+) (-)
Examples of Cash Inflow Examples of Cash Outflow
–asset life > 1 year
• Operating expenses (Opex):
–eg. maintenance, chemicals, fuel, tariff
paid
–asset life <= 1 year
• Fiscal costs:
–eg. royalty, taxes, duties, bonuses
• Other costs:
–eg. premium payments
• Operating income:
–eg. tariff received
• Other income:
–eg. premium received
NET CASH FLOW(1) = C AS H I NF LO W - C AS H O UT FL OW
= R ev en ue - ( Ro ya lt y + Ta x + Ca pe x + Op ex )
= Rev en ue - Roy alt y - O pe x - Tax - C ap ex
= I nc om e B ef or e Tax - Tax - C ap ex
= I nc om e A ft er Ta x - Ca pe x
CONCEPTS OF CASH FLOW
Note:(1)Examplefrom aRoyalty-Tax fiscalregime
Cash In
Royalty
Opex
Tax
Capex
Cash Out
Net Cash Flow After Tax
Cash Flow Model versus Financial (Accounting) Model
CONCEPTS OF CASH FLOW
TOTAL CAPEX4
$10,000$10,000$10,000$10,000 $10,000• Net Cash Flow Model simulates
actual flow of cash for each year.
,
1/5Cost$8,000
$10,000$10,000$10,000$10,000 $10,000
1/5Cost$8,000
1/5Cost$8,000
1/5Cost$8,000
1/5Cost$8,000
• Financial Model depreciates theasset over the assumed life of theasset.
• This result in a different profitpicture.
s h F l o w
CONCEPTS OF CASH FLOW
Net CashSurplus
Net CashDeficit
Sample of A Field Life Cycle Project
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 C a
Royalty & TaxesSurplusOpexDevelopment CapexExploration Capex
(-) Detailed Design(-) Construction/Fabrication(-) Hook-up/Commissioning(-) Development Drilling
DEVELOPMENT PERIOD
(+) PSC revenues (cost oil, profit oil)(-) Opex(-) Development Drilling(-) PSC costs
PRODUCTION PERIOD
(-) G&G studies(-) Seismic(-) Exploration Drilling
EXPLORATION PERIOD
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• Tax Payable
= Tax Rate * Taxable Income
• Taxable Income
= Income -Expenses – Capital Allowance
(less)
TAX & CAPITAL ALLOWANCE
Income
Expenses
(less)
IncomeBefore Tax
(equals)
• Capital Allowance:
– r i i n l l i n in fr m 1 st r i n RCapital Allowance
(less)
Income
Expenses
(less)
Income
Before Tax
(equals)
Capital Allowance
Tax Paid
(less)
Taxable Income
(equals)
IncomeAfter Tax
(equals)
– i i i i i
1st year of investment incurred (whichever later)
– rate varies with types of capital; investment in high risk
areas or in Secondary/Tertiary recovery will entitle for
higher depreciation rate (government incentive)
– Intangible Capex, such as portion of development
drilling (circa 80%), can be expensed off
Tax Paid
(less)
Taxable Income
(equals)
IncomeAfter Tax
(equals)
TAX & CAPITAL ALLOWANCE
• The most common types of Depreciation/ Depletion/ Amortisation to calculate Capital
Allowance :
1. Straight Line method
- Claimable in Equal amounts over number of years
2. Declining Balance method
- Claimable based on yearly fixed percentage of the unrecovered capital at the end of
the year
3. Depletion/Unit of Production method
- Claimable based on the fraction of remaining reserves produced during the year
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TAX & CAPITAL ALLOWANCE
Example : Capexto be depreciated at 25% p.a., First Production in Year 2
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Total
Annual Production 4 10 10 9 7 40
Capex 100
Straight Line Method
Capex to be Depreciated 100
Capital Allowance 25 25 25 25 100
TAX & CAPITAL ALLOWANCE
Example : Capex to be depreciated based on 25% of the non-depreciated balance, First Productionin Year 2
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Total
Annual Production 4 10 10 9 7 40
Capex 100
Declining Balance Method
Capex to be Depreciated 100 75 56 42 31
Capital Allowance 25 19 14 11 31 100
Balance Non-depreciated 75 56 42 31 0
Note :
Since the production ends in Year 5, the remaining non-depreciated will be capitalised fully.
TAX & CAPITAL ALLOWANCE
Example : Capex to be depreciated based on the ratio of the annual production to the reserves at the beginning of the year times the non-depreciated balance, First Production in Year 2
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Total
Annual Production 4 10 10 9 7 40
Reserves @ 1 st January 40 36 26 16 7
Depletion/Unit of Production Method
Capex 100
Capex to be Depreciated 100 90 65 40 18
Capital Allowance 10 25 25 22 18 100
Balance Undepreciated 90 65 40 18 0
TAX & CAPITAL ALLOWANCE
25 25 25 2525
31
25 2530
40
n c e
Straight Line Declining Balance Depletion
• Straight Line method allow constant CCA claim compared to Declining Balance
and Depletion/Unit of Production methods
19
14
1110
22
18
0
10
20
Year 1 Year 2 Year 3 Year 4 Year 5
C a p
i t a l A l l o w a
TAX & CAPITAL ALLOWANCE• CAPEX and OPEX are treated differently• OPEX is treated more favorably that can be claim as an expense
immediately• CAPEX is claimed over the life of the asset or depending on
declining method used• The benefit of capital allowance is diminishes as of results of
delay
TAX & CAPITAL ALLOWANCE
Capital Allowance: Straight Line Method
Exercise : Capex to be depreciated at 25% p.a. using STRAIGHT LINE method,First Production in Year 2
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Total
Annual Production 4 10 10 9 7 40
Capex 20 100 80
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Total
Capital Allowance (Year 1)
Capital Allowance (Year 2)
Capital Allowance (Year 3)
Capital Allowance (Year 4)
Capital Allowance (Year 5)
Capital Allowance (Year 6)
Total Capital Allowance
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TAX & CAPITAL ALLOWANCE
Capital Allowance: Straight Line Method
Exercise : Capex to be depreciated at 25% p.a. using STRAIGHT LINE method,First Production in Year 2
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Total
Annual Production 4 10 10 9 7 40
Capex 20 100 80
SUGGESTEDANSWER
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Total
Capital Allowance (Year 1) 5 5 5 5 20
Capital Allowance (Year 2) 25 25 25 25 100
Capital Allowance (Year 3) 20 20 20 20 80
Capital Allowance (Year 4)
Capital Allowance (Year 5)
Capital Allowance (Year 6)
Total Capital Allowance 30 50 50 50 20 200
TAX & CAPITAL ALLOWANCE
Tax Losses Carry Forward
Example:
Year 1 Year 2 Year 3 Total
Net Income Before Tax 60 120 120 300
(less) Capital Allowance (110) (80) (80) (270)
Tax Payable @ 40% (20) 16 16 12
Tax Losses Carryforward (20) (4) - -
(less ) Tax Paid - - 12 12
Net Income After Tax 60 120 108 288
TAX & CAPITAL ALLOWANCE
Tax Deductible
Revenue –Cash In 100.0 US$ MM
(less) Royalty (30.0) US$ MM
(less) Bonus (10.0) US$ MM
Revenue – Cash In 100.0 US$ MM
(less) Royalty (30.0) US$ MM
Income Before Tax 70.0 US$ MM
Tax Creditable
Income Before Tax 60.0 US$ MM
(less) Capital Allowance (10.0) US$ MM
Taxable Income 50.0 US$ MM
Tax Payable @ 38% (19.0) US$ MM
(less) Tax Paid (19.0) US$ MM
Income After Tax 41.0 US$ MM
(less) Capital Allowance (10.0) US$ MM
Taxable Income 60.0 US$ MM
Tax Payable @ 38% (22.8) US$ MM
(less) Bonus (10.0) US$ MM
(less) Tax Paid (12.8) US$ MM
Income After Tax 57.2 US$ MM