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Petroleum Economics 1
Petroleum Economics 1
Petroleum Economics 1
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.
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)
(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)
Creation of Association without legal entity : ETAP participation rate %; Company participation rate %
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
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
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)
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)
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;
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)
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
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:
Monthly Production
bbl/Day Contactors
0-5000 X%
5000-10000 Y%
> 10000 Z%
Production Sharing Agreements (4/5)
Example 1 : Example 2 :
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
AND
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
Company Capital
Assets
Markets
Reinvest ?
Analysis
Make a decision
Economical
Fiscal environment Technical evaluation
environment
Economic results
Political
Company strategy
environment
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
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.
Risk exists whenever the actual outcome can differ from the expected
outcome positively or negatively!
Debt Equity
WACC = id(1-t) + ie
Debt+ Equity Debt+ Equity
Ct
NPV
t
(1 i)
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.
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
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
General Approach:
Payback.
Return on Capital Employed.
Net Income.
Profitability Index.
Internal Rate of Return.
Other Measures of Value : Payback
Example :
Cash Flow Year 0 Year 1 Year 2 Year 3
Project Gamma -2 2 0 0
Project Omega -2 1 1 5
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.
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 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
Capital Budgeting is concerned with finding the optimal set of projects . IRR
cannot identify that set.
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?
Field data
Fiscal data
Economic data
Product data
Cash flow
Economic Indicators
Project Economic Evaluation : Inputs : Field Data
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
Cash flow
Economic Indicators
Concept
Pre-
Feasibility FEED Project FID Project
Feasibility
Abandon
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
Feasibility study