Merak Petroleum Economics Fundamentals 4 (1) .X

SIS Education
The Fundamentals of
Petroleum Economics
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Copyright © 2005 Schlumberger. All rights reserved.
No part of this document may be reproduced or transmitted in any form, or by any means,
electronic or mechanical, including photocopying and recording, for any purpose without the
express written permission of Schlumberger.
Merak™ is a trademark of Schlumberger.
Merak Peep® is a registered trademark of Schlumberger.
All other names and trademarks are the property of their respective owners.
Released in Canada, March, 2006.
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Contents
Chapter 1: Introduction 1
Course Objectives......................................................................................................................................2
Why Perform Economics on Oil & Gas Projects? ......................................................................................2
Basic Steps for Economic Analysis............................................................................................................2
Basic Cash Flow .................................................................................................................................................... 2
Production Volumes............................................................................................................................................... 3
Prices ..................................................................................................................................................................... 3
Royalties ................................................................................................................................................................ 3
Operating Expenses .............................................................................................................................................. 3
Capital Investments ............................................................................................................................................... 3
Income or Federal Taxes ....................................................................................................................................... 4
Chapter One Conclusion............................................................................................................................4
Chapter 2: Detailed Analysis 5

Components of Economic Analysis ...........................................................................................................6
Production Volumes...................................................................................................................................6
Definitions of Petroleum Fluids and Reserves....................................................................................................... 6
Reserve Classifications.......................................................................................................................................... 7
Proved Reserves ................................................................................................................................................... 7
Unproved Reserves ............................................................................................................................................... 8
Reserve Status Categories .................................................................................................................................... 8
Methods of Estimating Reserves & Production Volumes...........................................................................9
Performance Methods............................................................................................................................................ 9
Volumetric Methods ............................................................................................................................................. 10
Analogy and Statistical Methods.......................................................................................................................... 10
Combination of Methods ...................................................................................................................................... 11
Production Schedules .......................................................................................................................................... 12
Subordinate Products .......................................................................................................................................... 16
Curtailed Wells or Leases .................................................................................................................................... 16
Chapter Exercise 1 ..................................................................................................................................17
Pricing ......................................................................................................................................................19
Benchmarks ......................................................................................................................................................... 19
Base Oil Prices and Adjustments ........................................................................................................................ 21
Base Gas Prices and Adjustments ...................................................................................................................... 22
Interests ...................................................................................................................................................23
Ownership Interests ............................................................................................................................................. 23
Fiscal Regimes .................................................................................................................................................... 23
Canadian Royalties.............................................................................................................................................. 25
Working Interests ................................................................................................................................................. 27
Specifying Reverting Interests ............................................................................................................................. 27
Entering Over-Riding Royalties ........................................................................................................................... 28
Entering Net Profit Interests................................................................................................................................. 28
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Contents
Interest Definitions ............................................................................................................................................... 28

Basic Interest Equation: ....................................................................................................................................... 30
Calculating Net Revenue Interest (NRI) .............................................................................................................. 31
Operating Expenses ................................................................................................................................35
Overhead expenses............................................................................................................................................. 35
Industry Operating Cost Norms ........................................................................................................................... 35
Capital Investments and Depreciation .....................................................................................................36
Intangible Investments ......................................................................................................................................... 36
Tangible Investments and Depreciation .............................................................................................................. 36
Abandonment & Salvage ..................................................................................................................................... 39
Entering Sunk Costs ............................................................................................................................................ 39
Taxes .......................................................................................................................................................43
Taxable Income ................................................................................................................................................... 43
Tax Rates............................................................................................................................................................. 44
Negative Taxes .................................................................................................................................................... 45
Book Tax.............................................................................................................................................................. 46
Economic Limit.........................................................................................................................................51
Daily Economic Limit............................................................................................................................................ 51
Escalation and Inflation............................................................................................................................52
Inflation: Theory in a nutshell............................................................................................................................... 53
Price Impact on Project Economics ..................................................................................................................... 53
Percentage Escalation ......................................................................................................................................... 54
Monthly Escalation/Inflation ................................................................................................................................. 55
Percent De-escalation.......................................................................................................................................... 56
Inflation ................................................................................................................................................................ 56
Chapter 3: Discounted Cash Flow Analysis 59

Introducing Discounting Topics................................................................................................................60
Time Value of Money...............................................................................................................................60
Compounding....................................................................................................................................................... 60
Discounting .......................................................................................................................................................... 61
Net Present Value................................................................................................................................................ 62
Selecting a Discount Rate.................................................................................................................................... 63
Discount Methods and Timing ............................................................................................................................. 64
Economic Indicators.................................................................................................................................69
Rate of Return (ROR) .......................................................................................................................................... 69
Discounted Profitability Index (DPI) ..................................................................................................................... 70
Profit to Investment Ratio (PIR) ........................................................................................................................... 70
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Contents
Discounted Return on Investment (DROI) ........................................................................................................... 70

Payout Period ...................................................................................................................................................... 71
References 77
Glossary of Oil & Gas Terminology 79
Petroleum Economics: The Fundamentals v

Chapter 1: Introduction
In this Chapter
This chapter includes information for the following topics:
Course Objectives
Why Perform Economics on Oil & Gas Projects?
Basic Steps for Economic Analysis
Chapter One Conclusion
1
Course Objectives
This class is designed to give you an understanding of petroleum economics, which
can be applied to the use of Peep. We will estimate reserves or production rate
forecasts, sensitize on pricing schedules, determine estimated future costs and
expenses, select proper tax treatments, and calculate cash flows. From there, we can
calculate net present values and profit indicators, then apply risk methods and
advanced property analysis.
Why Perform Economics on Oil & Gas Projects?

Economic evaluations are prepared to justify exploration projects and development
wells, value a property for sale or exchange, make acquisitions, or obtain loans.
Management also uses economic evaluations for corporate budgeting, government
reporting, valuations of estates, lease bidding, work over justification, equipment
purchases, and investor reporting.
Basic Steps for Economic Analysis

For this class, we will create a simple cash flow using Excel as the calculation
engine. Several screen captures in this document are windows from the Merak Peep
application. Peep will not be used in this course but will be introduced in a separate
course offering.
Basic Cash Flow

A basic cash flow takes a production estimate and applies price to calculate a revenue
stream. From this revenue stream, we subtract royalties and operating expenses to
achieve an Operating Income. Capital is then removed to create a Before Tax Cash
Flow (BTCF). Income taxes are then calculated, and the After Tax Cash Flow
(ATCP) is created.
Revenue = Volume ∗ Price
Operating Income = Revenue – (Royalty + Opcosts)
BTCF = Operating Income – Capital
Taxable Income = Operating Income – Depreciation
ATCF = BTCF – Taxes Payable
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Production Volumes
The first step to an economic analysis is the forecasting of production volumes.
These values are estimates, created from an extrapolation of past performance, or
using a simulator or equation to predict new reservoir performance. Mathematical
methods of prediction are usually based on exponential or hyperbolic equations,
although sophisticated simulations are sometimes required on new or large reservoirs.
Prices
Price is the monetary value received for each unit of oil or gas produced and sold.
Secondary byproducts may also be sold from some reservoirs. Prices may be kept at a
constant value or change over time. These changes are predictions of how the price
will vary based on market conditions. The quality of the hydrocarbon being sold can
also impact the price received. In addition, some purchasers impose a surcharge or
transportation fee as a means for the producer to share in the cost of marketing the
petroleum products.
Royalties
Royalty is value deducted from the revenue stream, which usually has no obligation
toward covering expenses. It is considered to come “off the top,” after product
quality adjustments, but before operating costs or investments are deducted. Many
different formulas are used for the calculation of royalties, particularly in Canada.
Operating Expenses
Operating expenses are the day-to-day costs of operating a property and maintaining
production. Typical charges would be well tender fees, lease electricity, chemicals,
water disposal, and overhead. They are normally deductible for income tax purposes.
Capital Investments
Capital consists of investments for drilling, exploration, equipment and facilities.
Usually broken down into Tangible and Intangible categories. Capital expenditure is
used in the calculation of before tax cash flow. Capital depreciation is used in the
calculation of taxes payable.
Tangible investments are equipment purchases, such as pumping units, pipelines,
compressors, and buildings. They often have salvage value. Intangible investments
are drilling fees, mud and chemicals, logging, and other non-equipment charges.
They typically have no salvage value.
Costs to abandon an area or location are sometimes grouped with capital investments.
Spent at the end of the life of a project, they may be offset by any recoverable
equipment sold as salvage or transferred within the organization.
Petroleum Economics: The Fundamentals 3

Income or Federal Taxes

The calculation of taxes is typically performed as a separate calculation from cash
flow. This calculation utilizes depreciation rather than capital expenditure to
determine taxable income. A tax rate is applied to Taxable Income, taxes are
subtracted, and the After Tax Cash Flow is created.
Chapter One Conclusion

This chapter was designed to provide a basic understanding of cash flow analysis. No
discounting was performed, and the time value of money was not considered. As we
build on our understanding of the basic components, we will begin to incorporate
escalation, inflation and discounting into the equations.
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Chapter 2: Detailed Analysis
In this Chapter
Components of Economic Analysis
Production Volumes
Methods of Estimating Reserves
Pricing
Interests
Operating Expenses
Capital Investments and Depreciation
Taxes
Economic Limit
Escalation and Inflation
5
Components of Economic Analysis

This portion of the class is designed to cover, in detail, the components of economic
analysis. Production volumes, pricing considerations, royalties, interests, operating
expenses, capital and taxes will be explained and applied.
The first step in the analysis is the forecasting of production volumes. For simplicity
in basic equations, we will focus on oil production. Gas will be considered as a
secondary product to examine ratio forecasting.
Production Volumes
Definitions of Petroleum Fluids and Reserves

Reserves
The term "reserves" means the volumes of crude oil, natural gas, and associated
products that can be recovered profitably in the future from subsurface reservoirs.
Petroleum
Petroleum is a general term that applies to all naturally occurring mixtures that
consist predominantly of hydrocarbons. Petroleum includes natural gas, crude oil,
and natural bitumen.
Crude Oil
Crude oil is the portion of petroleum that exists in the liquid phase in natural
underground reservoirs and remains liquid at atmospheric conditions of temperature
and pressure. Crude oil may contain small amounts of nonhydrocarbons produced
with the liquids.
Crude oil may be subclassified as follows:
extra heavy: less than 10° API
heavy: 10 to 22.3° API
medium: 22.3 to 31.1° API
light: greater than 31.1° API
Natural Gas
Natural gas is the portion of petroleum that exists either in the gaseous phase, or in
solution in crude oil, in natural underground reservoirs, and is gaseous at atmospheric
pressure and temperature. Natural gas may include amounts of nonhydrocarbons.
Natural gas may be subclassified as associated or nonassociated gas. Associated
natural gas is found in contact with, or dissolved in, crude oil in a natural
underground reservoir. Nonassociated natural gas is found in a natural underground
reservoir that does not contain crude oil.
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Solution Gas
Natural gas that is dissolved in reservoir oil under reservoir conditions of pressure
and temperature and is liberated from solution by reduction in pressure and
temperature as the oil is produced through surface gas-oil separation equipment.
Condensate
Condensate is a hydrocarbon liquid—consisting mostly of pentanes and heavier
substances—that is in the gas (vapor) phase under reservoir conditions and condenses
to the liquid phase when the gas is produced through surface separation equipment on
a lease operating under ambient conditions.
Reserve Classifications
Reserves are estimated volumes of crude oil, condensate, natural gas, natural gas
liquids, and associated substances anticipated to be commercially recoverable from
known accumulations from a given date forward, under existing economic
conditions, by established operating practices, and under current government
regulations. Reserve estimates are based on interpretation of geologic and/or
engineering data available at the time of the estimate.
Reserve estimates generally are revised as reservoirs are produced, as additional
geologic and/or engineering data become available, or as economic conditions
change.
All reserve estimates involve some degree of uncertainty, the relative degree of
uncertainty may be conveyed by placing reserves in one of two classifications:
proved or unproved. Unproved reserves are less certain to be recovered than proved
reserves and may be sub-classified as probable or possible to denote progressively
increasing uncertainty.
Proved Reserves
Proved reserves can be estimated with reasonable certainty to be recoverable under
current economic conditions. Current economic conditions include prices and costs
prevailing at the time of the estimate. Proved reserves may be developed or
undeveloped.
In general, reserves are considered proved if commercial producibility of the
reservoir is supported by actual production or formation tests. In certain instances,
proved reserves may be assigned on the basis of electrical and other type logs and/or
core analysis
Proved reserves must have facilities to process and transport those reserves to market
that are operational at the time of the estimate, or there is a commitment or
reasonable expectation to install such facilities in the future.

Unproved Reserves
Unproved reserves are based on geologic and/or engineering data similar to that used
in estimates of proved reserves, but technical, contractual, economic, or regulatory
uncertainties preclude such reserves being classified as proved. They may be
estimated assuming future economic conditions different from those prevailing at the
time of the estimate.
Unproved reserves may be divided into two sub-classifications: probable and
possible.
Probable Reserves
Probable reserves are less certain than proved reserves and can be estimated with a
degree of certainty sufficient to indicate they are more likely to be recovered than
not.
Possible Reserves
Possible reserves are less certain than probable reserves and can be estimated with a
low degree of certainty, insufficient to indicate whether they are more likely to be
recovered than not.
Reserve Status Categories

Reserve status categories define the development and producing status of wells
and/or reservoirs.
Developed
Developed reserves are expected to be recovered from existing wells. Improved
recovery reserves are considered developed only after the necessary equipment has
been installed, or when the costs to do so are relatively minor. Developed reserves
may be sub-categorized as producing or non-producing.
Producing
Producing reserves are expected to be recovered from completion intervals open and
producing at the time of the estimate
Non-producing
Non-producing reserves include shut-in and behind-pipe reserves.
Undeveloped
Undeveloped reserves are expected to be recovered from new wells on undrilled
acreage, by deepening existing wells to a different reservoir, or where a relatively
large expenditure is required to recomplete an existing well or install production or
transportation facilities for primary or improved recovery projects. The basic
volumetric method is based on ownership and development maps, geologic maps
based on structure and thickness, electric logs and formation tests, reservoir and core
data, production performance. Volumetric estimation is most appropriate when no
actual performance data exists; you have a depletion drive reservoir, or a gravity
drive reservoir.
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Methods of Estimating Reserves & Production

Volumes
Methods to estimate reserves are categorized here as:
performance
volumetric
analogy/statistical
Performance Methods
Performance methods may be used after a field, reservoir, or well has been on
sustained production long enough to develop a trend of pressure and/or production
data that can be analyzed mathematically. These procedures are based on the
assumption that those factors that control the trends will continue in the future.
Decline Curve Analysis

The term "decline curve analysis" refers to the analysis of declining trends of the
production of oil or gas — the principal products of oil wells or gas wells,
respectively — versus time or versus cumulative production to estimate reserves.
After a field, reservoir, or well has been on sustained production long enough for the
producing characteristics to develop clearly defined trends, it may be possible to
extrapolate these trends to the economic limit to estimate reserves.
Performance Trends
Frequently, one or more of the "performance indicators" of a well or reservoir
exhibits a trend before the production rate of the principal product begins to decline.
Depending on reservoir type and drive mechanism, these performance indicators
include:
water/oil ratio (WOR)
water/gas ratio (WGR)
gas/oil ratio (GOR)
condensate/gas ratio (CGR)
bottomhole pressure (BHP)
flowing tubing pressure (FTP)
shut-in tubing pressure (SITP).
Production Decline Types

Three types of decline curves are commonly used: hyperbolic, harmonic, and
exponential.
Material Balance Method

The Material Balance method involves estimating the remaining volume in the
reservoir based on changes in the reservoir pressure as volumes are produced from
the reservoir.

Material balance methods may be used to estimate reserves when there is sufficient
reservoir pressure and production data to perform reliable calculations of
hydrocarbons initially in place and to determine the probable reservoir drive
mechanism. For reliable material balance calculations, the reservoir should have
reached semisteady state conditions, i.e., pressure transients should have affected the
entire initial hydrocarbon accumulation.
Reliable application of this method requires accurate historical production data for all
fluids (oil, gas, and water), accurate historical bottomhole pressure data, and
pressure-volume-temperature (PVT) data representative of initial reservoir
conditions.
Volumetric Methods
Volumetric methods are used when subsurface geologic data are sufficient for
structural and isopachous mapping of the objective field or reservoir. One of the
objectives of this mapping is to estimate oil and gas initially in place. The fraction of
oil and gas initially in place that is commercially recoverable may be estimated using
a combination of analogy and analytical methods.
Volumetric Estimate of Initial Oil in Place

N = ( 7758 ∗ A ∗ H n ∗ Φc ∗ ( ( 1– S w ) ÷ B oi ) ) ∗ E r
where:
7758 = Barrels per acre foot

N = STB of recoverable hydrocarbon
A = Area of reservoir in acres
Hn = Net reservoir sand thickness in feet
Φc = Average effective porosity of sand (decimal fraction)

Sw = Percent water saturation
B oi = Initial Oil formation volume factor rb/stb (reservoir bbl/stock tank bbl)
Er = Recovery efficiency factor (decimal fraction)
Analogy and Statistical Methods

Analogy and statistical methods are typically used for undrilled prospects, and to
supplement volumetric methods in a field or reservoir’s early stages of development
and production. In addition, the method may be used to estimate reserves for
undrilled tracts in a partially developed field or reservoir.
The methodology is based on the assumption that the analogous field, reservoir, or
well is comparable to the subject field, reservoir, or well, regarding those aspects that
control ultimate recovery of oil or gas. The weakness of the method is that this
assumption’s validity cannot be determined until the subject field or reservoir has
been on sustained production.
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Analogy Methods
Analogy methods involve using recovery factors (barrels per acre-foot or cubic feet
per acre-foot) or recovery efficiencies (percent recovery) observed in analogous
reservoirs to estimate oil and gas recovery from reservoirs being evaluated. Often,
per-well recoveries from analogous reservoirs may be used to estimate recoveries
from wells or reservoirs under study.
For complete validity, analogous and subject reservoirs should be similar regarding:
reservoir structure, especially average dip
depositional environment of reservoir rock
nature and degree of principal heterogeneity
ratio of net to gross pay
petrophysics of the rock-fluid system
reservoir fluid properties and drive mechanism
initial pressure and temperature
spatial relationship between free gas, oil, and aquifer at initial conditions
well spacing
well location
well completion and production method
Seldom, if ever, are all these requirements met, and adjustments usually must be
made to compensate for the differences.
Statistical Methods
Depending on the amount of data available from the area of interest, statistical
methods may be used to supplement analogy methods to estimate reserves.
Log-Normal Distribution of Reserves
Experts in this field of study have noted that, in a given geologic setting, a log-
normal distribution is a reasonably good approximation to the distribution of field
sizes, i.e., to the initial reserves of oil or gas in those fields.
Combination of Methods
Usually, more than one method is used to estimate reserves. Typically, in the early
stages of development and production of a field or reservoir, reserves are estimated
using a combination of analogy and volumetric methods. In some areas, it may be
feasible to use seismic data to help determine reservoir or field size before there are
sufficient well data to prepare reliable geologic maps.
As development continues, and the early wells begin to develop pressure and
production trends, reserves for those wells may be estimated using performance or
decline curve analysis. Reserves for undrilled tracts in a developing area may be
estimated by analogy with older wells in the same, or similar, reservoirs in the field.

Example
An oil company is considering drilling a new prospect. The staff has
evaluated available information such as logs, cores, and geological data
from nearby wells and estimated the following reservoir parameters:
A = 200 acres
Hn = 20 feet
Φ = 12%
Sw = 35%
B oi = 1.3 rb / stb
Calculate the original oil in place:
N = 7758 ∗ A ∗ Hn ∗ Fe ∗ ( (1 – S w) / B oi )
= 7758 ∗ 200 ∗ 20 ∗ .12 ∗ ( (1 – .35) / 1.3 )
= 1,861,920 bbls
If the Recovery Efficiency Factor is 15%, what is the Recoverable Oil?
= 1,861,920 ∗ .15
= 279,288 bbls
Production Schedules
In order to perform an economic analysis on reserves, how the volume will be
produced over time must be known.
Common techniques for scheduling production are:
Manual
Exponential
Hyperbolic
Harmonic
Manual Production
Manual is a specified amount per year or month or other time period.
Year 1 – 25, 000 bbls
Year 2 – 23,750 bbls
Year 3 – 21,723 bbls
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Exponential Decline
Exponential is a constant percent (loss ratio) per year. This is the most common
decline method. It displays as a straight line on semi-log rate vs. time paper. The
exponential equation for each day’s production is:
t
Q = Q i (1 - D)
Where:
Q = flow rate
Qi = Initial flow rate

T = Time
D = Effective decline rate (decimal % per year)
N = Cumulative production
To calculate the cumulative production N at any time use:

N = (Q - Q i) / l n (1 - D)
Note: If Q and Q i are in bbls/day then multiply equation by 365 days/year to get
volume produced:
Where:
ln = natural log of number

For example, if the initial rate on a well is 100 bbls per day, and the effective decline
rate is 20% per year, the cumulative production during the first year would be:
Q = Q i (1 - D) t
1
= 100 (1 – 0.20)
= 80 bbls/day
N = (Q - Q i) / ln(1 – D)
= ( ( 80 – 100 ) / ( ln( 1 – .2 ) ) ∗ 365 days/year
= 32,714 bbls
The cumulative volume through the second year would be:

2
Q = 100 ∗ ( 1 – .2 )
= 64 bbls/day
N = ( (64 – 100) / ln(1 – .2) ) ∗ 365 days/year
= 58,886 bbls
Monthly Methodology in Peep

Peep actually defaults to a monthly calculation base, rather than annual. You will still
have an annual effective decline rate, but you must modify the equation to calculate
any cumulative monthly value.
Note: This methodology assumes equal number of days is selected.
1/12
Qmonthly = Q i (1 – D)
Nmonthly = (Q – Q i) / ln(1 – D)
These values are then summed to annual numbers for reporting. For example, if the
initial rate on a well is 100 bbls per day, and the effective decline rate is 20% per
year, the cumulative production for the first month would be:
1/12
Q = Q i (1 – D)
1/12
= 100 – (1 – 0.20)
= 100 (0.9816)
= 98.16 bbls/day
N = (Q – Q i) / ln(1 – D)
= (98.16 – 100) / ln(0.8) ∗ 365.25
= -1.842 / -0.223 ∗ 365.25
= 3015.62 bbls
Effective Versus Nominal Decline

The effective decline rate, De , is frequently used in many computer model
calculations. The effective decline rate may be in better agreement with actual
production records. The nominal decline rate is used in some equations and is
normally used in nomographs.
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The effective decline rate may be expressed:

De = (Q i – Q) / Q i
Where: Q is measured after one year.
For example, if the production at the beginning of the year was 100 BOPD, and at the
end of the year was 80 BOPD, then the effective decline rate is:
De = (Q i – Q) / Q i
= (100 – 80) / 100
= .20 or 20%
The effective decline rate, D e , is related to the nominal decline rate, D n , by the
following equations:
–dn
De = 1–e
And
Dn = - ln ∗ (1- D e)
Effective Rate Nominal Rate

.095 .10
.181 .2
.259 .3
Hyperbolic and Harmonic Decline

With a hyperbolic decline, the value for “D” changes. “D” is the decline rate when
the production rate is “Q.” “Di” and “Qi” are the nominal decline rate and production
rate when T = 0. However, the concept of annual decline rate is less meaningful when
the instantaneous decline rate is continuously changing. For this reason, most
software packages use the relationship:
Dnominal = – ln (1 – Deffective)
To calculate the flow rate at any point in time:

-1/ n
Q = Qi ( 1 + n ∗ Di T )
Where
n = hyperbolic exponent (typically between 0 and 1.0)
Di = initial nominal decline rate
To calculate the cumulative production at any time:

n 1– n 1– n
N =( Q i / D i ∗ (1 - n) ) ∗ (Q i – Q ) ∗ 365 days/year
Where D i is the nominal decline rate.

The harmonic decline equation is the same, except that n is always equal to 1.
Subordinate Products
Once the primary product values have been calculated, you can then estimate the
secondary product production. Condensate, casinghead or associated gas, water, and
other liquids are examples of products usually scheduled as ratio values. These values
are usually predicted from well tests or production history relationships, and are
stated as GOR or Yield. GOR is gas/oil or scf/bbl. Yield is oil/gas or bbl/mmscf.
Notice the difference in volume units between GOR and Yield. Ratios may be
constant over time, or changing as the characteristics of the reservoir change.
The easiest method of predicting a secondary stream using a ratio is to simply
multiply the primary product by the value of the ratio in each production period. For
example, if the oil volume in Year One is 1000 bbls, and the ratio is 1200 scf/bbl,
then what is the gas volume?
Gas Volume = Oil ∗ Ratio Value
= 1000 ∗ 1200
= 1,200 MSCF
Curtailed Wells or Leases

Production of oil or gas from leases or wells may be curtailed for several reasons,
including pipeline limitations, limited market, or inability to handle all produced
water. Thus, before attempting to analyze production trends, the engineer should
determine whether the lease or well in question has been curtailed.
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Chapter Exercise 1
Production Scheduling Exercise
Oil Production:
Initial Rate = 1000 bbls/day (instantaneous)
Exponential annual decline = 10% effective
Gas Production:
Constant Ratio of 1200 scf/bbl
Find, for both oil and gas:

1. Rate at end of first year
2. Rate at end of second year
3. Production for Year One and Year Two
(See next page for solution)

Solution to Production Scheduling Exercise
t
1. First Year Oil Q = qi (1 - d)
1
= 1000 (1 – 0.1)
= 900 bbls/day
Q = Q oil ∗ ratio
First Year Gas = 900 ∗ 1200

= 1080 mscf/day
2
2. Second Year Oil Q = 1000 (1 – 0.1)
= 810 bbls/day
Q = 810 ∗ 1200
Second Year Gas = 972 mscf/day
3. Year One Production Noil = ( (q – q i) / l n (1 – d) ) ∗ 365
= ( (900 – 1000) / l n (1 – 0.1) ) ∗ 365

= 346,430 bbls
Ngas = 346,430 ∗ 1200

= 415,716 mscf
Noil = ( (810 – 900) / l n (1 – 0.1) ) ∗ 365

= 311,787 bbls
Year Two Production
Ngas = 311,787 ∗ 1200
= 374,144 mscf
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Pricing
Every economic evaluation needs price forecasts for each product. This value is used
to calculate the revenue in each time period. Most companies create price forecasts
for the various locations where products are sold, and then distribute the forecasts for
use in all evaluations. These are usually called base prices and the imperial units are
$/bbl for oil and $/MMBTU or $/MSCF for natural gas. Byproducts may also be sold
in $/bbl or $/gallon.
Prices are impacted by many factors. Quality of hydrocarbon, politics, supply
available, transportation surcharges, and proximity to market issues are usually
handled with price adjustments. Adjustments may be reductions (downward) or
premiums (upward).
A study by WTRG Economics on the history of oil prices is listed as a reference. One
of the main points brought out in this analysis is the fact that oil prices have
maintained an average price of $19.00US plantgate when adjusted for inflation (in
1996 dollars). History indicates that prices do spike due to specific events in our
world but then return to a consistent price, adjusted for inflation, over time.
Benchmarks
West Texas Intermediate
West Texas Intermediate (WTI) crude oil is of very high quality and is excellent for
refining a larger portion of gasoline. Its API gravity is 39.6 degrees (making it a
“light” crude oil), and it contains only about 0.24 percent of sulfur (making a “sweet”
crude oil). This combination of characteristics, combined with its location, makes it
an ideal crude oil to be refined in the United States, the largest gasoline consuming
country in the world.
Most WTI crude oil gets refined in the Midwest region of the country, with some
more refined within the Gulf Coast region. Although the production of WTI crude oil
is on the decline, it still is the major benchmark of crude oil in the Americas. WTI is
generally priced at about a $2-per-barrel premium to the OPEC Basket price and
about $1-per-barrel premium to Brent, although on a daily basis the pricing
relationships between these can vary greatly.
WTI is priced at Cushing Oklahoma.
Brent Blend
Brent Blend is actually a combination of crude oil from 15 different oil fields in the
Brent and Ninian systems located in the North Sea. Its API gravity is 38.3 degrees
(making it a “light” crude oil, but not quite as “light” as WTI), while it contains about
0.37 percent of sulfur (making it a “sweet” crude oil, but again slightly less “sweet”
than WTI).
Brent blend is ideal for making gasoline and middle distillates, both of which are
consumed in large quantities in Northwest Europe, where Brent blend crude oil is
typically refined. However, if the arbitrage between Brent and other crude oils,
including WTI, is favorable for export, Brent has been known to be refined in the

United States (typically the East Coast or the Gulf Coast) or the Mediterranean
region. Brent blend, like WTI, production is also on the decline, but it remains the
major benchmark for other crude oils in Europe or Africa. For example, prices for
other crude oils in these two continents are often priced as a differential to Brent, i.e.,
Brent minus $0.50. Brent blend is generally priced at about a $1-per-barrel premium
to the OPEC Basket price or about a $1-per-barrel discount to WTI, although on a
daily basis the pricing relationships can vary greatly.
NYMEX Futures
The New York Mercantile Exchange (NYMEX) futures price for crude oil, which is
reported in almost every major newspaper in the United States, represents (on a per-
barrel basis) the market-determined value of a futures contract to either buy or sell
1,000 barrels of WTI or some other light, sweet crude oil at a specified time.
Relatively few NYMEX crude oil contracts are actually executed for physical
delivery.
The NYMEX market, however, provides important price information to buyers and
sellers of crude oil in the United States (and around the world), making WTI the
benchmark for many different crude oils, especially in the Americas. Typically, the
NYMEX futures prices tracks within pennies of the WTI spot price described above,
although since the NYMEX futures contract for a given month expires 3 days before
WTI spot trading for the same month ceases, there may be a few days in which the
difference between the NYMEX futures price and the WTI spot price widens
noticeably.
OPEC Basket Price

For a discussion of crude oil pricing in general, and of the OPEC Basket price in
particular. OPEC collects pricing data on a "basket" of seven crude oils, including:
Algeria's Saharan Blend, Indonesia's Minas, Nigeria's Bonny Light, Saudi Arabia's
Arab Light, Dubai's Fateh, Venezuela's Tia Juana Light, and Mexico's Isthmus (a
non-OPEC crude oil). OPEC uses the price of this basket to monitor world oil market
conditions.
As mentioned above, because WTI crude oil is a very light, sweet (low sulfur
content) crude, it is generally more expensive than the OPEC basket, which is an
average of light sweet crude oils such as Algeria's Saharan Blend and heavier sour
crude oils (with high sulfur content) such as Dubai's Fateh.
Brent is also lighter, sweeter, and more expensive than the OPEC basket, although
less so than WTI. Since OPEC has (at least informally) tied its production
management activity to the goal of maintaining the OPEC Basket price between $22
and $28 per barrel, market watchers now pay close attention to this oil price
indicator.
Henry Hub Natural Gas

The Henry Hub is the largest centralized point for natural gas spot and futures trading
in the United States. The New York Mercantile Exchange (NYMEX) uses the Henry
Hub as the point of delivery for its natural gas futures contract. The NYMEX gas
futures contract began trading on April 3, 1990 and is currently traded 72 months into
the future. NYMEX deliveries at the Henry Hub are treated in the same way as cash-
market transactions.
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Many natural gas marketers also use the Henry Hub as their physical contract
delivery point or their price benchmark for spot trades of natural gas.
The Henry Hub is owned and operated by Sabine Pipe Line, LLC, which is a wholly
owned subsidiary of ChevronTexaco. The Sabine Pipe Line starts in eastern Texas
near Port Arthur, runs through south Louisiana, not far from the Gulf of Mexico, and
ends in Vermillion Parish, Louisiana, at the Henry Hub near the town of Erath. The
Henry Hub is physically situated at Sabine’s Henry Gas Processing Plant.
The Henry Hub interconnects nine interstate and four intrastate pipelines, including:
Acadian, Columbia Gulf, Dow, Equitable (Jefferson Island), Koch Gateway, LRC,
Natural Gas Pipe Line, Sea Robin, Southern Natural, Texas Gas, Transco, Trunkline,
and Sabine’s mainline.
Collectively, these pipelines provide access to markets in the Midwest, Northeast,
Southeast, and Gulf Coast regions of the United States.Sabine currently has the
ability to transport 1.8 billion cubic feet per day across the Henry Hub. Relative to
the total U.S. lower 48 average daily gas consumption of 60.6 billion cubic feet per
day in 2000,the Henry Hub can handle up to 3.0 percent of average daily gas
consumption.
Approximately 49 percent of U.S. wellhead production either occurs near the Henry
Hub or passes close to the Henry Hub as it moves to downstream consumption
markets. This is based on 2000 production levels reported for the Gulf of Mexico and
the onshore Louisiana and Texas regions encircling the Gulf of Mexico.
Other price points include: AECO, Sumas and Chicago.
Base Oil Prices and Adjustments

Oil prices are normally quoted in imperial as $/bbl, or in metric as $/m3, some
countries may use a mass measurement such as $/ton. Purchasers will post prices
based on location and quality, relating back to industry-accepted benchmarks as
described above.
This Peep example shows a constant base price of $18.65 per barrel with a downward adjustment of
$1.3987, for a net price of $17.2512 per barrel.

Base Gas Prices and Adjustments

Gas prices can be stated in imperial as $/mscf or $/MMBTU. Most purchasers list gas
prices as $/MMBTU. BTU, or British Thermal Unit, is the amount of energy required
to raise the temperature of one cubic foot of water one degree Fahrenheit. The metric
heat energy equivalent is refered to as $/GJ or gigajoule.
A heating standard measurement unit of 1000 is used to convert the $/MMBTU price
to $/mcf. If the gas is richer, contains liquids such as propane or butane, then the
BTU value will be greater than 1000. The inverse holds true for gas that contains
other components, such as helium or nitrogen, in the stream. This factor is used to
adjust the gas price received, and is in addition to adjustments for transportation
surcharges or pipeline fees.
To adjust a gas price for a BTU value other than 1000, divide the factor by 1000. The
resulting number is then multiplied by the $/MMBTU price to result in a $/mscf.
Gas Price $/mcf = $/MMBTU ∗ (BTU / 1000)
= 2.00 ∗ (1120 / 1000)
= 2.00 ∗ 1.120
= $2.24/mscf
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Interests
Ownership Interests
The ownership of petroleum resources plays a critical role in the calculation of
petroleum economics. Whoever owns the mineral rights can, and usually does,
extract a royalty from the resource Producer.
Royalties are usually calculated based on the revenue, with no regard for
profitability.
There are two basic types of Resource Ownership:
Private Ownership
State Ownership
Private Ownership
When a person or corporation holds the mineral rights, they charge the producer a
leasehold or freehold royalty.
The terms of this royalty are usually negotiated between the leaseholder and the
producer. The royalty is usually expressed as a fixed percentage of production or
revenue.
Private ownership of mineral rights is most common in the United States. However,
there are also examples of this found elsewhere (e.g. railway lands in Canada).
State Ownership
Most of the world’s petroleum resources are owned by the country in which they
exist. The government of that country then takes the responsibility for managing the
resource.
Fiscal Regimes
One tool that governments use to manage their natural resources is the fiscal regime.
The fiscal regime dictates who owns the resource once it is produced (i.e. brought to
the surface) and how the revenue generated by the production of the resource is
allocated.
There are two main types of fiscal regimes:
production sharing contracts
concessionary regimes
Concessionary regimes (also know as royalty/tax regimes) are more typical in
western or developed nations, while production sharing contracts (PSC) are more
commonly seen in developing nations.
Production Sharing Contracts

Production sharing contracts are characterized by the following:

under production sharing contract (PSC) systems, the government retains

ownership of the hydrocarbons.
companies can reclaim costs incurred from production revenues, subject to
constraints.
oil companies negotiate a right to a share of the production revenues (profit
split).
companies may also pay corporate tax on profit share.
Production Sharing Contracts are often negotiated and calculated on a field
or block of wells
Production Sharing Regime Flowchart
Concessionary
Concessionary contracts are characterized by the following:
individuals or companies buy the right to extract and sell mineral resources
(a concession)
the state owns resources but transfers title to the licensee at the wellhead
licensee receives all sales revenues in the first instance
licensee company is then liable for royalties and taxes (examples of
concessionary systems include the UK, the United States and Canada)
royalties are payable on value of oil/gas produced – irrespective of project
viability or profitability
usually have specific petroleum taxes — e.g. UK Petroleum Revenue Tax
(PRT)
taxes usually based on profit-sensitive basis
Concessionary Regime Flowchart
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Canadian Royalties
Canada and all of its petroleum producing provinces use concessionary fiscal
regimes.
There are many different royalty regimes in Canada. The Federal Government has a
Frontier regime, and each of the provinces have their own unique regimes. In most
provinces there are separate regimes for oil and gas, different regimes in various
geographical and/or geological areas, different regimes for varying types of oil
(heavy, light) and gas (solution, non-solution) as well as incentives for exploration
and low productivity wells.
The dozens of royalty regimes applied in Canada will be broken down into two
general types for the example purposes.
Western Canadian Regimes

Most of the regimes of the major petroleum producing provinces (Alberta, B.C. and
Saskatchewan) use a combination of price, production and vintage to calculate the
royalty rate, and hence royalties.
Vintage refers to the date on which the well was drilled. From time to time,
governments change the royalty regime. Any wells drilled on or after the regulated
date are considered to be of a different vintage.
Price sensitivity is built into most royalty regimes in Western Canada. If the price of
oil or gas goes above a certain level, a higher royalty percentage is levied. In order to
facilitate this calculation, governments publish Reference and Select Prices on a
monthly basis. Reference Prices reflect what is considered a fair market value for the
product and Select Prices are threshold above which additional royalty is payable (i.e.
if the Reference Price is less than the Select Price, the minimum rate is charged).
Select Prices are adjusted yearly for inflation.
Production sensitivity is also common in these types of regimes. The lower the
production rate is for a well in a given month, the lower the calculated royalty
percentage. Even in regimes where the basic royalty rate is not sensitive to
production rates, there is often a Low Productivity Allowance. This is to encourage
producers to continue production instead of shutting a well in after production has
declined significantly.

Valuing the Crown’s Share

The royalty rate (or percentage) indicates the portion of the production that is owned
by the Crown. Typically, the Crown will take payment in cash in lieu of the actual
production. For this reason the Crown’s share needs to be given a value. This value is
determined by the Reference Price, which is not necessarily the same as the Selling
Price received by the Producer.
When calculating royalties, it is important to use reasonable Reference and Select
Prices.
Also, because the Crown receives cash in lieu of production for royalties, it provides
the producer with allowances to cover certain costs involved in the gathering and
processing its share of the production.
Example – Alberta Gas Royalties
This is a simplified example meant to illustrate the equations involved in calculating
Gas royalties in Alberta. To accurately determine the Gas royalty percentage, the Gas
stream would have to be broken down into its individual Instream Components (i.e.
Methane, Ethane, Propane, Butane, Pentanes) each of which have a separate royalty
equation.
Gas Crown Royalties in Alberta are dependent upon:
Gas Reference Price
Gas Select Price (for New and Old gas)
Gas Vintage (New or Old)
Royalty % = 15(Select Price) + 40(Reference Price – Select Price)

________________________________________________________________________________________________
Reference Price
The minimum Crown royalty rate for New or Old Gas is 15%.
The maximum Crown royalty rate for New Gas is 30% and Old Gas is 35%.
Frontier Royalties
Regions of Canada that calculate royalties based (sometimes loosely) on the Federal
“Frontier” regime include: Frontier Lands in the Territories, Offshore production on
the East Coast and Oil Sands production in Alberta.
These regimes consist of various “Tiers” of royalties that change over time. Early in
the production cycle a low royalty rate is applied which then increases over time.
One of the significant events that influences the royalty rate is Payout.
Example – Alberta Oil Sands
Pre-Payout Royalty
The pre-payout royalty is 1% of gross revenues until project payout.
Post-Payout Royalty
At project payout the royalty payable is the greater of 25% of net revenue
and 1% of annual gross revenue. Post-payout royalties are limited to zero.
Payout
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Payout occurs when the Adjusted Cumulative Cost Base (ACCB) equals the
Cumulative Adjusted Gross Revenue (CAGR)
Return Allowance
Return Allowance is added to the Adjusted Cumulative Cost Base to extend
project payout. The Long Term Government Bond Rate is applied to the
following equation to determine the Return Allowance value: (Adjusted
Cumulative Cost Base - Return Allowance from Previous Period) -
(Cumulative Adjusted Gross Revenue)
Working Interests
The operating interest, also known as the working interest (WI), is the portion of
lease expenses that are paid by the working partner. It can be broken down by
product or capital type. The product revenues, operating costs, and overhead are
multiplied by the Operating Interest to determine your working interest share of each.
Some lease agreements specify a change in the interest positions when certain
hurdles or triggers are met. These changes in operating interests and royalties are
referred to in Peep as interest reversions. All the interest positions in Peep can be set
to change or revert. The default is that no reversion is specified. Up to three reversion
interests can be specified for each interest field in a case.
A reversion point or trigger can be specified four different ways:
capital amount to be recovered
oil volume to be produced
gas volume to be produced
date to be reached
Specifying Reverting Interests

All the interest positions in Peep can be set to change or revert. The default is that no
reversion is specified. Up to three reversion interests can be specified for each
interest field in a case. A reversion point or trigger can be specified in different ways:
a capital amount to be recovered (percentage or dollar amount)
a given volume of a specific product
a date to be reached
Each of the reversion trigger types is described in the table below:
Enter this … To revert interests …
Payout - % of All Capital Before-tax cash flow reaches a given percent of all the
capital in the case
Reversion Capital Before-tax cash flow reaches a specified amount
Volume When production total for a specific product reaches a
specified amount
Date When a given date is reached

Notes about reverting interests:

Peep displays the calculated reversion points on all summary reports.
If you do not enter any reversion triggers, Peep does not revert.
You can enter a reversion with more than one trigger. Peep reverts at the first
occurrence. For example, you can enter a reversion to occur at 200% of all
the capital in the case or in January, 1998. Peep reverts at whichever trigger
occurs first.
Entering Over-Riding Royalties

An over-riding royalty (ORR) is a burden that amounts to a given percentage of the
total lease production. When you are receiving an ORR, you often do not have a
working interest in production. All burdens are multiplied by the ORR/Burden
interest % defined under the Lease tab (Interests side tab). To evaluate a burden
interest, input a receivable burden in the Peep case. Then set the operating interest to
0 (zero), and set the ORR/burden interest to the appropriate value. The program will
calculate the value of the burden.
Sliding Scale ORR

A sliding scale royalty is a fraction of the monthly production that follows a sliding
scale of the crown’s percentage, with a maximum and a minimum limit set.
Typically, the fraction is set to 1/150 (5 to 15 percent). Peep defaults to a 5%
minimum and a 15% maximum, using 150 as the divisor. Essentially, the ORR is a
percentage equal to 1/150 of monthly production per well but is no more than 15%
and no less than 5%.
Entering Net Profit Interests

A net profit interest (NPI) is similar to an over-riding royalty except that an NPI is
paid when the operating income is positive. (The operating income is the total
revenue after royalties and operating costs are deducted.) Enter positive values if you
are paying the NPI; enter negative values if you are receiving the NPI. An NPI can
also be paid only when the before tax cash flow is positive (that is, after royalties,
operating costs, and capital costs are paid). If the NPI is based on cash flow, you will
need to create a new burden variable in your Peep model.
Interest Definitions
Working Interest:
Working Interest is the portion of lease expenses that are paid by the working partner.
If a company has a 50% working interest they would normally be obligated to pay
50% of all operating expenses and capital expenditures. They would normally also
receive 50% of the net revenue.
Capital Interest:
The portion of the capital investment a company is obligated to pay. Typically capital
interest and working interest will be the same, but not always.
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Net Revenue Interest:

This is a company’s portion of revenue less all royalty interest paid.
Royalty Interest:
A retained interest (usually by the land owner or mineral rights holder) deducted
from a working interest and having no obligation toward paying operating expenses
or capital expenditures.
Overriding Royalty:
This is an additional royalty created out of the working interest and having the same
term as this interest. This form of royalty may also become part of a farm-out
agreement. Overrides are normally less than 10% of the lease interest.
Net Profits Interest:
An additional interest that could be paid or received. A net profits interest is normally
taken out of the net income stream. Occasionally it is deducted from cash flow.
Commonly the NPI will be in the 5 to 10% range.

Basic Interest Equation:

Net Revenue Interest = Working Interest ∗ (1 - Total Royalty) + Overrides Received
Example:
The Interest Pie Chart
Assume:
Working Interest = 100%
Leasehold Royalty = 12.5%
Overriding Royalty = 5%
Interest Pie
ORR
5.00%
Leasehold Royalt y
12.50%
NRI
82.50%
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Calculating Net Revenue Interest (NRI)

Assume four equal partners (i.e. WI = 25% each)
Leasehold Royalty = 12.5%
Overriding Royalty = 7.5%
Therefore, the working interest pie looks like:
Working Interest Pie
25% 25%
25% 25%
And the NRI pie looks like:
NRI Pie
ORR
NRI 7.50%
20.00%
LH Roy
12.50%
NRI NRI
20.00% 20.00%
NRI
20.00%
Where: NRI = 0.25 ∗ (1 – (0.125 + 0.075)) + 0 = 0.20

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Chapter Exercise 2
Working Interest Exercise

What is the revenue share of a 75% working interest if you must pay a 12.5% Net
ORRI, and Crown Royalties totalling 25%?
Calculate the working interest revenue stream below, then subtract the royalty shares.
The result is the Net Revenue Interest (NRI).
Year Price Prod. WI ORRI Crown Net

Revenue Revenue
1 $2.00 500
2 $2.00 450
3 $2.10 400
4 $2.205 370
.5 $3.00 300
6 $3.30 260
Total

Solution to Working Interest Exercise
Year Price Prod. WI Revenue ORRI Crown Net Rev.

1 2.000 500 750.00 93.75 187.50 468.75
2 2.000 450 675.00 84.38 168.75 421.88
3 2.100 400 630.00 78.75 157.50 393.75
4 2.200 370 610.50 76.31 152.63 381.56
5 3.000 300 675.00 84.38 168.75 421.88
6 3.300 260 643.50 80.44 160.88 402.19
Total 2280 3984.00 498.00 996.00 2490.00
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Operating Expenses
Ongoing costs related to the day-to-day operations of a well, lease, or field, is usually
called Operating Expenses. They are identified with a specific property and might
include lease maintenance, treating fluids, general repairs, fuel and electricity, and
secondary or enhanced recovery operations. Common methods of scheduling
operating costs are:
Variable ($/bbl or $/mcf)
Well Count ($/well/month or $/well/year)
Fixed (M$/month or M$/year)
Overhead expenses
Overhead type charges such as salaries and office costs are usually grouped with
operating expenses in a basic cash flow analysis. In Peep they can be charged as a
percentage of operating or capital costs. The industry varies on their practice of
burdening projects with overhead costs. Some corporations have a standard rate,
which is applied to all projects while others ignore it completely.
Industry Operating Cost Norms

It is difficult to provide an average operating cost for a producer. Operating costs
vary dramatically dependent on many factors such as:
type of product: oil or gas
artificial lift requires power to generate

sour or sweet: sour gas is expensive to sweeten

distance to processing facility factor into gathering costs
onshore or offshore production has a major impact on opcosts
remote location with no road access requires helicopter costs to access
remote location may require an oil well’s production to be trucked rather
than shipped through a pipeline
completion zone: the deeper the well, the more costly maintenance is on the
well
well maturity: a mature oil well may be producing significant quantities of
water requiring disposal
Capital Investments and Depreciation

Capital is the amount of money invested in new exploration or on-going development
projects for drilling, equipment and facilities. Usually broken down into tangible and
intangible categories. capital expenditure is used in the calculation of before-tax cash
flow. Capital depreciation is used in the calculation of taxes payable.
Sometimes referenced as depreciation, depletion and amortization (DD&A), capital
recovery can be different based on corporation size, and is dependent on the laws of
each country.
Intangible Investments
Intangible investments are drilling fees, mud and chemicals, logging, and other non-
equipment charges. They are normally considered expensed or written off in the year
spent and have no recoverable salvage value. Some types of intangible investments
can be included in cost recovery in certain fiscal tax regimes.
Tangible Investments and Depreciation

Tangible investments are equipment purchases, such as pumping units, pipelines,
compressors, and buildings. Capital of this type is depreciated over time.
Depreciation may be defined as the lessening in value of a physical asset with the
passage of time.
With the possible exception of land, the consideration is characteristic of all physical
assets. Depreciation reduces taxable income by charging a part of the cost against
each year’s income.
There are three main methods for grouping DD&A:
Straight Line
Declining Balance
Unit of Production Depletion
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Straight Line
This depreciation method deducts an equal increment each year over the life of the
property. For example, a tank battery has an initial cost of $100,000, and will have a
useful life of 10 years. The basic straight line equation is
Annual Depr. Amt. = Initial Cost / Useful Life
= $100,000 / 10
= $10,000 / year for 10 years
Accelerated Recovery
Accelerated methods for computing depreciation apportion larger amounts of the
depreciable investment to earlier years in the life of the equipment. You get a faster
tax write-off or and earlier availability of money.
The two most common methods for accelerated recovery are Declining Balance and
Unit of Production Depletion. How and when these two methods are used is
dependent on governmental regulations and standards for book tax or financial
reporting.
Declining Balance Method

In the declining balance method, a depreciation rate is applied to the undepreciated
balance of the investment each year.
Yearly Depr. = Depr. Balance ∗ Yearly Rate
For example, assume the same 100 M$ investment as the 10 year life of the straight-
line method. The recovery schedule would be:
Year One 100∗0.20 $ 20.00
Year Two (100-20) ∗ 0.20 80∗0.20 $ 16.00
Year Three (80-16) ∗0.20 64∗0.20 $ 13.00
Year Four (64-13.00) ∗ 0.20 51.00∗0.20 $ 10.20
Year Five (51-10.20) ∗0.20 40.80∗0.20 $ 8.16
Year Six (40.8-8.16) ∗0.20 32.64∗0.20 $ 6.53
Year Seven (32.64-6.53) ∗0.20 26.11∗0.20 $ 5.22
Year Eight (26.11-5.22) ∗0.20 20.89∗0.20 $ 4.18
Year Nine (20.89-4.18) ∗0.20 16.71∗0.20 $ 3.34
Year Ten (16.71-3.34) ∗0.20 13.37∗0.20 $ 2.67
The remaining unrecovered balance is either handled as salvage or written off in the
next year. Peep takes the balance in the next year. If the economic life of the property
is less than the years of recovery, then all unrecovered balances are written off in the
last year of the property.

Unit of Production Depletion Method

The Unit of Production method is used to depreciate lease and well equipment that
has a life largely controlled by the physical depletion of reserves. It is a similar
calculation to that of cost depletion. The amount to be deducted each year may be
expressed as:
(Cost or Balance – Depreciation) ∗ (Yearly Production / Remaining Reserves)
For example, there is an initial investment of 1000 M$ to recover 200 MBBLS.

Using a simple exponential decline, the depreciation in the first few years would be:
Year Yearly Remaining Yr.Prod. / Yearly Depreciation

Prod Reserves Rem. Resv Depreciation Balance
1 50 200 0.250 250 750
2 40 150 0.267 200 550
3 30 110 0.273 150 400

4 20 80 0.250 100 300
5 10 60 0.167 50 250
This depletion method is most often used when recovering lease purchases or when
calculating the book or financial tax value of a property.
Other Methods
In some jurisdictions, other methods are used for depreciation. Most commonly, a
defined schedule assigning factors to each year following the investment.
Note that none of these depreciation values have financial meaning, as the investment
is actually paid as a lump sum and that is where it affects cash flows. DD&A is
purely an economic way of accounting for the investments for company reports and
tax calculations.
Canadian Sample Depreciation Types
Capital Type Examples Method

Capital Cost Allowance (CCA) Class Tangible investments 25% Declining Balance with ½ year
41 rule
Canadian Exploration Expense Intangible exploratory costs (drilling, Expense
(CCE) geophysical, etc.)
Canadian Development Expense Intangible development costs 30% Declining Balance
(CDE) (drilling, etc.)
Canadian Oil and Gas Property Purchase of oil and gas properties 10% Declining Balance
Expense (COGPE)
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Abandonment & Salvage

Capital categorized as abandonment receives no capital depreciation. The
abandonment entry in a Peep case gives you the ability to schedule costs that are
tagged to the economic limit of the case.
Capital categorized as salvage results in no change to the undepreciated capital pools.
The salvage entry in a Peep case gives you the ability to schedule revenue that is
tagged to the economic limit of the case.
Entering Sunk Costs

Sunk costs are costs that have typically occurred prior to the project evaluation. The
costs are considered spent and therefore are not included in the economics of a go
forward decision. These sunk costs though are typically included for purposes of
reducing taxes payable specific to the project.
If capital has already been spent for a case, you may enter the amount prior to the
evaluation date for the case. Capital entered in this manner will be treated as a tax
pool. Depreciation will be calculated, but the expenditure will not enter the before-
tax cash flow.

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Chapter Exercise 3
Capital Depreciation Exercise

Complete the following Depreciation schedule.
Investment: $1,000
Straight Line: 10 years
Declining Balance: 25%
Year Production Straight- Declining Declining Portion of Total UOP

Line Balance - Balance Production Depreciation
Balance Depreciation
1 100.00
2 90.00
3 81.00
4 72.90
.5 65.61
6 59.05
7 53.14
8 47.83
9 43.05
10 38.74
Total 651.32

Solution to Capital Depreciation Exercise

Declining Declining
Balance Balance Remaining Prod/ UOP Depr UOP
Year Production Straight Line Balance Depreciation Reserves Reserves Balance Depreciation
1 100.00 100 1000.00 250.00 651.3200 0.1535 1000.00 153.53
2 90.00 100 750.00 187.50 551.3200 0.1632 846.47 138.18
3 81.00 100 562.50 140.63 461.3200 0.1756 708.28 124.36
4 72.90 100 421.88 105.47 380.3200 0.1917 583.92 111.93
5 65.61 100 316.41 79.10 307.4200 0.2134 472.00 100.73
6 59.05 100 237.30 59.33 241.8100 0.2442 371.26 90.66
7 53.14 100 177.98 44.49 182.7600 0.2908 280.60 81.59
8 47.83 100 133.48 33.37 129.6200 0.3690 199.01 73.44
9 43.05 100 100.11 25.03 81.7900 0.5263 125.58 66.10
10 38.74 100 75.08 18.77 38.7400 1.0000 59.48 59.48
Total 651.32 1000 943.69 1000.00
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Taxes
Any activity that generates revenue, almost universally, pays tax to a government.
Taxes may be paid to municipal, state, provincial or federal governments.
Taxes are usually payable at a corporate level and are based on the profitability of
that corporation. Taxes payable are calculated based on taxable income and an
applicable tax rate.
Taxable Income
Taxable Income is not the same as Before-tax Cash Flow or Operating Income.
Taxable Income is defined as:
Taxable Income = Taxable Revenues – Eligible Deductions
Typically this means:

Taxable Income = Revenues – OpCosts – Burdens – Depreciation
Depending on the tax regime, expenses such as interest may be deducted from the
Taxable revenue.
Note: The major difference between BTCF and Taxable Income is that while Capital
Expenditures are used to calculate BTCF, Capital Depreciation is used for calculating
Taxable Income.
Taxable Income in the Canadian Resource Sector

In Canada, a Resource Allowance is calculated and deducted from the Federal
Taxable Income, however Crown Royalties are not deductible. How Resource
Allowance and Crown Royalties are deductible from Provincial Taxable Income
varies from province to province.
The Resource Allowance is calculated as follows:
Resource Allowance = 0.25 ∗ (Resource Income – Resource Operating Costs (field
and well expenses) – Tangible Capital and Gathering Capital Depreciation (CCA) –
Indian Royalties – Freehold Production Royalties)

It has been proposed in the 2003 Federal Budget that Resource Allowance and Crown
Royalties be deductible according to the following schedule:
Year Deductible % of Deductible % of

Resource Allowance Crown Royalties
2003 90 10
2004 75 25
2005 65 35
2006 35 65
2007 0 100
Tax Rates
The Tax Rate represents the amount of the Taxable Income that is owed as tax. This
Tax Rate may be expressed as a simple percentage or may involve more complicated
calculations.
The Tax Rate may change with time, income, price or production levels.
Tax Rates in the Canadian Resource Sector

The 2003 Federal Budget has the following schedule of Federal Tax Rates. As of
2004, the Provincial Tax Rate in Alberta is 11.5.
Year Federal Resource Tax Rate

2003 28.12
2004 27.12
2005 26.12
2006 24.12
2007 22.12
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Example Tax Calculation
CASH FLOW STATEMENT
Year 1 2 3 4
Revenue 100 100 100 100

Capital Expenditure 240 --- --- ---
Operating Cost 10 10 10 10
Before Tax Cash Flow -150 90 90 90

Tax Payments 9 9 9 9
After Tax Cash Flow -159 81 81 81
TAXABLE PROFIT / LOSS Tax Rate: 30%
Year 1 2 3 4 Total
Revenue 100 100 100 100

Capital Depreciation 60 60 60 60 240
Operating Cost 10 10 10 10
Taxable Profit 30 30 30 30
Tax Payments 9 9 9 9
Negative Taxes
Sometimes the amount of Tax calculated turns out to be negative. However, you
would not actually get money from the government in this situation. How should this
be handled?
Stand-Alone Tax
If taxes were being calculated while modeling an entire taxable entity (i.e. the entire
Corporation), any negative tax would have to be carried forward.
In each time period with negative tax, the tax would be set to zero and the negative
amount would be carried forward as a ‘pool’ to be used to reduce any future positive
taxes.

Example:
Year Tax calculated Carry forward Tax payable
1 -100 100 0
2 -50 150 0
3 100 50 0
4 500 0 450
Flow-through Tax
If taxes are being calculated on a project-by-project basis, any negative tax could be
used to offset positive taxes payable by other projects in the company.
Therefore, including the negative tax in the cash flow calculations of a project more
accurately represents the project’s impact on the economics of the entire company.
Book Tax
Book tax accounting methods are not designed to report the cash generation potential
of a property. Rather, book tax valuations are designed to report the current
accounting value of the asset. Generally this is the original cost less any depreciation,
depletion and amortization charged to date. Book profit is the net income available
after cash costs (opcosts, taxes) and non-cash costs (DD&A).
Original costs of projects typically use the Unit of Production Depletion method for
recovery. That is, you cannot take more depreciation value in a year than that fraction
which is equal to the current production / total reserves.
Unit of Production Depletion Method

The Unit of Production method is used to depreciate lease and well equipment that
has a life largely controlled by the physical depletion of reserves. It is a similar
calculation to that of cost depletion. The amount to be deducted each year may be
expressed as:
(Cost or Balance – Depreciation) ∗ (Yearly Production / Remaining Reserves)
For example, there is an initial investment of 1000 M$ to recover 200 MBBLS.

Using a simple exponential decline, the depreciation in the first few years would be:
Year Yearly Remaining Yr.Prod. / Yearly Depreciation

Prod Reserves Rem. Resv Depreciation Balance
1 50 200 0.250 250 750

2 40 150 0.267 200 550
3 30 110 0.273 150 400

4 20 80 0.250 100 300
5 10 60 0.167 50 250
6 10 50 0.20 50 200
7 10 40 0.25 50 150
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As the reserve base declines, the fraction that can be recovered changes
proportionately. If new reserves are credited to the property, then the deductible
fraction will change. Normally, only Proven Reserves can contribute to the book tax
reserve base. In other words, production that can be economically and realistically
recovered will contribute to the book value.
This type of reporting tends to show maximum shareholder value that is gained with
each new property that is completed, since the recovery of development costs is
generally spread out over a longer period of time.
For example, compare a five-year Straight Line recovery to UOP Depletion. Use the
same 1000 M$ original investment and 200 MBBLS. Assume a $20 oil price.
Year Yearly Revenue 5 Yr SL Book Profit for Yearly Book Profit

Prod Depr. SL Depl for Depl
1 50 1000 200 800 250 750
2 40 800 200 600 200 600

3 30 600 200 400 150 450
4 20 400 200 200 100 300
5 10 200 200 0 50 150
6 10 200 0 200 50 150

7 10 200 0 200 50 150

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Chapter Exercise 4
Tax Exercise
Complete the following chart.
Capital is depreciated using 5 year straight-line
Tax Rate is 20%
Year Revenue OpCost Capital Deprec. BTCF Flow- Stand- Flow- Stand-
s Through Alone Through Alone
Tax Tax ATCF ATCF
1 100 20 5000
2 200 20
3 5000 20
4 3000 20
5 2000 20

Solution to Tax Exercise
Year Revenue OpCosts Capital Depr. BTCF Flow- Stand- Flow- Stand-
Through Alone Through Alone
Tax Tax ATCF ATCF
1 100 20 5000 1000 -4920 -184 0 -4736 -4920
2 200 20 1000 180 -164 0 344 180

3 5000 20 1000 4980 796 448 4184 4532
4 3000 20 1000 2980 396 396 2584 2584
5 2000 20 1000 1980 196 196 1784 1784
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Economic Limit
Once you have a revenue stream associated with operating and capital expenses, you
can determine an economic limit for the project. Economic limit usually refers to the
point in time that continued operations of the property are no longer commercially
viable. Peep defines the economic limit of a case to be when the highest cumulative
before tax cash flow is attained.
The economic limit is derived on a before tax basis rather than an after tax basis. The
rational behind this method is as follows:
taxes are typically calculated at a corporate level
the decision to discontinue producing petroleum product does not typically
affect corporate taxes
Given these factors, the economic limit is best determined on a before tax cash flow
basis.
Note: It is rare that the economic limit date varies between ‘before-tax cash flow’ and
‘after-tax cash flow.’
Daily Economic Limit

Peep does not calculate an economic limit based on this methodology but it is
illustrated here as another method for determining economic viability.
The basic equation for a daily economic limit is:
Economic Limit = Cost per Day / Revenue per unit
= (Opex / days in month) / Revenue per unit
For example: what is the economic limit in bbls/day if operating costs are $1500/month (January)
and the oil price is $15.00/bbl? No other adjustments will be made in this example.
Economic Limit = (1500 / 31) / 15.00
= 3.23 bbls/day

Economic Limit – Cumulative Before Tax Cash Flow
Cumulative Cash Flow

Economic
Limit
5000
4000
3000
2000
1000 Cum BTCF
M$
0 Cum ATCF
-1000 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
-2000
-3000
-4000
Time
The diagram above illustrates an economic case that has a production life of 15 years
but due to decreasing revenue coupled with fixed costs the economic limit occurs in
year 12. A workover occurred in year 6 resulting in a decrease in before tax
cumulative cash flow. The impact was not as great on the after tax cash flow because
the additional capital expenditure qualified for 100 writeoff reducing taxes payable in
that year.
Escalation and Inflation

Escalation and inflation rates are used to estimate how product prices will change and
what capital or operating expenses will cost in the future. For example, you may
know the cost to install a compressor today, but what will it cost when you plan to
install one in 5 years? Or you want to predict that oil prices will increase by $2.50
over the next 18 months, and gas will be 20% higher.
Many companies use the terms escalation and inflation synonymously, but they can
actually be separate calculations, both changing the value received. Inflation is
usually associated with a currency, accounting for real changes in the value of the
currency due to politics or policy. Escalation is used to predict the future value of a
price or cost above the forecast inflation rate. This may occur because of exceptional
supply/demand issues in a specific region or for specific goods or services.
In combination, they act to calculate the future (or nominal) value of a cost or
revenue from the current (real) value. The difference comes in reporting, which
should allow both real (including escalation but without inflation) and nominal
(includes both escalation and inflation) values.
It is important to understand the source for the capital or operating cost expenditure.
Although you may be analyzing the project in a certain country, the materials and
labor may be sourced from another country in that country’s currency. Further,
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product prices may be calculated in another currency. Understanding the dynamics of

currency and inflation will enable the analyst to determine the risks apparent in
operating in a certain country.
Inflation: Theory in a nutshell

Inflation is frequently the consequence of society’s spending beyond its capacity to
produce. Other things being equal, increases in a country’s total money supply tend
to increase total spending. Once high employment levels are reached and total output
becomes virtually fixed, this added spending only serves to make prices spiral
upward.
Price Impact on Project Economics

Because price volatility can have such widespread impact on project economics,
many companies try to estimate how prices will change over time. These price
projections are then applied to the project analysis. Price escalation formulas are the
most common means of estimating these changes. Changing prices can have a critical
impact on petroleum project economics. Consider the following table, which
summarizes the economics from an acquisition study.
Profit Indicators
Assuming $1,500,000 Acquisition Price

Oil Price Case
$15.00 $18.00 $21.00 $24.00

Rate of Return (%) 0 27.75 51.69 75.73
after tax
Payout (Years) after – 2.74 2.01 1.58

tax
Net .97 1.68 2.51 3.44
Income/Investment
after tax
Reserves (MBBLS) 419 608 646 716

Cumulative Cash -41 1014 2265 3654
Flow (M$)
Present Worth at 10% -261 520 1399 2334

Disc Rate (M$)
∗ Note: a 16.67% change in oil price (between $18/bbl and $21/bbl) makes a 120% change in
cumulative cash flow (1014 M$ versus 2265 M$).

Percentage Escalation
In calculating a future value using percentage escalation, multiply an initial value by
a set of fractions. Percent escalation is the most common method of escalation, and
the basic formula for an annual escalation is:
t
P = P i (1 + E)
Where
P = Price per production unit
Pi = Initial price
E = Escalation percent (annual)
t = Time in years
Example 1: calculate the price of a barrel of oil in the fifth year if the initial average annual price is
$15.00 per barrel with a 5% escalation.
4
P = 15 (1 + .05)
= $18.23/bbl
Example 2: In January, 1998 the oil price is 20.00 $/Bbl. The monthly revenue escalation rate in
January, 1998 is 1.0%. The oil price calculated for February, 1998 is:
t
P = P i (1 + E)
Where
Pi = 20.00 $/Bbl
E = 1%
t = 1
1
P = 20.00 (1 + 0.01)
= 20.20 $/Bbl
Assuming the monthly revenue escalation rate in February, 1998 is 0.5%, the oil price calculated
for March, 1998 is:
1
P = 20.20 (1 + 0.01)
1
= 20.20 (1 + 0.005)
= 20.301 $/Bbl
You can enter a negative escalation rate. The resulting calculation differs from percent de-
escalation.
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Monthly Escalation/Inflation
To modify the annual escalation equation for Peep’s default of monthly, use the
equation:
1/12 t
P = Pi ( 1 + E )
Notice that the escalation rate is not simply divided by 12, but raised to the power of
one divided by 12. This takes into consideration the fact that escalation will
compound monthly. Example: An annual nominal escalation rate of 12%
compounded monthly will result in an annual effective interest rate of 12.6825%.
Peep compounds inflation and escalation monthly and will always display an
effective annual interest rate.
The example below left shows an annual effective inflation rate of 6%. The example
below right shows the monthly inflation rate applied to achieve an effective annual
rate of 6%.

Percent De-escalation
De-escalation is the opposite of escalating. In escalation, an initial value is multiplied
by a set of fractions to generate escalated future values. De-escalation divides future
values by the escalation rates to return to constant dollar (unescalated) values. The
de-escalation process starts at the last entry in the column and works up to the first
entry. The equation is:
t
P = P n / (1 + E)
Inflation
Inflation changes input values using the same calculation as escalation, but the
difference is seen from a timing perspective. If you select the real radio button on a
case input form, Peep will automatically inflate the values to nominal prior to case
calculation. Peep will not inflate if you indicate that your input is already adjusted for
inflation (nominal). You would still need to choose the Escalate at run-time feature or
manually escalate any variable for additional escalation to apply.
Note: This section is intended to introduce Peep’s handling of inflation, currency and
escalation. A detailed analysis of the subject is covered in Peep course offerings.
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Chapter Exercise 5
Inflation Exercise
Inflation Exercise
You are anticipating buying some equipment from the US next year. The price
of the equipment would be US $1MM today. The US inflation rate is expected to
be 2%.. The forecast exchange rate is at $0.72 US to Cdn dollars. Canada’s
inflation rate is expected to be 3%.
What is the REAL Price of this purchase in Canadian Dollars?
(See next page for solutions)

Solution to Inflation Exercise

Steps M$
Real US Dollars for Purchase 1000.00
US Inflation Rate 2.00%
Nominal US Dollars for Purchase 1020.00
US to Cdn conversion rate 0.72
Nominal Cdn Dollars for Purchase 1416.67
Cdn Inflation Rate 3.00%
Real Cdn Dollars for Purchase 1375.405
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Chapter 3: Discounted Cash Flow
Analysis
In this Chapter
Introducing Discounting Topics
Time Value of Money
Economic Indicators
59
Chapter 3: Discounted Cash Flow Analysis
Introducing Discounting Topics

Once cash flows have been calculated, and the economic limit determined, you can
then apply financial indicators to determine the profitability of the project. Peep
provides a number of these indicators, and we will begin our discussion with the
Time Value of Money, and conclude with Profitability Indicators and Special
Calculations.
Time Value of Money

Money is worth less, the longer you have to wait to receive it. In the same regard,
money received yesterday is worth more than money received today. Consider that
you can take yesterday’s earnings and invest it, earning additional value. If you have
to wait to receive money, you must delay the investment, therefore potentially losing
money.
Also consider that inflation will erode the value of money. For example, if the
inflation rate is 5%, a dollar today is worth $1.05 next year, or $1.00 ∗ (1 + .05). In
general, goods purchased in one year’s time will cost 5% more.
This time value of money concept is applied through Compounding and Discounting.
Compounding
Compounding refers to moving a present value forward in time to a future value. A
savings account would be one example of a compounding investment. If the savings
account compounded yearly then each year a new balance would be calculated on the
account based on the cash in the account and the interest rate.
Compounding
n
FV = PV ∗ (1 + i)
Where FV = Future Value

PV = Present Value
i = Interest Rate
N = Number of time periods
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Time Value of Money
30000
25000
20000
15000
10000
5000
0
2000 2002 2004 2006 2008 2010
year
In the above diagram an initial investment of $10,000 is being compounded annually

with a 10% interest rate yielding a value of $25,000 after 10 years. If this same
investment was not compounded annually but rather calculated once at the end of the
10th year then the final value would only be $20,000.
Discounting
Discounting, is the opposite of compounding, and is used to move future cash flows
back in time to a present value. The basic formulas are:
Discounting
n
PV = FV ∗ (1 / ( 1 + I ) )
Where FV = Future Value

PV = Present Value
n = Number of Time periods
i = Interest or Discount Rate
For example, would you rather receive $100 now or $150 in five years? Assume that PV=$100,
FV=$150, n=5, i=10%.
A) By Comparing Future Values (Compounding)

n
FV = PV ∗ (1 + i)
5
= 100 ∗ (1 + .10)
= $161 > $150
B) By Comparing Present Values (Discounting)

n
PV = FV ∗ (1 / (1 + i) )
5
= 150 ∗ (1 / (1 + .10) )
= $93 < $100

Therefore, if you can earn 10% on your money, you would rather have the $100 today. Now work
the same problem, but assume i=8%.
5
FV = 100 ∗ (1 + .08)
= $147 < $150
5
PV = 150 ∗ (1 / (1 + .08) )
= $102 > $100
If you can earn only 8% on your money, you would rather have $150 in five years.
This basic discounting formula can be used for any period, and the periods summed
to create what is commonly called Present Worth. The next table illustrates a period-
by-period discounted cash flow, using a 15% factor.
Period Cash Flow Formula Discounted Value

1 804,780 1 699,808
1/(1+0.15) =1/1.15
2 753,142 2 588,113
1/(1+0.15) =1/1.3225
3 753,142 3 567,576
1/(1+0.15) =1/1.52
4 753,142 4 497,406
1/(1+0.15) =1/1.75
5 753,142 5 392,374
1/(1+0.15) =1/2.01
6 753,142 6 320,524
1/(1+0.15) =1/2.31
Total 4,820,185 3,065,807
Net Present Value

With the concepts of discounting and compounding covered we can now look at a
project’s cash flow over time and determine the net present value (NPV) for the
project.
Net Present Value Example
Year Investment Revenue Cash Discount Discounted

Flow Factor Cash Flow
10%
0 20 0 -20 1.000 -20
1 30 0 -30 0.9091 -27
2 40 0 -40 0.8264 -33
3 40 0 -40 0.7513 -30
4 0 40 40 0.6830 27
5 0 45 45 0.6209 28
6 0 50 50 0.5645 28
7 0 55 55 0.5132 28
8 0 60 60 0.4665 28
9 0 65 65 0.4241 28
10 0 70 70 0.3855 27
255 NPV at 10%: Æ 84
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The example above is a project with an 11-year life (including time zero). In the first
four years the project is development and does not generate any revenue resulting in
negative cash flow. In the remaining 7 years the project produces revenue and
generates positive cash flow. Armed with the understanding that cash flow today is
worth more than cash flow in the future we can apply a discount rate to the cash
flows. As the time period increases the discount factor is reduced.
When we review the results we see that the total undiscounted cash flows for this
project equal 255 while the discounted cash flows equal 84. This 84 is described as
the Net Present Value at a discount rate of 10%.
What does this mean?
If as investors we expected a rate of return equal to 10% then we would consider any
investment that yielded a NPV at a 10% discount rate equal to or greater than zero.
This project is therefore considered economically viable from an NPV standpoint.
This next table illustrates Peep’s ability to calculate and report the cash flow using
several different discount rates. The previous example did not consider 4 separate
cash flow streams. Peep provides a NPV for Operating Income, Before Tax Capital
invested, Before Tax Cash Flow and After Tax Cash Flow.
Using consistent discount rates and methods allows projects with different cash flow
periods to be compared on an equal basis.
Selecting a Discount Rate

Corporations normally calculate a weighted average cost of capital (WACC). This is
derived from two components:
debt, in the form of bank loans or bonds
equity, in the form of common and/or preferred stocks
Providers of debt financing require a return on investment based on several factors.
Some of those factors could relate to the bond rating of the company, the type of
industry the business is in and the company’s current financial condition.
Providers of equity financing (shareholders) expect to receive a rate of return based
on the assumed risk of the enterprise. Shareholders realize their return on investment
through stock dividends and/or appreciation of the stock price.

Debt financing is typically a fixed rate and is considered of lower risk. Interest must
be paid prior to any returns being paid out to shareholders. Because of these factors
the rate of return on debt is assumed to be lower.
Typically a WACC in North America is around 10%. Analysis of Canadian oil and
gas producer stocks indicates returns in the area of 6% though.
Corporations may use different discount rates for different types of analysis. For
acquisitions they may discount at a higher rate and for dispositions a lower rate.
Discount Methods and Timing

The examples and formulas in the time value of money section were calculated
assuming an annual time period with discounting occurring at the end of the period.
There are several options available in Peep for discounting purposes. Corporations
vary in what method is used. It is important to understand the discount method being
utilized and it’s impact on data entry and results in Peep.
End-Year Discounting
n
End-Year Discount Factor = 1 / (1 + i)
Where i = annual discount rate
Mid-Year Discounting
To calculate mid-year discounting, you need to assume that capital is moved to the
middle of the year, and that each year’s cash flow is also received as a lump sum
payment at that same time. Modify the general formula by subtracting half a year
from the exponent year.
(n-0.5)
Mid-Year Discount Factor = 1 / (1 + i)
So for Year 1, the exponent would be 0.5, Year 2 = 1.5, Year 3 = 2.5, and so on, making the 10%
rate for:
1.5
Year 2 Discount Factor = 1 / (1 + 0.10)
= 1 / 1.1537
= .8668
This factor is then multiplied by the year’s value to report the discounted value, or net present
value.
Beginning-Year Discounting
(n-1)
Beginning-Year Discount Factor = 1 / (1 + i)
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Monthly Discounting
To calculate monthly discounting, you should still assume an annual effective
discount rate, but modify the formula to be:
1/12 n
Monthly Discount Factor = 1 / [(1 + i) ]
So if the discount rate were 10%, then for month 2 the formula would read:
1/12 2
Monthly Discount Factor = 1 / [(1 + 0.10) ]
2
= 1 / [1 + (1.008))
= 0.9921
The discounted monthly values are then summed to calculate the annual discounted
value, or net present value.

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Chapter Exercise 1
Discounting Exercise
Fill in the table below, using the formulas described in the preceding
pages.
You can use the Excel template provided but do not use Excel
functions.
Use a discount rate of 10%
Year Cash Flow Mid-Year Mid-Year Year End Year End

Discount Present Discount Present
Factor Value Factor Value
1 100
2 100
3 100
4 100
5 100
6 100
Total 600

Solution to Discounting Exercise
Mid-Year Mid-Year Year End Year End

Discount Present Discount Present
Year Cash Flow Factor Value Factor Value
1 100 0.9535 95.35 0.9091 90.91
2 100 0.8668 86.68 0.8264 82.64
3 100 0.7880 78.80 0.7513 75.13
4 100 0.7164 71.64 0.6830 68.30
5 100 0.6512 65.12 0.6209 62.09
6 100 0.5920 59.20 0.5645 56.45
Total 600 456.78 435.53
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Economic Indicators
The economic analysis of a project would not be complete without the addition of
economic indicators. NPV is an economic indicator that has already been discussed
in the previous section. This section will cover several common economic indicators
as follows: Rate of Return (ROR), Discounted Profitability Index (DPI), Profit to
Investment Ratio (PIR or ROI), and Payout. Companies may use different names but
the equations are fairly standard within the petroleum industry.
Rate of Return (ROR)

The rate of return (ROR) or internal rate of return (IRR) is the single discount rate
that produces a NPV of zero. It is also described as the discount rate that equates the
present worth of cash flows to be equal to the present worth of the investments
The two charts illustrate how Peep calculates the ROR for Before and After Tax Cash
Flows. You can estimate the ROR from the NPV table based on the values displayed.
The Economic Indicators section shows the actual values of the ROR.
Drawbacks to ROR as a profitability indicator are that it favors high initial earnings
projects over long life cash generation projects. If this indicator is used independent
of other indicators it can lead to incorrect investment decisions. In the example above
the ATCF ROR is 36.7%. If this project had a cost of capital of 10% it is unlikely

that funds generated from this project could be reinvested at 36.7%. Selecting
projects solely on a higher ROR may lead to incorrect decisions.
In some cases due to the nature of the cash flow stream the project may actually have
multiple RORs. This may happen in acceleration type projects or projects with
investments that occur in later time periods. It is recommended that ROR not be used
in these situations.
Discounted Profitability Index (DPI)

This indicator is a measure of investment efficiency, and is used to evaluate multiple
rates of return projects relative to the investment requirements. Consistent use of the
same discount rate is necessary when comparing projects by using DPI. This
indicator is sometimes called PI. In Peep PI and DPI is the same calculation.
DPI =( Net Present Value + Capital) / Capital
If NPV is $5,000,000 and capital is $1,500,000, then the DPI is:

DPI = (NPV + Capex) / Capex
= (5,000,000 + 1,500,000) / 1,500,000
= 4.333
Profit to Investment Ratio (PIR)

Also know as the Return on Investment (ROI), this indicator is similar to DPI. It
simply divides total NPV by total capital. Known as the “bang for the buck”
indicator, it is very useful for ranking projects when capital is limited.
PIR = Net Present Value / Capital
If NPV is $5,000,000 and capital is $1,500,000, then the PIR is:

PIR = Net Present Value / Capital
= 5,000,000 / 1,500,000
= 3.333
Discounted Return on Investment (DROI)

Similar to both DPI and PIR, this indicator includes the cost of managing a
company’s funds, often called capital overhead. It is also used for ranking projects
with similar capital outlays.
DROI = Net Present Value / (Capital + Overhead on Capital)
If NPV is $5,000,000, capital is $1,500,000, and overhead is $15,000, then the DROI is:
DROI = Net Present Value / (Capital + Overhead on Capital)
= 5,000,000 / (1,500,000 + 15,000)
= 3.3003
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Payout Period
The Payout period is the time to return an investment. It is calculated from the net
cash flow stream. The point at which the cumulative net cash flow stream becomes
positive is the Payout. There are advantages and disadvantages to using this method
as an indicator of income potential. Some of the advantages are:
simple and easy to calculate
measure of rate at which revenue is generated early in a project
measure of time risk. The quicker the payout, the less the risk
estimates the time at which a liability to the treasury is removed
The simple graph above indicates a payout in the third year of a project. But this
simple graph fails to consider the disadvantages of this indicator. It fails to:
consider the time value of money
consider the magnitude and timing of cash flows after the pay back period
measure total cumulative cash flow
consider that a project may have multiple payout periods
For example, the chart below displays a total $1000 investment.

Each of the three cash flows indicates a three-year payout, but the overall
profitability of each is very different.
Period Proposal A Proposal B Proposal C

Initial Inv. -1000 -1000 -700
1 500 200 -300

2 300 300 500
3 200 500 500

4 200 1000 100
5 200 2000 0
6 200 4000 0
Cash Flow Total 600 7000 100
Peep calculates two payout indicators, Standard and Project.

Standard payout is the point in time when the undiscounted cumulative cash flow
becomes positive, measured from the case start date. Once the standard payout date is
reached any capital expenditure past this date is not included in the calculation.
Project payout is the point at which the undiscounted cumulative operating income
(before capital) exceeds the total capital in the case. Peep moves all the capital
(including abandonment and salvage) to the first month in the case and then
determines the point at which the cash flow becomes positive, measured from the
case start date.
72 www.sis.slb.com
Chapter Exercise 2
Profitability Exercise
Using the values in the tables below, calculate the DPI, PIR and DROI for this
project for Before and After Tax values. Assume capital overhead of 50 M$,
and use the 0%, 10% and 15% Discount Rates.
Disc Rate Operating Capital Before Tax After Tax

% Income Cash Flow Cash Flow
0 7633.3 1500.0 6133.3 3417.9

8 4751.5 1487.3 3264.1 1679.7
10 4327.2 1484.4 2842.8 1421.0
12 3971.7 1481.5 2490.3 1203.5
15 3537.4 1477.2 2060.2 936.5
20 2999.2 1470.5 1528.7 603.5
Before Tax After Tax

DPI @ 0%
DPI @ 10%
DPI @ 15%
PIR @ 0 %
PIR @ 10%
PIR @ 15%
DROI @ 0 %
DROI @ 10%
DROI @ 15%

Solution to Profitability Exercise

Before Tax After Tax
DPI @ 0% 5.09 3.28
DPI @ 10% 2.92 1.96
DPI @ 15% 2.39 1.63
PIR @ 0% 4.09 2.28
PIR @ 10% 1.92 0.96
PIR @ 15% 1.39 0.63
DROI @ 0% 3.96 2.21
DROI @ 10% 1.85 0.93
DROI @ 15% 1.35 0.61
74 www.sis.slb.com
Chapter Exercise 3
Cash Flow Exercise

This exercise encapsulates the majority of the components discussed in this
manual. It is intended as an introduction to petroleum economic evaluations.
Actual economic evaluations are typically much more complex.
Using the provided Excel spreadsheet, build an economic evaluation. The
template has been preset for an exponential production equation.
Enter the following values at the top of the spreadsheet:

Working Interest = 100%
Initial Rate = 200,000 barrels in Year One
Decline % = 20
Royalties = 25% of revenue
Federal Tax Rate = 30% of Taxable Income
Enter the following values in the appropriate columns:

Oil Price = $16.50 per barrel, inflated by 1.5% per year after year one
Opcosts = $5.25 per barrel and $20,000 per year, inflated by 1.5% per
year after year one
Capital = $5,000,000 in year one
Calculate the following:

In the Capital Depreciation column depreciate the capital utilizing a declining
balance of 20%
Using the formulas from this document calculate the Net Present Value of this
project on a before and after tax basis utilizing a discount rate of 10%. Use an
End of Year discount method.
Through Excel’s NPV Function estimate what the ROR will be for this project
OR Utilizing Excel’s IRR Function calculate a BTROR and ATROR.
Based on a 10% cost of capital is the project economic?

Solution to Cash Flow Exercise
BTNPV10% $545.90 ATNPV10% $17.59

BTROR 15% ATROR 10%
76 www.sis.slb.com
References
For further reading, please refer to the following reference materials:
The Institute of Petroleum - http://www.petroleum.co.uk/
American Petroleum Institute - http://api-ec.api.org/frontpage.cfm
Society of Petroleum Engineers - http://www.spe.org/
Petroleum Society: Canadian Institute of Mining, Metallurgy & Petroleum -
http://www.petsoc.org/
Petroleum Communication Foundation - www.centreforenergy.com
WTRG Economics - http://www.wtrg.com/
BP Statistical Review of World Energy June 2005 -
http://www.bp.com/genericsection.do?categoryId=92&contentId=7005893
Oil and Gas Fiscal Regimes of the Western Canadian Provinces and Territories -
http://www.energy.gov.ab.ca/docs/tenure/pdfs/FISREG.pdf
Government of British Columbia Oil and Gas Royalty Handbook -
http://www.em.gov.bc.ca/subwebs/resourcerev/royataxs/handbook/default.htm
Saskatchewan Crown Royalty and Freehold Production Tax Programs and Payments -
http://www.ir.gov.sk.ca/Default.aspx?DN=3661,3430,3384,2936,Documents
Alberta Energy- http://www.energy.gov.ab.ca/default.asp
77
Glossary of Oil & Gas Terminology
API
American Petroleum Institute
AT
After Tax
Abandonment
Converting a drilled well to a condition that can be left indefinitely
without further attention and will not damage fresh water supplies
or potential petroleum reservoirs as defined by governing bodies
Associated Gas
Natural gas that is produced along with crude oil
BOE
Barrels of Oil Equivalent
BT
Before Tax
B.T.U.
British Thermal Unit – the heat required to raise the temperature
of 1 lb. Of water through 1 F
Barrel
A unit of measurement of volume for petroleum products. One
barrel is the equivalent of approximately 35 Imperial gallons.
Battery
Equipment to process or store crude oil from one or more wells
Complete a well
Finish the work on a well and bring it to a productive state
Condensate
A mixture of pentanes and heavier hydrocarbons, recoverable
from an underground reservoir and gaseous in its virgin reservoir
state, but liquid at the conditions under which its volume is
measured or estimated
Concessionary Regime
The operator of the oil or gas well has ownership of the resources
but is obligated to pay a royalty to the governing body
Cubic Foot
The volume of gas that fills a cube that is one foot by one foot by
one foot under set temperature and pressure conditions. The
standard pressure is 14.73 psia and the standard temperature is 60
degrees Fahrenheit.
79
Glossary
Curtailment
Limiting the production capability of a well due to the constraints
of the processing facility or gathering system. It may also be used
to describe facility down time (also referred to as turnaround
time).
Development well
A well drilled in proven territory in a field for the purpose of
completing the desired pattern of production. Sometimes called an
exploitation well.
Discovery well
An exploratory well which discovers a new oil or gas field
Dry hole
An exploratory or development well found to be incapable of
producing either oil or gas in sufficient quantities (i.e.
uneconomic) to justify completion
Degrees API
Equals: (141.5 / specific gravity @ 60 F) – 131.5
Density
The gravity of crude oil, indicating the proportion of large,
carbon-rich molecules, generally measured in lbs per cubic foot or
degrees on the API gravity scale
Downstream business
That portion of the oil and gas industry focused on marketing,
refining and petrochemicals
Ethane
In addition to its normal scientific meaning (C2H6), a mixture
mainly of ethane which ordinarily may contain some methane or
propane
Exploratory well
A well which is drilled to test for the presence of oil or gas in a
previously undeveloped area. Also called a wildcat well.
Farm-in
The secondary party in a farm-out agreement
Farm-out
The name applied to a specific form of assignment wherein the
Leassee grants a conditional interest to another party in
consideration for the drilling of a well within a specified length of
time on given acreage. It is usually undertaken where the Lessee
has leases on a relatively large block of acreage and does not wish
to undertake the sole cost of developing it.
Field
The surface area above one or more underground petroleum pools
sharing the same or related infrastructure
Formation
A sedimentary rock deposit having common physical
characteristics (often called a bed or zone). A lithologic unit. In oil
areas each formation is given a name, frequently as a result of the
study of the formation outcrop at the surface. Other names are
based on the fossils found in the formation.
Fuel gas
Gas used to fuel a generator for the purpose of providing power to
surface facilities. A significant factor in some countries in the
calculation of royalties.
Gas
Any fluid, either combustible or noncombustible, which is
produced in a natural state from the earth and which maintains a
gaseous state at ordinary temperature and pressure conditions
Gas Heat Content

Used to convert gas volume to gas heat energy. Expressed in
BTU/cubic foot or its metric equivalent. Content is determined
after gas shrinkage.
Gas Heat Energy

It is the total energy contained in the produced gas stream. It can
be a calculated value by multiplying the gas volume by the heat
content. .
Gas-Oil Ratio (GOR)

The ratio of gas to oil as produced from a well. Usually stated as
the number of cubic feet produced with a barrel of oil.
80 www.sis.slb.com
Glossary
Gas Processing Plant

A facility designed (1) to achieve the recovery of natural gas
liquids from the stream of natural gas which may or may not have
been processed through lease separators and field facilities and (2)
to control the equality of the natural gas to be marketed.
Gas Shrinkage
Accounts for the amount of raw gas production that is reduced due
to the elimination of natural gas liquids, acid gases and/or fuel gas
Heavy Crude Oil

Oil with a gravity below 28 degrees API
Hydrogen Sulphide (H2S)

This compound is the cause of sourness in natural gas. It is one of
the most dangerous of industrial gases. It must be removed prior to
transport in a pipeline. Pipeline gas contains less than 0.0016
percent H2S
Joule
The basic SI unit of energy used to measure energy content. On
joule is the equivalent of energy required to heat one gram of
water by approximately one quarter of one degree Celsius. Since
the joule is such a small unit of energy, the natural gas industry
normally works in large multiples – e.g. Gigajoule (GJ) = 1 billion
joules.
Light Crude Oil

Light petroleum with a gravity above 28 degrees API
Lithology
The character of a rock formation
Methane
The principal constituent of natural gas; the simplest hydrocarbon
molecule, containing one carbon atom and four hydrogen atoms
Midstream Business
Typically refers to a gas plant that strips NGLs from the sales gas
stream. Also referred to as a straddle plant
Multiple Zone Well

The method used to complete a single well in such a way that
production is segregated and is obtained from more than one
completion formation
NI
Net Income
NPI
Net Profit Interest is similar to an ORR except that an NPI is paid
on the operating income (revenue less royalties less operating
costs)
NPV
Net Present Value
Natural Gas or Raw Gas

A highly compressible, highly expandable mixture of
hydrocarbons having a definite specific gravity and occurring
naturally in a gaseous form
Natural Gas Liquids (NGL)

Liquids obtained during natural gas production, including ethane,
propane, butanes and condensate
Non-associated gas
Natural gas which is in reservoirs that do not contain significant
quantities of crude oil
OPEC
Organization of Petroleum Exporting Countries
ORR
Overriding Royalty is a burden that amounts to a given percentage
of a specified lease production
Operating interest
The operating interest is that portion of the working interest
charged with the operational responsibility of the lease. This
operating interest handles all accounting, charging or remitting to
each working interest its prorata share of expenses and profits.
Pool
A natural underground reservoir containing, or appearing to
contain, an accumulation of petroleum

Glossary
PSC
Production Sharing Contract. The government maintains
ownership of the resource and pays the operator for the resource
according to the contract.
Propane
A liquefiable hydrocarbon with a chemical formula (C3H8).
Market grade contains trace elements of methane, ethane and
butane.
Quality Adjustment
An adjustment to the price of oil typically due to degrees API
and/or chemical composition
Rich gas
Gas containing a lot of compounds heavier than ethane, about 0.7
US gallons of C3 + per mcf of raw gas
Ring Fence
Many fiscal regimes require the calculation of burdens or taxes on
independent areas where deductions from one area can be used in
another area
STB
Stock Tank Barrel. See barrel.
Standard Conditions
Standard conditions for the measurement of gas are 101.325 kPaa
and 15C in metric and 14.65 psia and 60F in imperial
Step-out well
A well drilled adjacent to or near a proven well to ascertain the
limits of the reservoir
Sweet oil & gas

Petroleum containing little or no hydrogen sulphide
Sales Gas
Gas which after processing, has the quality to be used as a
domestic or industrial fuel. It meets the specifications set by a
pipeline transmission company and/or distributing company.
Specific Gravity
The ratio of weight of volume of a body to the weight of an equal
volume of some standard substance. In the cases of liquids and
solids the standard is water (equal to 1); and in the case of gases,
the standard is air. The specific gravity is numerically equal to the
density. Particularly in the case of oils, the specific gravity is
determined through the use of a hydrometer.
Upstream Business
That portion of the oil and gas industry focused on producing and
processing oil and gas resources
WACC
Weighted Average Cost of Capital
Working Interest
The portion of lease expenses that are paid by the working partner
They would also normally receive an equal portion of the revenue.
It is formed by the granting of a lease by the owner of the mineral
rights.
Workover
To perform one or more of a variety of remedial operations on a
producing oil well with the hope of restoring or increasing
production
Zone
The term “zone” as applied to reservoirs, is used to describe an
interval which has one or more distinguished characteristics, such
as lithology and/or porosity.
82 www.sis.slb.com

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Chapter 2: Detailed Analysis 5

Interest Definitions ............................................................................................................................................... 28

Chapter 3: Discounted Cash Flow Analysis 59

Discounted Return on Investment (DROI) ........................................................................................................... 70

Glossary of Oil & Gas Terminology 79

Petroleum Economics: The Fundamentals v

Why Perform Economics on Oil & Gas Projects?

Basic Steps for Economic Analysis

Basic Cash Flow

Petroleum Economics: The Fundamentals 3

Income or Federal Taxes

Chapter One Conclusion

Components of Economic Analysis

Definitions of Petroleum Fluids and Reserves

Petroleum Economics: The Fundamentals 7

Reserve Status Categories

Methods of Estimating Reserves & Production

Decline Curve Analysis

Production Decline Types

Material Balance Method

Petroleum Economics: The Fundamentals 9

Volumetric Estimate of Initial Oil in Place

7758 = Barrels per acre foot

Hn = Net reservoir sand thickness in feet

Φc = Average effective porosity of sand (decimal fraction)

Er = Recovery efficiency factor (decimal fraction)

Analogy and Statistical Methods

Petroleum Economics: The Fundamentals 11

Calculate the original oil in place:

If the Recovery Efficiency Factor is 15%, what is the Recoverable Oil?

Qi = Initial flow rate

To calculate the cumulative production N at any time use:

Petroleum Economics: The Fundamentals 13

The cumulative volume through the second year would be:

Monthly Methodology in Peep

Effective Versus Nominal Decline

The effective decline rate may be expressed:

Effective Rate Nominal Rate

Hyperbolic and Harmonic Decline

To calculate the flow rate at any point in time:

To calculate the cumulative production at any time:

Where D i is the nominal decline rate.

Petroleum Economics: The Fundamentals 15

Curtailed Wells or Leases

Production Scheduling Exercise

Find, for both oil and gas:

(See next page for solution)

Petroleum Economics: The Fundamentals 17

Solution to Production Scheduling Exercise

First Year Gas = 900 ∗ 1200

3. Year One Production Noil = ( (q – q i) / l n (1 – d) ) ∗ 365

= ( (900 – 1000) / l n (1 – 0.1) ) ∗ 365

Ngas = 346,430 ∗ 1200

Noil = ( (810 – 900) / l n (1 – 0.1) ) ∗ 365

Petroleum Economics: The Fundamentals 19

OPEC Basket Price

Henry Hub Natural Gas

Base Oil Prices and Adjustments

Petroleum Economics: The Fundamentals 21

Base Gas Prices and Adjustments

Production Sharing Contracts