The Economics of Upstream Petroleum Project

1. Introduction

Projects in the upstream petroleum industry are characterized by large capital

investment, in addition to that, there some other factors that make this sector different
from other investment opportunities, such as: time lag between expenditures and
revenues, high levels of uncertainty & risk, and of course, most of the projects involve
high technology.

1.1 The Life Cycle of Petroleum Projects

The phases of typical oil and gas project can be described as follows: Pre Licensing
Prospecting, Mineral Acquisition/Contracting, Exploration, Appraisal, Development,
Production, and Closure.

 Pre Licensing Prospecting

Pre-license prospecting typically involves the geological evaluation of relatively
large areas before acquisition of any petroleum rights.

 Mineral Acquisition/Contracting
Mineral interest acquisition involves the activities related to obtaining the
mineral rights to explore for, develop and produce oil or gas in a particular area.
Typically the oil and gas company receives a mineral interest if the negotiation is
successful. A mineral interest is an interest in a property that gives the owner the
right to share in the proceeds from oil or gas produced.

 Exploration
Exploration is detailed examination of an area for which a mineral interest has
been acquired. Generally, the geographical area has demonstrated sufficient
potential to justify further exploration to determine whether oil and gas are
present in commercial quantities.

 Appraisal
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 Appraisal phase involves confirming and evaluating the presence and extent of
reserves that have been indicated by previous Geological and Geophysical testing
and exploratory drilling. Exploratory wells may have found reserves; however,
appraisal is necessary in order to justify the capital expenditure related to the
development and production of the reserves – in other words confirming that the
reserves are commercial.

 Development
This phase involves undertaking the steps necessary to actually achieve
commercial production. Typically this have involves: drilling additional wells
necessary to produce the commercial reserves, constructing platforms and gas
treatment plans, constructing equipment and facilities necessary for getting the
oil and gas to the surface and for handling, storing, and processing or treating the
oil and gas, constructing pipelines, storage facilities and waste disposal system.

 Production
The production phase involves extracting the oil and gas from the reservoir and
treating the oil and gas in order to assure that it meets marketing standards.

 Closure
At the end of the productive life of an oil and gas field, the site typically must be
restored to its pre-existing condition. Accordingly, the closure phase includes
plugging and abandoning wells, removing equipment and facilities, rehabilitating
and restoring the operational site and abandoning the site.

1. Basic Concept of Oil and Gas Fields Development

The purpose of this section is to briefly describe the basic concept of field development.
Plan of Development (POD) is the document submitted by the International Oil
Companies to the authorized government body for their approval. The POD documents
provide a brief description of the technical information on which the development is
based.
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Conceptually, oilfield (or gas field) plan of development cover aspects, such as: reserves,
field scenario, drilling, production forecast, field facilities and abandonment/site
restoration as shown in figure 1.

Figure 1. Elements of Oil Plan of Development

3.1. Reserves

Reserves are defined as those quantities of petroleum which are anticipated to be

commercially recovered from known accumulations from a given date forward.
According to Society of Petroleum Engineers (SPE) 1, reserves can be divided into three
categories, namely: proved, probable and possible reserves.

Proved reserves are those quantities of petroleum which, by analysis of geological and
engineering data, can be estimated with reasonable certainty to be commercially
recoverable, from a given date forward, from known reservoirs and under current
economic conditions, operating methods, and government regulations.

Probable reserves are those unproved reserves which analysis of geological and
engineering data suggests are more likely than not to be recoverable. In this context,
when probabilistic methods are used, there should be at least a 50% probability that the

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quantities actually recovered will equal or exceed the sum of estimated proved plus
probable reserves.

Possible reserves are those unproved reserves which analysis of geological and
engineering data suggests are less likely to be recoverable than probable reserves.

In the POD documents, the reserves that is normally used for technical design as well as
the economic calculation are the proved reserves, surely, some companies have their
own methods or formula for further discount to reflect the reserve‘s risk

3.2. Field Scenario

It contents a brief review that sets out clearly the principles and objectives when making
field management decisions and conducting field operations and, in particular, how
economic recovery of oil will be maximized over field life. Field development scenario is
one of the most important sections in the plan of development; it also discusses other
aspects, such as: whether the field development will be in phases or in full development,
production mechanism, number of wells, etc.

3.3. Drilling

The oil wells are drilled with the main objectives to obtain the information and to
produce the hydrocarbon (oil and/or gas). Drilling operation are carried out during all
stages of the project life cycle, expenditure for drilling represent a large portion of the
total project’s capital expenditure (Capex); typically 20-60% 2. Therefore, drilling
aspects are also covered in the plan of development documents.

3.4. Production Forecast

Based on the reserves estimated (proved reserves), field scenario and drilling program,
production forecast can be developed. Typical production profile can be seen in figure 2.
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The production will reach a peak level after one or two year of start-up, it will stay peak
for certain period which is called “plateau period”, the field will then naturally decline
due to lower pressure support, the declining production will continue until the field
reach its economic limit3.

Figure 2. Typical Production Profile

3.5. Field Facilities

Wherever the oilfield is located (offshore or onshore), the surface facilities is one the
most important factor that have to be considered in developing the field. Jahn, Cook and
Graham (2008)4 write that:

“ ….Oil and gas are rarely produced from a reservoir already at an export
quality; more commonly, the process engineer is faced with a mixture of oil,
gas and water as well as small volume of substances, which have to be
separated and treated for export or disposal. Surface facilities have to be
designed to cope with produced volumes which change quite considerably
over the field lifetime, whilst the specification for the end product, for
example export crude, generally remains constant. The consequences of a
badly designed process can be, for example, reduced throughput or

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4

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 expensive plants modifications after production start-up. However, building
in overcapacity or unnecessary process flexibility can also be very costly.”

In most fields, the surface facilities can be grouped into four parts: wells, gathering
system, processing plant and export facilities. Surface facilities are the main component
of capital expenditure in the field development.

3.6. Abandonment and Site Restoration

Eventually every field development will reach the end of ist economic life time. If options
for extending the field life have been exhausted, then abandonment and site restoration
(also called decommissioning) will be necessary. Decommissioning is the process by
which the operator of an oil or gas installations will plan, gain approval and implement
the removal, disposal or re-use of an installation when it is no longer needed for ist
current purpose.

Decommissioning cost refer to the future costs associated with the dismantlement,
abandonment, restoration and reclamation of oil and gas wells, properties, and other
facilities, such as plants, pipelines, and storage facilities 5. The cost of decommissioning
may be considerable, and comes of course at the point when the project is no longer
generating funds6.

2. Types of Petroleum Arrangements

The principal forms of contract that are currently employed between host country and
petroleum companies can be grouped into three broad categories: the concession

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agreement, the production sharing contract and the service contract as shown in Figure
57.

Figure 3. Petroleum Arrangements

McMichael and Young expanded the Johnston’s classification in Figure 4 by including

three additional types of agreements; purchase contracts, loan agreements, and revenue
sharing contract8.

Figure 4. SPE Petroleum Arrangements

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2.1 Concessionary System

The concession was the original system used in world petroleum arrangements, and it is
still the most widely used today. Under a concession, Contractor is given the exclusive
right to explore for hydrocarbon in the given concession area, to produce any discovery
therein, to acquire ownership of the oil and gas ultimately produced, and to freely
dispose of all such production. In fact, many improvements have been made to the basic
and traditional concession to update it and achieve the objectives of government policy.
These improvements are mainly related to an increase in the government take through
additional payments (high royalty, excess profit tax) and a better control of petroleum
activities by introduction of state participation9,10

The main features of the early concession are as follows:

9
Le Leuch, Chapter 5: Contractual Flexibility in New Petroleum Investment Contract, in
Beredjick & Walde, Petroleum Investment Policies in Developing Countries, 1988. p. 89

King & Spalding LLP, An Introduction to Upstream Government Petroleum Contract:

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Their Evolution and Current Use, OGEL, 2005, p. 15

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 o International Oil Company (IOC), at its own risk and expense, generally has
the exclusive right to explore for and exploit petroleum reserves in the
concession area.
o The IOC owns the production from within its concession area
o The IOC pays the royalty either in Cash or Production.
o The IOC pays taxes to the host country on profit it derives from the
production
o A Great disadvantage to the host government of the concession agreement is
that it greatly limits the involvement by the host government.

In the modern concession11, the concession area is only limited for certain block (instead
of the whole country or province which was normally found in the early type of
concession agreement), the period is generally shorter 12. Unlike the earlier agreements,
the modern concession contains clauses specifically imposing a scheme of development
based upon a monetary commitment for each year of the term. A company holding
concession is obligated to a work program and to the relinquishment of a portion of the
acreage on a specified schedule13.

4.2 Production Sharing Contract

The concept of production sharing originated in Indonesia where the first agreement of
this type was signed in 196614; the concept is now used in numerous countries. It is
important to remember that the production sharing concept was designed to give the
government a greater degree of control over the operations of oil companies. The
success of the production sharing concept is mainly due to political motivations, because

11
It is now also known as a “Royalty/Tax” system.
12
20 years instead of 60 years in average

Smith, Dzienkowski, A Fifty-Year Prospective on World Petroleum Arragements,

13

OGEL, 2005, p.36

The first PSC was signed in 1966 between the Independent Indonesia American Petroleum
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Company (IIAPCO) and The State Oil Company Permina (now PERTAMINA).

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under the agreement the oil company is referred to as a contractor and is only entitled
to a portion of the production15.

In a production-sharing contract between a contractor and a host country, the

contractor typically bears all risk and costs for exploration, development, and
production. In return, if exploration is successful, the contractor is given the opportunity
to recover the investment from production, subject to specific limits and terms. The
contractor also receives a stipulated share of the production remaining after cost
recovery, referred to as profit hydrocarbons. Ownership is retained by the host
government; however, the contractor normally receives title to the prescribed share of
the volumes as they are produced16.

The main features of Production Sharing Contract (PSC) are as follows:

o The IOC is appointed by the host government as the contractor for certain
area.
o The IOC operates at its sole risk and expense under the control of the host
government.
o Any production belongs to the host government
o The IOC is entitled to a recovery of its costs out of the production from the
contractual area.
o After cost recovery, the balance of production is shared on a pre-determined
percentage split between the host government and the IOC.
o The income of the IOC is liable to taxation
o Equipment and installations are the property of the host government

15
Le Leuch, Chapter 5: Contractual Flexibility in New Petroleum Investment Contract,
in Beredjick & Walde, Petroleum Investment Policies in Developing Countries, 1988. p.
90
16
See McMichael and Young (2001), p.119

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4.3 Service Contract

The term service contract encompass those various contract in which the host
government contract with a service company or an International Oil Company for the
performance of services related to the exploitation of petroleum resources 17.

The risk service contract appears similar to the production sharing contract but differs
in certain important matters. Its basic distinctive feature is that it reimburses the
contractor in cash, not in crude oil, although it may have provisions permitting the
contractor to buy back an amount of crude oil at an international selling price equivalent
to the amount to be paid to the contractor18.

4.3.1 Pure Service Contract

A pure-service contract is an agreement between a contractor and a host country that
typically covers a defined technical service to be provided or completed during a specific
period of time. The service company investment is typically limited to the value of
equipment, tools, and personnel used to perform the service. In most cases, the service
contractor's reimbursement is fixed by the terms of the contract with little exposure to
either project performance or market factors. Payment for services is normally based on
daily or hourly rates, a fixed rate, or some other specified amount. Payments may be
made at specified intervals or at the completion of the service. Payments, in some cases,
may be tied to the field performance, operating cost reductions, or other important
metrics19.

4.3.2 Risk Service Contract

These agreements are very similar to the production-sharing agreements with the
exception of contractor payment. With a risk service contract, the contractor usually
receives a defined share of production (in kind). As in the production-sharing contract,
the contractor provides the capital and technical expertise required for exploration and
development. If exploration efforts are successful, the contractor can recover those costs

Ramadan, Zekri, Development of a Petroleum Contractual Strategy Model, SPE 84852,

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2003, p. 4
18
See Le Leuch (1988), p. 92
19
See McMichael and Young (2001), p.119
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from the sale revenues and receive a share of profits through a contract-defined
mechanism.

3. “Project Based“ System

Before we move to the detail project cash flow analysis, it is very essential to understand
the relation among the reservoir, property (contract terms) and the project itself. Figure
5 help us to clarify the concept.

Figure 5. The Project Based System

The current SPE system is based on project (“project based system”); there are three
elements: Reservoir, Project and Property (Lease). Reservoir is “basic resource entity”
where we have to estimate the volume of the reserves (“in-place volumes”), Project is
“basic entity” for investment tracking, production and cash flow schedule. When the
company invest, they surely expect to produce certain quantities of the reservoir.
Project involves extraction activities and any necessary process needed before the
product is sent to the market (consumer). Property or lease is related to the ownership
and type of contract as well as the terms and conditions.

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4. Oil (Gas) Field Economics

Figure 6 shows the general concept of constructing the project economics model, there
are three categories of information needed; first, the sub-surface and surface
information, second, fiscal terms and conditions and third, the oil or gas price
assumptions.

Sub-surface information include the estimated amount of reserves, expected production

profile, number of development drilling wells, etc. Surface facilities include the
production facilities (onshore or offshore), pipeline, storage, etc. fiscal terms are
depending upon the type of contract as well as the terms and conditions which can be
found in the detail contract. Generally, the oil price assumptions are provided by head
office of the IOC, in many cases, it may also be assumed that oil prices are flat during the
contract period or in other cases, it is assumed that the prices are escalated.

Figure 6. Constructing the Field Economics Model

Field
Fiscal Economics
Terms

Oil
Price

Production Facilities Capex

Rate Design Opex
Reserves

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5. Typical Economic Assumptions and Data Input

Production & Cost:

 Exploration: X years, Development (drilling, facilities, etc): Y years

 Production period: 20 – 30 years
 Reserves recovered during contract period: XYZ million barrels
 Production decline rate : X%
 Operating / Production Cost = X $/barrel
 Finding & Development Cost =X $/barrel
 Discount rate: 10% - 15%

6. Steps for Constructing Cash Flows

First, let us begin with two main types of upstream petroleum contract, namely:
Concession or Royalty Tax (R/T) and Production Sharing Contract. (For the purpose of
this illustration, these two type of contracts are selected, even though the case for
service contract is not discussed, the calculation steps are basically the same, in many
cases, in fact, the calculation for service contract model tends to be more simple).

The main difference between Concession or Royalty Tax (R/T) and Production Sharing
Contract as shown in figure 7 below is that the cost recovery mechanism. In Royalty Tax
(R/T) system, there is no cost recovery mechanism, therefore, the cost recovery ceiling
normally is not recognized20, the profit oil split is also not available. In many cases, the
calculation steps for Royalty Tax (R/T) system are tend to be more simple than PSC.

Figure 7 simply shows the general flow chart, some detail elements of contracts such as:
bonus, capital depreciation methods, domestic market obligations (DMO) if any, taxes
other than corporate income tax, are not available in the figure.

20
Of course, it is alwalys possible to introduce something new, including applying the cost
recovery ceiling in Royalty Tax system.
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 Figure 7. Division of Gross Production

PSC system tends to be slightly more complicated as shown in figure 8, in many

countracts, the royalty is applied in the PSC system. It is common in the PSC terms that
the cost recovery allowed to be recovered each year is limited to a certain percentage of
Gross Revenue (so-called "cost recovery limit") 21. If the actual cost is more than the limit,
the unrecovered cost is carried forward to the following year. If the actual cost is less
than the cost recovery limit, then there is "excess cost oil". The treatment for excess cost
oil can be divided into three categories:

1. The excess costs are divided between government and IOC similar to the profit
oil split.

2. The excess cost oil is divided between government and IOC with a certain split
(difference with the profit oil split).

21
The range of cost recovery ceiling is 30% - 80% of gross revenue (Johnston, 2006)
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 3. The excess cost oil is not divided between government and IOC, all excess costs
oil goes directly to the government.

Profit oil is shared between the government and IOC, the share may be fixed, or sliding
scale to certain parameters, such as: Production Rate, ROR, “R” Factor or directly linked
to oil prices.

Figure 8. Flow of Gross Production (PSC)

Figure 9 and Figure 10 shows the formula to calculate the project economics indicators
for each system.

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 Figure 9. Cash Flow Calculation for Royalty Tax System

Figure 10. Cash Flow Calculation for PSC

Based on the production and cost data, production profile and oil (gas) price forecast,
the project cash flow profile is developed. It is worth noting that a good skill in excel

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spreadsheet is valuable, especially if the system involve sliding scale profit oil split, cost
recovery limit, etc. When the cash flow profiles are developed, the next step is to let
excel functions to calcucate the investment parameters, such as: IRR and NPV and Profit
to investment, discounted payback, etc.
7. Sensitivity Analysis

In order to investigate the economic performance in the base case input data, sensitivity
analysis is performed. This indicates how robust the model is to variations in one or
more parameters, and also highlights which of inputs in the model is the most sensitive.
These inputs can then be addressed more specifically.

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