Lecture 1

Chapter 5
Lecture 1 Defining a Project and
Its Alternatives

Defining a Project and Its Alternatives Example: A

Waterflooding Project

PET 412E: Petroleum and Natural Gas Economics

Dr. Emre Artun

Istanbul Technical University
5.1
 Lecture 1
Agenda

Defining a Project and

Its Alternatives

Example: A
Waterflooding Project

1 Defining a Project and Its Alternatives

2 Example: A Waterflooding Project

5.2
 Lecture 1
Introduction

Engineering involves many choices among alternatives.

Before studying the economic aspects and attractiveness Defining a Project and
Its Alternatives
of a project and its alternatives, it is very important to
Example: A
clearly define the project and objectives of the study. Waterflooding Project

Key components of the defining process are as follows:

1. Define objectives
Well defined and unbiased objectives
Creates business value
Meet company objectives

2. Scope project boundaries

Scope of the economics: which part of the
business/operations should be included in the economics
so that financial impact of the project is captured

5.3
 Lecture 1
Introduction

3. Determine the size of the prize and business case

In all proposals, the following questions should be asked: Defining a Project and
Its Alternatives
Why do this at all? (Why should we make this investment
Example: A
at all, what is the opportunity, how big is the potential Waterflooding Project

pay-off?)
Why do it now? (Is this the right time, would it be better to
do it in the future?)
Why do it this way? (Are there ways that we can make the
project even more profitable?)

4. Establish ‘reference case’

The key alternative, that is typically a ‘what we would likely
do if we don’t make this investment’, called the ‘reference
case’.
We always want to compare the ‘investment case’ against
the ‘reference case’.

5.4
 Lecture 1
Introduction

Defining a Project and

5. Identify assumptions Its Alternatives

Example: A
Macro-assumptions: Waterflooding Project

Inflation rate
Tax rate
Internal hurdle rate
Project assumptions:
Market growth rate
Prices (for income and expenses)
Sales volume
Market share
Operating costs
Production

5.5
 Lecture 1
Introduction

Defining a Project and

Its Alternatives

Example: A
6. Identify alternatives Waterflooding Project

There are always different ways of achieving the same

objectives which are called alternatives
Decisions are among alternatives; it is desirable that
alternatives be clearly defined and that the merits of all
alternatives be evaluated.
There is no need for a decision unless there are two or
more courses of action possible.

5.6
 Lecture 1
Mutually and Non-mutually Exclusive Alternatives

For economical analysis purposes, these alternatives must

be broken into 2 sub-classifications:
1. Comparison of mutually exclusive alternatives Defining a Project and
Its Alternatives

Making an analysis of several alternatives from which only one Example: A

Waterflooding Project
can be selected, such as selecting the best way to develop a
new process, product, mining operation, or oil/gas reserve.

2. Comparison of non-mutually exclusive alternatives

Analyzing several alternatives from which more than one can
be selected depending on capital or budget restrictions, such
as ranking research, development, and exploration projects to
determine the best projects to fund with available dollars.

In both cases, it is critically important to compare them

equally. Investment alternatives must be separated from
each other if they are mutually exclusive.
It’s a good rule of thumb to develop at least three
alternatives to expand the realm of possibilities.
5.7
 Lecture 1
Example: A Waterflooding Project

Let’s consider alternative ways of applying a waterflooding

project in a given oil field:
Defining a Project and
Its Alternatives

Waterflooding Example: A
Waterflooding Project

Peripheral Pattern

5-spot 7-spot 9-spot Line-drive

Peripheral injection 5-spot pattern injection 7-spot pattern injection

Injectors
Producers

5.8
 Lecture 1
Example: A Waterflooding Project

Why do we start water flooding in this field? Defining a Project and

Its Alternatives
The answer is to increase oil recovery from the reservoir.
Example: A
Why should we start water flooding now? Waterflooding Project

We should start water flooding before a severe reduction

in reservoir pressure happens.

kw µo krw µo
M= =
µw ko µw kro
as µo increases, M also increases, so the waterflood
efficiency decreases.

M < 1; favorable displacement

M > 1; unfavorable displacement

5.9
 Lecture 1
Example: A Waterflooding Project
Why do it this way?
The water injection program can be applied in a field at
different patterns. We should decide on what kind of a
Defining a Project and
pattern we will use; namely peripheral injection, 5-spot, Its Alternatives

7-spot, 9-spot, line-drive patterns: Example: A

Waterflooding Project
Peripheral injection 5-spot pattern injection 7-spot pattern injection

Injectors
Producers

The proposed water flood pattern should satisfy the

following:
1 Provide desired oil production capacity
2 Provide sufficient water injection rate to field oil productivity
3 Maximize oil recovery with a minimum of water production
4 Take advantage of known reservoir uniformities- i.e.
directional permeability, regional permeability differences,
formation fractures, dip, etc.
5 Be compatible with the existing wells.
5.10
 Lecture 1
Key Steps for a Complete Economic Evaluation

After defining these, the economic-analysis study can be Defining a Project and
initiated. The key steps for a complete economic evaluation are Its Alternatives

the following: Example: A

Waterflooding Project
1 Prepare a cash flow analysis (Chapters 2, 3, 4)
2 Calculate economic indicators and incremental value
(Chapter 5)
3 Perform decision analysis (sensitivity and risk) (Chapter 6)
Cash flow for each of the defined alternative must be
clearly stated so that appropriate calculations can be done
to obtain the key economic indicators.
The cash flow model presented in the previous chapter is
applied for each alternative, and corresponding economic
indicators are calculated.

5.11
 Lecture 2

Chapter 5
Lecture 2 Introduction

Net Present Value

(NPV), with i ∗
Economic Indicators
Rate of Return,
compared with i ∗
PET 412E: Petroleum and Natural Gas Economics Other Indicators

Graphical Methods

Dr. Emre Artun

Istanbul Technical University
5.1
 Lecture 2
Agenda

Introduction
1 Introduction Net Present Value
(NPV), with i ∗

Rate of Return,
compared with i ∗
∗
2 Net Present Value (NPV), with i Other Indicators

Graphical Methods

3 Rate of Return, compared with i ∗

4 Other Indicators

5 Graphical Methods

5.2
 Lecture 2
Introduction
There is probably no single measure of profitability that
considers all the factors or dimensions of investment
projects that are pertinent to the decision maker.
Introduction
However, it is useful to establish characteristics of ideal Net Present Value
economic indicators that can be used for project (NPV), with i ∗

evaluation. Rate of Return,

compared with i ∗

Attributes of an ideal economic indicator can be listed as Other Indicators

follows: Graphical Methods

Consistent with corporate goals

Easy to understand and apply
Permits cost-effective decision making
Provides a quantitative measure for acceptance or rejection
Permits alternatives to be compared and ranked
Incorporates time-value of money
Including time value of money is a critical attribute
because a proposed investment would be unattractive
unless it will be recovered with interest.
The rate of interest should be at least the minimum rate of
return that is attractive in the particular circumstances.
This rate will be designated throughout the course as i ∗ . 5.3
 Lecture 2
Introduction

Introduction

There are a number of possible ways to evaluate proposed Net Present Value
(NPV), with i ∗
alternatives: Rate of Return,
compared with i ∗
Net present value (NPV), with i ∗ Other Indicators

Rate of return (ROR), compared with i ∗ Graphical Methods

Payout time
Profit-to-investment ratio
Discounted profitability index (DPI), with i ∗
Graphical indicators (Cumulative cash-position diagram,
NPV profile, cumulative NPV diagram)

5.4
 Lecture 2
Net Present Value (NPV)
The sum of discounted cash flows over the life of the
project by taking into account the timing of future of cash
flows.
Introduction
Future cash flows occurring at different time periods are Net Present Value
discounted to a single lump-sum present value: (NPV), with i ∗

Rate of Return,
compared with i ∗
n
X Fk Other Indicators
NPV =
(1 + i)k Graphical Methods
k =0

Time-zero values of series of payments are compared.

Since the initial costs are already at time-zero, no interest
need to be applied to initial costs.
Where an estimated salvage value occurs, the present
worth of the salvage value must be subtracted to obtain
the present worth of the net disbursements.
When alternatives that represent a certain type of
continuous service or an equipment needed have different
estimated lives, the least common multiple of the
estimated lives of the two alternatives should be
considered. 5.5
 Lecture 2
NPV Excel Functions

Function for end-year values:

Introduction
The following Excel function calculates end-year NPV: Net Present Value
(NPV), with i ∗
NPVend−year =NPV(discount rate,cash-flow values)
Rate of Return,
compared with i ∗
In this function, 1st value of the cash series is also
discounted; this needs to be fixed when the 1st value is Other Indicators

Graphical Methods
also the ‘time-zero’ value by taking it out of the Excel’s
NPV equation and adding it separately without
discounting,
e.g., =NPV(10%, A2:A7)+A1.
The function uses the following equation:
n
X valuesk
NPV =
(1 + i)k
k =1

5.6
 Lecture 2
NPV Excel Functions
Function for any schedule:
The following function calculates the NPV at set dates
(could be mid-year, end-year or any desired date schedule Introduction

during the year). Net Present Value

(NPV), with i ∗
NPVany −schedule = XNPV(discount rate,cash-flow values, Rate of Return,
dates for discounting) compared with i ∗

Other Indicators
The function uses the following equation: Graphical Methods

n
X Pk
NPV = dk −d1
k =1 (1 + i) 365

where, dk is the k th , or, the last, payment date; d1 is the 0th

payment date; Pk is the k th , or, the last, payment.
End-year NPV formula can be used to obtain the mid-year
NPV’s using the following equation:

NPVmid−year = Year-Zero Cash Flow+NPVend−year (1+i)0.5

5.7
Rate of Return, Compared with i∗
Lecture 2

Net present value calculation is carried out with the

assumption of an interest rate, at which there are other
investment opportunities
Introduction
As a frequently-used economic indicator, the rate of return Net Present Value
(ROR) is the interest rate at which the present worth of the (NPV), with i ∗

net cash flow is zero (the discount rate where the NPV of Rate of Return,
compared with i ∗
the investment just balances the NPV of the money Other Indicators

coming in from the investment) Graphical Methods

$50 $100 $150 $200 $250
NPV ($)

ROR≈15%
0
$-50

0 5 10 15 20 25 30 35

Interest rate (%)

Calculation of ROR can be manually carried out by

trial-and-error and interpolation: Two or more interest rates
are assumed, present worths are calculated and the rate
of return is found by interpolation. 5.8
 Lecture 2
Incremental Rate of Return Analysis

For cost-only alternatives, rate of return analysis for Introduction

Net Present Value

individual projects would not be possible (NPV), with i ∗

For such kind of projects, an incremental analysis Rate of Return,

compared with i ∗
procedure can help to choose the better alternative. Other Indicators

Incremental analysis for cost-only projects A and B can be Graphical Methods

performed as:
1 Compute the cash flow for the difference between the
projects (A,B) by subtracting the cash flow of the lower
investment cost project (say, A) from that of the higher
investment cost project (say, B).
2 Compute the rate of return on this incremental investment
(RORB−A ).
3 Accept the investment B if and only if RORB−A > i ∗ .

5.9
 Lecture 2
Rate of Return Calculation Using Microsoft Excel

Another and more practical option is to use Microsoft

Excel’s Goal-Seek or Solver utilities or related functions: Introduction

Function for end-year values: Net Present Value

(NPV), with i ∗

The following function calculates end-year ROR through Rate of Return,

compared with i ∗
interpolation to get the ROR within 0.00001% accuracy: Other Indicators
RORend−year =IRR(cash-flow values, guess) Graphical Methods

Function for any schedule:

The following function calculates ROR for set dates (could
be mid-year, end-year, or any desired date) through
interpolation to get the ROR within 0.00001% accuracy:
RORany −schedule =XIRR(cash-flow values, dates, guess)

Note
Rate of return tends to favor short-life, high initial earnings
projects over longer life, lower earnings projects.

5.10
 Lecture 2
Payout Time

Definition
The length of time it takes to receive the accumulated net
revenues equal to the total investment. (i.e., the length of time Introduction

it takes to get the invested capital back) Net Present Value

(NPV), with i ∗

Rate of Return,
compared with i ∗
Simple indicator to calculate and can be expressed in
Other Indicators
terms of before tax or after tax revenues. Graphical Methods

It is not a sufficient indicator itself to judge the worth of an

investment because:
1 It tells the decision maker nothing about the rate of earnings
after payout time
2 It does not consider the total profitability of the investment
opportunity
Although it is a popular criterion among some managers, it
has several important limitations including the following:
It does not measure profitability
It ignores all cash flows subsequent to payback point
including the salvage value
It ignores the time value of money
5.11
 Lecture 2
Cash-Position Curve
If we were to set up a special account for a given
investment project, we could keep track of the cumulative
project account balance as a function of time. Such a
project account balance, when plotted graphically, is called Introduction

Net Present Value

a cash position curve (NPV), with i ∗

Rate of Return,
Total net profit from investment compared with i ∗
Cumulative net cash position

Other Indicators

Graphical Methods
Payout time
+

-
Initial investment

The intersection point of the curve with the x-axis

represents the payout time
All other factors equal, the decision maker would like to
invest in projects having the shortest possible payout time. 5.12
 Lecture 2
Profit-to-Investment Ratio
Definition
The ratio of total net (undiscounted) profit to investment. It is a
dimensionless number relating to the amount of value added or Introduction
profit generated per dollar invested (i.e., investment efficiency). Net Present Value
(NPV), with i ∗

Let C be the initial investment and I the net income derived Rate of Return,
compared with i ∗
from it. Then the profit-to-investment ratio is defined as: Other Indicators

Graphical Methods
I − |C|
P/$invested =
|C|
The profit-to-investment ratio is easy to calculate and can
be expressed in before tax or after tax terms.
The objective would be to select prospects that maximize
profits per unit of money invested.
The major weakness of this ratio is that it does not reflect
the time-rate pattern of income from the project.
Some companies use the net income-to-investment ratio:

I
NI/$invested =
|C|
5.13
 Lecture 2
Discounted Profitability Index (DPI)

Very similar to the profit-to-investment ratio except the Introduction

terms used are discounted. Net Present Value

(NPV), with i ∗

Defined as: Rate of Return,

compared with i ∗

NPV at i∗ Other Indicators

DPI = +1
|discounted investment at i∗ |
Graphical Methods

In this way, the denominator captures all capital and

exploratory expense investments, excluding operating
expenses during the life of the project.
Also known as:
Discounted profit-to-investment ratio
Investment efficiency
Present value index

5.14
 Lecture 2
Discounted Profitability Index (DPI)

Introduction
It is based on the same logic with NPV through the Net Present Value
concept of time value of money. (NPV), with i ∗

Rate of Return,
Since the present value depends on the assumed interest compared with i ∗

rate (or minimum attractive rate of return), i ∗ , the ratio Other Indicators

must always be specified together with the interest rate. Graphical Methods

For upstream operations in the petroleum industry (i.e.,

capital-constrained, long-term environments), DPI is a
preferred metric over rate of return.
This indicator has the following advantages:
Captures the time value of the money
Provides a measure of profitability per dollar invested
Reflects the time-rate pattern of income from the project.

5.15
 Lecture 2
Value Creation
Value creation (VC) is the amount of NPV generated above the
same investment at a DPI hurdle rate (DPIh ), which is the
minimum DPI to accept an investment case, as determined by
the company. Value created is calculated by the following Introduction

equations: Net Present Value

(NPV), with i ∗

Rate of Return,
compared with i ∗
VC = NPVi ∗ − [(DPIh − 1)(|PVi ∗ of the investment|)
Other Indicators
VC = [(DPI − DPIh )(|PVi ∗ of the investment|)] Graphical Methods
40
35

B
30
NPV (million $)
25

VCB ≈ $12 million

Line for DPIh = 1.3
20

A
15

VCA ≈ $10 million

10
5
0

0 5 10 15 20 25 30 35 40 45 50 55 60

PV of investment (million $)
5.16
 Lecture 2
Cumulative Cash-Position Diagram
Cumulative cash-position diagram shows how much cash
is invested at each period including interest.
Typically plotted with values calculated using the rate of
return so that the final cash position is zero. Introduction

The values calculated in each period may be called the Net Present Value
(NPV), with i ∗
project balance (PB) at that specific time Rate of Return,
compared with i ∗
Consider a case where I0 is the initial investment, and
Other Indicators
A1...5 are annual payments (+/-) during a project: Graphical Methods

(-) (+) (+) (+) (+)

I0 A1 A2 A3 A4 A5
PB5= PB4(F/P,i*,1)+A5=0
0 1 2 3 4 5

PB4= PB3(F/P,i*,1)+A4
PB0

PB3= PB2(F/P,i*,1)+A3 PB4(F/P,i*,1)

PB0(F/P,i*,1)
PB2= PB1(F/P,i*,1)+A2 PB3(F/P,i*,1)

PB1= PB0(F/P,i*,1)+A1
PB2(F/P,i*,1)
PB1(F/P,i*,1)
5.17
 Lecture 2
Cumulative NPV Diagram
Cumulative NPV diagram is plotted by calculating the NPV
of the project after each period, and plotting it as a
function of time Introduction

This plot shows the cash returns and final present value as Net Present Value
(NPV), with i ∗
well as the discounted payback or the break-even point Rate of Return,
(the point where the initial investment is paid back). This compared with i ∗

time is the discounted version of the payout time, which Other Indicators

Graphical Methods
also incorporates the time-value of the money.
The lowest point in this diagram is called the maximum
capital exposure or maximum capital at risk
$100,000

$50,000 Discounted payback

$-
0 1 2 3 4 5

$(50,000)

$(100,000)

$(150,000) Maximum capital exposure

Maximum capital at risk

$(200,000)

5.18
 Lecture 2
NPV Profile
NPV profile is plotted to see how the NPV of a project
changes with different interest rates
This plot is very useful in identifying the sensitivity of NPV Introduction
to the interest rate. Net Present Value
(NPV), with i ∗
The point where the curve intersects with the x-axis Rate of Return,
(NPV=0) is indicates the rate of return. compared with i ∗

Other Indicators

Graphical Methods
$50 $100 $150 $200 $250
NPV ($)

ROR≈15%
0
$-50

0 5 10 15 20 25 30 35

Interest rate (%)

5.19