Lecture 1

Chapter 4
Lecture 1 Introduction, Terms
and Concepts

Cash-Flow Model for Petroleum Properties Cash-Flow Elements

Cash-Flow
Construction
PET 412E: Petroleum and Natural Gas Economics

Dr. Emre Artun

Istanbul Technical University
4.1
 Lecture 1
Agenda

Introduction, Terms
and Concepts

Cash-Flow Elements

1 Introduction, Terms and Concepts Cash-Flow

Construction

2 Cash-Flow Elements

3 Cash-Flow Construction

4.2
 Lecture 1
Introduction

Net cash flow is the basis for all economic decisions,

which is formed by year-by-year (or month-by-month) Introduction, Terms
sums of all projected investments, incomes and expenses. and Concepts

Cash-Flow Elements
Net cash flow can be calculated by either of the following: Cash-Flow
Construction
Before-tax basis (only cash items)
After-tax basis (cash and non-cash items)
Net-cash-flow items for petroleum properties:

Cash items Non-cash items

Working interest revenue Depreciation
Operating expenses (OpEx) Depletion
Capital expenses (CapEx)
Taxes
Overhead
Property sales
Leasehold costs

4.3
 Lecture 1
Terms and Concepts (1/4)
Revenues
Funds received by the company.
Introduction, Terms
and Concepts
Operating income Cash-Flow Elements

Money taken by the company from the sale of crude oil, natural Cash-Flow
Construction
gas, natural-gas liquids, and refined products.

Costs and expenses

Costs of doing business that must be paid by the company.

Taxes
Federal, foreign, and other income taxes paid by the company.

Salvage value
The amount of money that would be realized upon the sale of
an equipment/machinery for some other use, after using it for a
period of time.
4.4
 Lecture 1
Terms and Concepts (2/4)
Intangible (drilling and development) costs
Certain expenses incurred by the company for drilling to
develop new crude oil and natural gas reserves, including Introduction, Terms
money spent for site preparation, road building, fuel, repairs, and Concepts

Cash-Flow Elements
installation of equipment, contract services, and dry hole costs
Cash-Flow
(items with no salvage value). Construction

Tangible (drilling and development) costs

Costs of materials placed in the well, casing, tubing, tanks,
wellhead, flowlines, etc. (which have salvage value and can be
charged against depreciation). Equipment costs may also
qualify for investment tax credit.

Depreciation
A method of capital recovery to recognize the decline in the
value of machines/equipments/plants due to wear and tear of
normal use and to obsolescence. Amortization of capitalized
investment so as to spread cost over a period of time for tax
purposes.
4.5
 Lecture 1
Terms and Concepts (3/4)

Book value
Introduction, Terms
Current values in the capital accounts not yet recovered by and Concepts

depreciation or depletion. Cash-Flow Elements

Cash-Flow
Construction

Depletion (by cost)

An allowance to amortize mineral-right purchase, or leasehold
costs paid to land owners to recognize the reduction in value of
the investment.

Depletion (by percentage)

Specified percentage of gross income (after royalties) from the
sale of minerals removed from the mineral property during the
tax year. (Typically, only small companies may take this
allowance.)

4.6
 Lecture 1
Terms and Concepts (4/4)

Leasehold costs
Costs of acquisition of mineral interests from landowners. Introduction, Terms
and Concepts

Cash-Flow Elements
Mineral interests Cash-Flow
Construction
Sums of all rights to minerals in place (rights of owning the
minerals, not the surface land).

Royalty interest
Typically, in the range of 1/8 (12.5%) to 3/16 (18.75%)
percentage of the total production from the property, free of
development/operating expenses, belonging to the owner.

Working interest
Interest in minerals in place bearing the development and
operating costs.

4.7
 Lecture 1
Concept of Salvage Value

Example Introduction, Terms

and Concepts

A machine, costs $11,000 now and has a 10-year life with Cash-Flow Elements

annual operating costs $500 the first year and increasing $50 Cash-Flow
Construction
per year each of the next 9 years. Salvage value is $2,000.
What is the equivalent annual cost of operating this machine
for the next 10 years if the interest rate is 8%?

Solution:

t=0 1 2 3 4 5 6 7 8 9 10

4.8
 Lecture 1
Concept of Salvage Value
Example
A machine, costs $11,000 now and has a 10-year life with
annual operating costs $500 the first year and increasing $50 Introduction, Terms
and Concepts
per year each of the next 9 years. Salvage value is $2,000. Cash-Flow Elements
What is the equivalent annual cost of operating this machine Cash-Flow
for the next 10 years if the interest rate is 8%? Construction

Solution:
P=-500*(P/F,8%,1)=(-500)(0.926)=-$463.0
P=-550*(P/F,8%,2)=(-550)(0.857)=-$471.5
P=-600*(P/F,8%,3)=(-600)(0.794)=-$476.3
P=-650*(P/F,8%,4)=(-650)(0.735)=-$477.8
P=-700*(P/F,8%,5)=(-700)(0.681)=-$476.4
P=-750*(P/F,8%,6)=(-750)(0.630)=-$472.6
P=-800*(P/F,8%,7)=(-800)(0.583)=-$466.8
P=-850*(P/F,8%,8)=(-850)(0.540)=-$459.2
P=-900*(P/F,8%,9)=(-900)(0.500)=-$450.2
P=-950*(P/F,8%,10)=(-950)(0.463)=-$440.0
P=2000*(P/F,8%,10)=(2000)(0.463)=$926.4
P
= -$3,727.5 4.9
 Lecture 1
Concept of Salvage Value

Example
A machine, costs $11,000 now and has a 10-year life with Introduction, Terms
and Concepts
annual operating costs $500 the first year and increasing $50
Cash-Flow Elements
per year each of the next 9 years. Salvage value is $2,000.
Cash-Flow
What is the equivalent annual cost of operating this machine Construction

for the next 10 years if the interest rate is 8%?

Solution:
P
P=-$11,000-$3,727.5 = -$14,727.5
Equivalent annual cost, A = ?
A = -$7,272.5(A/P,8%,10) =(-$7272.5)(0.149)
A = -$2,194.4

t=0 1 2 3 4 5 6 7 8 9 10

4.10
 Lecture 1
Income
To perform a reliable economic-evaluation study for a
petroleum property, reliable production-performance
estimates are necessary
Introduction, Terms
Using forecasting methods presented in Chapter 2, and Concepts

performance of the reservoir should be estimated Cash-Flow Elements

considering the: Cash-Flow

Construction

Reservoir’s geology,
Best estimates of reservoir properties (based on the
interpretation of the petrophysical field data)
Field development plans (drilling program, production
schedule and artificial lift plans)
To convert the forecasted performance to revenue
calculations the following must be known:
1 Working interest
2 Landowner’s royalty
3 Prices of hydrocarbons produced (oil, gas, natural-gas
liquids)
Prices vary depending on the market conditions and
geographic location. Wellhead price is used for economic
analysis (not market price or posted price).
4.11
 Lecture 1
Direct Costs and Expenses

The most important kinds of costs that should be

considered in oil/gas property valuation studies include the
Introduction, Terms
following items: and Concepts
1 Exploration costs (before any production and income are Cash-Flow Elements

established on a property. i.e., geological studies, Cash-Flow

Construction
geophysical studies and exploration drilling)
2 Development costs (expenditures related to drilling and
completion of wells, production and transportation facilities
to make the wells ready such that fluids can be recovered
from the reservoir to the surface and can be transported to
the field terminal)
3 Production costs
4 Other types of operating costs
5 Taxes
Depreciation and depletion on producing oil/gas properties
also are chargeable against the gross income from a
property for tax calculation purposes. Neither of them is a
direct or out-of-pocket cost.

4.12
 Lecture 1
Development costs

Development costs should be divided into two groups -tangible

and intangible costs so that portions of it can be deductible for Introduction, Terms
and Concepts
tax purposes: Cash-Flow Elements

1 Tangible cost: Cost of any item or piece of equipment that Cash-Flow

Construction
may depreciate with time or has a salvage value after
being installed and/or used is a tangible cost. Surface
installations and equipments are tangible costs. These
include wellheads, pumps, separators, tanks, pipelines,
etc.
2 Intangible cost: Cost of items that cannot have a salvage
value are intangible costs. Wages, fuels, supplies, repairs,
road building, preparation of drilling and tank sites,
equipment installation, and clean-out operations are
intangible costs and may be treated as current expenses
and deducted in the year they are rendered.

4.13
 Lecture 1
Operating costs
Current expenses other than development costs that
occured after starting production
For valuation purposes, operating costs may be limited to Introduction, Terms
intangible costs such as wages and salaries, fuel and and Concepts

power, minor repairs and maintenance, clean-outs, Cash-Flow Elements

Cash-Flow
extraction costs, and treating costs, all items that are not Construction
subject to depreciation.
Operational, maintenance and repair costs for labor and
material: These may occur due to workovers,
gas-processing plants, gas-water injection plants,
salt-water-disposal plants, etc.. These costs are usually
stated in terms of cost/well/month and total monthly cost
can be calculated by multiplying the cost with the number of
the wells.
Overhead costs: These include general and administrative
costs, which are usually small yet important on a per unit
production basis. Losses that might be occasioned through
fires, pipeline breaks, and damages can be considered as
general costs.
Interest: If there is a loan from an outside source on which
interest is paid, interest may be considered as a cost.
4.14
 Lecture 1
Taxes
The typical method for calculating the income tax is as follows:
1 Total revenue
minus
Introduction, Terms
2 Deductions and Concepts

Total operating costs Cash-Flow Elements

Intangible development costs Cash-Flow

Construction
Depreciation
equals
3 Net Income Before Depletion Allowance
minus
4 Depletion Allowance
At 50% of Net Income Before Depletion Allowance, or
At a percentage of Total Revenue, or
At cost
equals
5 Net Taxable Income
and
6 (Tax Rate) × (Net Taxable Income)
equals
7 Federal Income Tax 4.15
 Lecture 1
Net Cash Flow Table for Petroleum Properties

Gross Production WI Production Revenues Capital Investment Oper. & Main.

Year Oil Gas Oil Gas Oil Gas Total Tangible Intangible Expenses
Introduction, Terms
and Concepts
1 1 2 3 4 5 6 7 8 9 10
Cash-Flow Elements
2
↓ Cash-Flow
Construction
Total

Net Revenue After Net Cash Flow Income Net Cash Flow
Year Expenses (NCF) Before Tax Tax (NCF) After Tax Depreciation

1 11 12 13 14 15
2
↓

Total

Net Revenue After Depletion Net Revenue After Expenses,

Year Expenses, Depreciation Cost Gross Net Allowable Depreciation, Depletion Tax

1 16 17 18 19 20 21 22
2
↓

Total

4.16
 Lecture 1
Net Cash Flow Table for Petroleum Properties

Introduction, Terms
1 : Future oil production volumes, forecasted by and Concepts

engineering analysis. Cash-Flow Elements

Cash-Flow
2 : Future gas production volumes, forecasted Construction

by engineering analysis.
3 : WI(1 − Oil Royalty Fraction) × 1
4 : WI(1 − Gas Royalty Fraction) × 2
5 : 3 × Oil Price
6 : 4 × Gas Price
7 : 5 + 6

4.17
 Lecture 1
Net Cash Flow Table for Petroleum Properties

8 : Tangible capital investment (eligible for

depreciation allowance) Introduction, Terms
and Concepts
9 : Intangible capital investment (ineligible for Cash-Flow Elements

depreciation allowance) Cash-Flow

Construction

10 : Future (operational, maintenance, repair)

costs, forecasted by engineering analysis.
11 : Net revenue after expenses, 7 − 10

12 : Net cash flow (NCF) before tax,

7 - 8 - 9 - 10

13 : 22

14 : 12 - 13

4.18
 Lecture 1
Net Cash Flow Table for Petroleum Properties

15 : Depreciation calculated using any method

that the Tax Law allows Introduction, Terms
and Concepts
16 : 11 - 9 - 15 Cash-Flow Elements

Cash-Flow
17 : Depletion allowance based on cost Construction

depletion
18 : 7 × Depletion Allowance Percentage

19 : 0.5 × 16

20 : max( 17 ,min( 18 , 19 ))

21 : 16 - 20

22 : 21 × Tax Rate (Note: If 21 is negative,

22 must be written as zero.)

4.19
 Lecture 1
Depreciation and Depletion Allowances
As the taxpayer (company), we would like these
allowances to be as high as possible as allowed by the Tax
Law Introduction, Terms
and Concepts
The higher these values are, the less tax we have to pay
Cash-Flow Elements
Depreciation Method is selected by performing a Cash-Flow
Construction
present-value analysis among the methods that the Tax
Law allows
The one with the highest present-value should be selected
In the template given, both cost depletion and percentage
depletion is evaluated and the higher one is used for a
given year
Some countries may limit the depletion method to only
cost or percentage
If only cost depletion is allowed, the value in Column 17
should be written in Column 20
If only percentage depletion is allowed, the minimum of
Columns 18 and 19 should be written in Column 20
If both methods are allowed, a present value analysis can
be performed and the one with the highest should be used.
4.20
 Lecture 2

Chapter 4
Lecture 2 Depreciation

Depletion
After-Tax Analysis: Depreciation and Depletion

PET 412E: Petroleum and Natural Gas Economics

Dr. Emre Artun

Istanbul Technical University
4.1
 Lecture 2
Agenda

Depreciation

Depletion

1 Depreciation

2 Depletion

4.2
 Lecture 2
Introduction

Depreciation

Depletion
Depreciation is a system of accounting which aims to
distribute the cost or other basic value of tangible capital
assets, less salvage (if any), over the estimated useful life
of the unit in a systematic and rational manner
A non-cash charge, deductible from the tax-base, as an
allowance for the exhaustion, wear-and-tear, and
obsolescence of the material purchased. In calculating
income taxes, some portion of taxes can be deducted due
to these tangible items.
A process of allocation, not a process of valuation.

4.3
 Lecture 2
Introduction

Depreciation
Depreciation for the year is the portion of the total charge
Depletion
under such a system that is allocated to the year.
Only tangible items can have depreciation charges
(typically, well and surface equipment)
If these items retain their useable/reuseable value after
some period of time, they are called depreciable.
The amount of money that would be realized upon their
sale for some other use is called salvage value
Terms book value and unamortized cost are typically used
to describe the difference between the cost of an asset
and the total of the depreciation charges made to date
against the asset

4.4
 Lecture 2
Methods of Depreciation Accounting

Depreciation

Depreciation accounting methods are classified as the Depletion

following based on the aim:

1 Giving uniform depreciation throughout the entire service
life (straight line)
2 Giving greater depreciation in the early years of life than in
the final years of life (declining balance, sum of the years,
units of production)
As long as the company is consistent in the methods used,
typically any method is acceptable for tax purposes based on
the Tax Law of the country of operation.

4.5
 Lecture 2
Methods of Depreciation Accounting
Most commonly used methods are:
1 Straight-line depreciation
2 Declining-balance depreciation Depreciation

Depletion
3 Sum-of-the-year-digits depreciation
4 Units-of-production depreciation
5 Combined methods (switching)

Note: Combined Methods

To allow high-depreciation in early years, it is common to
switch from one method to another in the middle of the
whole duration of the project. For example; starting with
double-declining balance and then switching to
straight-line deprecation after 2 years.
In the petroleum industry, the typical depreciation
calculation includes 11-year life for the equipment, with
sum-of-the-year-digits method applied during the first two
years, followed by double declining balance method.
4.6
 Lecture 2
Straight-Line Depreciation Accounting
An equal amount from the taxable income is deducted
each year.
The full service life of the asset is estimated as well as the Depreciation
prospective net salvage value at the end of the life. Depletion

The annual depreciation rate to be applied to the initial

cost of the asset being written off is computed as follows:
C−S
D=
n
where D is the depreciation allowance, C is the initial cost of
the asset, S is the salvage value, n is the estimated life of the
asset, in years. 1/n becomes the depreciation rate which
remains constant throughout the life of the asset.
Depreciation rate can also be calculated by expressing the
salvage value as a fraction of the initial cost of the asset:

100% − estimated percentage salvage value

Depreciation rate =
estimated service life in years
Excel Function: =SLN(C,S,n)
4.7
 Lecture 2
Declining Balance Depreciation Method

150-200% of the straight-line rate is applied to the

undepreciated balance of the asset, which is the book Depreciation
value. Depletion

A constant rate and declining balance result in gradually

decreasing depreciation allowance.
Because of the nature of the calculation, total depreciation
cannot exceed the cost of the asset less salvage value.
The depreciation amount can be calculated as:
F
D= Cu
n
where F is the depreciation factor and Cu is the undepreciated
balance.
If F is 2, it is called double-declining balance.
Excel Function (where t: calculated period, n: total
number of periods): =DDB(C,S,n,t,F)

4.8
 Lecture 2
Sum of the Years Digits Method

A declining rate per year is applied to the difference

between initial cost and salvage value (C − S)
Depreciation
The depreciation rate is calculated from a fraction in Depletion
which:
the numerator represents the remaining life of the asset
the denominator represents the sum of the digits in the total
estimated life of the asset

n−m+1
D= Pn (C − S)
i=1 i

where
C: Initial cost of the asset,
S: Estimated salvage value
n: Estimated life of the asset, in years
m: Life of the asset up to the time of calculation, in years
Excel Function (where t: calculated period, n: total
number of periods): =SYD(C,S,n,t)

4.9
 Lecture 2
Units of Production Method

Based on the equipment usage as a function of recovered

reserves
Requires reasonably accurate estimation of recoverable Depreciation

reserves Depletion

Result is a fixed amount of depreciation per unit produced.

For the case of crude oil, for example, the difference
between the initial cost and the salvage value is divided by
the total estimated net working interest barrels of oil to be
recovered.
This fraction gives the depreciation per barrel, which can
be applied to the estimated production per year to
calculate the depreciation amount:
(C − S)P
D=
R
where, R is the total recoverable reserves and P is the
estimated annual production. Although does not have an Excel
function, can be implemented by the following formula (where
P: period production, R: total reserves): =SLN(C,S,n)*n*P/R
4.10
 Lecture 2
Selecting Depreciation Methods

As long as the Tax Law permits, companies may utilize Depreciation

any kind of depreciation method and switching from one Depletion
method to another can also be permitted.
Turkish Tax Law on Depreciation
Straight-line and declining balance methods can be used.
Switching from declining-balance to stratight-line is permitted
Switching from straight-line to declining-balance is not permitted

Companies would try to find the method or series of

methods that would help them to maximize the allowance
The common approach is to calculate the cumulative
present value of all allowances and choose the one that
gives maximum value

4.11
 Lecture 2
Introduction

Applicable only to those natural resources that become Depreciation

progressively exhausted in the process of production for Depletion

utilization by man
Metallic mineral deposits, coal beds, and accumulation of
oil and natural gas are examples
From a conservation viewpoint, such natural resources are
called non-renewable that can be created only by geologic
processes over geologic time.
In contrast, natural resources such as surface waters,
ground waters, and soil are renewable resources.
Renewable resources may be sustained and/or
periodically renewed within perhaps tenths to hundreds of
years through rainfall, solar, or wind energy.

4.12
 Lecture 2
Introduction

Depreciation

Depletion

Depletion in the petroleum industry is an annual deduction

from the income tax viewpoint.
Only an operating owner or an owner of an economic
interest (royalty owners) may claim the allowance. Two
permissible methods of computing the depletion allowance
are:
1 Cost depletion
2 Percentage depletion

4.13
 Lecture 2
Cost Depletion

Depreciation
Includes the cost of acquiring a mineral property and the Depletion
exploration expenditures incurred including mineral rights
acquisition, lease bonuses, geological, geophysical survey
costs, legal costs, assessment costs, etc.
Computed by dividing the adjusted basis of the property
for a given year to the total number recoverable units (e.g.
bbls of oil) at the beginning of the year, multiplied by the
number of units, for which payment is received during that
year (e.g. bbls of oil of production).
Adjusted basis is the original cost of the property less the
total depletion allowed (cost and percentage) on the
property since its acquisition

4.14
 Lecture 2
Cost Depletion

Depreciation

It can be calculated from the following equation: Depletion

 
P
CD = B
R
where,
CD is annual cost depletion allowance
B is the adjusted basis of the property
P is the units of production sold (payments received for)
R is the recoverable units of production at the beginning of
the year.

4.15
 Lecture 2
Percentage Depletion

Depreciation

Percentage depletion permits the deduction of a Depletion

percentage of gross income from a mineral property

specified by Tax & Petroleum Laws
This cannot exceed 50% of taxable income from the
property after all deductions except depletion have been
taken.
If depletion allowance is the 15% of the amount that is
produced in a year, income generated by the sales of 15%
of the volume of the oil at the wellhead price is not subject
to taxation (if it does not exceed 50% of the gross income
after other deductions).

4.16
 Lecture 2
Percentage Depletion

Example Depreciation

Consider the following assets A, B, and C with specified cash-flow characteristics. If the Depletion
Law allows to use either Cost Depletion or Percentage Depletion of 15% determine the
depletion allowance that can be included in the taxable income.
Property
A B C
Gross production, bbl 150,000 160,000 120,000
WI production, bbl 131,250 140,000 105,000
Gross income $ 3,937,500 $ 4,200,000 $ 3,150,000
Operating costs $ -1,200,000 $ -2,400,000 $ -2,000,000
Depreciation $ -600,000 $ -650,000 $ -550,000
Taxable income before depletion $ 2,137,500 $ 1,150,000 $ 600,000
Depletion allowances
Cost depletion $ 435,000 $ 450,000 $ 425,000
Percentage depletion at 15% $ 590,625 $ 630,000 $ 472,500
50% of taxable income $ 1,068,750 $ 575,000 $ 300,000
Allowable depletion $-590,625 $-575,000 $-425,000
Taxable income $ 1,546,875 $ 575,000 $ 175,000

4.17