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ALL NATIONS UNIVERSITY COLLEGE
KOFORIDUA

DEPARTMENT OF OIL AND GAS ENGINEERING
LECTURE NOTES
OIL AND GAS ECONOMICS
LECTURER
MR
...
0 THE ECONOMICS OF EXPLORATION AND PRODUCTION PROJECT
Projects in the upstream petroleum industry are characterized by large capital investment; in
addition to that, there are 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
...

High level of regulation
Complex tax rules
Specialised financial accounting rules
...
This requires that any study of the basic economics of this important
industry must direct great deal of attention to the massive monetary outlays of investment,
and how those investments are recovered through the cash flows from the operation
...

These three elements are brought together in the forecast of future cash flow which will result
from making an investment
...

For a company to remain in business, it must generate positive net cash flow if it is to remain
solvent, pay its debts, and provide a return to its investors, and to have money for new
investments
...
It must embrace all cost
which will be incurred as a result of the operation, including both a portion of the company’s
overhead as well as an operation’s impact on the total income tax paid by the company
...

This process involves answering three critical questions:
 What will it cost?
 What is it worth?
 Will it earn enough profit?
These questions cannot be answered easily or simply, but require sophisticated forecasting
and calculation techniques
...
The right, along with the right to simply share in the
proceeds from the sale of any mineral produced is called mineral interest or an economic
interest
...
S
...
In countries outside the U
...

(Ghana, Nigeria etc) ownership of mineral rights resides solely with the government
...

1
...

 Exploration
...

 Development
...

 Closure
...
1
...
This also involves broad reconnaissance work to
identify an area of interest
...


1
...
2 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
...
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
...
1
...

Generally, the geographical area has demonstrated sufficient potential to justify further
exploration to determine whether oil and gas are present in commercial quantities
...
1
...

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
...
1
...
Typically this involves:

 Drilling additional wells necessary to produce the commercial reserves
...

 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
...

1
...
6 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
...
1
...
Accordingly, the closure phase includes:
 Plugging and abandoning wells
...

 Rehabilitating and restoring the operational site
...

1
...
The POD documents provide a
brief description of the technical information on which the development is based
...

 Field scenario
...

 Production forecast
...

 Abandonment/site restoration as shown in figure 1
...
elements of oil plan of development
1
...
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
...

1
...
1
...

1
...
1
...
In this context, when probabilistic
methods are used, there should be at least a 50% probability that the quantities actually
recovered will equal or exceed the sum of estimated proved plus probable reserves
...
2
...
3 POSSIBLE RESERVES
Possible reserves are those unproved reserves which analysis of geological and engineering
data suggests are less likely to be recoverable than probable reserves
...

1
...
2 FIELD SCENARIO
It contains 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
...

1
...
3 DRILLING
The oil wells are drilled with the main objectives to obtain the information and to produce the
hydrocarbon (oil and/or gas)
...
Therefore, drilling aspects are also covered in the
plan of development documents
...
2
...
Forecasting is an essential part of the
preparation of any economic evaluation
...
Without
the forecast, a valid economic evaluation cannot be completed
...
Typical production profile can be seen in figure 2
...
Typical Production Profile

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 limit
...
2
...
In most fields, the surface
facilities can be grouped into four parts:
 Wells
...

 Processing plant and
 Export facilities
...

1
...
6 ABANDONMENT AND SITE RESTORATION
Eventually every field development will reach the end of its economic life time
...
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 its current purpose
...
The cost of decommissioning may be
considerable, and comes at the point when the project is no longer generating funds
...
3 ECONOMIC LIMIT
Economic limit for oil field production is the point at which production declines to
an extent that producing the hydrocarbon would cost more than the worth of the
hydrocarbon
...
The economic limit is the point at which the hydrocarbon
production ceases to yield an operating profit
1
...

 The Production Sharing Contract
...


Figure 3
...
Shows the additional SPE Petroleum Arrangements
system
...

1
...
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
...
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 participation
...

 The IOC owns the production from within its concession area
...

 The IOC pays taxes to the host country on profit it derives from the production
...

In the modern concession, 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
...
A company holding concession is obligated
to a work program and to the relinquishment of a portion of the acreage on a specified
schedule
...
5
...
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
...
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
...
The contractor also receives a stipulated
share of the production remaining after cost recovery, referred to as profit hydrocarbons
...

The main features of Production Sharing Contract (PSC) are as follows:
 The IOC is appointed by the host government as the contractor for certain area
...

 Any production belongs to the host government
...

 After cost recovery, the balance of production is shared on a pre-determined
percentage split between the host government and the IOC
...

 Equipment and installations are the property of the host government
...
5
...
The risk service contract
appears similar to the production sharing contract but differs in certain important matters
...

1
...
3 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
...
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
...
Payments may be made at
specified intervals or at the completion of the service
...

1
...
4 RISK SERVICE CONTRACT
These agreements are very similar to the production-sharing agreements with the exception
of contractor payment
...
As in the production-sharing contract, the contractor provides
the capital and technical expertise required for exploration and development
...

1
...
Figure 5 help to clarify the concept
...
The Project Based System

The current SPE system is based on project (project based system)
...

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
...
Project
involves extraction activities and any necessary process needed before the product is sent to
the market (consumer)
...

1
...

 Fiscal terms and conditions
...

Sub-surface information includes the estimated amount of reserves, expected production
profile, number of development drilling wells, 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
...


Figure 6
...
(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)
...
In Royalty Tax (R/T) system, there is no cost
recovery mechanism, therefore, the cost recovery ceiling normally is not recognized, the
profit oil split is also not available
...
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
...
Cash flow model for both Concessional and Production Sharing Contract
agreement
...
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")
...
If the actual cost is less than the cost recovery limit, then there
is "excess cost oil"
...

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

1
...
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
...

1
...
Before the oil and gas
are sold, the well fluid must be separated, treated, and measured
...
Heater treaters then remove the water and other impurities from the
oil
...
When the oil is sold, it is measured as it is transferred from the storage tanks to either
a truck transport or an oil pipeline
...

2
...
They are in the order of
importance:
 Market (supply/Demand)
 Reliability (production rate)
 Location (transportation)
 Quality (refining cost and yield)
 Availability (reserves)
Market is has the greatest effect on crude oil price
...
Crude oil
quality reflects the products that can be refined from a particular crude oil and the cost to the
refiner to do so
...
Reliability is
controlled by production rate and productive capacity, while availability refers to reserves
...
1 SUPPLY/PRICE/DEMAND RELATIONSHIPS
Crude oil buying, selling and transport are large and complex business
...
It is impossible to change any one of
these three without affecting one or both of the other two
...
Conversely a significant change in price
will affect both supply and demand
...
For example, a major
price increase commonly leads to an increase in supply as the result of additional drilling
...
The result is an imbalance of supply and demand, which may lead a lower price
...
1
...
Prices for crude oil in international trade are universally quoted in
U
...
dollars per API barrel of 42 U
...
gallons at 60 0F
...
This method of measurement derives from Europe,
where most of crude oil has been received by ocean going tankers, and weight (displacement)
was an easier gauge
...


2
...
2 FUTURE CRUDE OIL PRICES
Forecasting crude oil prices over the productive life of an oil field which is anticipated to be
produced for another 20 or 50 years has not been easy
...
This may hold true for 10 or 20 years into
the future
...
There is a general agreement among the leading forecasters that
crude oil will be more valuable in the future than it is at present
...
2 THE VALUE OF CRUDE OIL
Oil is the most important energy source, accounting for more than a third of the world
primary energy mix (see Figure 8)
...
In volume terms, oil production/
consumption fell after the second oil crisis in 1979 and bottomed in 1983
...


Figure 8: The World Primary Energy Mix in 2005-source, BP
Crude oil is a global commodity
...
Oil trading has come a long
way from the stable, controlled system of the Majors, which ended in the late 1960s, through
OPEC’s quota system in the 1970s and the first half of the 1980s to the market mechanism
since the mid-1980s
...


2
...
It is the hand-inhand technical development of oil well drilling techniques and the mass production of the
automobile in the U
...
that fostered the modern petroleum industry
...

2
...
1 PETROLEUM GEOGRAPHY AND HISTORY
The centres of oil exploration activities and success around the world have varied through
history
...

The standard Oil (Exxon) empire soon after got its start in the Pennsylvania oilfields
...
By 1938, just before the World War II, Venezuela had become
the largest producer of crude oil after U
...
Saudi Arabia and Russia now leads the
list of producing countries
...
The six largest oil producers in order of daily production are: Saudi Arabia,
Russia, U
...
Iran, China and Norway
...
3
...
The oil companies prospered, host governments seemed to reasonably content with
the concession agreements, demand for oil was growing rapidly and supply was ample
...
Through the golden era the international
oil business was pretty dominated by the “Seven Sisters” (British Petroleum-BP PLC,
Chevron, Exxon- ExxonMobile Corp
...
These companies exerted a strong stabilising influence on the oil
industry throughout the world during this era
...
3
...

 To provide the government with an “inside window” on the petroleum industry to
enable its bureaucracy to judge the performance of the multinationals within the
specific country
 To assure continuity of supply both at the crude oil producing, and refining and
marketing stages at home
...
3
...
This was due in part to new competition from independent
newcomers to the international oil business, primarily in Libya
...
Membership consists of: Saudi Arabia, Iran, Venezuela, Iraq, UAE, Nigeria,
Kuwait, Libya, Indonesia, Algeria, Qatar, Angola and Ecuador
...
4 CRUDE OIL AND PETROLEUM PRODUCTS
There are over 130 crude grades around the world
...
Crude oil needs to be refined into petroleum products (gasoline (petrol),
heating oil and other to be consumed
...
(This does not
mean that product prices set crude prices, the two are interactive)
...
Each stream of crude has its own
property and each generates different combinations of products
...
5%) is called ‘sweet’ and one with a high sulphur content (more
than 1
...
’ To measure crude gravity, the API (American Petroleum Institute)
standard is often used
...

Medium grades are in between
...
All of these factors affect
crude prices
...
Buyers have to pay the additional costs of
transport when buying crude or products at a FOB price, while CIF prices include costs of
transportation
...
5 BENCHMARK/MARKER CRUDE
Marker crude is oil from a specific field or region which is traded in spot markets and is
considered a standard
...

They are strategically located throughout the world to facilitate pricing of crude produced
from other oil fields in the general area of the marker crude
...
A benchmark crude grade serves as the reference for
crude of similar qualities and locations
...

However, in light of the development of spot and futures markets, the role of Arabian Light
was taken over by West Texas Intermediate (WTI)-in U
...
and Brent- from the UK
...

It is politically acceptable to producers and end users
The spot price is widely reported
It is reasonably immune to manipulation
...
They
are essentially self regulated, conducted in full view of anyone who wishes to observe and the
price of transactions are reported quickly and widely throughout the world
...

2
...
Since the days following Col
...
S
...
” This is the
practise that the buyer making the posting is willing to pay for each barrel of oil that he takes
or “lifts,” provided it meets the specifications for the API gravity, sulphur content BS &W
(Basic sediment and water)
...
In the OPEC countries however, the price is determined by governments
...

2
...
1 CRUDE OIL PRICING MODEL/FORMULAR
Two major factors in pricing a crude oil are its API gravity and the amount of sulphur it
contains
...
This approach to pricing crude oil is sometimes referred to
as the “Quality Bank System
...
1, makes a linear
adjustment for the oils API gravity and the percent sulphur that it contains
...
1
Where:
Base price/bbl= Current price for 00 API sweet oil
A= Scale factor for API gravity of the oil-$/0API
B= Markdown factor for presence of sulphur- $/% Sulphur
...
The base price used will
reflect the spot market value of crude (for an oil of 00 API) at any particular time and will
change quite frequently, while as A and B will remain unchanged for a period of time and
may actually be fixed by agreements between the parties
...


2
...
2 SPOT CASH AND FUTURE MARKETS
There are two basic types of markets in crude oil: The “wet” barrel or cash market where oil
is bought and sold in individual deals between buyer and seller, and the future market where
trades are made through a formal commodities exchange for some specified future delivery
date
...
Dealing is done by telephone or telex
...
However, the world
market in crude oil has had just the opposite history with long term purchase contracts giving
way to spot sales
...

2
...
3 HEDGING
Hedging is a future market technique by which investors insure against risk of market
changes in price
...
A crude oil trader, who may wish to
avoid the risk of significant decline in price of crude oil say the next 90 days, can contract to
deliver a specified number of future barrels at a fixed agreed price
...
If the price goes up
during the period he has lost the opportunity to take advantage of the change since he will
receive only the previously agreed price
...
It is a technique or strategy employed as a
protection against adverse price movements in the cash, or spot market
...
6
...

Brokers: Brokerage firms differ from traders in the fundamental distinction that brokers do
not take title to crude oil, but rather bring buyers and sellers together for which they receive a
commission
...
Otherwise striking a
bargain with any confidence is hardly possible
...
Trader is understandably somewhat reluctant to
disclose his purchase price to a prospective purchaser
...
However, neither the trader
nor the broker has any responsility of publicising his/her dealings
...


2
...
7
...
These transactions typically involve trading of crude oil or petroleum products in
exchange for goods, services or finances
...
g
...
Other countries pay for
petroleum products, e
...
, with cargoes of sugar or cashew nuts
...
Typically under these agreements, hard currency loans are provided and
the principal and interest are paid by crude cargo deliveries
...
Closely related to
barter deals are crude-for-product swaps and processing arrangements
...
Under
crude-for-product swaps, a certain volume of crude is swapped for refined products
...
Some products are taken back, while the rest
is sold to the refiners or on the spot market
...

2
...
2 TENDER
A tender sale involves a purchaser (government entity) who solicits bids for certain volumes
of crude oil
...
The price may be fixed for the term, or may be varied according to a pre-defined
source of published price quotes
...
7
...
Forward transactions (i
...
, sales at a fixed price for a fixed future delivery) cover
purchase and sale of cargoes with delivery scheduled typically for one to three months ahead
...
Volumes of oil traded on a spot basis are thought to
amount to about 30% of international oil trade
...
7
...
Producing countries took control of the upstream sector and, as a result, the oil
industry was transformed
...
Contracts were typically FOB-priced since tanker transportation remained
with international oil companies (IOCs)
...
The
Majors lost control of oil prices, and oil prices were set at OPEC meetings as official selling
prices
...
Against this background,

long-term contracts offered some degree of supply security
...
Although comprehensive data are scarce, it is
thought that more than 50% of internationally traded crude is under long-term contracts
...
The situation is similar for Russian crude oil, which is transported to
refineries by crude oil export pipelines
...
For producing countries, long-term contracts
guarantee market access for their crude
...
On this basis, refiners
can optimise their operation by buying residual volumes through spot trading
...
8 COMMODITY EXCHANGE
The three principal commodity exchanges for petroleum are:
 The NYMEX (New York Mercantile Exchange) is located in the world Financial
Centre in lower Manhattan
...
Contracts for heating oil and
unleaded gasoline are traded for delivery in New York harbour
...
This is more than twice world
consumption, and fifty times the daily production of WTI
...

 The IPE (International Petroleum Exchange) is located adjacent to the Tower of
London on the Thames
...
Heating oils are also
traded for delivery at various North Sea ports
...

 SIMEX (Singapore Mercantile Exchange) which trades in Persian Gulf Dubai crude,
North sea Brent crude and heavy fuel oils delivery in the far east
...
Their
transactions being entirely in “paper barrels
...
9 SALE OF NATURAL GAS
The sale of natural is done by transporting them through pipelines
...
The
more economic method of transporting natural gas great distances is in the form of LNG
(liquefied Natural Gas)
...
Due to the number and nature of impurities that natural gases may contain, it is
customary to include quite stringent specifications in the contract
...
0 FINANCING AND OWNERSHIP OF THE OIL AND GAS INDUSTRY
The U
...
and Canada are the only two countries in the world where individual ownership of
mineral rights is allowed
...
S
...
Therefore, oil and gas companies wishing
to obtain a mineral interest in Ghana must do so by executing lease agreement with the
Government of Ghana
...
1 BANK FINANCING
The major banking institutions of the world are an important source of funds to the oil and
gas industry
...
Bank loan tends to be more flexible, but are generally more costly than other forms of
financing
...

Capital is the base for a business
...
Capital is
defined as wealth, which is created over a period of time through abstinence to spend
...

It is the aggregate of funds used in the short-run and long-run
...

3
...
It is very difficult to
imagine the process of production without capital
...
Capital is a scares resource and must be
utilised judiciously
...
2
...
It is:
 To promote a business- Capital is required at the promotion stage
...

 To conduct business operations smoothly- Business firms also need capital for the
purpose of conducting their business operations such as research and development,
advertising, sales promotion, distribution and operating expenses
...
This includes development expense such as purchase of
sophisticated technology
...

 To pay Taxes- The firm has to meet its statutory commitments such as income tax,
corporate tax etc
...


 To replace the assets-The business needs to replace its assets like plant and
machinery after a certain period of use
...

 To support welfare programmes-The Company may also have to take up social
welfare programmes such as establishment of scholarship schemes and health
campaign programmes
...

3
...
2 TYPES OF CAPITAL
Capital can be broadly divided into two types: fixed capital and working capital
...
2
...
1 FIXED CAPITAL
Fixed capital is that portion of capital that is invested in acquiring long-term assets such as
land and buildings, plant and machinery etc
...

It provides the basic assets as per the business needs
...

They are intended to generate revenues
...
2
...
1
...
Most
of the common fixed assets are land, buildings, machinery, motor vehicles etc
...
They cannot be seen or
touched but very valuable to the business e
...
, goodwill, brand names, trademarks,
patents, copyright etc
...

3
...
2
...
It is the portion of capital that makes a
company work
...
Working capital is also called circulating capital
...
The regular needs refer to the purchase of materials,
payments of wages and salaries, expenses etc
...
These
other assets are stocks of raw materials, supplies needed for manufacture, stocks of finished
goods ready for sale, semi-processed items or components, debtors and other short-term
investments if any
...
3 METHODS AND SOURCES OF FINANCE
Method of finance is the type of finance used-such as a loan or a mortgage
...
From a financial statement, we can
read in what form the capital is tied up (fixed assets or current assets) and how these are
financed (from own capital or borrowed funds)
...
If one buys a long-term asset utilising funds from short-term sources,
the asset has to be sold off to repay the short-term loan, in the event of pressure to repay the
loan
...
3
...
The long-term methods outlined below are used to purchase fixed assets such as land
and building, plant etc
...
Money invested by owners, partners, and promoters is
permanent and will stay with the business throughout the life of the business
...
The capital so raised is called share capital
...
The
shareholder is entitled to dividend in case the company makes profits and the director
announce dividend formally in the general body meetings
...

3
...
1
...
They are:
 Cumulative preference share-A shareholder gets his right to the arrears of the
dividend accumulated over a period of time
...
In other words, the
holders of accumulative preference shares enjoy the right to receive, when profit
permit, the dividend missed in the years when the profits were nil or inadequate
...
Hence the unpaid dividend in arrears cannot be
claimed in future
...
They get their normal fixed rate of dividend as per their entitlement
...

 Redeemable preference shares-These shares are repaid at the end of a given period
...

 Non-redeemable preference shares- These shares continue as long as the company
continues
...

Equity Share capital- Capital raised through issue of equity share is called equity share
capital
...
An equity shareholder does not enjoy

any priorities such as those enjoyed by a preference shareholder
...
The profits after paying all
claims belong to the equity shareholders
...

Equity shareholders are the real risk bearers of the company
...
Therefore, the rate of dividend on equity share is not fixed
...
They
form a very significant source of finance
...
Particularly in times of growth and expansion, retained profits can be advantageously
utilised
...
The promoters should be able to offer assets of the
business as security to avail of this source
...
3
...
2 DEBENTURES
Debentures- Debentures are the loans taken by the company
...
A debenture
holder is a creditor of the company
...
Payment of interest on the debenture is the first charge against
profits
...
This is an additional source of long-term finance
...
The debentures are of different types based on the terms and conditions
...
The success of the finance manager lies in designing an instrument suitable
to the needs of the investors and which will pull in as much funds as possible
...
In terms of cost, debentures are
cheaper than equity shares
...
These debentures
continue as loan for the defined period
...
Then onwards, these shareholders will be entitled to dividend, which
will be normally higher than the rate of interest on debentures
...

 Non-Convertible Debentures- These debentures will not be converted into equity
shares
...

 Secured Debentures- These debentures are safe because the assets of the company are
offered as security towards the payment of the debentures
...

 Partly Secured Debentures- These debentures are partly covered by security
...


 Unsecured debentures- There are no security for these debentures
...

 Redeemable debentures- These debentures are repaid on a specified date
...

Government Grants and Loans- Government may provide long-term finance directly to the
business houses or by indirectly subscribing to the shares of the companies
...

3
...
2 MEDIUM- TERM FINANCE
Medium-term finance refers to such sources of finance where the repayment is normally over
one year and less than three years
...
The sources of
medium-term finance are as follows:
Bank Loans- Bank loans are extended at fixed rate of interest
...
These are secured loans
...
In other words, the possession of asset can be taken by making a down payment of a
part of the price and the balance be repaid with fixed rate of interest in agreed number of
instalments
...
The seller is the owner of the asset till the last instalment is paid
...

Lease or Renting- Where there is the need for fixed asset; the asset need not be purchased
...
The company who owns the asset
is called lessor and the company which takes the asset on lease is called lessee
...
On the expiration of the
lease agreement, the owner takes the asset back into his custody
...
Only possession of the asset passes from lessor to the
lessee
...
But when the business want a certain asset for a short medium
period, lease can significantly reduce the financial requirements of the business to buy the
asset
...
Venture capital is
normally provided in such projects where there is relatively higher degree of risk
...
Many
banks offer such finance through their merchant banking divisions, or specialist banks that
offer advice and financial assistance
...
In the case of viable or feasible projects, the merchant banks may participate
in the equity also
...

The funds, so provided by the venture capital, can be used for acquiring another company or
launching a new product or financing expansion and growth
...
3
...
The
following are the sources of short-term finance
...
The specified amount is intended as a ceiling of the credit available at any
one time, and is based on the bank’s assessment of the credit worthiness of the
borrower
...
Business practice not withstanding- there is no
legal obligation on the part of the bank to actually extend the promised credit
...

 Revolving Credit Agreement: This involves actual legal commitment on the part of
the bank
...
The portion which is drawn down is, also subject to the
agreed interest charges
...

 Transaction Loan: This type of loan is undertaken when a firm has need of funds for
a specific purpose or project
...
The principal determinant of the loan and its
terms is the bank’s evaluation of the cash flows which the project is expected to
generate
...
This type of arrangement is known as Production Payment Interest
(PPI)
...
Interest is charged on day-to-day basis on the actual amount
overdrawn
...

 Trade Credit- This is a short-term credit faculty extended by the creditors to the
debtor
...
After selling the stocks, the trader pays the cash
and buys fresh stocks again on credit
...
This is called bills payable
...
4 ECONOMIC EVALUATION DATA SOURCES
The sources of data for the economic evaluation may be an integration of all geotechnical,
engineering and commercial disciplines:







Geosciences-hydrocarbons in place estimates
...

Facilities and cost engineers- Development plan and cost profiles
...

Taxation- Tax and fiscal advice
...
5 ECONOMIC ANALYSIS
The economic analysis of a project should provide the decision makers with the following
information:
 A view of the future cash flows of the project, both positive in the form of revenue
and negative in the form of expenditure and taxes
...

 The relative ranking of the project in comparison with alternative investment options
...

 Forecasts of the effect of the project on the overall company position
...
6 MEASURE OF PROFITABILITY
Management needs an objective means of measuring the economic worth of individual
investment proposals in order to have a realistic basis for choosing among them and selecting
those which will mean the most to the company’s long-run prosperity
...
Typical
investment requires an up-front cash payment to acquire asset – ownership of something of
value to the business
...
People invest in corporations in anticipation that their
investment will provide returns worth more than their investment
...
The growth in
shareholder equity is a principal sign of performance
...
The rate at which the composite grows might be called the
appreciation rate/ average opportunity rate
...
It should be noted that the
motive for being in oil and gas business is to make financial profit- not just to find, produce
and transport petroleum!
3
...


 Net Cash Flow = Revenue – Cost – Government Take (Taxes)
 Discount the net cash flow to account for the “ Time value of money”
 Determine the economics metrics of the net cash flow, such as profit (or loss) and
return on investment
...
8 CASH FLOW AND COSTS
Cash flow is the movement of money into and out of the oil and gas project
...
The total cash flow of the oil and gas
company over a period (typically a quarter or full year) is equal to the change in cash balance
over this period: positive if the cash balance increases (more cash becomes available),
negative if the cash balance decreases
...
It includes cash earnings plus changes to working capital
...

 Investment Cash flows: Cash received from the sales of long-life assets, or spent on
capital expenditure (investments, acquisitions and long-life assets)
...


3
...
Costs in the oil and gas industry include:






Capital expenditure (CAPEX)
Operating expenditure (OPEX)
Abandonment costs
Sunk Costs
Opportunity costs
3
...
1 CAPITAL EXPENDITURE (CAPEX)

CAPEX is an expenditure creating future benefits
...
Usually CAPEX is incurred at the
beginning of the oil and gas project and consists mainly of: Geological and Geophysical
costs, drilling costs and facility costs
...
9
...

3
...
3 SPECIAL COST TERMS
This includes:
 Abandonment costs: The cost associated with the abandonment of the oil and gas
project as a result of under- producing or non-producing oil well
...

 Sunk costs: Is a past cost that has already been incurred and cannot be recovered
...
It is the sacrifice related to the
second best choice available to the company
...
0 EQUITY AND DEBT CAPITAL
Capital that is used for financing oil and gas projects may be classified into two fundamental
categories:
 Equity Capital: Is that capital by those individuals or organisations who have
invested in the oil and gas project in the hope of receiving a profit
...
In return, the lenders receive interest from the borrowers, but
normally do not receive any other benefits that may accrue from the use of the capital
in the venture it finances
...

Accounting- All accounting is based on the fundamental accounting equation, which is:
Assets = liabilities + ownership
...
Ownership is the
worth of what the firm owes to its stockholders (or equity or net worth)
...

Cost Accounting: Cost accounting is very important to the economic-study analyst because it
is concerned principally with decision making and control in a firm
...


4
...
For example, GH C100 of today’s money invested for one year and earning 5% interest
will worth GHC 105% after one year
...


4
...
The percentage of the principal that is paid as a fee
over a certain period of time (typically one month or year) is called the Interest Rate
...
The amount of simple interest
is calculated using:
I=Pxnxi
Where P = principal amount lent or borrowed, n = number of interest periods (e
...
Years), I =
interest rate per interest period
...


4
...
g
...

Example 1
...

Solution
...
1, Therefore, simple interest
(I) = 100 x 3 x 0
...
Therefore, the amount to be paid on the loan for the 3 years
would be GHC 100 + GHC 30 = GHC 130
...
1
Thus GHC 133
...
This can be
compared to directly with the GHC 130 given when simple interest is used
...

4
...

F = future sum of money: the equivalent worth of one or more cash flows at a relative point
in time called the future
...


The use of cash flow (time) diagrams is strongly recommended for situations in which the
analyst needs to clarify or visualise what is involved when flows of money occur at various
times
...
1

The cash flow diagram employs several conventions:
 The horizontal line is a time scale with progression of time moving from left to right
...
For example, the end of period 2 is coincident with the beginning of period

3
...

 The arrows signify cash flows
...

 The cash flow diagram is dependent on point of view of either the lender or the
borrower
...

Before evaluating the economic merit of a proposed investment, Tullow oil Ghana limited
insists that its engineers develop a cash flow diagram of the proposal
...
Annual disbursements
will be GHC 3000 at the end of each year for operating and maintaining the production wells
...


Solution
...
5 INTEREST FORMULAR FOR DISCRETE COMPOUNDING AND DISCRETE
CASH FLOWS
To Find

For single cash
flows:
F

Given

P

Factor by which
to be given

(1 + i)N

Factor Name

Single payment
compound
amount

Factor,
Function,
Symbol
(F/P, i %, N)

P

F

1
(1  i) N

Single payment
present worth

(P/F, i%, N)

For uniform
series
(annuities):
F
P

A

(1  i ) N  1
i

Uniform series
compound
amount

(F/A, i%, N)

Uniform series
present worth

(P/A, i%, N)

A

F

Sinking fund

(A/F, i%, N)

(1  i ) N  1
i (1  i ) N
i
(1  i ) N  1

A

Capital
(A/P, i%, N)
i (1  i ) N
Recovery
( I  i)  1
The table above provides a summary of the six most common discrete compound interest
factors
...
Furthermore,
the formulas also assume discrete (i
...
, lump-sum) cash flows spaced at equal time intervals
on a cash flow diagram
...
6 INTEREST FORMULAS RELATING PRESENT AND FUTURE WORTHS OF
SINGLE CASH FLOW

i = Interest Rate per Interest period
1

2

3

N-2

N= number of interest Period

N-1

N

P = Present Worth

F= Future Worth

The cash flow diagram above shows a present single sum , P , and a future single sum, F,
separated by N periods with interest at i % per period
...
7 INTEREST FORMULAS RELATING A UNIFORM SERIES (ANNUITY) TO ITS
PRESENT AND FUTURE WORTH
P= present worth

amount

A

1

A = uniform annual

A

2

N = number of interest period
A

3

F= future worth
A

N-1

i = interest rate per period

A

N

The above shows a general cash flow diagram involving a series of uniform receipt, each of
amount A, occurring at the end of each period for N periods with interest at i % per period
...
P (present worth) occurs one interest before
the first A (uniform payment)
...


4
...

To Find

Given

Factor by which
to be given

For single cash
flows:
F

P

erN

P

F

e  rN

For uniform
series
(annuities):
F

A

e rN  1
er  1

P

A

e rN  1
e rN (e N  1)

A

F

er  1
e rN  1

A

P

e rN (e r  1)
e rN  1

Factor Name

Continuous
compounding
compound
amount
(single cash
flow)
Continuous
compounding
present worth
(single cash
flow)
Continuous
compounding
compounding
amount
(uniform series)
Continuous
compounding
present worth
(uniform series)
Continuous
compounding
sinking fund
Continuous
compounding
Capital
Recovery

Factor,
Function,
Symbol
(F/P, _r %, N)

(P/F, _r%, N)

(F/A, r_%, N)

(P/A, r_%, N)

(A/F, r_%, N)

(A/P, r_%, N)

4
...

A project should determine whether a proposed capital investment and its associated
expenditures can be recovered over time in addition to a return on the capital that is
sufficiently attractive in view of risks involved and alternative uses limited funds
...
Consequently, several methods commonly are used in practice
...

4
...
1 BASIC METHODS
There are six basic methods for making economic studies
...
W)
 Annual worth (A
...
W)
Rate of return:
 Internal rate of return (I
...
R)
 External rate of return ( E
...
R)
 Explicit reinvestment rate of return (E
...
R
...
9
...
1 NET PRESENT WORTH (NPW)
Present worth is the same as present value (PV)
...
The criterion
for deciding the worthiness or other wise of NPW is that: as long as the net present worth,
N
...
W
...

4
...
1
...
1
...

 If NPW = 0, then the investment is yielding a rate of return equal to the discount rate
used, i
...

 A negative value means that the investment will yield a rate of returns less than I, thus
destroying value
...
In other words, a positive NPW, is the amount of
additional money that can be invested in the project and still realise a rate of return
equal to i
...
9
...
2 ANNUAL WORTH METHODS
The term annual worth (A
...
The net annual worth of
a project is its annual equivalent receipts (R) minus annual equivalent expenses (E), less its
annual equivalent capital recovery (C
...
Mathematically, N
...
W
...
R
...
e
...

The annual worth method is also often called the annual cost when only costs are involved
...
9
...
3 FUTURE WORTH METHODS
The escalation to a future value is the inverse of present value discounted
...
W
...
The
alternative is recommended
...


4
...
1
...
R
...
It commonly called by several other names, such as investor’s
method, discounted cash flow method, internal yield, marginal efficiency capital, receipts
versus disbursement method, and profitability index
...

The resultant interest rate is termed the internal rate of return (I
...
R)
...
The calculation is made after defining the series of anticipated
future cash flows to be received from the investment
...
Begin by selecting a reasonable solution interest rate, and discount all the cash
flows back to time zero
...

 If the present value of benefit cash flows exceeds the investment, then the trial
discount rate was too low
...

 Else, if the present value of benefit cash flows is less than the initial investment, then
the trial discount rate is too high
...
0 RISK, UNCERTAINTY AND SENSITIVITY
The petroleum exploration and production industry is characterised as a “risk business
...
Traditional methods
of coping with risk are: diversification, sheer size and vertical integration of oil and gas
production and downstream refining and marketing
...
This is
called assumed certainty
...
However, in reality virtually all situations (in the oil and gas
industry) there is doubt as to the ultimate results that will be obtained from an investment
...
In economic analysis the actual values or outcomes are
known only after a project is undertaken or completed
...
This concept implies that the range of possible
outcomes can be determined and the probability of each occurring can be estimated
...

In dealing with uncertainty, it is often very helpful to determine to what degree changes in an
estimate would affect an investment decision; that is, how sensitive a given investment
situation is to change in a particular factor which is not known with certainty
...

Conversely, if a small change in the relative magnitude of a factor will reverse an investment
decision, the decision is highly sensitive to that factor
...
0 RISK ANALYSIS
The most critical decision in petroleum exploration is not which prospect to drill- it is which
basin or trend (Play) to explore
...
Because of the similarity of reservoir type and trap geometry,
commonality of the hydrocarbon charge, and consistent exploration and development
methods, it is possible to carry out economic evaluations of plays as full-cycle economic
ventures
...

Risk analysis utilises principles of statistics, probability theory and utility theory to limit the
risk of failure
...
For Example stratigraphy may help us predict the
presence and quality of reservoir rocks; Geochemistry may give us better idea whether or not
oil or natural gas has migrated into the area of our prospect, thus allowing better estimates of
the chance of hydrocarbon presence; Geophysics may help refine our estimates as to how

large an accumulation may be contained in the trap, thus the “ size of the prize,” as well as
the likelihood that the trap indeed contains reservoired oil or gas; Drilling technology may let
us reduce our investment by testing the prospect at lower cost; and reserve technology may
allow us to develop and produce the successful prospect more efficiently, thus increasing our
profit
...
This is the basic value-creating act
...
After the exploration prospect has been
identified, there are key tasks involved throughout the life cycle of the petroleum
exploration and development
...


NOTE!
Certainty: Only one possible outcome
Uncertainty: Recognition that more than a single outcome is possible, with each outcome
having a finite probability of occurrence
...

High Risk: The chance of incurring a large loss, even if the probability of doing so is very
small
...

Probability: The chance between 0% and 100% that a particular outcome will occur
...
All other probabilities in this range describe uncertainty
...
1 TYPES OF RISK
There are many varieties of such risks including such items as:

 Technical Risks: Dry holes, Geological, Engineering, Storm damage, Earthquake,
Timing etc
...

 Political Risks: Governmental Policy, Government regulations, Laws,
Nationalisation, Environmental, Timing, Exchange rate, Financing/Capital, Taxation,
Export/Import, Personnel
...
These are:
 Uncertainty of occurrence
 Uncertainty of magnitude
 Uncertainty of production rate
...
Once a discovery is made, uncertainty of
magnitude, which includes both volume and value, and rate become the dominant
uncertainties
...

Regulatory considerations can be subdivided into fiscal and non-fiscal considerations
...


5
...
1 DEALING WITH RISK AND UNCERTAINTY
There are four fundamental approaches to coping with risk and uncertainty:





Diversification
Reduction of exposure
Avoidance
Insurance
...
This reduces exposure by taking
lesser interest in a greater number of ventures
...
Insurance does not
reduce risk, but distributes it over time and shares it with others in the same insurance pool
...
0 DEPRECIATION
Depreciation is the decrease in value of physical properties with the passage of time
...
The actual amount of depreciation can
never be determined until the asset is retired from service
...
These benefits are in the form of future cash flows
resulting from:
 The use of the asset to produce salable goods or services
...

It is because of these anticipated cash flows that the asset has commercial value
...


6
...
Primarily, it is important to consider depreciation for two reasons:
 To provide for the recovery of capital that has been invested in physical property
...
Depreciation cost is deductible in
computing profits on which income taxes are paid
...
2 TYPES OF DEPRECIATION
Depreciation, or decrease in value of an asset, has several causes, some of which are very
difficult to anticipate or predict
...

6
...
Property used in connection with the
production of income is depreciated when its estimated life is greater than 1 year
...

 Estimated life

 Salvage value and date in service
 Method of calculating depreciation
...

These recovered funds thus are available to the firm for other use or investment
...

Depreciation methods used in the mineral industry are:







Straight line method
Declining Balance method
...

Sum-of-the-years’-digits method
Sunking fund method
Service output method
...
3
...
This straight line relationship gives rise to the method
...
This method of computing
depreciation is widely used
...

Straight-line depreciation is the simplest and most-often-used technique, in which the
company estimates the salvage value of the asset at the end of the period during which it will
be used to generate revenues (useful life) and will expense a portion of original cost in equal
increments over that period
...
Salvage value is also
known as scrap value or residual value
...
In other words, it is the
depreciable cost of the asset divided by the number of years of its useful life
...
Book value at the beginning of
the first year of depreciation is the original cost of the asset
...

book value = original cost − accumulated depreciation Book value at the end of year
becomes book value at the beginning of next year
...


Bookvalue
at
Depreciation
beginning of year
expense
$3,000
$17,000 (original cost)
$14,000
$3,000
$11,000
$3,000
$8,000
$3,000
$5,000
$3,000

Accumulated
depreciation
$3,000
$6,000
$9,000
$12,000
$15,000

Book value at
end of year
$14,000
$11,000
$8,000
$5,000
$2,000 (scrap value)

If the vehicle was to be sold and the sales price exceeded the depreciated value (net book
value) then the excess would be considered a gain and subject to depreciation recapture
...
If the sales price is ever less than the book value, the resulting capital loss is
tax deductible
...

If a company chooses to depreciate an asset at a different rate from that used by the tax office
then this generates a timing difference in the income statement due to the difference (at a
point in time) between the taxation departments and company's view of the profit
...
3
...
This may be a more realistic reflection of an asset's actual expected

benefit from the use of the asset: many assets are most useful when they are new
...
Under this method the book
value is multiplied by a fixed rate
...
For this reason, this technique is
referred to as the double-declining-balance method
...
First, calculate
straight-line depreciation rate
...
With double-declining-balance method,
as the name suggests, double that rate, or 40% depreciation rate is used
...


Book value
at Depreciation Depreciation Accumulated Book
beginning of year
rate
expense
depreciation

value at
end of year

$1,000 (original cost) 40%

$400

$400

$600

$600

40%

$240

$640

$360

$360

40%

$144

$784

$216

$216

40%

$86
...
40

$129
...
60 - $100 $29
...
60
$100 (scrap value)

When using the double-declining-balance method, the salvage value is not considered in
determining the annual depreciation, but the book value of the asset being depreciated is
never brought below its salvage value, regardless of the method used
...
In the last year of

depreciation a subtraction might be needed in order to prevent book value from falling below
estimated Scrap Value
...
This has the effect of converting from declining-balance depreciation to
straight-line depreciation at a midpoint in the asset's life
...


6
...
3 SUM-OF-YEARS' DIGITS METHOD
Sum-of-years' digits is a depreciation method that results in a more accelerated write-off than
straight line, but less than declining-balance method
...

Depreciable cost = original cost − salvage value
Book value = original cost − accumulated depreciation
Example: If an asset has original cost of $1000, a useful life of 5 years and a salvage value
of $100, compute its depreciation schedule
...
Since the asset has useful life of 5 years, the years' digits are: 5,
4, 3, 2, and 1
...
5+4+3+2+1=15
The sum of the digits can also be determined by using the formula (n2+n)/2 where n is equal
to the useful life of the asset
...

Bookvalueat
beginning of year

Total
Depreciation
depreciable
rate
cost

Depreciation
expense

Accumulated
depreciation

Book value at
end of year

$1,000(original cost) $900

5/15

$300 ($900 * 5/15)

$300

$700

$700

$900

4/15

$240 ($900 * 4/15)

$540

$460

$460

$900

3/15

$180 ($900 * 3/15)

$720

$280

$280

$900

2/15

$120 ($900 * 2/15)

$840

$160

$160

$900

1/15

$60 ($900 * 1/15)

$900

$100 (scrap value)

7
...
Such deductions are allowed for individuals and
companies
...
The cost of assets not currently consumed
generally must be deferred and recovered over time, such as through depreciation
...

Other systems allow depreciation expense over some life using some depreciation method or
percentage
...
Many systems that specify depreciation lives and methods for
financial reporting require the same lives and methods be used for tax purposes
...
) and personal property
(equipment, etc
...
1 CAPITAL ALLOWANCES
A common system is to allow a fixed percentage of the cost of depreciable assets to be
deducted each year
...
Deductions are permitted to individuals and businesses based on assets placed in
service during or before the assessment year
...
Fixed percentage rates are specified by
type of asset
...
The tax law or regulations of the country specifies
these percentages
...

8
...
Depletion is used
in connection with mining properties, oil and gas wells, timber lands and so on
...
As some of the mineral is mined and sold, the reserve decreases and the value of
the property normally diminish
...




---