# Economics: fundamental equations for oil and gas property evaluation

Series Development Geology Reference Manual Methods in Exploration Economics and risk assessment Fundamental economic equations for oil and gas property evaluation Peter R. Rose Web page PDF file (requires access)

## Profit or loss equation

The viability of any business venture can be expressed as the difference (either profit or loss) between revenue and costs. In other words, ${\mathbf {Profit}}\ {\mathbf {or}}\ {\mathbf {(Loss)}}={\mathbf {Revenue}}-{\mathbf {Costs}}$

In modern business, this simplistic equation becomes complicated by various forms of taxes and tax provisions, such as depreciation and allowable depletion calculations. Such complications—plus the accounting procedures they have engendered—obscure the financial performance of most businesses.

However, there is a second reason why most business ventures today are not so simplistic: money is often invested months before revenues begin to be generated and years before profits begin to be realized. Profits are not received as lump sums or even in predictable installments. Also, maintenance costs are incurred repeatedly during a project's lifetime. So the time value of money invested and received must be taken into account.

## Evaluating a producing property

The purchase of any oil and gas producing property is a complex business venture. The basic economic equation for evaluating a producing property is as follows: $P=(N\times R\times W)-T-C-F-I$

where

• P = After-tax profit or (loss), expressed as present value of the cumulative net cash flow stream
• N = Net revenue interest
• R = Reserves
• C = Operating costs
• F = Federal income taxes
• I = Investments

Several important observations can be made about Equation (2). First, the owners of the producing property usually pay 100% of the costs but receive a reduced proportion—ordinarily from about 70% to 87.5%—of the revenue from production. This reduced proportion is the net revenue interest (NRInet revenue interest). The remainder goes to the royalty owners—generally the landowner. Second, the equation expresses the profit or (loss) as if it were a "lump sum" payment, whereas it is actually received over a long period of time, a net cash flow stream combining production decline, price fluctuations, expenses (including taxes), and inflation. Third, to consider the time value of money, the net cash flows are expressed as a discounted cash flow stream, so the entire venture can be comparedto current alternative financial investments. Wherever a dollar value is expressed as a present value (PV), it means that the value has been discounted to reflect the time value of money.

Uncertainty attends every item in Equation (2) except the net revenue interest. These uncertainties are diverse, relating to geology, engineering, law, politics, economics, and Acts of God. It is the special responsibility of the geotechnical professional to estimate the magnitude of reserves, production rates, and costs; to reduce the level of uncertainty as much as possible through sound scientific and technological judgment (and investigation, where warranted); and to convey estimates—as well as uncertainty levels—to management accurately and consistently. Otherwise, management's investment decisions may be misguided and imprudent. Thus, the financial responsibilities and consequences of geotechnical predictions and estimates are enormous.

## Expected net present value equation for drilling ventures

The financial value of any proposed oil or gas drilling venture can be evaluated by assuming a successful project (Equation 2) and by adding one additional important consideration: the chance of success or failure. This leads to the expected value of the venture, as shown by Equation (3): ${\text{Expected net present value}}$ $={\text{ Chance of success (after-tax net present value)}}$ $-{\text{ Chance of failure (after-tax dry hole cost + associated geotechnical and lease costs)}}$

Thus, expected net present value (ENPVexpected net present value) represents the risk-weighted value of a proposed drilling venture. Assuming accurate and consistent perception of both reserves and chance of success, ENPVexpected net present value represents the probabilistic value of each venture and thus becomes a primary tool for decision-making and program forecasting. The ENPVexpected net present value is the average value that could be expected if the venture or similar ventures could be repeated many times. Some ventures will result in successes and some will result in failures, but on the average, we expect to make the expected net present value.

The next questions (covered in the next two chapters) concern methods for estimating (1) reserves, rates, and costs, and for estimating (2) chances of success and failure.