Changes

==Data requirements==

==Data requirements==

The basis of economic evaluation of any proposed drilling venture—a new field, pool, or just a single well—is the ''cash flow model'' of investments, expenses, taxes, and wellhead revenues involved with the project. The values for the parameters in this model must come from a geotechnical analysis (including maps, cross sections, and reservoir analysis) of the anticipated new field or well and from geotechnical estimates of area, ultimate recoverable reserves, and projected well production schedules. Here are the general data that are required:

 

The basis of economic evaluation of any proposed drilling venture—a new field, pool, or just a single well—is the ''cash flow model'' of investments, expenses, taxes, and wellhead revenues involved with the project. The values for the parameters in this model must come from a geotechnical analysis (including maps, [[cross section]]s, and reservoir analysis) of the anticipated new field or well and from geotechnical estimates of area, ultimate recoverable reserves, and projected well production schedules. Here are the general data that are required:

# All front end costs—leases, geology and geophysics (G & G), overhead, exploration drilling, and completion costs

# All front end costs—leases, geology and geophysics (G & G), overhead, exploration drilling, and completion costs

# Projected dry hole costs

# Projected [[dry hole]] costs

# Ultimate recoverable reserves (including secondary recovery)

# Ultimate recoverable reserves (including secondary recovery)

# Field area (and thus number of producing wells), unless it's a single-well project

# Field area (and thus number of producing wells), unless it's a single-well project

# Abandonment costs

# Abandonment costs

# Annual federal income taxes. The model can be adapted for the analysis of international prospects by changing this item in the cash flow model to "outsider's take." Simply apply the [[About taxes|tax rules]] for that country.  

# Annual federal income taxes. The model can be adapted for the analysis of international prospects by changing this item in the cash flow model to "outsider's take." Simply apply the [[About taxes|tax rules]] for that country.  

# Anticipated price or cost escalation schedule, if any (the example shown in 1 uses the constant dollar concept, thus no price or cost escalation schedule is provided). Inflation (loss of purchasing power) is also assumed to be zero.

# Anticipated price or cost escalation schedule, if any (the example shown in [[:Image:Charles-l-vavra-john-g-kaldi-robert-m-sneider capillary-pressure 1.jpg|Table 1]] uses the constant dollar concept, thus no price or cost escalation schedule is provided). Inflation (loss of purchasing power) is also assumed to be zero.

# Net revenue interest (NRI) of lease (1.00 - royalty interest) and company share of working interest

# Net revenue interest (NRI) of lease (1.00 - royalty interest) and company share of working interest

# Company discount rate

# Company discount rate

==Calculations in the cash flow model==

==Calculations in the cash flow model==

The ''net cash flow'' (NCF) for each assumed time period, including time 0, can be determined using the following equation.

The ''net cash flow'' (NCF) for each assumed time period, including time 0, can be determined using the following equation.

:<math>\text{After-tax NCF } = (\text{Net revenue interest}~ \times ~\text{Production} ~\times ~\text{Wellhead price})~ - ~\text{Wellhead taxes}~ - ~\text{Operating costs}~ - ~\text{Federal income taxes}~ - ~\text{Investments} \ </math>

:<math>\text{After-tax NCF } = (\text{Net revenue interest}~ \times ~\text{Production} ~\times ~\text{Wellhead price})</math>

::<math>-~\text{Wellhead taxes}~ - ~\text{Operating costs}~ - ~\text{Federal income taxes}~ - ~\text{Investments} \ </math>

Some of the economic parameters presented later utilize ''after-tax net operating income'' (NOI) as a measure of profit. After-tax NOI is defined as follows:

Some of the economic parameters presented later utilize ''after-tax net operating income'' (NOI) as a measure of profit. After-tax NOI is defined as follows:

:<math>\text{After-tax NOI} = (\text{Net revenue interest}~\times~\text{Production}~\times~\text{Wellhead price})~-~\text{Wellhead taxes}~-~\text{Operating costs}~-~\text{Federal income taxes} \ </math>

:<math>\text{After-tax NOI} = (\text{Net revenue interest}~\times~\text{Production}~\times~\text{Wellhead price})</math>

::<math>-~\text{Wellhead taxes}~-~\text{Operating costs}~-~\text{Federal income taxes} \ </math>

 

[[File:Test.png|thumbnail|'''Table 3.''' Cash flow model for example multiwell extension project.]]

For now, let's assume we are provided the cash income tax number, so we are ready to look at an example problem for a single development well. The assumptions for this example problem and a completed worksheet are presented in Table 1.  

[[File:Charles-l-vavra-john-g-kaldi-robert-m-sneider capillary-pressure 3.jpg|thumbnail|'''Table 4.''' Assumptions for example multi well extension project]]

|-

|-

|-

|-

|-

|-

|-

|-

|-

| —Cash Taxes, $M || 0.000 || 66.891 || 193.309 || 98.278 || 47.305 || 20.163 || 3.274 || -3.798 || -4.422

| '''NCF AFIT, $M''' || '''-1375.000''' || '''1359.098''' || '''578.462''' || '''314.450''' || '''168.376''' || '''87.377''' || '''44.916''' || '''19.417''' || '''4.795'''

:::^{IDC's (100 % expensed for tax calculation) = $950,000}<br>

::<sup>Estimated [[dry hole]] cost if the well is unsuccessful is $750,000 (After-tax = $750,000 x (1 - 0.34) = $495,000)

After the revenue and expenditure schedule has been determined, we can now calculate cash income taxes for our project. Finally, once the cash income taxes have been calculated for each year, the cash flow time diagram can be prepared and we are ready to calculate the net present value for our venture. (For an example and explanation of a cash flow time diagram, see the previous chapter on [[The time value of money|The Time Value of Money]].)

A completed cash flow time diagram is shown in Table 2 along with the equivalent net present value calculation.

|+ Table 2. Net Present Value Calculation

|-

! Time || Cash Flow || Discount Factor || Present Value

| 3 || 314.450 || 0.8890 || 279.5

For now, let's assume we are provided the cash income tax number, so we are ready to look at an example problem for a single development well. The assumptions for this example problem and a completed worksheet are presented in [[:Image:http://wiki.aapg.org/File:Charles-l-vavra-john-g-kaldi-robert-m-sneider_capillary-pressure_1.jpg|Table 1]]. A completed cash flow time diagram is shown in [[:Image:Rose_time-value-of-money_1.jpg|Table 2]] along with the equivalent net present value calculation.

The same steps also apply to a multiwell project. Field development projects are constructed by combining individual well models in a realistic time frame. The income tax calculation must be done on a total project basis since oil and gas taxation applies to the total property. An example of a multiwell field extension project is shown in Table 3. Since the project has a longer life than the example development well, the results are summarized in a slightly different format. The production, investment, and tax assumptions for the multiwell extension project are outlined below the table.

The same steps also apply to a multiwell project. Field development projects are constructed by combining individual well models in a realistic time frame. The income tax calculation must be done on a total project basis since oil and gas taxation applies to the total property. An example of a multiwell field extension project is shown in [[:Image:Test.png|Table 3]]. Since the project has a longer life than the example development well, the results are summarized in a slightly different format. [[:Image:Charles-l-vavra-john-g-kaldi-robert-m-sneider_capillary-pressure_3.jpg|Table 4]] presents the production, investment, and tax assumptions for the multiwell extension project.

| '''Totals''' || '''680.632''' || '''1101.931''' || '''11991.572''' || '''7225.000''' || '''4766.572''' || '''1131.851''' || '''3634.721''' ||  || '''2729.760''' || || '''6859.396'''

:^{NRI = 0.875}<br>

:^{Wellhead tax on oil and gas revenue is 8%}<br>

:^{Annual operating cost is $24,000/well. Note in the last four years the operating costs are not a multiple of $24,000. This is because the typical well produces only a fraction of a year in the eighth year.}<br>

:^{Incremental tax rate is 34%}<br>

:^{Oil price is $18.00/bbl. Gas price is $1.50/MCF}<br>

:^{Cost of Failure is assumed to be the after tax cost of 2 [[dry hole]]s.}<br>

::^{(750,000 x (1 - 0.34) x 2 = $990,000)}<br>

::^{Time 0 investments made on 1-1-91:}<br>

:::^{DHC's (100% expensed for tax calculation) = $1,500,000 (for two dry  holes)}<br>

:::^{Tangible expenditures (depreciable basis for tax calculation) = $600,000}<br>

:::^{Lease bonus and G&G = $100,000}<br>

:::^{Tangible expenditures (depreciable basis for tax calculation) = $300,000}<br>

::^{The production forecast for the typical well in the Example Development Well was used for the Multiwell Extension Project. A typical well was assumed to be placed on production at the beginning of each of the years 1991, 1992, 1993, and 1994.}<br>

==Points to remember==

==Points to remember==

Here are a few final points that are important to remember concerning cash flow models:

Here are a few final points that are important to remember concerning cash flow models:

# Cash flow analysis is the third step in evaluating a proposed (or existing) petroleum property; it occurs after estimating (a) the reserves, rates, and costs and (b) the chance of success.  

# Cash flow analysis is the third step in evaluating a proposed (or existing) [[petroleum]] property; it occurs after estimating (a) the reserves, rates, and costs and (b) the chance of success.  

# Do not carry out cash flow analysis of "risked reserves"—the cash flow model is built on the success case

# Do not carry out cash flow analysis of "risked reserves"—the cash flow model is built on the success case

# Net cash flow is the sum of outlays and inflows.

# Net cash flow is the sum of outlays and inflows.

# If prices and costs are assumed to be in terms of constant purchasing power, then the discount component should only include the real interest component. The inflation component should not be included. If the prices and costs are escalated, then the discount rate selected should include the real interest rate and the inflation component.

# If prices and costs are assumed to be in terms of constant purchasing power, then the discount component should only include the real interest component. The inflation component should not be included. If the prices and costs are escalated, then the discount rate selected should include the real interest rate and the inflation component.

# Higher discount rates tend to favor shorter term and lower dollar volume projects (in preference to longer term and higher dollar volume projects), whereas lower discount rates allow substandard projects that may be a drag on corporate earnings. Either excess is deleterious, but the excessively high discount rate is clearly more harmful.

# Higher discount rates tend to favor shorter term and lower dollar volume projects (in preference to longer term and higher dollar volume projects), whereas lower discount rates allow substandard projects that may be a drag on corporate earnings. Either excess is deleterious, but the excessively high discount rate is clearly more harmful.

# Some firms use mid-year discounting (rather than end-of-year discounting) as being more realistic<ref name=Megill_1988>Megill, R. E., 1988, An introduction to exploration economics, 3rd ed.: Tulsa, OK, PennWell Books, 238 p.</ref>. Some firms use continuous rather than annual discounting.

# Some firms use mid-year discounting (rather than end-of-year discounting) as being more realistic.<ref name=Megill_1988>Megill, R. E., 1988, An introduction to exploration economics, 3rd ed.: Tulsa, OK, PennWell Books, 238 p.</ref> Some firms use continuous rather than annual discounting.

# Although the final cumulative net present value can only be determined by projecting the cash flow model out through the full life of the field, the final few years will typically represent only a small fraction of its worth. Ordinarily, a field production model of about 15 years will be adequate for most purposes, except in the case of very large fields or in cases of "late" [[enhanced oil recovery]] (EOR) projects on older fields.

# Although the final cumulative net present value can only be determined by projecting the cash flow model out through the full life of the field, the final few years will typically represent only a small fraction of its worth. Ordinarily, a field production model of about 15 years will be adequate for most purposes, except in the case of very large fields or in cases of "late" [[enhanced oil recovery]] (EOR) projects on older fields.

# The present value of most projects will decrease as successively higher corporate discount rates are utilized. The exception would be an acceleration project<ref name=Thompson_etal_1985>Thompson, R. S., and J. D. Wright, 1985, Oil property evaluation, 2nd ed.: Golden, CO, Thompson-Wright Associates, 212 p.</ref>. The discount rate at which the present value is zero is called the ''discounted cash flow rate of return'' ([[Key economic parameters|DCFROR]]).

# The present value of most projects will decrease as successively higher corporate discount rates are utilized. The exception would be an acceleration project<ref name=Thompson_etal_1985>Thompson, R. S., and J. D. Wright, 1985, Oil property evaluation, 2nd ed.: Golden, CO, Thompson-Wright Associates, 212 p.</ref>. The discount rate at which the present value is zero is called the ''[[Key economic parameters#Discounted cash flow rate of return|discounted cash flow rate of return]].''

# All figures and estimates should be objective. You should neither purposefully ''overestimate'' (to sell the deal) nor ''underestimate'' (to be conservative and thereby protect yourself from being wrong). Be professional, give it your best shot

# All figures and estimates should be objective. You should neither purposefully ''overestimate'' (to sell the deal) nor ''underestimate'' (to be conservative and thereby protect yourself from being wrong). Be professional, give it your best shot

# It is a good idea to make several cash flow "cases" using different assumptions for reserves, number of wells, initial potentials (IPs), and decline rates. This is easy to do using modern software. Such ''sensitivity analyses'' give the decision maker a better idea of the range of possibilities for project outcomes. However, one shortcoming of many sensitivity analyses is that no probability of occurrence can be assigned to a given case. As a result, the decision maker has an idea of the ''range'' of possible outcomes, but no sense of the ''chance'' of occurrence of any one outcome Fortunately, this deficiency is readily correctable by using probabilistic ranges for key variables and Monte Carlo simulation to combine such variables. (For more information on ranges and probabilities, see the chapter on "Uncertainties Impacting Reserves, Revenue, and Costs.")

# It is a good idea to make several cash flow "cases" using different assumptions for reserves, number of wells, initial potentials (IPs), and decline rates. This is easy to do using modern software. Such ''sensitivity analyses'' give the decision maker a better idea of the range of possibilities for project outcomes. However, one shortcoming of many sensitivity analyses is that no probability of occurrence can be assigned to a given case. As a result, the decision maker has an idea of the ''range'' of possible outcomes, but no sense of the ''chance'' of occurrence of any one outcome Fortunately, this deficiency is readily correctable by using probabilistic ranges for key variables and Monte Carlo simulation to combine such variables. (For more information on ranges and probabilities, see the chapter on "Uncertainties Impacting Reserves, Revenue, and Costs.")

==See also==

==See also==

* [[Expected value and chance of success]]

* [[Risk: expected value and chance of success]]

* [[The time value of money]]

* [[Economics: time value of money]]

* [[Dealing with risk aversion]]

* [[Risk: dealing with risk aversion]]

* [[Fundamental economic equations for oil and gas property evaluation]]

* [[Economics: fundamental equations for oil and gas property evaluation]]

* [[Key economic parameters]]

* [[Economics: key parameters]]

* [[Economics of property acquisitions]]

* [[Economics of property acquisitions]]

* [[About taxes]]

* [[Taxes]]

* [[Introduction to economics and risk assessment]]

* [[Introduction to economics and risk assessment]]

* [[Uncertainties impacting reserves, revenue, and costs]]

* [[Uncertainties impacting reserves, revenue, and costs]]

[[Category:Economics and risk assessment]] [[Category:Pages with unformatted equations]]

[[Category:Economics and risk assessment]] [[Category:Pages with unformatted equations]]