Dr. Alfred Kjemperud The Bridge Group AS fileDr. A. Kjemperud CCOP, Pattaya, September 2003 2 Petroleum Investments • Petroleum Investments are: ¾capital intensive ¾irreversible

Basic Economic Principles

Dr. Alfred KjemperudThe Bridge Group AS

Dr. A. Kjemperud 2CCOP, Pattaya, September 2003

Petroleum Investments

• Petroleum Investments are:capital intensive irreversible risky

• Economic analysis and modeling is a method to reduce the risk when taking decisions

• Discounted cash flow modeling is based on basic economic principles


Economic Modeling

• Main elements in a discounted cashflow model:

CashflowNet Present ValueInternal rate of ReturnOther decision criteria

Expected Monetary ValueMaximum Sustainable riskPay back timeNumber of return of investmentsBreak even oil price


Cash flow – one year

Income- costs= Net cash flow


Cash flow every year

Income- costs

= Net cashflow

Year

Income- costs

= Net cashflow

Income- costs

= Net cashflow

0 1 2 time


The real world[Million USD] SUM Revenue from oil+as.gas 28426.5Revenue from gas+cond. 0Gross project revenue 28426.5 Royalty [million usd] 7031.6 Royalty % 24.7 %Net Project Revenue 21394.9Cost recovery 0.0Total capex 977.4 - Depreciations 977.4 - Expensed opex 2252.9Total costs 3230.3Total unrecov. costTotal cost cum.Cost recovery limit 21394.9Total costs recovered 3230.3Total costs recovered cum.Profit basis (op. Income) 18164.6State profit 1083.6State profit % 6.0 %Contractor profit 17081.0Contractor profit [%] 94.0 %Contractor revenue 20311.3Contractor revenue 20311.3 Total CAPEX 977.4 Total OPEX 2252.9Net cashflow before inc. tax 17081.0 Total income taxes 5124.3Net cashflow after tax 11956.7

Income

Cost

Net Cash flow


OutflowOutflow

-600

-400

-200

0

200

400

600

800

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029

Mill

ion

USD

Outflow


Inflow

-400

-200

0

200

400

600

800

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029

Mill

ion

USD

InflowOutflow


Cash Flow

-400

-200

0

200

400

600

800

2003

2005

2007

2009

2011

2013

2015

2017

2019

2021

2023

2025

2027

2029

Mill

ion

USD

InflowOutflowcash flow


Cumulative Cash flow

-500

0

500

1000

1500

2000

2500

3000

3500

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029

Mill

ion

USD

Cash flow

Cummulative cashflow


Cash Flow over time

• We can’t just add up inflow and outflow. This is due to:

InflationTime Value of MoneyUncertainty


Inflation

• As long as there is inflation thevalue of 1$ today is more than 1$ in the future.

• One could buy more for 10$ in 1980 than in 2003 - and probably more in 2003 than in 2010

• Inflation is adjusted for by using real values instead of current values


Inflation corrected

-500

0

500

1000

1500

2000

2500

3000

3500

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029

Mill

ion

USD

Cash flow


Inflation corrected

Current Values

Real Values


Present Value

• Future in- and out-flow must be discounted to be comparable.

• Net present value of a project is the sum of discounted cash-flow elements.

• Discount rate should be the rate of return of the best alternative use of money


Time value of money

• Alternative investmentsBank - small riskFonds - higher riskOther projects- high risk


Future Value

• F = P(1+i)n

Example$1000 invested at 10% for five years:

F = $1000(1+0.10)5 = $1,611

F = future valueP = Present value (principal)i = Interest raten = Number of time periods


Present Value• P = F/(1+i)n

• Example

After 5 years at 10 % interest in the bank you are paid back $1000. What was the principal?

P= $1000/(1+0.10)5

P= $1000/1.6105

P= $ 621

F = future valueP = Present value (principal)i = Interest raten = Number of time periods


NPV formula (end year)

...where:Vt - the net income in year t i - discount rate N - total numbers of years (project duration)

P1

(1 + i)1P2

(1 + i)2PN

(1 + i)N= + + ... +P0 +

Pn

(1 + i)n( )∑n = 0

N

NPV =


Time value of money

-500

0

500

1000

1500

2000

2500

3000

3500

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029

Mill

ion

USD

Cash flow


Inflation corrected

+ Value of time corrected

Current Values

Real Values

Discounted Values


Risk premium

• Petroleum projects always possess a certain risk of failure

• The risk vary due to a multitude of factors (geological, technical, political

economical)

• A risk premium is often added to the discount factor


Discounting incl. risk premium

-500

0

500

1000

1500

2000

2500

3000

3500

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029

Mill

ion

USD

Cash flow


Inflation corrected


++ Risk corrected

Current Values (0%)

Real Values (3%)

Discounted Values (7%)

Risk corrected Discounted Values (5%)


NPV formula (mid year)

...where:Vt - the net income in year t i - discount rate N - total numbers of years (project duration)

P1

(1 + i)(1-0.5)

P2

(1 + i)(2-0.5)

PN

(1 + i)(N-0.5)= + + ...... +P0 +

Pn

(1 + i)(n-0.5)( )∑n = 0

N

NPV =


Discounting

707

758

-500

0

500

1000

1500

2000

2500

3000

3500

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029

Mill

ion

USD

Cash flow


Inflation corrected


++ Risk corrected end year

++ Risk corrected mid year


Net Present Value1 Calculate separately

the present value of all the cash-flow elements

2 Add together the discounted cash-flow elements

Time 0 1 2Cash-flow -100 80 70

Present value:-100

7562

-100 + 75 + 62 = 37

80/(1.06)

The net present value of the cash-flow of the project is 3770/(1.06)2

interest rate is 6%


Present Value

Year Cash Flow NPV 5% NPV 10% NPV 15% NPV 20%2003 -200 -200.0 -200.0 -200.0 -200.02004 -50 -47.6 -45.5 -43.5 -41.72005 10 9.1 8.3 7.6 6.92006 100 86.4 75.1 65.8 57.92007 100 82.3 68.3 57.2 48.22008 200 156.7 124.2 99.4 80.4

SUM 160 86.8 30.4 -13.6 -48.3


Present Value - IRR

-100

-50

0

50

100

150

200

0 5 % 10 % 15 % 20 %

Discount Factor

NPV

IRR


Economic Decision Criteria

• The discount rate that yields NPV=0 defines the Internal Rate of Return (IRR)

A simple decision criteria would be:

Accept all project with IRR > discount factor

Drop all project with IRR < discount factor


ExerciseNet Present value - IRR

•Use the cash flow given in the table to the right as basis for calculating NPV at 0,5,10,15 and 20 % discount rate. Use the result to find the approximate Internal Rate of Return (IRR).•If you have time use both end year and mid year discounting

Year Cash Flow•2003 -300•2004 -100•2005 10•2006 100•2007 200•2008 300


Present Value

-300SUM

3002008

2002007

1002006

102005

-1002004

-3002003

NPV 20%NPV 15%NPV 10%NPV 5%Cash FlowYear


Discounted Cash Flow

-101.5-50.115.499.8210SUM

120.6149.2186.3235.13002008596.5114.4136.6164.52002007457.965.875.186.4100200636.97.68.39.11020052

-83.3-87.0-90.9-95.2-10020041-300.0-300.0-300.0-300.0-30020030

NPV 20%

NPV 15%

NPV 10%

NPV 5%

Cash FlowYear


IRR

-150

-100

-50

0

50

100

150

200

250

0 5 % 10 % 15 % 20 %

Discount Factor

NPV

IRR = ~11.5%

Documents

Dr. Alfred Kjemperud The Bridge Group AS fileDr. A. Kjemperud CCOP, Pattaya, September 2003 2 Petroleum Investments • Petroleum Investments are: ¾capital intensive ¾irreversible