EP00 Chapter07 Economics

EP00 - Introducing the E&P Business
Shell Learning Centre
Chapter 7 Petroleum Economics

Contents
7.1 INTRODUCTION ....................................................................................................................... 3
ROLE OF THE PETROLEUM ECONOMIST............................................................................ 4
Lease bidding............................................................................................................................ 4
Selection of "best" option .......................................................................................................... 4
Reporting................................................................................................................................... 4
Unitisation discussions.............................................................................................................. 4
Fiscal changes .......................................................................................................................... 4
Contracts................................................................................................................................... 4
THE METHOD .......................................................................................................................... 5
THE REQUIRED INFORMATION AND ITS ACCURACY ........................................................ 7
EXPLORATION ECONOMICS ................................................................................................. 9
REFERENCES........................................................................................................................ 10
7.2 PROJECT CASH FLOWS ...................................................................................................... 12
INTRODUCTION..................................................................................................................... 12
CASHIN................................................................................................................................... 12
THE TECHNICAL COSTS ...................................................................................................... 12
GOVERNMENT TAKE ............................................................................................................ 12
DEPRECIATION ..................................................................................................................... 13
CASH SURPLUS CALCULATION.......................................................................................... 14
CASH SURPLUS AND NET INCOME.................................................................................... 15
THE NET APPROACH............................................................................................................ 16
7.3 PROJECT PROFITABILITY ................................................................................................... 18
INTRODUCTION..................................................................................................................... 18
VALUING A CASHFLOW........................................................................................................ 18
THE DISCOUNTED CASH FLOW METHOD ......................................................................... 19
THE MECHANICS OF DISCOUNTING .................................................................................. 20
THE DISCOUNT RATE........................................................................................................... 20
PROFITABILITY INDICATORS .............................................................................................. 21
EARNING POWER ................................................................................................................. 22
DISCOUNTING A CASHFLOW WITH AN HP CALCULATOR .............................................. 23
7.4 INFLATION.............................................................................................................................. 24
A PRICE INDEX...................................................................................................................... 24
THE INFLATION RATE........................................................................................................... 25
THE INFLATION RATE........................................................................................................... 26
TYPES OF MONEY ................................................................................................................ 26
THE STAGES IN THE ECONOMIC EVALUATION................................................................ 27
EXCHANGE RATES AND INFLATION .................................................................................. 28
CURRENCY CHANGES AND CASHFLOWS ........................................................................ 29
2001 Shell International Exploration and Production B.V.
Page 1
7.5 UNIT COSTS AND BREAKEVEN PRICES........................................................................... 30

INTRODUCTION..................................................................................................................... 30
UNDISCOUNTED UNIT COSTS ............................................................................................ 30
DISCOUNTED UNIT COSTS ................................................................................................. 31
BREAKEVEN PRICES............................................................................................................ 32
NET UNIT COSTS .................................................................................................................. 33
7.6 GUIDELINES FOR THE PRESENTATION OF ECONOMICS ............................................... 35
EXAMPLE OF A GROUP BUDGET PROPOSAL .................................................................. 35
Shell Share.............................................................................................................................. 35
Total Requirement................................................................................................................... 35
GENERAL ............................................................................................................................... 36
7.7 DISCOUNT FACTORS ........................................................................................................... 37
List of Figures
7.1
7.2
7.3
7.4
7.5
7.7
7.8
7.9
7.10
7.11
7.12
Shells Capital Expenditure in the Period 1972-1991

Breakdown of the Revenues of a Medium Cost Oil Field
Production Forecast
The Cumulative Cashflow
The Cumulative Cashflow (at 15$/bbl)
Profit from a Project An Accountants View
Cumulative Cashflow and Economic Indicators
Present Value Profile
Type of Money
Currencies and Type of Money
Breakeven Prices
3
6
6
7
9
16
22
22
28
29
34
List of Tables
7.1
7.2
Calculation of a Price Index

Apparent Discount Rates for Various RT-Discount Rates and Inflation
25
27
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7.1 INTRODUCTION
"The objectives of the Royal Dutch/Shell Group of Companies are to engage efficiently,
responsibly and profitably in the oil, gas, chemicals, coal, metals and selected other
businesses, and to play an active role in the search for and the development of other sources of
energy."
So begins the Group's Statement of General Business Principles, which then discusses
responsibilities to 4 groups of interested parties: shareholders, employees, customers, and
society as a whole. In line with these objectives very large investments are made annually,
particularly in the Exploration and Production Function, as seen in Figure 7.1.
The annual rate of "upstream" investment rose very fast in the 1970s and has averaged $ 5 billion
since 1980. The lean years 1986-87 reflect the oil price collapse, whilst the peaks in 1979, 1985
and 1989 include major acquisitions in the USA, Colombia and Nigeria. Excluding acquisitions,
total 1972-91 investments were about $ 75 billion. Such sums spent in finding and developing
new oil and gas fields should lead to the creation of enough production capacity to offset the
decline of existing sources. The funds must, of course, be invested profitably. Quoting again from
the Business Principles:
"Profitability is essential to discharging these responsibilities and staying in business. It is a
measure both of efficiency and of the ultimate value that people place on Shell products and
services. It is essential for the proper allocation of corporate resources and necessary to support
the continuing investment required to develop and produce future energy supplies to meet
consumer needs. Without profits and a strong financial foundation it would not be possible to fulfil
the responsibilities outlined above. (....) Criteria for investment decisions are essentially
economic, but also take into account social and environmental considerations and an appraisal of
the security of the investment.
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ROLE OF THE PETROLEUM ECONOMIST

Investment opportunities are regularly proposed to E & P management. They may involve the
development of a newly discovered oil or gas field, or exploration for hydrocarbons in a new area.
There may also be the chance of a farm-in or farm-out deal or even the acquisition of an entire
company, like Belridge in 1979 or HOCOL in 1989.
It is the petroleum economist's job to advise on the economic attractiveness of these
opportunities, taking into account the many uncertainties regarding reservoir behaviour,
development costs, future energy prices and relationships with governments. He will also be
involved in some or all of the following activities:
Lease bidding
Often the company has to bid in order to acquire acreage. The bidding parameter may be the size
of a signature bonus, the Group's share of production, a price discount for domestic supplies, etc.
The economist will help establish the value of this parameter.
Selection of "best" option
Usually a choice has to be made between development options. There may be more than one
production method (water or gas injection, beam pumps, gaslift), development plan (underwater
completion or deviated drilling from a platform) or evacuation method (truck, rail, pipeline, tanker).
Profitability plays an important part in such decisions.
Reporting
The project proposals of operating companies are formally presented to EP management at the
annual Programme Discussions. Prior to this, the Data Books are prepared, setting out the
technical and economic merits of the proposals. In addition, where the proposed expenditure
exceeds the chief executive's discretionary limit, a formal budget proposal (known as a Return
502F) will have to be submitted for approval.
Unitisation discussions
If a field straddles the boundaries of several license blocks held by different licensees, the
production of the field will be shared between the various parties. This sharing involves frequent
unitisation discussions, in which the economist normally takes part.
Fiscal changes
If fiscal changes are being discussed within or with the host government, the petroleum
economist will inform his management on the economic consequences.
Contracts
These may cover the sale of hydrocarbons, the sale or purchase of the right to use facilities such
as pipelines, or the purchase of services or materials from third parties.
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THE METHOD
The petroleum economist basically sees the proposed venture as a "black box", which initially
absorbs shareholders' investment funds and later generates money that reaches them in the form
of dividends. Inside the black box the investments are turned into steel, concrete, facilities, etc.;
oil sales revenues are received; and operating costs, royalties and taxes are paid. The forecast of
the annual amounts of money absorbed or generated is called the cashflow of the venture. The
example in Figure 7.2 illustrates the relation between revenues, technical costs, host government
take and cashflow for a venture whose major parameters are shown in Figure 7.3 and the
accompanying table.
The oil price assumption of $30 per barrel is high, as the evaluation of this project preceded the
1986 fall in oil prices. The effect of lower oil prices is discussed later.
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Page 6
Development of this 26 million barrel, medium-cost oilfield would lead to the cashflow of Figure
7.2. The dominant cost element in the early years is the capital expenditure ($100m) needed to
build the platform, production facilities and pipeline and to drill and complete the wells. The
remaining technical costs cover maintenance, lifting, treatment, transportation, insurance and
overheads: these operating costs are dominant during the last years of the venture, and are the
eventual cause of abandonment of the field.
The largest single cost element is generally the host government take, in this example
consisting of royalty and taxes. The relative magnitude of the various cashflow items can be
judged from a cumulative cashflow, as shown in Figure 7.4.
This cumulative cashflow curve also illustrates several of the so-called profitability indicators.
The investor can see from figure 7.4 that he will have to invest $ 70 million (the depth of the cash
sink, or exposure), which will be retrieved in total after the payout time of 6.3 years, and that the
project will have earned him a cash surplus of $ 83 million by the time the field is abandoned
after 18 years.
The most important profitability indicators, however, result from discounting the cashflow. In this
process the cashflow elements of later years are reduced by a discount factor reflecting the time
value of money. The Present Value Cash Surplus is the sum of the discounted cashflow and
represents the value of the project to the investor. The Earning Power is a measure of the
project's return on capital.
THE REQUIRED INFORMATION AND ITS ACCURACY
In order to analyse a project economically, the petroleum economist will build an economic model
of the venture, normally using a computer. The model parameters will be based on information
gathered from various departments of the company and a large part of the economist's time can
be devoted to this data gathering.
The accuracy of the information obtained varies considerably. With limited well data, only rough
guesses can be made and the accuracy will be rather poor. As more and more appraisal and/or
development wells are drilled, the accuracy of the estimates will gradually improve. In view of this
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uncertainty, the most probable outcome of the venture is defined as the Base Case. The
economic results for this base case should be regarded with some reserve.
In order to appreciate the effect of possible variations on the base case, a set of "sensitivities" are
defined, evaluated and analysed. Typical examples are:
different oil/gas price assumptions;
alternative reserves estimates;
different production behaviour;
increased capital expenditure;
changes in operating expenses;
delayed production start-up.
Study of such sensitivities reveals the project's vulnerability to parameter variations. Measures
can then be taken to limit the most damaging sensitivity (or reduce its chance of occurrence). If,
for instance, the economics are very sensitive to the reserves estimate, a suitably placed
appraisal well could limit the risk. If the main risk is "capex overrun", special attention needs to be
paid to cost optimisation and realistic budgeting.
As regards the oil price, this is so unpredictable that it is now standard practice to repeat the
economics at (typically) three different "screening values". Figure 7.5 shows the cumulative
cashflow graph for the example of Figure 7.2, with the $30/bbl oil price assumption replaced by a
screening value of $15/bbl. The payout time increases to 8 years, total revenues drop by more
than 50% and government take is much reduced. The economic lifetime of the project has shrunk
by 5 years to 13 years, reducing the total amount of oil recovered. Finally it can be seen that the
cash surplus has dropped to a dangerously low level, which threatens the overall viability of the
project.
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For very large projects, such as development of the Troll field offshore Norway, a statistical
approach called "Monte Carlo" analysis is sometimes used to study the combined effect of
parameter variations. A multitude of possible outcomes of the venture is analysed and the results
presented in the form of expectation curves. As computing power increases, this method may be
applied to smaller projects.
EXPLORATION ECONOMICS
Uncertainty of outcome is most pronounced for exploration ventures. For this reason a statistical
approach, similar to techniques used in gambling theory, is often used. The exploration costs,
such as bonuses, seismic and drilling, are compared with the prices of lottery tickets. The Present
Values of the possible results are regarded as the prizes. As in a lottery, it is important to have an
idea of the probability of getting the rewards.
The range of possible geologic results and their probabilities can be deduced from the presence
of reservoir rock, source rock, cap rock and structures in the licence area. Computer programs
like PAQC digest this information, generating expectation curves for the reserves. For a
representative set of outcomes rough development plans will be conceived and economically
analysed. The results will again be presented in the form of expectation curves and statistical
properties such as the Expected Monetary Value and the required probability of success.
Page 9
REFERENCES
For course participants who are sufficiently intrigued and want to learn more about this subject, a
list of useful books and publications is given for further reading.
R.G. Lipsey and P.O. Steiner, "Economics"
(Harper & Row, New York, 6th Edition, 1981) General textbook on macro- and micro-economics,
not specifically related to oil.
The "Campbells", "Mineral Property Economics":
Vol. 1. Economics Principles and Strategies (1978) Vol. 2. Energy Sources and Systems (1978)
Vol. 3. Petroleum Property Evaluation (1978) Petroleum Evaluation for Financial Disclosures
(1982) Campbell Petroleum Series, Norman, Oklahoma (USA 73072) Very thorough on the
economic and financial basis, and a good introduction to the required petroleum engineering
foundations.
A.P.H. van Meurs, "Modern Petroleum Economics"
(Van Meurs & Associates Ltd., Ottawa, Canada, 1981) Interesting because it considers not only
the viewpoint of a private oil company but also that of a State Oil Company and a producing
government.
P.G. Moore and H. Thomas, "The Anatomy of Decisions"
(Penguin Books Ltd., Harmondsworth, Middlesex, England, 1984) Discusses decision trees and
their statistical basis, which are required for evaluating exploration proposals.
P.D. Newendorp, "Decision Analysis for Petroleum Exploration"
(Petroleum Publishing Company, Tulsa, USA 1976) A standard reference text for Exploration
Economics.
S.H. Schurr and B.C. Netschert, "Energy in the American Economy 1850-1975"
(John Hopkins Press, Baltimore, 1960) An economic study of the history of oil in USA.
R.E. Megill, "An Introduction to Risk Analysis"
(PennWell Publishing Company, Tulsa, Oklahoma, 1984) Good introductory text for risk analysis
plus some useful comments on competitive lease bidding.
R.E. Megill, "An Introduction to Exploration Economics"
(PennWell Publishing Company, Tulsa, Oklahoma, 1979) A simple but interesting introduction.
Also: "Evaluating and Managing Risk - A Collection of Readings" (Sci Data Publishing, Tulsa,
Oklahoma, 1985) A collection of 14 articles taken from several magazines, journals, etc., dealing
with subjects ranging from Investment Indicators to Bidding Strategies. Recommended.
O.E.C.D., "OECD Economic Outlook"
(Organisation for Economic Co-operation and Development (OECD), Paris, France. Published
semi annually.) Contains forecasts of the inflation rates in the OECD member Countries.
Page 10
International Monetary Fund, "International Financial Statistics"

(I.M.F., Washington D.C., USA, published monthly). Excellent source of information on historic
economic data of virtually all countries.
SIPM, "Exploration Bulletin" - Articles by R.M. Jonkman:
Bulletin no. 253 (1990/6), page 15: Exploration Economics; Bulletin no. 255 (1991/2), page 17:
Value and Cost of Appraisal; Bulletin no. 259 (1991/6), page 20: Finding Costs and the Value of
Reserves.
SIPM-EPC, "Petroleum Contracts" (1992). SIPC-FN/PL, Manual of Investment Evaluation.
Page 11
7.2 PROJECT CASH FLOWS

INTRODUCTION
A project cashflow is a model of the financial consequences of an investment. It covers a project's
entire life, making it possible to derive measures of value and economic performance, which are
based on the project as a whole. It is therefore exempt from the accountant's need to introduce
non-cash items, such as depreciation of asset value, to obtain meaningful measures of short-term
performance. It is simply an assessment of money required or money generated. The figures are
obtained, generally on an annual basis, by subtracting the cashout (the sum of payments made
on behalf of the venture, comprising technical costs and government take) from the cashin
(the sum of payments received as a result of the venture) to give the cash surplus or cash
deficit. The initial deficits have to be supplied by the investors in the project; the subsequent
surpluses accrue to them as their remuneration.
CASHIN
The main cashin element is the company's share of the gross revenues derived from
hydrocarbon sales. To model this, the economist needs a production forecast and a set of
assumptions about prices. Given the impossibility of forecasting the long-term oil price, it is usual
to take a representative constant level for the "marker crude", deriving the corresponding prices
of local crude, gas and NGL with appropriate formulas.
Other possible cashin items include:
partner payments, notably by State oil companies coming in after a project has started and
refunding their share of prior costs;
payments for use of project assets by another (own or third-party) venture. e.g. a pipeline
tariff paid or allocated;
payments for acquisition of an interest in the venture.
THE TECHNICAL COSTS

Project costs are either capital expenditure (capex) or operating expenses (opex). In principle
expenditure is capitalised if it creates an asset with a lifetime of more than one year, whereas the
cost of short-lived assets, perishable goods and services is opex. The exact definitions, however,
depend on the local tax legislation.
Typical capital items are platforms, production facilities, pipelines and production wells. Typical
operating costs are maintenance, insurance, lifting, well repairs and workovers, tanker rentals,
and tariffs paid for using a third-party pipeline. Overheads too are a significant opex element.
Capex is predominant in a project's early years.
GOVERNMENT TAKE
Host Government Take depends on the contract terms and the local fiscal system. In traditional
systems the company pays a royalty, based on the value of oil and gas recovered, plus one or
more taxes levied on "taxable income". Under production-sharing arrangements the company's
share of produced hydrocarbons is limited by a cost-related formula; tax and even royalty may be
levied as well.
Royalty is normally a percentage of gross revenues from the sale of hydrocarbons, and may be
due in cash or in kind. It is payable from the start of production onwards.
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Tax is a percentage of taxable income, which is calculated by subtracting fiscally allowable costs
from revenues:
TAXABLE INCOME = REVENUES - FISCAL COSTS
(1)
The fiscal costs are defined in the host country's fiscal legislation. Royalties and opex are
normally allowed in the fiscal year in which they are incurred. Capex is replaced by the
depreciation allowance (see next section), which is intended to spread the cost deduction over
the life of the asset and so reflect its gradual loss of value.
FISCAL COSTS = ROYALTY + OPEX + FISCAL DEPRECIATION
(2)
Tax is usually the main cashout item in the middle period of a project's life. It is due only when
there is a fiscal profit. As this can only be determined after the end of the fiscal year, settlement is
often much later than receipt of the corresponding revenue. Advance provisional payments may,
however, be required. The economist must know the mechanism, and assign tax payments to the
periods when they are actually made.
In years when fiscal costs exceed revenues, there is a fiscal loss. However, where tax is
assessed on a corporate basis and the company as a whole is already tax-paying, a project's
fiscal loss means a reduction of the company's profit and tax bill: the fiscal costs of the project are
effectively being claimed against corporate income, and the incremental tax attributable to the
project is negative and will appear as a plus in the project cashflow. If the company is not a
taxpayer, or if "ring-fencing" applies, then the project must be seen in isolation, and in that case
its fiscal losses are carried forward to be offset against profits later on. Over the life of the project
the total tax bill is still the same, but the deferment of tax relief has an adverse effect on the
economics.
DEPRECIATION
The depreciation allowance, or fiscal depreciation, is not itself an element of the cashflow. Its only
role is in the calculation of tax; and it should be noted that the allowance claimed for that purpose,
being determined by local legislation, is different from the "Group rules" depreciation used by
accountants when determining profits and book values according to a procedure common to all
Group operating companies.
Three types of depreciation scheme are the most common in fiscal legislations:
1.
Straight Line Method: The assets are depreciated in equal amounts over a number of
years, e.g. 25% of initial value each year for 4 years. Depreciation may start as soon as
money is spent, or may have to wait until the asset involved is in use.
2.
Declining Balance Method: Each year a fixed percentage (e.g.25%) of the nondepreciated
net book value at the end of the previous year is depreciated (again, it may or may not be
necessary to wait until the asset concerned is in service). This construction results in having
incompletely depreciated assets at the end of the venture. Generally, these undepreciated
balances are claimable in full in the final year.
3.
Depletion Method: In this system - also known as the Unit-of-Production method depreciation is calculated as the book value (non-depreciated assets) at the end of the
previous year multiplied by the ratio of the current year's production to the reserves at the
beginning of the year. The depreciation per barrel remains constant unless total recoverable
reserves change, when the method can lead to complications.
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Since depreciation reduces taxable income, fast depreciation leads to a lower tax bill in the early
years of a project, thus improving its early cashflow at the expense of its later cashflow. This has
a beneficial effect on the economics. Of the systems described, the simple straight-line method is
the most favourable from this point of view.
CASH SURPLUS CALCULATION
A project's cash surplus (or deficit) in any one year is given by
CASH SURPLUS = REVENUE -OPEX-CAPEX -ROYALTY TAX
(3)
In a typical tax/royalty system,

ROYALTY = ROYRATE * REVENUE
(4)
TAX = TAXRATE * (REVENUE - ROYALTY - OPEX - FISC. DEPR.)
(5)
Suppose, for example, that in a particular year

production = 15 million bbl
oil price
= $18/t)bl
capex
= $75 million
royalty rate = 20%
opex
= $30 million
tax rate
= 75%
We need to know the fiscal depreciation, which depends on previous capex. Assume, for the
purpose of this illustration, that it is $50 million - arising, for instance, from a 5-year straight-line
rule with prior capex of $175 million: (175+75) * 20% = 50.
Calculate revenue, technical cost, and government take:
Revenue =15mbbl x $18/bbl
= $270 million
Capex
= 75
Opex
=30
Technical cost
= $ 105 million
Royalty = 20% x $270 million
= 54
Taxable income:
(revenue)
270
(royalty)
54
(opex)
30
(depreciation)
50
(fiscal costs)
134
(taxable income)
136
Tax =75% x $136 million
=102
Government take
= $ 156 million
The cash surplus is therefore $ 270 m-$105 m-$156 m
=$9 million
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CASH SURPLUS AND NET INCOME

The accounting profit, or net Income, is generally defined as
NET INCOME = REVENUE-OPEX-DEPRECIATION-ROYALTY-TAX
(6)
In which, as already mentioned, the depreciation is not necessarily the same as the fiscal
depreciation allowance. Suppose, nevertheless, that in the example given above they are equal.
Then the net income for the year in question is
$270m - $30m - $50m - $54m - $102m = $34 million
The element common to the cash surplus and net income formulas is called the Cash
Generation:
So,
CASHGEN
= REVENUE - OPEX - ROYALTY TAX
(7)
and
CASH SURPLUS
= CASHGEN - CAPEX
(8)
NET INCOME
= CASHGEN DEPRECIATION
(9)
In our example the cash generation is $ 84 million, of which $ 75 million is used in capital
investment. Depreciation, however, is only $ 50 million, giving a $ 34 million net income. When
capex exceeds depreciation, cash surplus is less than net income; when depreciation exceeds
capex, cash surplus is greater than net income. Their totals over a project's life are equal, but the
net income lies in a narrower range of values.
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THE NET APPROACH

The step-by-step method of building annual cashflows simulates in detail the financial
transactions relating to a project. The method is easy to program with appropriate computer
software. In the days before such software was available the calculations were time-consuming
(especially when sensitivities had to be calculated too), and to speed up the analysis, frequent
use was made of the net approach described below. This approach is still of value as it enables
the main sensitivities to be quickly evaluated on hand calculators. It will be illustrated for a
tax/royalty system, but can also be adapted to production sharing.
Page 16
Going back to equations (3) - (5) and combining them, we get the following formula:
CASH SURPLUS
= (1 -TAXRATE) * {(1 - ROYRATE) * REVENUE - OPEX}

- {CAPEX - TAXRATE * FISCAL DEPRECIATION}
(10)
This can be rewritten as

CASH SURPLUS
= NET REVENUE - NET CAPEX - NET OPEX
(11)
where the "net" terms are defined as follows:

Net revenue is the revenue remaining after royalty and tax (before any reduction for allowable
costs) have been paid:
NET REVENUE
= (1 -TAXRATE) * (1 - ROYRATE) * PRICE * PROD (12)
Net capex is the actual capital expenditure minus the tax relief on this expenditure:
NET CAPEX
= CAPEX - TAXRATE * DEPRECIATION
(13)
Net opex is likewise the actual operating expenses minus the related tax relief:
NET OPEX
= (1-TAXRATE)* OPEX
(14)
Changes in production profile, oil price or royalty rate affect Net Revenue only, whilst changes in
the capex or in the depreciation rules affect Net Capex only, and changes in opex affect Net
Opex only. The power of this in sensitivity analysis will now be seen.
If the net approach is used in the example given earlier, the following is obtained:
NET REVENUE
= (1-0.75) x (1-0.20) x 18 x 15
NET CAPEX
= 75-0.75x50
= $ 37.5m
NET OPEX
= (1-0.75) x 30
= $ 7.5m
NETTECH. COST
CASH SURPLUS
= $ 54.0m
=$ 45.0 m
= $ 9.0 m
The result is, of course, the same as before; but one can now see immediately that (for instance)
a 20% cut in the production rate would reduce the cash surplus by 20% of $ 54m, or $ 10.8m, or
that doubling the opex would reduce the surplus by $ 7.5 m. These conclusions could not have
been drawn so easily with the step-by-step method.
The above formulae can be used both on an annual basis and on a cumulative project basis. It
should however be clearly understood that, although a change in the level of the revenues does
not affect the tax relief on capital expenditure, it may affect very significantly the timing of that
relief if the company is not already a taxpayer. By using the net approach one ignores part of the
effect of the possible carrying forward of fiscal allowances. The result is that sensitivities may
tend to be understated.
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7.3 PROJECT PROFITABILITY

INTRODUCTION
Most upstream project cashflows follow a standard pattern: they show a series of cash deficits
during the investment phase, followed by a series of cash surpluses during the production phase.
The surpluses may be interrupted if there is a major mid-life investment (compressors, secondary
recovery), and there may well be a deficit year when the project is abandoned; but broadly
speaking, a typical project involves investing in the short term in the expectation of earning steady
surpluses in the long term. To decide if it is profitable we need a means of consistently valuing
sums of money spent or received at different times over a long period.
The key lies in the concept of the cost of capital. Venture capital comes, in the first instance,
from shareholders and lenders. By combining their required rewards in suitable proportion, the
overall cost of capital can be assessed in % per year. This then sets a marker, which the overall
business return should exceed. Now if capital is applied to a specific project we forgo the
opportunity to use it for other investments, from which - on average - a return matching the cost of
capital should have been obtainable. The project is only worth doing if its reward exceeds that of
the alternative investment. Its value is measured by the extent to which it exceeds.
VALUING A CASHFLOW
Suppose, just for simplicity, that our cost of capital is 10% per year. Consider the following
potential project cashflow ($m):
Year
Cash
-50
-145
70
65
60
45
25
Let us see how closely we could reproduce this cashflow by making an alternative investment
at10%p.a.lfwe
invest the indicated amounts in years 1 and 2;
add, each year, 10% to the balance invested;
withdraw the indicated amounts in years 3 to 6;
withdraw all of the final balance in year 7 (or make it up if negative),
then the alternative investment develops as follows:

Year
1
2
3
Interest accrued
5
20
Investment
50
145
Withdrawals
-70
Balance
50
200
150
4
15
5
10
6
5
7
1
-65
100
-60
50
-45
10
-11
0
Our cashflow from this is
65
60
45
11
-50
-145
70
The project is better than this alternative investment, as it brings us an extra $ 14 million in the
last year.
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We could make the alternative cashflow match the project exactly in years 1-7 by investing some
money in year 0. If we invest $ 7 million, the above table becomes:
Year
0
1
2
3
4
5
6
7
Interest accrued
1
6
21
16
11
6
2
Investment
7
50
145
Withdrawals
-70
-65
-60
-45
-25
Balance
7
58
209
160
111
62
23
0
Our alternative cashflow is now -7
-50
-145
70
65
60
45
25
The project is better than this by precisely the $ 7 million that it does not require us to spend in
year 0. This $ 7 million is in a real sense the value of the project: it is the maximum, which we
ought to be prepared to pay to acquire its cashflow.
THE DISCOUNTED CASH FLOW METHOD
How was the figure $ 7 million arrived at? It is simply the amount which would have to be put into
the alternative investment in year 0, in order to produce in year 7 enough extra money to bridge
the gap between (a) the $11 million that would otherwise be available from that investment and
(b) the $ 25 million expected from the project. In other words it is the sum which, if put on
compound interest at 10% for 7 years, would grow to $14 million. Now the compound interest
formula states that, if an amount C is invested fort years at an interest rate expressed as a
fraction r, it will increase to Ct, where:
The reader may verify that 14x1.10 ^ = 7 (more accurately 7.2).

We call the result of formula (2) the Present Value (PV) of C^. The process of converting a future
value to a present value in this way is called discounting. The discount rate (r) and the
reference date must always be stated. In our example, $ 7 million is the 10% PV at year 0 (of
$14 million in year 7).
If we discount separately (at 10%) the seven annual elements of the project cashflow, and add
together the results, we shall arrive at the same $ 7 million PV which we previously got by
discounting the difference between project cashflow and alternative cashflow. The reason is that
the alternative cashflow is 'itself neutral (has zero PV) at this discount rate: the discounting
process cancels out the interest additions. This procedure of discounting each year's surplus (or
deficit) separately, and adding, is the normal way to calculate the PV of a cashflow and its result
is known as the PV Cash Surplus (PVCS) or Net Present Value (NPV). Applied to our example,
the procedure gives a PVCS of
Page 19
THE MECHANICS OF DISCOUNTING

The discounting operation can be performed in several ways:
(a) by the direct method illustrated above;
(b) the same, but getting the multipliers from a table of Discount Factors;
(c) by a streamlined and much less error-prone version of method (a), suitable for calculators of
the HP1 IC type and described at the end of this chapter;
(d) by using appropriate computer software.
The tables required for method (b) are included in section 7.7. It will be observed that the table for
each discount rate has two parts, headed Full Year Discounting and Half Year Shift
Discounting. So far in this chapter we have worked with whole years, which is appropriate (i) if
money movements occur at annual intervals or (ii) if it is a fair approximation to assume that they
are uniformly spread over the year. For the long projects typical of E&P, the latter assumption is
usually perfectly valid within the accuracy of our modelling. We then use the full year factors: for
instance, to discount at 10% from year 7 to year 0 the required factor is found from the 10% table
to be 0.51316. Our reference date is effectively 1st July of the reference year. This is the normal
EP practice.
Half year shift factors are needed 'if, for instance, we are evaluating a proposal to spend money
(capex) at the end of year 0 for an immediate and continuous benefit (opex reduction). To
discount the benefit in years 1, 2 etc. we can take 1/7/0 as reference date and use full year
factors; but then the capex should be discounted just half a year, which is achieved using the half
year shift factor for year 1 = 0.95346.
THE DISCOUNT RATE
The NPV can be calculated for any discount rate (r). When r is equal to the cost of capital, the
NPV is, as we saw earlier, a real measure of project value. However, it is not enough just to
screen projects (require them to have a positive NPV) at this discount rate. More is needed to
offset the fact that there is often a substantial gap between the aggregate cashflow expected on
the basis of investment proposals and the overall cashflow of the Upstream Sector. This gap
reflects the erosion of project profitability by various influences at field, opco and Sector level respective examples being the imposition of new environmental standards, expenditure on
company infrastructure, and the costs of research and technological development.
For such reasons the NPV at the cost of capital should not be just positive, but substantially
positive. In general, the NPV decreases as the discount rate increases. Accordingly, a discount
rate substantially higher than the cost of capital is normally used for project screening. The
NPVs are reported at both rates (as well as at 0%) and at various oil prices - a "grid" of values
providing a framework for judgment.
Page 20
PROFITABILITY INDICATORS
The main measures of a venture's profitability are the Net Present Values shown on the "grid". A
number of other useful indicators can also be derived from the cashflow and its elements.
The annual cashflow itself provides an essential portrait of the project and should always be
presented in support of the economics, at least in pictorial form. The only useful indicator
obtainable directly from it is the economic life, i.e. the time until the cashflow turns permanently
negative. This corresponds to the production rate falling below the economic limit or
abandonment rate, which (in a tax/royalty system) is found by equating revenue with royalty plus
opex. The economic life should be checked against the concession expiry date.
More information can be derived from the cumulative cashflow. This is a running total of the
annual figures (so its values apply at the end of each year), and it finally arrives at the ultimate
cash surplus. On the way, it tells us:
-
the exposure, or maximum value of the cumulative cash deficit: this is the amount the
investor would stand to lose if the project were to be terminated by some disaster at the
most unfavourable moment;
the payout time, or time until the cumulative cashflow turns positive: this indicates how long
the investor will take to recover his original investment.
Neither of these, however, is true indicators of profitability as they take no account of what
happen later in the project's life.
All of the quantities discussed so far are expressed in money or in years. In order to be able to
compare projects of different sizes and scopes, it is useful to have a measure expressed as a
ratio. A convenient one is the Profit / Investment Ratio or PIR, defined by
PIR = Ultimate Cash Surplus ^Capital Expenditure
(17)
(Note that the term "profit" is here misused.) The ratio can also be defined on a PV basis, e.g.
8% PIR = 8% PV Cash Surplus -- 8% PV Capex
(18)
In the latter form it is a good measure of reward per unit of value invested.
Page 21
EARNING POWER
The NPV of a project depends, of course, on the discount rate applied. Provided that the project
has a conventional cash flow, in which all of the deficit years precede the first surplus year, the
NPV will decrease as the discount rate increases. It will be positive at low enough rates
(assuming that the ultimate cash surplus, or 0% NPV, is itself positive) and it will be negative at
high rates as the discounting will then bear much more heavily on the surpluses than on the
deficits. There is, therefore, one particular discount rate for which the NPV will be zero. In Shell
companies this rate is generally called the Earning Power; elsewhere it is more often referred to
as the Internal Rate of Return, or IRR.
Page 22
The earning power may be found by plotting NPV against discount rate; such a plot is called a
present value profile. The earning power is read off where the curve crosses the axis. Some
computer software and some calculators (the HP12C, but not the HP11C), have functions, which
do the IRR calculation by iterative methods.
For a conventional cashflow the following are true:
-
if the discount rate is less than the earning power, the NPV will be positive;
if the discount rate is more than the earning power, the NPV will be negative.
Herein lies the convenience of this profitability indicator. If a project has an earning power of 20%,
it is not necessary to have established whether (for instance) 12%, 15% or 18% is the proper
discount rate to be used for screening; provided we know that the screening rate is less than
20%, the project is economically justified.
Thus the earning power is basically a screening tool. It is not a suitable criterion when comparing,
ranking, or optimising projects. Its other value is as an indicator of robustness: this will not be
pursued here, but, broadly speaking, the higher a project's earning power the greater degree of
risk it can withstand.
When the cashflow is not conventional the PV profile may cross the axis several times, giving
multiple "earning powers". Sometimes it may be obvious which one is meaningful but usually it is
best to stick to NPVs and leave earning powers alone. A typical example is an acceleration
project, where an incremental investment is made in order to recover some oil earlier than it
would otherwise have been recovered: the reward is the gain in the PV of the revenue. The NPV
will be negative at 0%, positive - 'if the project has any merit - for a range of discount rates, and
ultimately negative again. In such cases "earning power" is meaningless, and the economic
decision has to be based on the nature of the range of positive NPVs.
DISCOUNTING A CASHFLOW WITH AN HP CALCULATOR
Determining an NPV with an HP calculator simple. We first fill the "stack" with copies of the 1 year discount factor; then, whenever multiplication by an unspecified quantity is invoked, this
factor is used and regenerated. To discount at 15%, prime the calculator as follows:
1.15
1/x
ENTER
ENTER
ENTER
The cashflow is then fed in backwards. Suppose it runs from year 1 to year N. The cash surplus
for year N is entered, followed by x (multiplication); this has the effect of discounting it back to the
middle of year N-1. Year N-1 's cash surplus is then entered followed by + and then by x: this
yields the combined NPV of years N and N-1, discounted back to year N-2. One continues in this
way (replacing + by-in deficit years) until finally the year 1 deficit is entered, followed by - and x,
giving the NPV of the total cashflow with reference date the middle of year 0. As an example of
the method, let us discount at 15% the cashflow
(10)
Page 23

Immediately after priming (see above), the keystrokes are
1
x
2
+
x
3
+
x
4
+
x
10
x
and the result is 0.857
7.4 INFLATION
So far the subject of inflation has not been mentioned. For a multinational company like Shell, the
discount rate for a venture in an inflation-prone country would have to be set appreciably higher
than the discount rate for a low inflation country elsewhere. Such an approach would be rather
cumbersome for an investor who wishes to compare projects in different countries with different
inflation rates. For this reason Shell has opted for another approach. The cashflow is calculated in
the normal (nominal) currency of the country involved. This cashflow will then be corrected for the
effects of inflation and converted into dollars, before the profitability indicators are evaluated. In
this way, the present values and earning powers of various projects in different countries can be
compared directly without worrying about currency translations and local inflation rates.
A PRICE INDEX
The world's economies have often experienced periods of prolonged and rapid changes in price
levels. Over the long swing of history price levels have sometimes risen and sometimes fallen. In
recent decades, however, the course of prices has always been upward. The price level can be
measured by an index of the economy's prices. A "price index number" for a given year is defined
as the ratio of the cost of purchasing a "shopping basket" of commodities in that year to the cost
of purchasing that same basket in the "base year", multiplied by 100. In table 7.3 an index is
calculated for a simple case.
The three most common indices are the "consumer price index" (CPI), which covers commodities
bought by the typical consumer; the "producer price index" (PPI), which covers wholesale prices;
and the "gross domestic product" (GDP) deflator, which covers everything produced and sold
within the economy. The IMF statistics usually report the GDP deflator, which is often taken as
the general rate of inflation (GRI).
Page 24
Page 25
THE INFLATION RATE

The annual rate of inflation is defined as the percentage rate of change in the yearly average of
some price index from one year to the next.
The rate of inflation for the example shown in Table 7.1 would be 23.4%. The rate of inflation is
not constant. It varies with time, location and the composition of commodities in the basket
TYPES OF MONEY
For an economic evaluation in the presence of inflation, the Shell Group of companies make use
of four basically different "types of money", possibly in more than one currency. The most familiar
type is the "money of the day" (MOD), also called nominal money or current money. This is the
money, which as coins, bank notes and cheques, changes hands all over the world in exchange
for goods and services. It has the (face) value as printed or stamped on it. Its purchasing power
will change with time, as seen in the preceding paragraphs. To overcome this varying purchasing
power of money of the day, the "real terms" (RT), or "constant value money" (CVM) money was
introduced. This imaginary money keeps the same purchasing power at different moments in
time.
As a unit of real terms money one can use any currency, provided that a reference date is added,
e.g. US dollars of 1.1.1991 or Dutch Guilders of 1.7.1990. Although in principle every date can be
chosen as a reference date, in practice one normally takes either January 1st, or July 1st as a
reference date. To convert a MOD-price into a RT-price, one merely has to divide by the ratio of
the price indices:
Observe that this relation is similar to the discounting equation described in section 7.3.
The third type of money is the "present value", of money promised or due in the future. This is
obtained from the forecast amounts by "discounting", in order to account for foregone "alternative
investment opportunities" and risk. If this discounting is applied to the RT-cashflow, the discount
rate is referred to as the "real terms discount rate", r.
Page 26
The present value can also be calculated by discounting the MOD-cashflow. In which case the
discount rate is called the apparent discount rate, "rapp"'-
From Table 7.2 it should be noted that the apparent discount rate is always larger than the sum of
the inflation rate and the RT-discount rate (for r > 0).
Important input data for the cashflow are the estimates for the technical costs and the future oil
prices. This introduces a fourth type of money, the "estimate date money" (EDM). In general the
estimates of the capital and operating costs will be based on "today's" prices, or sometimes on
past prices when a similar project was last executed. In the latter cases prices will be brought up
to today's date. Since, however, the transactions will not take place today, possible cost
increases or decreases during the lifetime of the project must be taken into account by means of
an "escalator". This escalation serves a dual purpose:
It corrects for the effect of inflation
It corrects for changing market conditions
If, for lack of better information, the market effect is disregarded, the "market factor" equals one.
In that case there is no reason to distinguish between real terms money and estimate date money
with the same reference date.
THE STAGES IN THE ECONOMIC EVALUATION
The input data for the cashflow is given in estimate date money. Since the tax payments will be
based on actual (MOD) revenues, and furthermore actual (MOD) depreciation schedules must be
worked out based on actual (MOD) investments, cashflow calculations must be performed in
money of the day. The resulting cashflow is then converted into present value real terms money
in order to allow for a ranking of projects in different host countries (Figure 7.10).
Page 27
EXCHANGE RATES AND INFLATION

If free trade exists between two countries "A" and "B" and the exchange rate is not subject to
government regulation, then one may expect a relation between the purchasing power of the
respective currencies and the exchange rate. Goods bought in country "A" and sold unchanged in
country "B" cannot make an excessive profit or others would follow the example, which would
eventually lead to an adjustment of the exchange rate. If it were impossible to make any profit
with such transactions, the following equation would hold:
In real terms money the exchange rate will remain constant if there are no restrictions to free
trade, i.e. there is purchasing power parity.
Page 28
It may be concluded that in the long term the above equation is reasonably valid but fairly large
short term fluctuations may occur also depending on interest rate differentials and balance of
payment movements. If the free trade assumption is violated, as is the case e.g. for East-West
trade, deviations of the equation can be very large.
In such cases there exists often a "black money market", where the exchange rate is probably
closer to the theoretical rate than the official rate. Under normal situations the above mentioned
theoretical relation is commonly used to predict future exchange rates for cashflow purposes.
CURRENCY CHANGES AND CASHFLOWS
In most operating companies cashflows will be made in the local currency, since taxes need to be
calculated and paid in the local currency. Some of the capital assets may be acquired locally, but
in many cases foreign manufacturers and contractors will be involved, which will be paid in their
own currency if so desired. The resulting cashflow has to be presented in RT US dollars. And
finally, for budget purposes, the capital requirements of the project have to be presented in both
MOD US dollars and in MOD of the local currency. This diversity of currencies together with the
four "types of money", results in a fairly complex evaluation procedure. Since the exchange rates
are constant in real terms money, the actual calculation converts all data to RT before a currency
translation (Figure 7.11).
Page 29
7.5 UNIT COSTS AND BREAKEVEN PRICES

INTRODUCTION
By "unit costs" we mean costs determined on a per barrel basis - gross or net of tax, discounted
or undiscounted, as appropriate. The concept is useful for
-
comparing the costs of projects of different sizes;
establishing the breakeven oil price for a project;
setting the tariff for the use of a shared facility;
assessing the relative severity of tax systems.
It also leads to the PV Unit Cash Surplus, or NPV per barrel, another profitability indicator that
could be used (for instance) to
-
rank projects when the long-term constraint is not money but production;
assess, by comparing with the company's estimate of "finding costs", whether the barrels
produced are paying for their own replacement.
UNDISCOUNTED UNIT COSTS

To illustrate unit costs we shall use the following cashflow, in $ million:
The $1329 million cashin is generated by the production of 66.4 million bbl of oil. Dividing these
two values gives the Unit Cashin of $20/bbl, which in this case is of course the same as the oil
price: if, however, we were assuming a price that varied with time, then the Unit Cashin would
represent a weighted average.
Page 30
Dividing the $1147 million cashout by the total production gives $ 17.27/bbl. This is the Unit
Cashout - the total of Unit Technical Cost (UTC) and unit government take. The difference
between Unit Cashin and Unit Cashout is the Unit Cash Surplus, amounting to 20 - 17.26 =
$ 2.73/bbl, which could also have been obtained by dividing the Ultimate Cash Surplus by the
total production.
Here are the (undiscounted) unit figures for all the components of our cashflow:
Of the $20 revenue generated by one barrel, $10.37 (52%) goes in government take and $6.89
(34%) in technical cost, leaving 14% as cash surplus. The technical cost element is (on this
undiscounted basis) about equally split between capex and opex.
DISCOUNTED UNIT COSTS
The discounted or PV Unit Technical Cost, etc., are the Present Value counterparts of the unit
figures discussed above. The PV Unit Technical Cost is the ratio of PV technical cost (i.e. PV
capex + PV opex) to PV production. For the example cashflow the PV unit figures at discount
rates of 0%, 8% and 15% are given below. At 0%, of course, they reproduce the figures already
shown.
Page 31
On a discounted basis the PV unit capex is now much more important than the PV unit opex.
Further, the PV unit capex increases with the discount rate, as lightly discounted capex is divided
by heavily discounted barrels. The PV unit opex, however, is effectively a weighted average; as
the discount rate increases, the later years lose weight; and since the opex per barrel is highest in
those years, the PV unit opex goes down. The PV unit cashout increase is entirely due to the
increase in PV unit capex: "up front" capital has a strong effect on PV Unit Technical Cost.
BREAKEVEN PRICES
In calculating breakeven prices the usefulness of the Discounted Unit Cost concept is clearly
demonstrated. "Breakeven", at a given discount rate, occurs when the NPV is exactly zero;
equivalently, the Earning Power is equal to the discount rate. The condition for breakeven is
PV(CASHIN)
= PV (CASHOUT)
or PV (PRICE * PRODUCTION)
= PV (CASHOUT)
If the entire production is sold at a constant price, this condition becomes

PRICE * PV (PRODUCTION)
= PV (CASHOUT)
or PRICE
= PV (CASHOUT) / PV (PRODUCTION)
= PV (UNIT CASHOUT)
On an after-tax basis this is not a very useful formula since the cashout includes tax and royalty,
which themselves depend on price. On a pre-tax basis, however, the cashout is simply capex
plus opex. It follows that breakeven on a pre-tax, or total project, basis will occur if
PRICE
= PV {UNIT (CAPEX + OPEX)}
In other words,
PRE-TAX BREAKEVEN PRICE
= PV UNIT TECHNICAL COST
Page 32
The 15% PV UTC should always be shown in the economics section of budget proposals, in
addition to the profitability indicators discussed in Chapter 7.3.
NET UNIT COSTS
An alternative way to present unit costs is based on the "net approach":
CASH SURPLUS
= NET REVENUE - NET CAPEX - NET OPEX
Dividing all terms by the total production:

UNIT CASH SURPLUS
= UNIT NET REV. - UNIT NET CAPEX -UNIT NET OPEX
where
UNIT NET REVENUE
= (1 - TAXRATE) x (1 - ROYRATE) x UNIT REVENUE
UNIT NET CAPEX
= UNIT CAPEX-TAX RATE x UNIT DEPRECIATION
UNIT NET OPEX
= (1 - TAXRATE) x UNIT OPEX
For the example given above, we find:
This table shows the increasing dominance of the PV Unit Net Capex term at higher discount
rates. It also allows the breakeven price to be calculated on a full after-tax basis. For breakeven,
Page 33

PV UNIT NET CASH SURPLUS

=0
or
PV UNIT NET REVENUES
= PV UNIT NET TECH. COST
If the price is constant this becomes

(1 - TAXRATE) * (1 - ROYRATE) * PRICE = PV UNIT NET TECH. COST
In other words, the breakeven price on a full after-tax basis equals the PV Unit Net
Technical Cost "grossed up" for tax and royalty:
Implicit in the use of this formula is the assumption that - at least approximately - the PV Unit Net
Technical Cost, and notably the PV (i.e. timing) of depreciation, is independent of the oil price.
Where this is not true - e.g. in a "newcomer" situation where early revenues may not cover the
depreciation allowance in full, causing it to be partly carried forward - the breakeven price has to
be ascertained by rerunning the full cashflow model and using graphical or trial and error
methods. The same applies under more complicated fiscal systems, or when the PV unit opex
and/or PV unit capex are themselves significantly price-dependent via the assumed impact of the
oil price on costs (e.g. fuel) or on the timing of abandonment.
For the example above, recalling that tax
= 70% and royalty = 20%,
BREAKEVEN PRICE AT 15%
= 3.86/ {(1 - 0.70) * (1 - 0.20)}

= $16.1 /BBL
The amount by which the breakeven price exceeds the PV UTC (the difference, in this example,
between $16.1 and $ 8.66) is one measure of the impact of the fiscal system. The adjoining
diagram shows the separate impacts of royalty and tax at various discount rates.
Page 34
7.6 GUIDELINES FOR THE PRESENTATION OF ECONOMICS

The guidelines for the presentation of economics in Programme Documentation and in Group
Budget Proposals are given respectively in two Shell Group procedures, EP-59000 (updated
annually) and the "Financial Procedure Manual". They should be read by those who prepare
proposals for the larger projects, which require the approval of SIPM and SIPC.
Typically a Group Budget Proposal would comprise a summary, as shown below.
EXAMPLE OF A GROUP BUDGET PROPOSAL
GROUP BUDGET PROPOSAL
(Example based on MIE (3.8.2) slightly modified)
COMPANY
: Shell Projects (Production)
GROUP EQUITY INTEREST

production.
: 100% SECTOR/CATEGORY: Upstream gas
FOR
: The engineering and drilling costs of developing

the G2-A and G2-B offshore gasfields.
KEY FACTORS:
Concession
: Discovery date: June '88 Expiry date: Dec. 2017
Shell interest
: 60% - operator
Partner
: Chexxacon40%
Expected recovery
: 8.5 mrd m3
FINANCIAL DIMENSIONS
(all figures in millions MOD; 1 US $=Q 2.00 at 1.7.92)
(Shell share 5.1 mrd m3)
Shell Share
LC
100%
US$
LC
Total Requirement
100
50
Previous firm appropriation
This Proposal
96
48
166
'92 '93 '94 '95 '96
83
160
Total
Phasing (Shell share figures)
US$
80
Overrun
Total
Later 50/50 Allowance 90/10
LC
4 40 30 22 -
- 96
14
110
US$
2 20 15 11 -
- 48
55
Page 35
SUMMARY ECONOMICS
(US$ million RT 1.7.92 based on 50/50 estimates)
Key assumptions
* Standard gas contract terms; price
* Load factor 0.67
* Tax 50% based on oil-related formula. * Inflation 4%

Dubai
price
Net Present Value RTEP
Key Sensitivities
(Shell share)
Prod.
Capex 90/10
US$/bbl
0%
8%
15%
Sales-20%
delay 1 year
NPV
RTEP
NPV
RTEP
NPV
RTEP
8%
8%
8%
12
106
39
11
19
34
18
23
16
29
17
15
179
68
24
23
63
22
50
20
56
21
20
301
116
46
32
111
31
92
28
101
30
BEP
6.0
7.9
9.5
UTC
5.3
6.4
7.4
Payout time: 6 years
Other sensitivities: Pipeline tariff $3 instead of $2/boe -> NPV ($15,8%) = $ 58 million.
GENERAL
The G2 offshore concession consists of 2 fields, both of which are overpressured "turtleback"
structures in sandstone. The platform, above the G2-A field, will be a single train minimum
facilities production platform in line with latest industry techniques. The G2 platform has been
selected as the nodal point for this system, providing space for receiving and launching facilities.
Page 36
7.7 DISCOUNT FACTORS

The following formulae are used to calculate Discount Factors:
Page 37
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Chapter 7 Petroleum Economics

2001 Shell International Exploration and Production B.V.

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7.5 UNIT COSTS AND BREAKEVEN PRICES........................................................................... 30

Shells Capital Expenditure in the Period 1972-1991

Calculation of a Price Index

2001 Shell International Exploration and Production B.V.

EP00 - Introducing the E&P Business

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2001 Shell International Exploration and Production B.V.

EP00 - Introducing the E&P Business

Shell Learning Centre

ROLE OF THE PETROLEUM ECONOMIST

2001 Shell International Exploration and Production B.V.

EP00 - Introducing the E&P Business

Shell Learning Centre

2001 Shell International Exploration and Production B.V.

EP00 - Introducing the E&P Business

2001 Shell International Exploration and Production B.V.

Shell Learning Centre

EP00 - Introducing the E&P Business

Shell Learning Centre

EP00 - Introducing the E&P Business

Shell Learning Centre

different oil/gas price assumptions;

alternative reserves estimates;

different production behaviour;

increased capital expenditure;

changes in operating expenses;

delayed production start-up.

2001 Shell International Exploration and Production B.V.

EP00 - Introducing the E&P Business

Shell Learning Centre

2001 Shell International Exploration and Production B.V.

EP00 - Introducing the E&P Business

Shell Learning Centre

EP00 - Introducing the E&P Business

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International Monetary Fund, "International Financial Statistics"

2001 Shell International Exploration and Production B.V.

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7.2 PROJECT CASH FLOWS

payments for acquisition of an interest in the venture.

THE TECHNICAL COSTS

EP00 - Introducing the E&P Business

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2001 Shell International Exploration and Production B.V.

EP00 - Introducing the E&P Business

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In a typical tax/royalty system,

TAX = TAXRATE * (REVENUE - ROYALTY - OPEX - FISC. DEPR.)

Suppose, for example, that in a particular year

royalty rate = 20%

Royalty = 20% x $270 million

Tax =75% x $136 million

The cash surplus is therefore $ 270 m-$105 m-$156 m

2001 Shell International Exploration and Production B.V.

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CASH SURPLUS AND NET INCOME