Petroleum Economic Evaluation

with oil price analysis and sensitivity modeling

Seung Hoon OH
Petroleum Economist, KNOC August 2004

Index
Part 1. Main concepts Part 2. Methodology Part 3. Optimum Investment Part 4. Oil field Evaluation Part 5. Sensitivity reporting Case study (Oil asset)

Part 1. Main concepts

Production curves
- To be induced through the Engineering calculation - Mainly consider the following factors Drilling plan of new wells for production period Workovers plan of repairing the existing wells Workovers (New pumps, Restoring wells, Re-completion, etc) Re

The detailed to be except this workshop

Oil (gas) Price Forecasts

- Determine if the crude is marketable or NonNonmarketable

Marketable crude
- Long-term price forecasting Long* Non-consecutive forecasts to be modified to be fixed Nonevery year ex) Yr 2005 : $25, Yr 2010 : $29 Yearly Escalation rate = (29/25)1/5 - 1 = 3% Yr 2004 $24.3 Yr 2005 $25.0 Yr 2006 $25.8 Yr 2007 $26.5 Yr 2008 $27.3

- Short-term price forecasting Short* Regarding the forecasting as a base price in starting year of total production period. * Escalating the base price with a growth rate every year ex) Yr 2005 : $25, Growth rate 5%

Yr 2004 $25.0

Yr 2005 $25.0

Yr 2006 $26.3

Yr 2007 $27.6

Yr 2008 $28.9

Non-marketable crude
- To be induced with the real sales prices correlation prices analysis with marketable prices (Brent, WTI, Dubai etc). - To develop the relative equations (functions) between a Brent and a local crude (LC : Non-marketable) Nonex) Y (LC price) = - 20 + 1.5 X (Brent price)

Crude Brent
(Forecasted)

Yr 2005 $ 28 $ 22

Yr 2006 $ 32 $ 28

Yr 2007 $ 30 $ 25

Yr 2008 $ 35 $ 32.5

Local CR
(Calculated)

Equation : Y (LC price) = - 20 + 1.5 X (Brent price)

-

Local crude (LC) price shall be induced from the equation of Brent and LC prices trends. prices

Discounting Rate (WACC : Weighted Average Cost of Capital)

- Capital cost to discount the Net Cash Flow that will be occurred in the Oil & Gas assets acquired - Necessary to evaluate the future cash flows to make the price of a oil asset - To be calculated, considering the internal financial structure, systematic market risk and cost of external capital financed

- WACC Induction Beta (B) coefficient forecasting * Systematic risks measured with profits analyses profits Internal cost of capital (Ke) calculation (Ke) * Cost of capital under the current capital structure External cost of capital (New Debt) (Kd) (Kd) determining * Cost of capital in case of borrowing Corporate tax rate assumption (or confirmation) * To decrease Kd rate with tax shield effects Kd

- WACC Induction (continued) Sharing ratio of Capital and Debt in new investment * S: Capital , D: Debt D/S ratio ( example of calculating WACC) * Assumption (A oil Company with debt) ( Rm Market average rate of return (surplus over Rf) Rf) Bu without debt company (Un-levered) : 1.4 (UnBL with debt company (Levered) : 2.05 (Current) Current D : 2000m$, Current S : 3000m$ Ke = 10% + 2.05*1.2(Rm) = 12.46%, Kd= 11%, Kd= T=30% * Investment financing : New borrowing 4000m$

( example of calculating WACC) New Structure : D 6000m$, S 3000m$ New BL with debt company (Levered) : 3.36 (Modified) Ke = 10% + 3.36*1.2(Rm) = 14%, Kd= 11%, T=30% Kd= * Final Investment structure : Paid-in capital : 3000m$, Debt : 6000m$ Paid-

WACC Result 0.14*3000/9000 + 0.11*6000/9000*(1-0.3) 0.11*6000/9000*(1= 0.098 (9.8%)

Costs and Expenses

Transport cost
-

To include all of costs that move the produced crude from Oil field to the place a buyer designated To be absorbed into a production cost immediately Recognize the cost in proportion to production

Costs and Expenses

CAPEX (Capital expenditures)
-

All of costs related to drilling a new wells, repairing wells, purchasing pumps and rerecompletion etc The costs related with maintaining the current capacity or repairing should be absorbed immediately The costs of increasing the production should be written off over the usage-years (Ex : drilling costs, usagePumps etc) (Capitalized in purchasing year, Depreciated every year)

Costs and Expenses

OPEX (Operation Expenses)
-

All of costs related to operating an oil company, such as a salaries (service contracts), performance compensation, field maintenance fee etc in an oil production site This costs function shall be semi-variable form costs semiNecessary to forecast the cost function and ascertain the fixed or the variable from total costs tracing historical data.

Costs and Expenses

G&A (General Administration expenses)
-

All of costs related to operating an oil company, such as a regular salaries, supervisory fee, related insurance fee, housing cost and office supplies etc This costs function shall be semi-variable form costs semiand elevated in proportion to production Necessary to forecast the cost function and ascertain the minimum level (fixed).

Part 2. Methodology
Main Economic Evaluation method
Traditional
(Not Considering time value)

DCF
(Considering time value)

Payback period Accounting rate of return

Net Present Value Internal rate of return (IRR)

Payback period method

- Payback period : time to be taken to recover the invested in the first year (investment point) - Criteria of Decision-Making DecisionExclusive cases : To select the one that is taking the shortest time (period) in recovering the invested amount Independent Cases : To select the ones that is taking the time (period) within the target recovering period

Payback period method

Strong points Easy to understand and to use To remove the uncertainty Liquidity-oriented management LiquidityTo prevent the obsolescence risks unforecasted Weak points Not consider the cash flows after the recovering To ignore time-value of cash flows time-

Payback period method

Yr Oil (KN) Oil (PM) Oil (OC)

<P/B Example>
Assumption Available investment cash : 3,000m$ Mutual Independent Invest to 1st Oil (KN), 2nd Oil (PM) Mutual Exclusive Invest to only Oil (KN)

1 2

-1500m$

-1500m$

-1500m$

200

100

1300

700

100

250

800

1400

-300

1000

2000

P/B

2 Yr

3 Yr

4 Yr

Accounting rate of return (ARR) method

- ARR : Annual average net income (AANI) divided by annual average investment (AAI) AANI = Sum of yearly Net Income divided by Investment Period (number of years) ARR = AANI / AAI

Accounting rate of return (ARR) method

- Criteria of Decision-Making DecisionAccept the investment of oil asset in case of ARR being higher than the ARR targeted internally Strong points Easy to understand and to use Availability of accounting data not modified

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Weak points Ignore time-value of cash flow timeConsider not cash flows but accounting income <ARR Example> Assumption & Calculation Investing 40,000m$ in first year (Periods n=4yrs) * Annual income (on the accounting) 1st Yr 3,000m$, 2nd Yr 3,500m$, 3rd Yr 4,500, 4th Yr 5,000m$ AANI = (3000+3500+4500+5000)/4 = 4,000m$ AAI = 40,000/2 = 20,000m$ ARR = 4,000/20,000 = 20%

Net Present Value (NPV) method

- NPV : Value of discounting the future cash flows with a capital cost (r = WACC) NPV = -Investing CF0 + CF1/(1+r)1 +CF2/(1+r)2 + + CFn/(1+r)n n : production years, r : WACC, CF : annual cash flow

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Net Present Value (NPV) method

- Criteria of Decision-Making DecisionExclusive cases : To select the one that has the biggest NPV result among the several investment plans Independent Cases : To select the ones that have the positive NPV results within the budget NPV > 0 Accept

Net Present Value (NPV) method

<NPV Example> Assumption WACC=10%, Invest 1,500m$ (N oil asset) NPV = 150/(1.1)1+300/(1.1)2+450/(1.1)3 + 600/(1.1)4 + 1,875/(1.1)5 - 1,500 = 796m$ Accept N oil investment because of positive NPV result

CF Forecast YR
0 1 2 3 4 5

CF
-1,500m$ 150 300 450 600 1,875

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Internal Rate Return (IRR) method

- IRR : Discount rate which can make the NPV be zero NPV (0) = -Investing CF0 + CF1/(1+irr)1 +CF2/(1+irr)2 + + CFn/(1+irr)n n : production years, CF : annual cash flow IRR can be calculated through trial and error error

Internal Rate of Return (IRR) method

- Criteria of Decision-Making DecisionExclusive cases : To select the one that has the biggest IRR result among the several investment plans Independent Cases : To select the ones that have the IRR results over WACC within the budget IRR > WACC Accept

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Internal Rate of Return (IRR) method

YR

CF Forecast CFCFK CF-N CF-1800 450 500 830 200 100 6%

<IRR Example> Assumption K-oil asset : 1,200m$ investment N-oil asset : 1,800m$ investment WACC : 15% K-oil investment, Accept IRR 22%>15% N-oil investment, Reject IRR 6%<15%

0 1 2 3 4 5 IRR

1200 280 320 400 700 600 22%

Comparison of Economic Evaluation Methods

<Prerequisites of Evaluation method> Consider the measured cash flows (CF) Discount cash flows for the time-value of money time(T/V)
Method ARR IRR NPV

Keep available in maximizing the wealth (Max)

Cash Flow T/V (time(timevalue)

Max of wealth

Payback

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Part 3. Optimum Investment

Method of transferring the present wealth to the future (= Investment)
- Investing in Financial assets of financial market - Investing in Physical assets with production opportunity Investment behavior, only Investment (production) opportunity existing - Investment is optimized if Marginal Rate of Transformation (MRT) of invest opportunity curve is equal to Marginal Rate of Substitution (MRS) of indifference curve.

Investment behavior, only Investment (production) opportunity existing (Graph of Optimizing)

Optimum Investment W1 C1 C*
Investment (W0-C0) (W0-

MRT = MRS (C*)

Indifference curve

C0

W0

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Investment behavior, Investment (production) opportunity and Market opportunity co-existing co- Firstly the investment is optimized in the point in which Investment opportunity curve (IOC) comes in contact with Market opportunity curve (MOC) (Optimum Investment Decision) - Secondly the financing is optimized on the above MOC curve with a investors preferences to the borrowing or investors loan (Optimum Financing Decision)

Investment behavior, Investment (production) opportunity and Market opportunity co-existing coW0*(1+r ) W1
Indifference curve

Optimum Investment MRT = -(1+r)

C1

C*

Optimum financing MRS = -(1+r)

C0

W0
Investment (W0-C0) (W0-

W0*
NPV Increment

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Part 4. Oil Field Evaluation

Practical production curve development
Targeted acquisition area geologic analysis (OIP) Calculation of Recoverable Reserves (Production scale setting)

Reliable Production curve selection considering advisory reserves data reserves

Base Oil Price (input price) selection

- Search of marketable crude having a high correlation

Statistical method

Correlation Testing Method

Heuristic method
Cost Analysis (Local crude)

Graph Comparison (dispersion, linear) Regression analysis (Linear, logarithmic Exponential etc)

Superior to heuristic testing

Direct survey (Local marketing Manager interview)

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Base Oil Price (input price) selection

- Base price (production starting year) forecasting Induce the relative equation from historical price data between the marketable (MC) and the local (LC) MC price = LC price + a (constant) Review and collect the MC prices overview of prices worldworldlevel petroleum research organizations.

Base Oil Price (input price) selection

- Base price (production starting year) forecasting Base price of local crude shall be induced from the forecasted price of marketable crude, with base price applied to the relative equation. - Respective base prices forecasts by production years General application After the base price of starting year decided, it is supposed to be escalated as much as predetermined increasing rate annually (ex: yearly 3% or 5% increase of previous years years price)

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Base Oil Price (input price) selection

- Respective base prices forecasts by production years General application (Graph)
Oil price($/bbl) Increasing rate 5%

Increasing rate 3% 14 13 Production years

Base Oil Price (input price) selection

- Respective base prices forecasts by production years

Marketable crude prices reflecting application prices

Oil Price Outlook (Brent $/B)

<Equation>

Year

2005

2010

2015 31

2020 35

Brent = 0.8*LC + Price 21 28 10 <Annual increasing rate of Brent> ($35/$21) (1/15) 1 = 0.035 3.5%/year

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Base Oil Price (input price) selection

- Respective base prices forecasts by production years Marketable crude prices reflecting application prices
Oil price($/bbl) Local $31.25 (Brent $35) Local $13.75 (Brent $21) 200 5 202 0 Production years

Increasing rate 3.5%/y

Calculation of Discounting rate (WACC)

<Assumption> New project investment financing plan - Internal capital (retained earnings, cash) 70% - External capital (debt) 30% - Cost of capital Ke = 15%, Kd = 9%, Tax = 20% <Calculation> Kw (WACC) = 0.15*0.7 + 0.09*0.3*(1-0.2) = 0.127 0.09*0.3*(1Discounting rate : 12.7%

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Net Cash Flows Forecasts

NCF1~n = ( Revenue - Cost ) X (1-t) + Depreciation X t (1-

Sales amount (Revenue) = Annual oil production X annual base oil price

Production cost = Transport + CAPEX + OPEX + G&A + the other

After-tax Aftercash flows Deducting all of taxes

-

Incremental effect of CF in Dep Tax shield effects

National tax Local tax

Discounting the NCF with WACC

<Discounting the NCF> NPV NCF = NCF1/(1+ Kw)1 + NCF2/(1+ Kw)2 + + + NCFn/(1+ Kw)n = Max Acquisition cost (Theoretical) asset to be targeted : Practical> Theoretical) <Pricing the Oil Practical> NPV NCF + Possibility of finding more + Goodwill NPV NCF (upper limit) limit) Financial distress Production risks (lower limit) limit)

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Part 5. Sensitivity reporting

Search of the Key factors affecting NPV
The characters of Key factors - Variable with NPV changing - Having the high co-relationship with NPV co- Necessary factors related to the revenue or the cost Main Key factors to be considered - Production curves - Oil Prices - CAPEX investment

Relationships between key factors and NPVs

Relating functions development - Production and NPVs - Oil prices and NPVs - CAPEXs and NPVs Key factors inputting range for sensitivity testing (Inputting range shall be set subjectively) - Production curves : 90% of base production ~ 120% - Oil Prices : $11/b ~ Base price ~ $20/b - CAPEX investment : 90% of base CAPEX ~ 120%

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Reporting Sensitivity by key factors Production or CAPEX sensitivity (example)

NPV(8%) 90% 100% (Base) 120% 364mm$ 478mm$ 707mm$ NPV(9%) 336mm$ 443mm$ 657mm$ NPV(10%) 311mm$ 411mm$ 611mm$ NPV(11%) 289mm$ 382mm$ 569mm$

Oil Price (example)

NPV(8%) $12/B $14/B(base) $17/B 275mm$ 478mm$ 783mm NPV(9%) 254mm$ 443mm$ 727mm$ NPV(10%) 234mm$ 411mm$ 677mm$ NPV(11%) 216mm$ 382mm$ 632mm$

Thank you for your attentions

Gamsahamnida () Seung Hoon OH
Petroleum Economist/ Korea National Oil Corp

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